The subprime mortgage crisis of 2008 was one of the main contributors to the broader global financial crisis of the time. Also known as the Great Recession, it was the worst economic downturn since the Great Depression of the 1930s. For many Americans, it took years to recover from the financial crisis. The causes of the subprime mortgage crisis are complex. We'll explain the factors that led up to the crisis, as well as its long-term effects.
What was the subprime mortgage crisis?
The subprime mortgage crisis occurred from 2007 to 2010 after the collapse of the U.S. housing market. When the housing bubble burst, many borrowers were unable to pay back their loans. The dramatic increase in foreclosures caused many financial institutions to collapse. Many required a bailout from the government.
Besides the U.S. housing market plummeting, the stock market also fell, with the Dow Jones Industrial Average falling by more than half. The crisis spread around the world and was the main trigger of the global financial crisis.
The subprime mortgage crisis explained in detail
Subprime mortgages are loans given to borrowers who have bad credit and are more likely to default. During the housing boom of the 2000s, many lenders gave subprime mortgages to borrowers who were not qualified. In 2006, a year before the crisis started, financial institutions lent out $600 billion in subprime mortgages, making up almost 1 out of 4 (23.4%) mortgages.
Cheap credit and relaxed lending standards allowed many high-risk borrowers to purchase overpriced homes, fueling a housing bubble. As the housing market cooled, many homeowners owed more than what their homes were worth. As the Federal Reserve Bank raised interest rates, homeowners, especially those who had adjustable-rate mortgages (ARMs) and interest-only loans, were unable to make their monthly payments. They could not refinance or sell their homes due to real estate prices falling. Between 2007 and 2010, there were nearly 4 million foreclosures in the U.S.
This had a huge impact on mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) -- investment products backed by the mortgages. Subprime mortgages were packaged by financial institutions into complicated investment products and sold to investors worldwide. By July 2008, 1 out of 5 subprime mortgages were delinquent with 29% of ARMs seriously delinquent. Financial institutions and investors holding MBS and CDOs were left holding trillions of dollars' worth of near-worthless investments.
The subprime mortgage crisis led to a drastic impact on the U.S. housing market and overall economy. It lowered construction activity, reduced wealth and consumer spending, and decreased the ability for financial markets to lend or raise money. The subprime crisis ultimately extended globally and led to the 2007–2009 global financial crisis.
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A timeline of events
The cause of the crisis was years in the making and didn't happen overnight.
2000 to 2003
Interest rates during this time period were lowered from 6.5% to 1% due to the dot-com bubble and the Sept. 11, 2001 terrorist attacks. Low interest rates provided cheap credit, and more people borrowed money to purchase homes. This demand helped lead to the increase in housing prices.
2004 to 2006
Home prices were rapidly rising, and the Fed under Alan Greenspan raised interest rates to cool the overheated market over a dozen times. From 2004 to 2006, interest rates went from 1% to 5.25%. This slowed demand for new houses. Many subprime mortgage borrowers who were unable to afford a conventional 30-year mortgage took interest-only or adjustable-rate mortgages that had lower monthly payments.
The interest rate hikes increased the monthly payments on subprime loans, and many homeowners were unable to afford their payments. They were also unable to refinance or sell their homes due to the real estate market slowing down. The only option was for homeowners to default on their loans. Home prices fell for the first time in 11 years in the fall of 2006.
2007
A wave of subprime mortgage lender bankruptcies began in early 2007 as more homeowners began to default. By the end of the crisis, 20 of the top 25 subprime mortgage lenders would close, stop lending, or go bankrupt.
The National Bureau of Economic Research would later retroactively declare December 2007 as the start of the Great Recession. Despite the unfolding crisis, 2007 was a good year for the stock market. The Dow Jones Industrial Average and the S&P 500 each hit record peaks on Oct. 9, 2007.
2008
In March 2008, Bear Stearns became the first major investment bank to collapse, sending shockwaves through the stock market. The bankruptcy of Lehman Brothers in September 2008 triggered a global financial meltdown.
In October, President Bush signed the Troubled Asset Relief Program (TARP) into law to buy back mortgage-backed security and inject liquidity into the system. By that point, the U.S. was shedding 800,000 jobs every month. Household worth had plummeted by 19%. The U.S. government began a series of bank bailouts to prevent financial markets from totally collapsing.
2009
Bank bailouts continued into 2009. A few weeks after taking office, President Obama signed off on a $787 billion stimulus package. The stock market continued to plunge, hitting a low in March 2009. Though the Great Recession would officially end in May 2009, unemployment didn’t peak until October and remained elevated for several years.
What caused the subprime mortgage crisis?
There are many different parties that deserve blame for the subprime mortgage crisis. It wasn't one group or individual that caused the crisis, but multiple players that were focused on short-term gains.
Financial institutions
Banks, hedge funds, investment companies, insurance companies, and other financial institutions created the MBS and CDOs. They continued to repackage and sell them to investors who believed they were safe investments. The different financial institutions aggravated the situation by taking more risk than necessary.
Mortgage lenders
Improper mortgage lending practices played a large role in the crisis. Mortgage lenders relaxed their lending standards and handed out interest-only and adjustable-rate mortgages to borrowers who were unable to repay. In other cases, some mortgage lenders even committed mortgage fraud by inflating borrowers' incomes so they'd qualify for a home loan.
Credit rating agencies
Credit agencies had conflicts of interest and did not give the proper ratings many believed the subprime mortgages deserved. They gave AAA ratings to risky MBS and CDOs.
Regulators and government
Regulators repealed certain laws, giving financial institutions the ability to invest customers' money in complicated investment products. Deregulation also allowed banks to expand their markets, merging with different institutions. This made them "too big to fail." Due to the banking law changes, banks were also able to offer subprime customers interest-only and adjustable-rate loans.
Home buyers and sellers
People borrowed to buy houses even if they couldn't really afford them. While there were some buyers subject to predatory lending practices, many took on too much risk and bought houses they should not have. After the Fed raised interest rates, home buyers were unable to afford their mortgage payments.
Investors
Investors wanted investments that were low risk but earned high returns like an MBS. They fueled demand for subprime mortgages.
Each of the different parties were irresponsible and reckless in their actions. This led to the subprime mortgage crisis.
Subprime mortgage crisis effects
The subprime mortgage crisis severely weakened the global financial system. Some of the fallout:
- The crisis and the subsequent global financial crisis caused $7.4 trillion in stock market paper losses.
- About $3.4 billion in real estate wealth was wiped out.
- Many companies went bankrupt, and about 7.5 million Americans lost jobs. The unemployment rate doubled, from 5% at the start of the crisis to 10% in 2010. While the economy added jobs after the crisis, many were lower-paying and less-secure jobs.
- During the financial crisis, the net worth of American households declined by about $17 trillion, a loss of 26%.
By the time government bailout programs officially ended in 2014, the Fed had pumped more than $4 trillion into the U.S. economy.
As a result of the recession, Congress responded by passing multiple laws to help prevent another financial crisis from happening again. They passed the Dodd-Frank legislation, which included the Mortgage Act and the Consumer Financial Protection Act.
These acts introduced banking regulations and created a Consumer Financial Protection Bureau. The new laws included provisions designed to curb subprime lending. For example, Dodd-Frank prohibits lenders from issuing mortgages that a borrower likely can't afford and restricted lending practices that created incentives for steering customers into subprime loans.
FAQs
The subprime mortgage crisis was triggered by risky lending practices. When interest rates froze and the housing bubble began to collapse, borrowers couldn't afford their payments. As massive foreclosures ensued, the fallout spread to the global financial system.
One noteworthy figure who profited from the subprime mortgage crisis was Michael Burry, who bought securities that would skyrocket if homeowners in the U.S. defaulted on their mortgages in large numbers. Burry's story is chronicled in the book and film The Big Short. Burry's bet earned $100 million for himself and over $700 million for his hedge fund.
