Causes and Effects of the U.S. Subprime Mortgage Crisis

Causes and Effects of the U.S. Subprime Mortgage Crisis

The United States Subprime Mortgage Crisis was a financial crisis transpiring between 2007 and 2010 across the nation that stemmed from the collapse of a housing bubble and resulted in the 2007-2008 Financial Crisis. It also contributed to the Great Recession that affected critical markets across the world.

Causes of the Subprime Mortgage Crisis

Housing Bubble and Eventual Collapse

From a general perspective, the emergence and collapse of the housing bubble in the U.S. triggered that crisis. Note that the bubble emerged due to the high demand for housing properties during the 2000s that eventually resulted in rapid increases in the price of houses. Banks played a significant role in stimulating demand by making mortgages easily accessible to the public.

However, loan defaults became commonplace. Foreclosure of properties soon followed. At the same time, banks were unable to sell these properties, thus resulting further to the devaluation of housing-related securities. The housing bubble collapsed and triggered the crisis.

The collapse affected a wide range of stakeholders with significant exposures to the U.S. housing market to include homeowners, banks and other lending institutions, and investors that purchased mortgage-backed securities.

Questionable Banking and Lending Practices

Remember that banks played a crucial role in the emergence of the housing bubble. During the early 2000s, they were involved in questionable practices centered on lowering lending standards to encourage the public consumption of mortgages.

Some major examples of these practices included fraudulent underwriting or subprime lending and predatory lending. Under subprime lending, banks deprioritized proof of income and assets to make it easier for individuals to qualify for loans. Several banks also encouraged borrowers to be less honest in their loan applications.

Other banks pursued predatory lending that encouraged borrowers to secure risky loans for inappropriate purposes. As explained by The Economist, these banks sought individuals to avail high-risk housing loans so they can pocket the fees and pass these mortgages up to the financial food chain as mortgaged-backed securities.

Investments on Mortgaged-Backed Securities

Note that banks did not only provide mortgages to the public. They securitized these mortgages and sold them to investors both in the U.S. and abroad as mortgaged-backed securities. Investors initially deemed these securities as low-risk and high-return investments.

To be more specific, investors considered these securities backed by mortgages as safe for two reasons. First, the market value of real estate properties naturally appreciates. Second, if ever homeowners defaulted from their loans, lenders could easily cease their real estate properties and resell them in the market. Hence, these securities became highly demanded.

Of course, to exploit the demand, lenders needed to make mortgages more available to the public. Hence, they relaxed their policies or standards and made housing loans easily accessible to individuals with low income and poor credit. The entire relaxed lending practice was called subprime lending.

Failed and Infective Regulation and Policies

Results of the study conducted by the U.S. Financial Crisis Inquiry Commission and published in 2011 revealed that the crisis was avoidable only if the government was better equipped to control lending practices and stem the tide of toxic mortgages. It concluded further that the crisis resulted from a widespread failure in regulating financial institutions.

Several policies by the U.S. federal government were also blamed. According to Peter J. Wallison, a lawyer and a fellow at the American Enterprise Institute, noted that the government encouraged lending to make housing available to low-income families. He added that government agencies bought almost two-thirds of bad mortgages in the U.S. financial system or required by government regulations.

The Federal Reserves also lowered the federal funds rate target from 6.5 percent to 1.0 percent from 2000 to 2003. As a central monetary authority responsible for devising and implementing monetary policy, the lowering of interest rates encouraged borrowing. Accordingly, it did so to manage the economic implications of the dot-com bubble and the 9/11 Terrorist Attack.

Effects of the Subprime Mortgage Crisis

It is essential to highlight the fact that the subprime mortgage crisis eventually resulted to the 2007-2008 Financial Crisis that affected the United States and other countries with significant exposure to the U.S. financial system, including countries in Europe.

Collapse of U.S. Banking Institutions

Several banks and financial institutions in the U.S. folded following the crisis. A report by the Council on Foreign Relations mentioned that in April 2007, New Century Financial Corporation, then the largest U.S. subprime lender, filed for bankruptcy. In July of the same year, Bear Stearns, one of the largest U.S. investment banks, announced that two of its hedge funds lost almost all of their investor capital, thus forcing them to file for bankruptcy.

Other banking intuitions also collapsed, resulting in bailouts and acquisitions. Lehman Brothers filed for bankruptcy in September 2008. It was the largest bankruptcy in U.S. history. The Bank of America acquired Merrill Lynch & Co. for USD 29 per share while JPMorgan Chase & Co acquired Bear Sterns for USD 2 per share. The U.S. government seized control of federal mortgage insurers Fannie Mae and Freddie Mac.

Several other institutions underwent a similar fate. The bankruptcy of Washington Mutual and its seizure by Federal Deposit Insurance Corporation in September 2008 became the largest bank failure in U.S. history. Within the same month, Wells Fargo purchased Wachovia while Goldman Sachs and Morgan Stanley announced their conversion to bank holding companies.

The Federal Reserve rescued American International Group or AIG with a USD 85 billion loan. On 3 October 2008, as part of its fiscal policy, then U.S. President George W. Bush signed the Emergency Economic Stabilization Act that involved a plan for bailing out companies with USD 700 billion. The government bailed out AIG with USD 180 billion in late 2008.

Negative Impacts on the American Economy

Following the collapse of the American banking system was the negative impact on the American economy as determined by several macroeconomic and microeconomic indicators. For starters, data from the U.S. Bureau of Economic Analysis revealed that GDP began contracting in the third quarter of 2008 and did not grow further until the first quarter of 2010.

The rate of unemployment rose from 5 percent in 2008 to 10 percent in 2009 until it steadily declined to 9.6 percent in March 2013. The number of unemployed individuals increased from 7 million in 2008 to 15 million in 2009 until it fell to 13 million by early 2013.

Residential private investment fell from its peak of USD 800 billion in 2006 to USD 400 billion in the middle of 2009. Furthermore, the combined net worth of U.S. households and nonprofit organizations fell from USD 67 trillion in 2007 to USD 52 trillion in 2009 or a decline of USD 15 trillion or 22 percent.

Note that the U.S. stock market peaked in 2007 when its index exceeded 14000 points based on the Dow Jones Industrial Average. The collapsed of the housing bubble rattled the Dow Jones Industrial Average. On 27 February 2007, the index lost 416 points—the biggest one-day point loss since the 9/11 Terrorist Attack. The index entered substantial decline the following year that accelerated in October 2008.

The crisis had a significant effect on the American auto industry. The collapse of the financial system meant reduced in vehicle loans, thus resulting in declines in sales. Note that the troubled economy also affected the purchasing power of the consumers. The U.S. government bailed out Ford Motor Company, General Motors, and Chrysler with an amount of USD 80.7 billion.

European Contagion and Global Impact

Remember that the collapse of the U.S. housing bubble and the subprime mortgage crisis triggered the 2007-2008 Financial Crisis. The crisis rapidly developed and spread across the U.S. and further into countries with exposure to the U.S. financial system, thus resulting in a global economic shock.

To be more specific, the problems with subprime mortgage spread from the U.S. and to the world because foreign banks and hedge funds had substantial holdings of mortgage-backed securities and collateralized debt obligation. The BNP Paribas in France announced on 9 August 2007 that it could not liquidate these securities held by three of its hedge funds as investors started to become disinterested.

Other Europeans followed with similar announcements. The European Central Bank had to step in to offer low-interest credit lines to support these banks. Note that the impact on the European financial system was also a significant factor in the development of the European Sovereign-Debt Crisis or Eurozone Crisis that has taken place since the end of 2009.

FURTHER READINGS AND REFERENCES

  • Council on Foreign Relations. n.d. “The U.S. Financial Crisis: 1992-2018.” Council on Foreign Relations. Available online
  • Financial Crisis Inquiry Commission. 2011. The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial Economic Crisis in the United States. ISBN: 978-0-16-087727-8. Available via PDF
  • The Economist. 2010, April 27. “Predatory Lending.” The Economist. Available online
  • Wallison, P. J. 2009, October 15. “Barney, Frank, Predatory Lender.” Wall Street Journal. Available online