Subprime mortgage crisis

The central economic crisis of the 2000s, in which banks and other lending institutions granted home mortgages to borrowers who could not afford to pay them, leading to a price collapse in the US housing market and the worst global economic downturn since the Great Depression of the 1930s

Through much of the 2000s, US home prices were spurred on to ever-greater heights by historic low interest rates and relaxed lending standards. In late 2007, the booming US housing market collapsed as a result of the subprime mortgage crisis. As the crisis spread, banks and other lenders found themselves holding large amounts of bad debt, which in turn led to plunging property prices, tightening credit, and a near-collapse of the financial system. By decade’s end, the United States was facing the most punishing economic conditions since the Great Depression.

In decades past, banks and other lending institutions were very strict about whom they gave mortgages because they financed such loans through the deposits made by their customers. This changed in 1999, when the US Congress, with the support of the Bill Clinton administration, repealed the Glass-Steagall Act of 1933. This law was enacted in the aftermath of the Great Depression, an economic downturn that had put a full quarter of the US workforce out of work. Glass-Steagall separated the business actions of investment banks from those of regular commercial banks in an effort to control the sort of rampant speculation that had spawned the Depression. The act also established the Federal Deposit Insurance Corporation (FDIC), a government body that guarantees bank deposits up to a certain value. With the end of Glass-Steagall, banks were allowed to take more risks in order to produce greater returns for their investors.

Lead-up to Crisis

One way that banks sought to make greater profits was to sell the mortgages they issued to the bond markets. When the dot-com bubble burst in 2000, leading to the decade’s first economic recession in 2001, investors sought to find a new area to place their money. One investment seen as potentially very lucrative was the bond market, where banks were beginning to sell mortgage-backed securities—considered a safe investment because borrowers tended to pay their mortgages regularly for the life of their loans. Investors seeking to earn high interest rates could not place their money in US Treasury securities or municipal bonds, as the US Federal Reserve had dropped interest rates to 1 percent in June 2003 and kept them low in order spur the sluggish economy. High-yield mortgage-backed securities seemed a far better return on investment, especially in light of the fact that credit-rating agencies such as Fitch, Moody’s, and Standard & Poor’s (S&P) had claimed such securities were as safe as US Treasuries, the debt-financing instrument of the federal government.

Mortgage-backed securities, however, were not as safe as US Treasury securities and became less safe as more of them were sold to the bond market. As banks sold more and more such mortgage securities to the bond market, they were less careful about whom they were issuing mortgages. Fund managers in turn did little research on the mortgage securities they were buying, instead relying on the assurances of the credit-rating agencies. Moreover, such securities had no oversight and were not regulated by any independent financial institution or government body.

Subprime Market Expands

From 2002 to 2007, banks and other lending institutions invested heavily in the mortgage-bond market, an area that had been previously been controlled by the Federal National Mortgage Association (better known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (better known as Freddie Mac). These two government-sponsored enterprises (which are also publicly traded companies) were established to pool mortgage securities and expand opportunities for mortgage lending and new home purchases. Fannie Mae and Freddie Mac often helped grant loans to so-called subprime borrowers—people with poor credit histories and/or low incomes who might have difficulty paying their mortgages regularly. In the 2000s, private institutions wanted to lend to these borrowers as well. By 2006, Fannie and Freddie no longer dominated the market: banks and other private lending institutions had granted approximately 84 percent of subprime mortgages issued that year.

Banks earned a fee for each mortgage-backed security they sold to fund managers. By 2007, the mortgage-bond market was estimated to be worth $6 trillion, the largest chunk of the US bond market, then worth upward of $27 trillion. In fact, mortgage bonds were more valuable than US Treasury bonds during this period. The urge for ever-higher profits spurred banks and Wall Street investment houses to become even more creative, by bundling subprime mortgages, reselling them after holding them for short periods of time, and ignoring traditional lending standards, such as evaluating a potential borrower’s credit rating and income. Banks also moved away from traditional twenty- and thirty-year fixed rate mortgages and toward exotic mortgages. These included interest-only loans; adjustable rate mortgages (ARMs), in which low initial rates spiked after a fixed period; and negative amortization loans, in which a borrower’s debt actually increased month after month. These subprime mortgages came to dominate the bond market; by 2005, 20 percent of mortgages granted in the United States were subprime.

Collapse and Fallout

The drive for short-term profits spawned an unstable housing market. Beginning in 2007 and continuing through the end of the decade, banks started repossessing homes across the country as countless subprime mortgages reset to higher interest rates. A flood of borrowers had found themselves unable to continue repaying those mortgages. As repossessions increased, home prices across the country collapsed, leading to the first national reversal in home prices since the Great Depression. In January 2008, economists reported that the country had seen the largest single-year drop in new single-family home sales in twenty-seven years. In addition to affecting home sales and housing prices, the subprime mortgage crisis devastated the home-building industry, which had contributed as much as 6.3 percent of US gross domestic product in 2005. Moreover, the overall US economy—and the global economy—plunged into the worst economic downturn in decades, a downturn that came to be known as the Great Recession.

Many large and extremely powerful financial institutions that had invested heavily in mortgage-backed securities found themselves on the point of collapse. Although little noticed at the time, HSBC Bank announced in February 2007 that it would see larger-than-expected losses due to defaults on subprime mortgages. In April of the same year, one of the largest subprime mortgage lenders in the United States, New Century Financial, filed for bankruptcy. As the crisis spread, the US Federal Reserve began cutting interest rates. It would not only cut rates ten times between mid August 2007 and late October 2008, but it also began to loan money directly to both commercial banks and Wall Street investment houses. It even accepted now-toxic mortgage-backed securities as collateral, all in an effort to keep the financial system functioning.

In March 2008, at the prompting of the Federal Reserve, J. P. Morgan Chase bought out the Wall Street investment bank Bear Sterns. In September of the same year, another huge Wall Street firm, Lehman Brothers, filed for bankruptcy protection, which sparked a worldwide panic in the financial markets. By month’s end, Bank of America had acquired the Wall Street brokerage house Merrill Lynch; Wachovia Bank collapsed and was bought out by Wells Fargo the following month; and Washington Mutual became the largest bank failure in US history. Other banks around the world also faced collapse.

Also in September 2008, at the direction of the administration of President George W. Bush, the US Treasury bailed out Fannie Mae and Freddie Mac, which put the US government in charge of over $5 trillion in home mortgages. In order to save the private financial sector, the Bush administration asked Congress to pass the Troubled Asset Relief Program (TARP), which it did in October 2008. TARP used $700 billion to buy assets and equity from financial institutions to keep the country’s financial institutions stable and hold off a possible economic depression.

Impact

The subprime mortgage crisis led directly to the financial crisis that followed, in which credit tightened significantly and businesses and individuals could no longer get loans as easily. As a result, businesses that were unable to get new lines of credit sought to save money by making their organizations more efficient, which led to massive layoffs across the country. From December 2007 to June 2009, approximately 7.9 million jobs were lost, a decrease of 6.1 percent in the overall US workforce. Moreover, the subprime mortgage crisis had an enormous impact on the global economy, hitting the nations of Greece, Spain, Ireland, Italy, and Portugal particularly hard. Although the United States emerged from the recession in mid-2009, the national economy remained sluggish in the anemic recovery that followed. Hiring was weak and unemployment high through the end of the decade.

While interest rates remained at historic lows, many consumers were unwilling or unable to borrow money at the same levels they had through much of the 2000s. This was due in part to the fact that many consumers had spent far more than they earned in this period and were seeking to put themselves on a more secure financial footing. Others had been so severely hurt by stagnant wages, depreciated retirement accounts, and falling home prices in the fallout from the subprime mortgage crisis and the Great Recession that they simply could not borrow any more. Still others had been bankrupted by all that had transpired. Many economists believed it would take several years for the overall US economy to return to the levels of prosperity it had enjoyed at the end of the twentieth century.

Bibliography

Lewis, Michael. The Big Short: Inside the Doomsday Machine. New York: Norton, 2010. Print.

Morgenson, Gretchen, and Joshua Rosner. Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon. New York: Holt, 2011. Print.

Muolo, Paul, and Mathew Padilla. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. Hoboken: Wiley, 2008. Print.

The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do about It. Princeton: Princeton UP, 2008. Print.

Financial Shock: A 360º Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis. Harlow: Financial Times Prentice, 2008. Print.