The subprime mortgage crisis was a major contributor to the global financial crisis of 2007-2008. Also known as the “Great Recession”, this is the worst economic downturn since the Great Depression of the 1930s. For many Americans, it took years to recover from the financial crisis.

What is the subprime crisis?

The subprime mortgage crisis occurred from 2007 to 2010 after the collapse of the US housing market. When the housing bubble burst, many borrowers were unable to repay their loans. The dramatic increase in foreclosures has caused the collapse of many financial institutions. Many demanded a government bailout. In addition to the fall in the US housing market, 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 for the global financial crisis.

The subprime crisis explained in detail

Subprime mortgages are loans given to borrowers who have bad credit. They pose a high credit risk because they do not have a strong credit history. They are also more likely to default than others. During the housing boom of the 2000s, many lenders extended subprime mortgages to unqualified borrowers. In 2006, a year before the start of the crisis, financial institutions lent $600 billion in subprime mortgages, which represents nearly 1 in 4 mortgages (23.4%).

Cheap credit and relaxed lending standards have allowed many high-risk borrowers to buy overpriced homes, fueling a housing bubble. As the housing market cooled, many homeowners owed more than their homes were worth. As the Federal Reserve Bank raised interest rates, homeowners, especially those with 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 falling house prices. In the end, nearly 5 million homes have been seized since the start of the crisis.

This had a huge impact on mortgage-backed securities (MBS) and secured debt securities (CDOs) – mortgage-backed investment products. Sub-prime mortgages were bundled by financial institutions into complex investment products and sold to investors around the world. In July 2008, 1 in 5 subprime mortgages were in default with 29% of ARMs seriously in default. Financial institutions and investors holding MBS and CDOs were left with trillions of dollars in nearly worthless investments.

The subprime mortgage crisis has had a huge impact on the US housing market and the economy as a whole. This has reduced construction, reduced wealth and consumer spending, and diminished the ability of financial markets to lend or raise funds. The subprime mortgage crisis eventually spread globally and led to the global financial crisis of 2007-2009.

A timeline of events

The cause of the crisis took years to develop and did not happen overnight.

2000 to 2003

Interest rates during this period were lowered from 6.5% to 1% due to the dot com bubble and the terrorist attacks of September 11, 2001. Low interest rates provided cheap credit and more people borrowed money to buy houses. This demand has contributed to the increase in housing prices.

2004 to 2006

House prices were rising rapidly, and the Fed under Alan Greenspan raised interest rates to cool the overheated market more than a dozen times. From 2004 to 2006, interest rates rose from 1% to 5.25%. This has slowed demand for new homes. Many subprime mortgage borrowers who were unable to afford a conventional 30-year mortgage took out interest-only or adjustable-rate mortgages with lower monthly payments.

Interest rate hikes have increased monthly payments on subprime loans and many homeowners have been unable to meet their payments. They have also been unable to refinance or sell their home due to the downturn in the real estate market. The only option was for the owners to default on their loans. Home prices fell for the first time in 11 years in the fall of 2006.

2007 to 2008

As more homeowners began to default, 20 of the top 25 subprime mortgage lenders closed, stopped lending or were sold to avoid bankruptcy. Investment banks Bear Stearns and Lehman Brothers went bankrupt. At the end of 2008, the United States was in recession. Congress passed a Wall Street bailout to stabilize the economy.

What caused the subprime crisis?

There are many different parties to blame for the subprime mortgage crisis. It was not one group or individual that caused the crisis, but several actors who were focused on short-term gains.

Financial institutions

Banks, hedge funds, investment firms, insurance companies and other financial institutions have created MBS and CDOs. They kept repackaging them and selling them to investors who thought they were safe investments. The various financial institutions have made the situation worse by taking on more risk than necessary.

Mortgage lenders

Inappropriate mortgage lending practices played a significant role in the crisis. Mortgage lenders have relaxed their lending standards and given loans to people who shouldn’t have gotten a loan in the first place. They were greedy and handing out interest-only, variable-rate mortgages that borrowers were unable to repay. In other cases, some mortgage lenders have even committed mortgage fraud by inflating borrowers’ incomes so that they qualify for a mortgage.

Credit rating agencies

Credit agencies had conflicts of interest and did not give the proper ratings that many believed subprime mortgages deserved. They assigned AAA ratings to risky MBS and CDOs.

Regulators and government

Regulators have repealed some laws, giving financial institutions the flexibility to invest customers’ money in complex investment products. Deregulation also allowed banks to expand their markets by merging with different institutions. This made them “too big to fail”. Due to changes in banking laws, banks were also able to offer interest-only, adjustable-rate loans to subprime customers.

Home buyers and sellers

People were borrowing to buy houses even though they couldn’t really afford to pay for them. While some buyers were subjected to predatory lending practices, many took on too much risk and bought homes they shouldn’t have. After the Fed raised interest rates, home buyers couldn’t pay their mortgage payments.

Investors

Investors wanted low-risk but high-return investments like an MBS. They fueled demand for subprime mortgages.

Each of the various parties was irresponsible and reckless in their actions. This led to the subprime crisis.

Effects of the subprime mortgage crisis

The subprime mortgage crisis has severely weakened the global financial system. The crisis and the ensuing global financial crisis caused $7.4 trillion in paper stock losses and wiped out an estimated $3.4 trillion in real estate wealth. Many businesses went bankrupt and an estimated 7.5 million Americans lost their jobs, with the unemployment rate doubling to 10% in 2010. While the economy added jobs after the crisis, many were jobs less well paid and less secure. During the financial crisis, the net worth of American households declined by approximately $17 trillion, a loss of 26%.

The government has launched several bailout programs to help stabilize the economy. By the time the programs officially ended in 2014, the Fed had injected more than $4 trillion into the US economy. Following the recession, Congress responded by passing several 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 laws introduced banking regulations and created a Consumer Financial Protection Bureau. Since then, mortgage lending practices have evolved to comply with new practices imposed by law.