This paper examines the subprime mortgage crisis, tracing its origins to the expansion of easily accessible, high-risk home loans and adjustable-rate mortgages offered to borrowers with poor credit. Drawing on economists, IMF reports, and congressional analyses, the paper discusses how financial innovations such as collateralized debt obligations amplified systemic risk, how rising foreclosures destabilized the broader U.S. economy, and what role Fannie Mae and Freddie Mac played in creating a secondary market for subprime securities. The paper also reviews proposed legislative and regulatory remedies, including bankruptcy code reform, stricter lending disclosures, and the prohibition of predatory lending practices.
Many factors contributed to the subprime mortgage crisis, which began approximately ten years ago when the expansion of the housing market was fueled by easily accessible loans. There was a great deal of encouragement for buyers — many with poor credit — to purchase homes and take out loans that were beyond their means of repayment. Mortgage lenders frequently failed to perform accurate credit and background checks to verify that buyers could make their payments. In many instances, buyers were offered loans with adjustable interest rates, and such loans became known as subprime mortgages.
The initially low interest rates enticed buyers; however, these rates later reset to higher levels. Many buyers, when faced with the resulting higher mortgage payments, were unable to meet their obligations. Many buyers also took out home equity loans or second mortgages, leveraging rising home prices to fund various expenditures and discretionary spending. Collateralized debt obligations (CDOs) — high-risk loan packages assembled by banks — were then sold off to investors, spreading the underlying risk throughout the financial system.
Bianco (2008), in the work entitled "The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown," writes that a "steep rise in home foreclosures in 2006 spiraled seemingly out of control in 2007, triggering a national financial crisis that went global within the year." Consumer spending fell while the housing market "plummeted [and] foreclosure numbers continued to rise" (Bianco, 2008). The International Monetary Fund's Global Financial Stability Report, published April 8, 2008, stated that "falling U.S. housing prices and rising delinquencies on the residential mortgage market could lead to losses of $565 billion. When combining these factors with losses from other categories of loans originated and securities issued in the United States related to commercial real estate, the IMF puts potential losses at about $945 billion" (Bianco, 2008).
According to the IMF, there was "a collective failure to appreciate the extent of leverage taken on by a wide range of institutions — banks, monoline insurers, government-sponsored entities, hedge funds — and the associated risks of a disorderly unwinding" (Bianco, 2008). Many economists believe the U.S. housing bubble was at least in part caused by "historically low interest rates" (Bianco, 2008).
Jaffee (2008) analyzes the key issues raised by the subprime mortgage crisis and states that financial market innovations occur under three fundamental conditions, all highly relevant to the subprime mortgage-lending crisis:
(1) The existence of previously underserved borrowers and investors; (2) the catalysts of advances in technology and know-how; and (3) a benign and even encouraging regulatory environment (Jaffee, 2008).
Financial innovations are described by Jaffee as "risky undertakings, all the more so when they create new classes of risky loans and securities" (2008). He identifies three primary areas requiring analysis in relation to the subprime mortgage crisis: (1) issues directly and specifically relating to subprime mortgage lending; (2) issues relating to the securitization of subprime mortgages; and (3) issues affecting financial markets and institutions (Jaffee, 2008).
Jaffee notes that the benefits of subprime mortgage lending include the fact that this type of lending "funded more than 5 million home purchases, including access to first-time homeownership for more than 1 million households" (2008). He also observes that predatory lending is usually prevented by competitive market forces, which serve to "protect uninformed consumers from predatory forces" (Jaffee, 2008). Regarding loan modifications, Jaffee reports that home mortgage lenders and servicers "have traditionally been reluctant to modify loan terms; nevertheless, lenders and servicers have been amenable to current governmental plans, perhaps because the resulting loan modifications can be characterized as one-time emergency transactions" (Jaffee, 2008).
Jaffee further notes that the report of the President's Working Group on Financial Markets (2008) indicates that "incomplete disclosures and the securitization process caused investors to be duped into purchasing high-risk subprime mortgage securities. The purchasers of these securities, however, almost uniformly include only the most sophisticated institutional investors worldwide. The name 'subprime' also seems clear enough, and data documenting the extremely high foreclosure rates on subprime loans have been publicly available at least since 2002" (Jaffee, 2008).
With regard to house price inflation, Jaffee (2008) states that "rising home prices will discourage mortgage defaults — whereas falling home prices will dramatically increase the default rates." Underwriting standards have also been questioned, as lenders potentially had "more access to other borrower information that is not objectively available to investors" (Jaffee, 2008). For example, loan officers "may enforce either weaker or stronger standards at different times with respect to factors that are not objectively included on loan applications" (Jaffee, 2008).
Jaffee and Quigley (2007) offer two innovative proposals for addressing the predatory lending problem: (1) use a specifically designed FHA mortgage as a standard alternative loan, and require that all subprime lenders bring this alternative to the attention of their borrowers; and (2) create a new suitability standard that would require subprime lenders to affirm that the borrowers to whom they are lending meet that standard (cited in Jaffee, 2008).
A report published in the Los Angeles Times states that homeowners witnessed their property values fall by $1.2 trillion in 2004 and that 524,000 fewer jobs were created — both outcomes of the wave of loan defaults and rising foreclosures. Consumer spending weakened and auto sales fell drastically. Fannie Mae and Freddie Mac are reported to be the two government-sponsored enterprises that "created, and remain highly involved in, the secondary market for mortgage-backed securities." Prior to the subprime mortgage crisis, these two entities "owned or guaranteed $1.4 trillion, or 40%, of all U.S. mortgages" (Amadeo, n.d.).
"Fannie Mae, Freddie Mac, and lender accountability"
"Regulatory reform, disclosure requirements, and bankruptcy code changes"
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