The Subprime Mortgage Crisis and Its Impact on the U.S. Economy

Introduction

The subprime mortgage crisis first gained the public's attention when a steep rise in home foreclosures occurred in 2006, and then spiraled out of control in 2007. At that time, the mortgage meltdown triggered a national financial crisis that went global within the year. As a result, consumer spending dropped, the housing market plummeted, foreclosure numbers rocketed, and the stock market was shaken. All these problems have caused furious debate among consumers, bankers, and lawmakers as to the causes and possible solutions.

There are various theories to explain what led to the mortgage crisis. Many experts and economists believe that the crisis happened because of a number of factors in which subprime lending played a significant role.

The Housing Bubble and Interest Rates

The mortgage meltdown began with the bursting of the U.S. housing bubble, which started in 2001 and peaked in 2005. Bianco (3) defines a housing bubble as "an economic bubble that occurs in local or global real estate markets. It is defined by rapid increases in the valuations of real property until unsustainable levels are reached in relation to incomes and other indicators of affordability. Following the rapid increases are decreases in home prices and mortgage debt that is higher than the value of the property."

Many economists believe that the U.S. housing bubble was caused at least in part by historically low interest rates. Because of concerns following the dot-com bubble in 2000 and the resulting recession that began in 2001, the Federal Reserve Board cut short-term interest rates from about 6.5% down to 1%. Some criticized Alan Greenspan, former Chairman of the Federal Reserve Board, for creating the housing bubble, since it was the Fed's policy on interest rates that inflated the bubble. Others argued that the Fed operated from inaccurate inflation numbers, so the Fed funds rate was probably held lower and for a longer time than it should have been.

From 2004 to 2006, the Fed raised interest rates 17 times, from 1% to 5.25%. By that time, many economists predicted a housing market correction because of the over-valuation of homes during the bubble period.

Subprime borrowing was a key factor in the increase in home ownership rates and demand for housing during the bubble years. The U.S. ownership rate grew from 64% in 1994 to an all-time high of 69.2% in 2004. Some homeowners took advantage of the increased property values of their homes to refinance them at lower interest rates, and took out second mortgages to use for consumer spending. During this time, U.S. household debt as a percentage of income rose to 130% in 2007 — a figure 30% higher than the average earlier in the decade.

Along with the collapse of the housing bubble came high default rates on subprime, adjustable rate, Alt-A, and other loans made to higher-risk borrowers with lower income or lesser credit history than prime borrowers. Subprime mortgages totaled $600 billion in 2006 and accounted for approximately one-fifth of the U.S. home loan market. The volume of subprime loans climbed as rising real estate values led lenders to take on more risk. Some experts believe that Wall Street encouraged this risk-taking behavior by bundling the loans into securities that were sold to pension funds and other institutional investors.

Subprime Lending and Risk

A Federal Reserve study in 2007 reported that the average difference in mortgage rates between subprime and prime mortgages decreased from 2.8 percentage points in 2001 to 1.3 percentage points in 2007. This drop indicates that the risk premium lenders required to offer a subprime loan had declined — even though subprime borrower and loan characteristics had worsened overall during the 2001–2006 period, a change that should have produced the opposite effect. Instead, the declining risk premium led lenders to consider higher-risk borrowers for loans, leaving more and more banks exposed to default on the high-risk loans they made.

Some economists blame the emergence during the boom years of a new kind of specialized mortgage lender for worsening the crisis. These lenders were not regulated like traditional banks. Along with the increase of unregulated lenders came a rise in the kinds of subprime loans that should have raised alarms. The following types of problem loans became commonplace:

• Adjustable rate mortgages (ARMs)
• Interest-only mortgages
• Stated (no proof of) income loans
• NINJA (no income, no job or assets) loans

Such loans should have raised concerns about quality if interest rates increased or if borrowers became unable to pay their mortgages.

Some experts believe that mortgage standards became lax because of a "moral hazard" — that is, a lack of incentive to guard against risk because one is protected from its consequences — which occurred because each link in the mortgage chain collected profits while believing it was passing the risk on to others. Mortgage denial rates for conventional home loans reported under the Home Mortgage Disclosure Act dropped from 29% in 1998 to 14% in 2002 and 2003, supporting the argument that moral hazard led to lax lending standards.

Because mortgage brokers do not lend their own money, there is no direct correlation between loan defaults and their compensation. However, brokers did earn higher commissions for selling ARMs. The Mortgage Bankers Association claimed that brokers profited from the home loan boom but did not do enough to determine whether borrowers could repay the loans, leaving lenders and banks to absorb the resulting mortgage defaults.

Mortgage underwriters determine whether the risk of lending to a given borrower under certain conditions is acceptable. In 2007, 40% of all subprime loans were generated through automated underwriting — a process that required minimal documentation and allowed much quicker decisions. Many experts believe that lax controls and reliance on shortcuts led to the approval of buyers who, under a less automated system, would not have qualified.

Some economists also point to borrower behavior as a contributing factor. Easy credit and the assumption that housing prices would continue to appreciate encouraged some borrowers to obtain ARMs they could not realistically afford once the initial incentive period — typically two to three years — had passed. Once housing prices started to decline due to the market correction and the bursting of the housing bubble, the refinancing option that had been readily available during the boom became much more difficult. Homeowners who could not refinance predictably began to default on their loans when the rates reset to substantially higher interest rates and payment amounts.

Other economists blame predatory borrowing for contributing to the crisis. According to one study involving three million loans made from 1997 to 2006, applications containing misrepresentations were five times as likely to go into default. According to the Financial Crimes Enforcement Network, Suspicious Activity Reports of mortgage fraud increased by 1,411% between 1997 and 2005.

Conclusion and Personal Assessment

What seems clear from the available analyses of the mortgage meltdown and the subsequent decline of the U.S. economy is that there was no single cause of the financial crisis. The failure was caused by a catastrophic combination of circumstances, each of which contributed to the meltdown.

There is no doubt that all the factors discussed in this paper contributed to the financial crisis; some were much more critical than others, and their effects were more devastating. The behavior of the financial industry deserves to be placed at the top of any list of causes, given that industry actors had access to — or should have had access to — enough information to assess the consequences of their actions and inactions.

The Financial Crisis Inquiry Report (2011) provides the most thorough summary of the causes of the meltdown, and its conclusion that the crisis was avoidable is compelling. Not only does the Report's analysis of causes hold up to scrutiny, but it also raises the question of why governmental regulators failed to act. The Federal Reserve had the authority to set prudent mortgage-lending standards but did not exercise it. The SEC, according to the Financial Crisis Inquiry Report (2011), could have required larger capital reserves at major investment banks to curb their risky practices, but failed to tighten those standards. And wherever regulators claimed they lacked the authority to regulate the financial system, they were even more deficient in exercising the political will to obtain the authority that would have policed financial institutions and stopped their excesses. As the Report summarizes, additional causes of the crisis included:

• An inconsistent response by government policymakers that added to uncertainty and panic in financial markets.
• A systemic breakdown in accountability and ethics.
• A collapse in mortgage-lending standards and the mortgage securitization pipeline that "lit and spread the flame of contagion and crisis" (Commission, p. xxiii).
• Significant impact from over-the-counter derivatives.

In sum, there is more than enough blame to go around. Very little has been done since the crisis to reform the financial system in ways that would prevent this type of collapse from happening again.

Works Consulted

Bianco, Katalina. "The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown." 2008. Wolters Kluwer Law & Business. 15 April 2011.

Financial Crisis Inquiry Commission. Financial Crisis Inquiry Report (pp. xviii–xxv). New York: Public Affairs, 2011.

Mhatre, Pratik. "Impact of Subprime Mortgage Meltdown on Location and Volume of Home Foreclosures." 2011. Urban Planning Blog. 15 April 2011.

Schoen, John. "Housing Market Stirs, but Holds Economy Back." 2011. MSNBC.com. 15 April 2011.