Subprime Mortgage Crisis

The Subprime Mortgage Crisis was the collapse of a vast speculative bubble in US residential real estate, financed by increasingly low-quality subprime mortgages. Through the early 2000s, banks and mortgage brokers had originated mortgages to borrowers with poor credit and minimal down payments, securitizing these mortgages and selling them globally. When housing prices stopped rising and borrowers began to default, the entire structure collapsed, triggering the Great Recession.

The housing bubble formation

Through the 2000s, the US housing market experienced a speculative bubble. Low interest rates (the Federal Reserve kept rates at 1% from 2003 to 2004), easy credit, government policies encouraging homeownership, and a narrative of perpetually rising home prices fueled a frenzy.

Lenders, driven by the belief that housing prices never fall, originated mortgages to borrowers with poor credit and minimal equity. Subprime mortgages (mortgages to borrowers with subprime credit) grew from roughly 8% of originations in 2003 to 20% in 2006. ARM (adjustable-rate mortgages) with teaser rates were common — borrowers paid a low rate for two years, then the rate would reset much higher.

These mortgages were not held by the originators; instead, they were securitized. Banks originating mortgages immediately sold them to investment banks, which bundled them into mortgage-backed securities and tranched them into senior, mezzanine, and junior classes. The senior tranches were often rated AAA — supposedly as safe as Treasury bonds.

The mechanics of the collapse

The critical assumption underlying the entire system was that housing prices would never decline significantly. If prices held steady or rose, borrowers with little equity could refinance when their ARM rates reset. If they couldn’t afford payments, they could sell at a profit.

But from 2006 onward, housing prices began to decline. Borrowers with subprime mortgages and little equity suddenly found themselves underwater — they owed more than the house was worth. They began to default. Default rates on subprime mortgages spiked from ~5% in 2005 to 20%+ in 2007.

As defaults accelerated, mortgage-backed securities became “toxic.” No one knew what they were worth. Banks and investment firms that had accumulated large positions in these securities faced massive losses. The credit markets began to freeze as institutions stopped trusting each other’s balance sheets.

The contagion to financial institutions

The defaults and the mortgage-backed security losses rippled through the financial system. Bear Stearns, an investment bank with massive positions in mortgage securities, began to fail in March 2008. Lehman Brothers, the largest bankruptcy in US history, failed in September 2008. AIG, an insurance company that had sold credit default swaps on mortgage-backed securities, nearly collapsed and had to be rescued by the government. Washington Mutual failed; Wachovia failed; the list went on.

The crisis metastasized into a systemic financial crisis. Credit markets seized. Interbank lending halted. The commercial paper market, where corporations borrowed short-term, froze. The entire financial system was on the verge of collapse.

The consequences

The Great Recession followed. Unemployment surged from 5% to 10%. Home prices fell 30%+ from peak. Millions of people lost their homes through foreclosure. Consumer spending collapsed. The government and the Federal Reserve intervened massively through TARP (the $700 billion bank bailout), quantitative easing, and fiscal stimulus.

The full economic cost was enormous. Estimates of wealth destruction run to $13+ trillion. The loss of home equity and stock market wealth depressed consumer spending for years, slowing the recovery.

Legacy: The limits of financial engineering

The subprime crisis and the financial crisis it triggered demonstrated the dangers of opacity and leverage in financial systems. Complex securities that no one understood were sold to investors worldwide, spreading the risk globally. Leverage was extreme: banks and investment firms held 30, 40, or even 50 dollars of assets per dollar of capital, meaning that a small loss in asset values could wipe out shareholders.

The crisis also exposed moral hazard: financial institutions, assuming they were too big to fail, took excessive risks in the knowledge that government would rescue them.

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