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The Subprime Mortgage Crisis

What are subprime mortgages?

Typically, those who qualify for the most ideal mortgages with the best interest rates are those with good credit scores and minimal debt. A subprime mortgage is a type of loan granted to individuals with poor credit histories (typically below 600), who would not be able to qualify for conventional mortgages. Subprime mortgages charge interest rates that are above the typical interest rate because of the risk that is involved on the part of the lender.

What are subprime mortgages?

There are several different types of subprime mortgages, but the most common is the adjustable rate mortgage (ARM). ARMs can be misleading to subprime borrowers because they initially pay a lower interest rate. After the given period of time, their mortgages are set to a much higher rate. Therefore, their mortgage payments increase dramatically.

Whatishappens to your mortgage? A mortgage a stream of cash flows

Mortgage originators consist of banks, mortgage bankers and mortgage brokers. The mortgage broker connects the family with the lender. The broker collects commission. The family is then able to buy the house that they went. After the mortgage is sold, it is usually put in a group with other mortgages into a mortgage backed security, or MBS. The riskier portions of these securities are made into collateralized debt obligations, or CDOs. These are the portion of the MBS that other investors do not want. Private sector commercial and investment banks developed new ways of securing subprime mortgages: by packaging them into CDOs and then dividing the cash flows into different "tranches" to appeal to different classes of investors with different tolerances for risk.

Leading up to the crisis

Dean Baker, an analyst, identified the housing bubble in August 2002 that led up to the crisis. He said that between 1953 and 1995 the prices of houses reflected inflation, after 1995 however the price increases in houses were well over inflation. He predicted that a crisis would result from this but no one in the Federal Reserve would listen to him. Bakers analysis was confirmed by economist Robert Shiller who had proven that the real price of houses had not changed from 1895 to 1995.

How was the housing bubble identified?

According to Shiller, the real price of houses was relatively flat from 1890 to 1997, but since 1998, they have climbed 6 percent per year in the aggregate. He determined this by looking at housing price data he obtained from multiple sources 18901934 from Grebler, Blank, and Winnick (1956) 19531975 from the home-purchase component of the CPI-U 19751987 from the Office of Federal Housing Enterprise Oversight 19872005 from the Case-Shiller-Weiss index To fill in the gap, Shiller constructs an index of house prices from 1934 to 1953 by compiling data on the sales price of houses from five major cities based on newspaper advertisements.

Case-Shiller Index

The Home Prices line you see in the following graph comes from the Case-Shiller Price Index. This Index is based on data collected on repeat sales of single family homes. It was developed by economists Karl Case, Robert Shiller, and Allan Weiss. The index is normalized to have a value of 100 in the first quarter of 2000.

The housing bubble grew alongside the stock bubble in the mid 1990s. The stock bubble increased the wealth of people, which led them to spend money on consumption including bigger and better houses. The increased demand led house prices to rise. Then the stock bubble burst, which only caused the housing bubble to grow more. This is because people lost faith in the stock market and thought investing in a home would be a much safer alternative. Also going on at this time was the slow recovery from the 2001 recession. This led the Federal Reserve Board to cut interest rates in an effort to stimulate the economy. Fixed-rate mortgages, as well as other interest rates hit 50 year lows. This was a huge incentive to buy a home.

How did the housing bubble develop?

Some statistics of the housing bubble

The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Between 1997 and 2006, the price of the typical American house increased by 124% In 2006 the national median home price was 4.6 times the national median household income. The housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.

And then the bubble burst

"The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression, inflicting heavy damage on markets and institutions at the core of the financial system." International Monetary Fund, World Economic Outlook, April 2008

The Subprime Mortgage Crisis Explained:

Up until 2006, the housing market in the United States was flourishing due to the fact that it was so easy to get a home loan. Individuals were taking on subprime mortgages, with the expectations that the price of their home would continue to rise and that they would be able to refinance their home before the higher interest rates were to go into effect. 2005 was the peak of the subprime boom. At this time, 1 in 5 mortgages was subprime. However, the housing bubble burst and housing prices had reached their peak. They were now on a decline.

The Subprime Mortgage Crisis Explained:

At this point, many who had taken on these subprime mortgages and their interest rates were beginning to reset to the higher rates, making their monthly mortgage payments much higher than before. People then began to sell their homes but there was a problem to doing this. Since the price of homes had severely decreased, they did not have enough money after selling to cover the amount of the mortgage.

The Subprime Mortgage Crisis Explained:

If a person could not sell their home, this ultimately left the homeowner with one option, and that was to DEFAULT. When a home is defaulted, this is the first step towards foreclosure. After the notice of default, there is a reinstatement period before the home is put up for auction by the bank. If the defaulted loan isnt taken care of in a given amount of time, the bank resumes responsibility of the home and is put up for auction.

The Subprime Mortgage Crisis Explained:

However, when put in an auction, the bank usually sells the home at a price that is much lower than what it is worth. The amount that they receive in this process gets put towards the borrowers loan, but the borrower still has to account for the difference that they owe towards the loan. The process of auctioning off these houses creates a increase in supply of homes in the market, which will decrease the home prices.

The Subprime Mortgage Crisis Explained:

One of the major problems that came out of this crisis was that: Billions of dollars were lost in mortgage backed securities. What is a mortgage backed security? Once a bank has made thousands of mortgage loans, they often package up all the loans together and sell them to investors as bonds. It was believed that these bonds were very safe investments due to the fact that home prices were on the rise. If an individual was unable to pay the mortgage, it was thought that the homes would easily just be seized and sold. Investors continued to buy these mortgage backed securities because they continued to make a great amount of money. However, real estate prices began to fall, and the homeowners began to default their mortgages. This safe investment was turning out to be one that was of great risk and therefore, costing investors billions of dollars.

The Subprime Mortgage Crisis Explained:

The ratings of mortgage backed securities began to decline, to AA or even lower. This was a clear indicator of how these securities were thought of as a risky investment. The downgraded mortgage bonds were suddenly worth much less. A bank who was initially holding $100 billion in assets found that these assets could now be sold for much less, assuming they could even find someone to buy them. No investors wanted to take on this risk.

Impacts of the Subprime Mortgage Crisis:

Major banks suffered from huge losses. Lehman Brothers went out of business. Merrill Lynch had to sell itself to Bank of America for a fraction of its former value Countrywide Financial Corporation, the biggest U.S. mortgage lender, eventually gets taken over by Bank of America. The Federal Reserve began guaranteeing loans to Bear Stearns and other banks to prevent an all-out financial failure. Mortgage defaults led subsequently to the collapse and government rescue of Fannie Mae and Freddie Mac.

The Aftermath

There was a total of 2.2 million foreclosures in 2007, up 75% from the roughly 1.26 million RealtyTrac reported in 2006. RealtyTrac said 1% of all US households were in 'some stage of foreclosure' in 2007, up from 0.58% in 2006. By the end of 2008, home prices had dropped 20% from their 2006 peak.

Responses to the Crisis

Many programs have been enacted and legislation passed to help those who have been hit the hardest by the crisis. Some examples include the Emergency Economic Stabilization Act of 2008 and the Homeowners Affordability and Stability Plan.

Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps. A bill called the Derivatives Markets Transparency and Accountability Act of 2009 has been proposed to further regulate the CDS market. This bill would provide the authority to suspend CDS trading under certain conditions.

Where do we go from here?

Five main topics are important to consider when discussing solutions to the crises: liquidity, solvency, economic stimulus, homeowner assistance, and regulation. Liquidity: Central banks have expanded their lending and money supplies, to offset the decline in lending by private institutions and investors. Solvency: Some financial institutions are facing risks regarding their solvency, or ability to pay their obligations. Alternatives involve restructuring through bankruptcy, bondholder haircuts, or government bailouts Economic stimulus: Governments have increased spending or cut taxes to offset declines in consumer spending and business investment. Homeowner assistance: Banks are adjusting the terms of mortgage loans to avoid foreclosure, with the goal of maximizing cash payments. Governments are offering financial incentives for lenders to assist borrowers. Regulation: rules designed help stabilize the financial system (such as regulating derivatives) Discussions on theses topics are central to deciding what actions should be taken with regard to monetary policy, legislation, and potential programs.


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