During the 2000-2006 housing boom, American lenders issued a staggering total of $1.5 trillion in risky subprime mortgages, relying on rapidly appreciating home values to protect their investments. As home prices began declining in 2006, record numbers of debtors defaulted, leading to soaring home foreclosure rates, lender bankruptcies, and a general weakening of the U.S. economy. Mismanagement and outright fraud at all levels created a cascading national and international financial crisis leading to industry and government reform.
Home ownership has always been considered a bulwark of the American way of life. From the end of World War II until the presidency of Ronald Reagan, most home financing required at minimum a 20 percent down payment and featured fixed interest rates, a payoff period not exceeding thirty years, and strict requirements for income and creditworthiness that ensured a low default rate but priced lower income people out of the market. One of the arguments for deregulation was the claim that the lending industry, if freed from constraints, could supplant government subsidies to those otherwise unable to afford a home. The mortgage lending industry, specifically those companies specializing in subprime mortgages, began collapsing even before New Century Financial Corporation, one of the largest such lenders in the United States, declared bankruptcy in April, 2007. Many believe the collapse began earlier in the year.
During the early 1980’s, freed from federal regulations, what emerged was a new class of mortgage lending institutions, whose operations were based on originating large numbers of mortgages and selling them to Wall Street investment firms, which in turn sold bonds backed by mortgage investment portfolios. This process is called securitization. Rating agencies gave such investments their highest (AAA) rating based on high dividend rates and assumptions that the underlying mortgage loans were entirely secured by collateral and the risks of borrower default were low. Both assumptions proved to be false. There is suspicion that the ratings agencies themselves may have colluded with investment firms.
The enormous profitability of home loans to investors led to aggressive marketing of subprime instead of prime mortgages, especially those with adjustable interest rates that rise after two or so years, to risky borrowers. A subprime loan is a loan issued to a risky borrower. According to the federal government, risky borrowers are those with a credit score usually below 650 and who have a lower income, an unstable employment history, or a history of financial problems (such as a previous foreclosure, repossession, or bankruptcy).
A foreclosed home for sale in Stockton, California, in April, 2008.
Between 2000 and 2006, refinance transactions tapping home equity became much more common as well. The availability of so much credit was one factor in the rapid escalation of home prices between 2000 and 2006, marking the housing bubble. Inflation-adjusted home prices, which on the average increased by 0.4 percent per year between 1980 and 2000, nearly doubled between 2000 and 2006, putting a conventional mortgage beyond the means of most first-time home buyers. This inflationary trend created phantom equity for people who bought homes during the 1990’s, equity they were encouraged to tap by refinancing homes to pay off other debts, cope with a financial crisis, or simply indulge themselves.
The essentially fraudulent nature of the subprime mortgage industry is epitomized by Angelo Mozilo, cofounder and chief executive officer of Countrywide Financial Corporation, based in Calabasas, California. Mozilo’s annual salary at the height of the housing bubble topped $200 million. He was investigated for deliberately propelling his company toward financial collapse as he withdrew his own investment at the last minute and left ordinary stockholders with huge losses. Bank of America announced its $4 billion purchase of Countrywide in January, 2008. The name Countrywide is now synonymous with the subprime mortgage scandal.
There are many different types of subprime mortgages, and many classes of borrowers, including some who qualified for a conventional mortgage but were steered toward a subprime lender by an unscrupulous broker who collected a hefty commission. Racial minorities and the elderly were frequently singled out for the most predatory loans. Home builders and real estate agents and brokers participated in the subprime scandal by selling properties to buyers who clearly could not afford them. Brokers, who were paid on commission and had no further stake in the loan, told borrowers who worried about repayment terms that they could always refinance at a later date, taking advantage of appreciation in the interim. This proved an empty promise when property values started to decline and lending standards tightened.
One of the commonest types of subprime loan is the adjustable rate mortgage, or ARM. A typical ARM has an artificially low interest rate (often called a teaser rate) and correspondingly low payments for the first few years after issuance, after which interest rates and payments rise rapidly and become unmanageable for many with lower or fixed incomes. In theory, in these first years, the homeowner’s property appreciates and the homeowner’s credit rating improves, allowing for refinancing to a fixed-rate mortgage. Little known was that the refinancing homeowner would end up paying substantially in additional lender fees and a prepayment penalty.
Another common feature of a subprime loan is the balloon payment. Instead of paying down the loan in regular increments, the borrower pays interest only, or interest plus a small sum, and agrees to make a large lump sum payment at some point in the future. These optional-payment mortgages represent a minefield for the borrower, because they allow the borrower to pay less than the interest amount and add the deficiency to the principal of the loan, up to 110 percent of the original loan amount. This is known as negative amortization.
Another troublesome type of loan, the Alt-A or “liar mortgage,” proliferated during the same period. Also called stated-income loans, these were issued to people with good credit but without documentation of income. Carrying high interest rates and other undesirable terms, Alt-A loans appealed to speculators, or investors, who defaulted in large numbers when property values declined. Although the typical Alt-A borrower is perceived by the public and legislators as being undeserving of rescue (in contrast to a lower income borrower whose primary residence is threatened with foreclosure), the consequences of the collapse of this market to financial institutions and communities has been more devastating than that created by classic subprime loans.
In 2006, as interest rates on the large numbers of ARMs from 2004 started to reset to higher rates, a number of problems emerged and the housing bubble began to burst. Credit started to contract, with lenders refusing the most marginal loan requests. Home prices in the most rapidly appreciating markets, which coincided with the highest levels of subprime lending, began to decline. Unable to meet payments or refinance, people put their homes up for sale. This created a feedback loop, especially in Florida, Nevada, and California. More homes on the market, with fewer buyers able to purchase them, meant further price declines.
Lenders began the process of short sales—working with a homeowner to sell a property valued less than the remaining mortgage due—and foreclosures at record levels. In the heyday of subprime lending, foreclosure did not pose a threat to lender profits because property appreciation canceled out foreclosure costs. The lending industry counted on this. When the system started breaking down, investment firms stopped buying securitized subprime mortgages. Primary lenders, cut off from their main source of capital, shut their doors in droves.
In August of 2007, the nation’s secondary mortgage market temporarily shut down, leaving private-sector lenders without a source of money for home buyers. Countrywide Financial, the largest originator of subprime loans in the United States, appeared headed for bankruptcy. The Federal Reserve, headed by Ben Bernanke, responded by lowering the prime interest rate. The conduits for funding most home mortgages shifted to institutions with Federal Housing Administration
By mid-2008, it was apparent that the collapse of the subprime market had created a ripple effect extending through the home mortgage market to the economy in general. Nationwide, property values were dropping by 7.47 percent per year, and one in 171 homes was involved in foreclosure. Several regional banks heavily invested in the subprime market had failed outright, and many more were in serious trouble. In July, the U.S. government responded by enacting a sweeping housing rescue bill—the Housing and Economic Recovery Act—that included a provision for refinancing subprime mortgages with an FHA guarantee, a bailout of Fannie Mae and Freddie Mac (as recommended by Secretary of the Treasury Henry Paulson) that cost an estimated $25 billion, and grants and loans to communities to buy vacant foreclosed properties. Fannie Mae and Freddie Mac were bailed out by federal regulators in September.
In terms of its impact on the average American, the subprime mortgage crisis must rank near the top of the list of modern economic scandals. The effects are not confined to the United States, however, but have had serious repercussions in Europe and Asia because of heavy investment by foreign companies and sovereign wealth funds in mortgage-backed securities. Although a number of other factors, notably a sharp increase in energy costs, contributed to the overall decline in economic well-being in the United States between mid-2006 and mid-2008, the collapse of the housing market was clearly the triggering event.
Between December, 2007, and July, 2008, unemployment and bankruptcy filings rose significantly, while housing prices (in most areas), retail sales, and stock values continued to decline, leading to increasingly pessimistic predictions of the duration and depth of the recession. Any final assessment of the impact of the mortgage industry collapse must necessarily await the results of remedial legislation and future elections.
Securing a home loan now involves a process similar to that before the 1990’s: paying a 20 percent down payment and meeting strict requirements for income and creditworthiness. Furthermore, consumers who qualify for these harder-to-get loans now focus on securing fixed interest rates.
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DiMartino, Danielle, and John V. Duca. “The Rise and Fall of Subprime Mortgages.” Economic Letter: Insights from the Federal Reserve Bank of Dallas 2, no. 11 (November, 2007). A good introduction to the subprime mortgage crisis. -
Gramlich, Edward M. Subprime Mortgages: America’s Latest Boom and Bust. Washington, D.C.: Urban Institute Press, 2006. Written by a member of the Federal Reserve Board. The bulk of the book treats subprime lending as a positive force. The title and introduction, added just before the book went into print, show how rapidly conditions changed. -
Renuart, Elizabeth, and Alys Cohen. Stop Predatory Lending: A Guide for Legal Advocates. Boston: National Consumer Law Center, 2007. A good source of information on lender practices contributing to the subprime mortgage crisis. -
Sabry, Faten, and Thomas Schopflocher. “The Subprime Meltdown: A Primer.” New York: National Economic Research Associates, June 21, 2007. A brief introductory guide to the crisis in the subprime mortgage industry.
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