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The economic hardships caused by the COVID-19 pandemic probably came as little surprise to most people. A global health crisis and stay-at-home orders were bound to hit the bottom lines.
But in the 2000s, a far more complicated and economically damaging, crisis struck the financial sector. The bursting of the U.S. housing bubble translated into the near-collapse of banking, the stock market, and even the U.S. economy. We call the beginning of this catastrophe the subprime mortgage crisis.
What Was the Subprime Mortgage Crisis?
The subprime mortgage crisis was a multi-year, multinational event sparked by the U.S. housing bubble bursting. As housing prices fell and interest rates rose, homeowners – unable to pay the rising costs of their mortgages– fell into foreclosure left and right. This set off a chain reaction that led to banks collapsing, federal bailout programs, a stock market crash, and half a decade of high unemployment.
How Did the Subprime Mortgage Crisis Happen?
Exactly where you see the beginnings of the crisis depends on how you explain what went wrong.
For instance, you could say that some of the seeds were planted by racial redlining as far back as the 1940s. Skyrocketing wealth inequality beginning in the 1980s also played a role, as did the repeal of the Glass-Steagall Act in 1999, which had previously separated commercial and investment banks. Upon its revocation, the corner bank where you keep your savings could now move into new – often riskier – arenas.
But the mortgage crisis itself began this millennia.
Deregulation, Price Explosions, and Exciting New Investments
Following the “dot-com bubble” of the late ’90s, the early 2000s saw enormous price increases in the housing market. The median price of a new house shot from around $200,000 in 2000 to over $300,000 by 2007. While bubbles can form around almost anything (including tulip bulbs), the price of houses was inflated by more than just speculation.
To start, a slew of deregulatory actions and new financial products made it more possible for banks and investors to enter the market in untested ways. Banks began to offer mortgages to riskier individuals, many of whom couldn’t make their monthly mortgage payments. These risky mortgages were then split, bundled, and sold as investment securities, supposedly reducing the risk. At the same time, the house market boomed as mortgage investors bought homes with the purpose of flipping them for profit.
The risk of each of these moves was defused and hidden across the widening intersection between banking, investing, and the real estate market. In turn, this allowed key financial actors to take greater leverage. When a wave of foreclosures hit in 2006 and housing prices began to correct in 2007, it became increasingly obvious that something more significant than consumers overspending on housing had gone wrong.
>> More: What is Mortgage Default?
The Ground Shakes
What could (and should) have merely been a housing bubble brought about by an excited market became something far worse. But the extent to which the economy had been bet on the bubble was unclear to many until the end of the decade.
To begin, the financial innovations that had created new methods of bundling mortgages into investments hadn’t properly assessed their risk. At the same time, banks and hedge funds made a fortune off selling these securities, thereby inflating demand for the underlying mortgages.
In response to increased demand, lenders began to target borrowers they would have previously rejected as risky prospects. Interest-only loans entered the market, allowing subprime borrowers who couldn’t otherwise afford a loan to buy a house. Loan agents leapt over ethical concerns to dive past predatory into illegal practices to bring in more business. Not only did banks not step in, but they also ignored signs of fraudulent paperwork and congratulated agents with hefty bonuses.
Upon seeing the success of mortgage-backed securities, many banks began to package other kinds of debts as investments. But because these investments were so new and complicated, pricing them accurately was difficult, and their value often depended on word of mouth and market enthusiasm. Still, that didn’t stop banks, hedge funds, pensions, corporations, and mutual funds from getting in on the action.
The Walls Crumble
Between 2004 and 2006, the Federal Reserve began to raise interest ratesto throw cold water on an overheated economy – 17 times, to be exact. In response, lenders began to raise their interest rates. Homeowners with adjustable-rate and interest-only mortgages found themselves suddenly unable to make their monthly payments, and banks began to foreclose.
To get ahead of the market, investors began to sell the properties they intended to flip, accelerating the fall. As credit conditions worsened, borrowers who’d been told they could refinance their adjustable-rate mortgage loanslater found that banks were no longer interested. And who would be, when the price of the home was now worth less than the mortgage itself?
In turn, delinquencies and foreclosures skyrocketed. The effects bled into the investment market, where mortgage-backed securities were now as worthless as the properties upon which they were built. The value of other debts that had been repackaged and sold as securities began to crumble, too. Homeowners who’d been tapping their properties for cash found that they owed debts greater than the value of their homes. By the end of 2007, the Fed had to step in.
The Tide Pours In
The crisis continued well into 2008. By that point, three of the United States’ largest investment banks – Lehman Brothers, Bear Stearns, and Merril Lynch – had or would go under. Lehman was forced to declare bankruptcy, while the others were bought out at a fraction of their previous value. Many other lenders barely survived, only limping on after the government bailed them out.
At the same time, the U.S. economy feel into a deep recession. The stock market lost over 50% of its value in six months, while housing prices plummeted an average of 30%. Around 6% of the country’s workforce was suddenly unemployed. (It would take almost six years before the country reached pre-crisis levels of employment.) During this time, household net worth dropped almost $13 trillion dollars, or a shocking 20%.
While beyond the scope of this article, this experience contributed to experiences we’re familiar with today; political radicalization, economic instability, and destruction of our faith in institutions. The financial sector had created their worst self-inflicted wound in almost 80 years – and the rest of the country bled with them.
Subprime Mortgage Crisis Timeline of Events
- 1999: Congress repeals the Glass-Steagall Act, allowing all banks to take on risky investments
- 2001-2007: U.S. mortgage debt doubles
- 2004-2006: The Fed raises interest rates 17 times to slow a foaming economy
- December 2005: The U.S. Treasury yield curve inverts, heralding the upcoming recession
- 2005-2006: Foreclosure rates increase 42%
- September 2006: Home prices fall for the first time in a decade
- 2006-2008: Foreclosure rates triple
- 2007: 100 mortgage companies fold
- September 2007-June 2008: The Fed steadily reduces interest rates
- 2007-2012: The Federal Reserve steps in to inject liquidity into financial institutions and key markets in the broader economy
- Late 2008: Three of the largest investment banks in the U.S. go bankrupt or sell off at rock-bottom prices
- September 29, 2008: The stock market loses $1.2 trillion in a day as the Dow experiences the largest single-day point crash in history
- September 2008-2012: Banks complete four million foreclosures
- 2009: Congress passes the Troubled Asset Relief Program (TARP) to purchase toxic assets and strengthen the financial sector
- March 5, 2009: The Dow has officially lost over 50% of its value in six months
- 2010: Congress passes the Dodd-Frank Act establishing new agencies and policies to oversee and regulate the financial system
Who Is to Blame for the Subprime Mortgage Crisis?
There are many narratives about who to blame for one of the worst global financial disasters in modern history. These narratives range from the self-serving to the explanatory, but we’ll only explore a few here.
Homeowners and Mortgage Borrowers
Many politicians blamed the borrowers taking out the mortgage, which was frankly shocking, considering their voters were more likely to be homeowners than banks.
While it’s true that mortgage fraud went up in the period, there’s clear evidence that loan officers encouraged fraudulent reporting. And even though some argue that practice wasn’t widespread (despite countless anecdotes by borrowers), it’s ultimately the bank’s responsibility to check applications. Not just for reasons of legal jeopardy or moral rectitude – but because banks stand to lose money when borrowers can’t repay.
Furthermore, we now have numerous documents proving that banks weren’t the innocent victims of vicious fraudsters. Many launched campaigns actively targeting communities that would both struggle to afford loans and had limited expertise in banking. (For instance, that time that Wells Fargo attempted to use Black churches in Detroit to sell subprime mortgages.)
Quite simply, blaming borrowers when financial experts targeted, misled, and misinformed is one part absurd and ten parts disgusting.
>> More: What Is Redlining?
Government-sponsored Enterprises (GSEs)
GSEs like Fannie Mae and Freddie Mac are also popular targets in the blame game. And though they certainly played a role, they’re not the ones who kicked off the crisis. If anything, they operated essentially like all other banks in the market: by capitalizing on a current, widely accepted trend. Their ultimate sin was failing to be a break on a runaway bubble – and while that was a failure, blaming them for a worldwide economic collapse on that basis is a bit unfair.
>> More: Fannie Mae vs. Freddie Mac
As time has passed, more blame has been apportioned to investors who bought homes to flip, and not without reason. It was their speculation, in part, that drove up housing prices so significantly. And on their other side, it was their rapid exodus that seems to have precipitated the bubble bursting. At the same time, it’s important to remember that such investors started speculating because of a bubble that already existed.
One of the more problematic framings in term of blame is that government regulators are at fault. The trouble here is the revolving door issues were (and are) rife in regulation, allowing poorly paid government employees to leave and work for the companies they’d been monitoring just days before for far greater compensation.
The problem, though, is that there’s no reason that should be legal. Nor is there a reason that the regulations they were meant to enforce were that lax and permission. Carrying out poor regulation in a manner that’s potentially corrupt isn’t a regulator problem; it’s a legislator problem.
At the end of the day, Congress could and should have made tight, wise regulations and protected against conflicts of interest. Ultimately, they chose not to. I suspect, dear reader, you don’t need my help guessing why.
The Ones Who Started It All
If you’re looking for who’s to blame, you should probably look past the gatekeepers and individual borrowers to the people who held expertise, controlled the money – and reaped profit.
Banks and financial institutions spent much of the ’80s and ’90s (and countless dollars) lobbying for decreased regulations. When they got it, they proved yet again why they couldn’t be trusted, as they consistently and systematically underestimated risk, targeted risky borrowers, accepted fraudulent applications, and deceived customers. They ignored historical precedent, created models that fit goals over data, and leveraged vast swaths of the economy – all to make a buck.
While the phrase had yet to enter common parlance, banks ultimately acted as if they believed that they were “too big to fail” and would be bailed out if necessary. As it turns out, they were largely correct.
Will There be Another Subprime Mortgage Crisis?
One area of the crisis we’ve yet to focus on is how housing came to be speculative in the first place. Particularly in large cities, there are enormous barriers to constructing affordable housing in desirable locations. This consistently keeps demand above supply, which means that prices consistently rise.
So long as this situation remains, housing will be subject to bubbles, which draws speculation. With so much money to be made, financial institutions will eventually be drawn in again. And no matter how many specific financial products are banned, the problem will reoccur. The only questions are when it will happen, and how bad will it be.
Bottom Line: Subprime Mortgage Crisis
All the complexities of the subprime mortgage crisis boil down to one human failure: greed. Greed in the banking system, the housing market, investment circles, government regulators, Congress, and insurance companies, and more all played a hand in building up a bubble – and failed to take responsibility before it was too late, and culpability when it burst. Their failings cost millions of Americans their homes, then many millions around the world lost their savings and their jobs, helping to usher in the era of political and societal instability we still live in today.