This paper examines the subprime mortgage crisis through three interconnected questions: what caused the crisis, how bank regulation is designed to prevent financial crises, and why that regulation ultimately failed. The paper traces the crisis to the early 2000s U.S. housing bubble, fueled by low interest rates and rising household debt, and explains how mortgage-backed securities amplified the collapse. It then outlines how banking regulations function through reserve requirements and structural rules, before analyzing the regulatory gaps — including insufficient capital reserves, incentives for riskier lending, and the exclusion of investment banks and hedge funds from key oversight frameworks — that allowed the crisis to unfold.
It is largely agreed that the subprime mortgage crisis originated in the U.S. housing price bubble that occurred in the first half of the 2000s. The market bubble was driven by several factors, including low interest rates between 2002 and 2004 that made mortgages affordable for Americans who were previously unable to own a home. Mortgages and housing prices alone were not the entire cause. The low lending rates also encouraged Americans to take on debt of other types, with the end result being that Americans began to carry extraordinarily high debt-to-income ratios, which tied up larger and larger proportions of their income (Bernanke, 2009, paras. 7–8).
Many borrowers at all levels took on onerous mortgages with the expectation that they would be able to refinance quickly due to rising home values. However, homes could not continue gaining value at the levels seen in the early 2000s, and the housing bubble peaked in 2005–2006 (Lahart, 2007, para. 2). Borrowers who had relied on the rising value of their home to qualify for a better mortgage were subsequently unable to refinance to more favorable terms, and faced increasing difficulty affording their mortgages and other debts. Although typically referred to as the subprime mortgage crisis, subprime borrowers were not the only ones who experienced problems. Borrowers of all types found that their debt levels, combined with other factors, caused them to become delinquent and ultimately to default on their mortgages.
A second cause was the creation of new investment products built largely from groupings of subprime mortgages. These mortgage-backed securities allowed greater investment in the booming American financial markets, including many investments by foreign firms (Bernanke, 2009, paras. 6–8). As mortgage defaults rose, the value of mortgage-backed securities plummeted, and companies that relied on these products for liquidity found that they no longer held the assets they had counted on.
Crises can be prevented in two ways: by avoiding crisis situations in the first place, or by acting quickly to minimize situations that are on the verge of becoming crises. Bank regulations are designed primarily to keep banks from entering crisis situations in the first place, and — should that fail — to resolve harmful situations quickly and efficiently.
Regulations typically work in several ways. They can require banks and other financial institutions to hold a certain amount of liquid capital in reserve, which is intended to ensure that banks can always meet any obligations that become immediately due. Of course, a bank cannot hold liquid savings sufficient to cover all debts, or it would have no money available for loans or investments. Regulations therefore typically define a certain minimum percentage of assets that must be kept in reserve.
Regulations also define how companies can be structured and what kinds of relationships they may enter into. These rules are designed to prevent problems such as allowing one failing division of a bank to bring down the entire institution, and to prevent cascading failures within interconnected financial institutions. The regulations governing how commercial banks, bank holding companies, and financial holding companies can interact with one another are one example of such structural regulations (Jaffee & Perlow, 2008, pp. 42–43).
"Capital gaps, lending incentives, and oversight blind spots"
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