At the height of the crisis, nearly 10% of U.S. homes were in foreclosure.
FangXiaNuo for iStockphoto; Canva
The Subprime Mortgage Crisis Explained
After the smoke cleared from the dot-com bubble, the early 2000s were a heady time for the U.S. housing market, fueled by increasing demand and seemingly limitless financing. Investors were on the lookout for new, post-technology bubble investment opportunities, which they found in the form of loans to high-risk homebuyers, known as subprime mortgages.
During this period, the housing sector was the cornerstone of a strong economy, accounting for 40% of all new jobs created. Construction starts had more than doubled, from an average of 609,000 per year in 1995 to over 1.2 million in 2005. According to the Federal Reserve, average home prices across America doubled between 1998 and 2006, while in cities like Las Vegas, Miami, San Diego, and Washington, DC, prices jumped by more than 80%. This was an era of low interest rates and expanded credit for homebuyers. Homeownership rates, particularly among first-time homebuyers, swelled as high as 69%.
Who was behind this unprecedented financing? Believe it or not, there were global implications. Banks were approving mortgages and then pooling them together into interest-bearing packages known as mortgage-backed securities. The riskier, higher-yielding securities, known as “private label,” were then sold to investment banks and traded around the world for profit.
How Do Subprime Loans Differ from Other Types of Mortgages?
In the early 2000s, subprime loans were a newly introduced mortgage category. They allowed buyers with less than perfect credit (FICO scores of 600 and below) to afford a home of their own.
These homebuyers made payments at much higher monthly rates than payments made by others with better credit, thus compensating lenders for their increased risk.
Here are a few types of subprime mortgages:
Adjustable-rate mortgages (ARMs): Homebuyers made a small down payment while initial monthly payments began at a low “teaser” rate, which was actually less than fixed-rate mortgages. After a period usually around 2 years, these rates would shoot up.Balloon payment mortgages: Payments started out at a low rate and then grew larger, or “ballooned” at the end of the loan.Fixed-rate mortgages: These “plain vanilla” loans were common in the 1980s and early 1990s and featured rates that did not vary over the life of the loan. Often, fixed-rate mortgages had higher terms than adjustable-rate mortgages, making the latter seem more appealing.Hybrid mortgages: These loans started off at a fixed rate but later included an adjustment period, usually in sync with interest rates.Interest only: For the initial few years of this type of loan, the buyer only paid interest. When it reset, they had to pay interest plus principal.There were yet more types of mortgages during this period, such as the “No Income, No Job and No Assets” mortgage, or NINJA for short, which started off at a teaser rate that adjusted to a higher variable rate. An even riskier loan was the aptly-titled no down payment mortgages, which required no money up front.
Between 1995 and 2001, subprime mortgage originations skyrocketed from $65 billion to $173 billion. 80% of subprime loans were adjustable-rate mortgages, which contained a mix of the above features.
How Safe Were Subprime Loans?
Subprime mortgages created an illusion of affordability, but they often contained hidden fees. In addition to the adjustable rate, subprime borrowers had other added costs—sometimes even the principal increased over time.
Subprime loans were three times more common in low-income neighborhoods. Predatory lenders used unfair or discriminatory practices to convince borrowers to take on mortgages they couldn’t afford. Often, minorities were targeted: According to data from the Home Mortgage Disclosure Act, Latinos and African Americans were 2.8 times more likely to be offered a subprime loan than were whites. Ohio’s Assistant Attorney General, Jeffrey Loeser, described how predatory lenders would even go door to door selling subprime loans to consumers who didn’t understand them.
Understanding Adjustable-Rate Mortgage Terms
It’s easy to see why there was so much confusion surrounding adjustable-rate subprime mortgages—they’re quite complex.
The name of an adjustable-rate mortgage gives clues as to its terms:
A 5/1 ARM has an introductory rate of 5 years; after that, the rate could change once a year.A 3/1 ARM would have an introductory rate of 3 years, and the rate could change once a year after that.A 7/1 ARM would have an introductory rate of 7 years, and its rate could change once a year subsequently, and so forth.
After the teaser period, the ARM experienced an initial adjustment, which was commonly 2%. This meant that after the initial rate, the new rate would be a maximum of 2% higher. In addition, there could be subsequent adjustment periods, each having their own maximum percentage increase.
And to top things off, mortgage lenders tacked on another indexed rate to the total rate, which included a margin of usually 1%. For example, take a 5/1 ARM with a lender index of 1% and margin of 2.75%. After 5 years, the new total rate, which adjusted 2% higher, would be 4.75%. But say the margin was 5%. In this case, the new total rate would be 7.75%—that’s quite a jump!
Back in 2002, if you had a 3/1 ARM for $300,000, the initial interest rate would have been around 5%, and the monthly payment would have been about $1,610.
In three years, when the ARM initially adjusted, the new rate would have climbed to a rate of 7%, for a total of $1,995 a month. That’s a difference of $385 per month, or $4,600 more per year.
And that was only the first adjustment.
All too often, lenders did not prepare their customers for what would happen after the teaser period, or in the event that prevailing interest rates would increase. Subprime homeowners simply couldn’t afford to keep up; many went into default as a result.
What Happened When Subprime Mortgages Defaulted?
Speaking of interest rates, between 2004 and 2006, the Federal Reserve eyed inflationary pressures and took measures to correct them, raising the Fed Funds Rate 17 times from 1.0% to 5.25%. As interest rates rose, banks had to pay out more in interest to depositors, and so the interest rates on ARMs and other categories of subprime mortgages also had to adjust higher.
Subprime mortgage holders entered a crisis.
Millions of U.S. homeowners, spanning metropolitan areas like Detroit, Las Vegas, Miami and San Jose, defaulted on their loans. Florida and California were hit especially hard. By 2007, lenders had begun foreclosure proceedings on 1.3 million homes, with another 2 million in 2008—and even more to follow. By August, 2008 over 9% of all U.S. mortgages were either delinquent or in foreclosure.
What Were the Global Implications of the Subprime Mortgage Crisis?
If you’re wondering why the subprime borrowers couldn’t simply refinance their loans, the problem was that home values were decreasing during this period as well. Mortgage-backed securities contained thousands of subprime mortgages, and so when the market collapsed, so did their bond funding. These securities received credit downgrades, making them less attractive investments. This, in turn, caused lenders to stop approving the risky mortgages, which lowered demand for housing and caused home prices to fall.
It was like a string of dominoes.
First, New Century Financial Corp., a big subprime mortgage lender, filed for bankruptcy. Then agencies like Fannie Mae and Freddie Mac, whose mandate was to make home ownership affordable, suffered incredible losses because of outstanding loans they had allocated to mortgage-backed securities. The federal government had to bail them out in 2008.
Even investment banks became vulnerable, since they were no longer able to raise funds from securities markets. Lehman Brothers declared bankruptcy on September 15, 2008. A global financial crisis was underway.
What Was the Aftermath of the Subprime Mortgage Crisis? Can Another Crisis Be Avoided?
The subprime mortgage crisis sent the economy into a tailspin: Unemployment rose, and GDP fell. Consumer spending declined, and liquidity eroded. The United States entered the longest recession since World War II, known as the Great Recession, which lasted from December 2007 to June 2009.
In 2010, under the Troubled Asset Relief Program, or TARP, the U.S. Congress approved $700 billion to add liquidity to the markets, and the U.S. Treasury injected billions more to stabilize the troubled banking industry. Through this program, banks were encouraged to rework payments on mortgages that were “underwater” rather than seeking foreclosure. Homebuyers received temporary tax credits, and the Federal Housing Administration increased the amount it could insure on mortgages.
Between 2008 and 2014, the Federal Reserve slashed interest rates to nearly 0%. It also began a series of quantitative easing measures to increase the monetary supply and encourage lending until employment levels rose again, and it provided additional governmental support to stabilize sectors like the U.S. automotive industry.
Do Subprime Mortgages Still Exist?
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010 to reform the financial industry and prevent another crisis, a new regulatory agency was created: The Consumer Financial Protection Bureau. Its purpose is to provide stricter regulation over the banking industry and protect consumers against discrimination, including predatory lending. A section of Dodd-Frank, known as the Volcker Rule, prohibited banks from engaging in the trade of speculative assets, like risky, high-yield derivatives.
Yet subprime mortgages still exist today—they’re now known as nonprime loans. Thankfully, their structure is less complex than their historical counterparts; plus, most now come with rules that allow for the variable rates to be adjusted lower once the homeowner’s credit score improves.
The ARM share of the housing market has fallen dramatically; they make up less than 10% of residential mortgages today.
Is Another Subprime Mortgage Crisis Coming in 2022?
Michael Burry, one of the first investors to bet against subprime mortgages in the mid-2000s recently made another cryptic Tweet.