Subprime mortgage crisis
The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis. It led to a severe economic recession, with millions becoming unemployed and many businesses going bankrupt. The U.S. government intervened with a series of measures to stabilize the financial system, including the Troubled Asset Relief Program and the American Recovery and Reinvestment Act.
The collapse of the 2000s United States housing bubble and high interest rates led to unprecedented numbers of borrowers missing mortgage repayments and becoming delinquent. This ultimately led to mass foreclosures and the devaluation of housing-related securities. The housing bubble preceding the crisis was financed with mortgage-backed securities and collateralized debt obligations, which initially offered higher interest rates than government securities, along with attractive risk ratings from rating agencies. Despite being highly rated, most of these financial instruments were made up of high-risk subprime mortgages.
While elements of the crisis first became more visible during 2007, several major financial institutions collapsed in late 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession. Most notably, Lehman Brothers, a major mortgage lender, filed for bankruptcy in September 2008. There were many causes of the crisis, with commentators assigning different levels of blame to financial institutions, regulators, credit agencies, government housing policies, and consumers, among others. Two proximate causes were the rise in subprime lending and the increase in housing speculation. Investors, even those with "prime", or low-risk, credit ratings, were much more likely to default than non-investors when prices fell. These changes were part of a broader trend of lowered lending standards and higher-risk mortgage products, which contributed to U.S. households becoming increasingly indebted.
The crisis had severe, long-lasting consequences for the U.S. and European economies. The U.S. entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly 6% of the workforce. The number of jobs did not return to the December 2007 pre-crisis peak until May 2014. U.S. household net worth declined by nearly $13 trillion from its Q2 2007 pre-crisis peak, recovering by Q4 2012. U.S. housing prices fell nearly 30% on average and the U.S. stock market fell approximately 50% by early 2009, with stocks regaining their December 2007 level during September 2012. One estimate of lost output and income from the crisis comes to "at least 40% of 2007 gross domestic product". Europe also continued to struggle with its own economic crisis, with elevated unemployment and severe banking impairments estimated at €940 billion between 2008 and 2012. As of January 2018, U.S. bailout funds had been fully recovered by the government, when interest on loans is taken into consideration. A total of $626B was invested, loaned, or granted due to various bailout measures, while $390B had been returned to the Treasury. The Treasury had earned another $323B in interest on bailout loans, resulting in a $109B profit as of January 2021.
Background and timeline of events
The immediate cause of the crisis was the bursting of the United States housing bubble which peaked in approximately 2006. An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage interest rates reset higher.As housing prices fell, global investor demand for mortgage-related securities evaporated. This became apparent by July 2007, when investment bank Bear Stearns announced that two of its hedge funds had imploded. These funds had invested in securities that derived their value from mortgages. When the value of these securities dropped, lenders demanded that these hedge funds provide additional collateral. This created a cascade of selling in these securities, which lowered their value further. Economist Mark Zandi wrote that this 2007 event was "arguably the proximate catalyst" for the financial market disruption that followed.
Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial firms. In the years leading up to the crisis, the U.S. received large amounts of foreign money from fast-growing economies in Asia and oil-producing/exporting countries. This inflow of funds combined with low U.S. interest rates from 2002 to 2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types were easy to obtain and consumers assumed an unprecedented debt load.
As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities, which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses were estimated in the trillions of U.S. dollars globally.
While the housing and credit bubbles were growing, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. These entities were not subject to the same regulations as depository banking. Further, shadow banks were able to mask the extent of their risk taking from investors and regulators through the use of complex, off-balance sheet derivatives and securitizations. Economist Gary Gorton has referred to the 2007–2008 aspects of the crisis as a "run" on the shadow banking system.
The complexity of these off-balance sheet arrangements and the securities held, as well as the interconnection between larger financial institutions, made it virtually impossible to re-organize them via bankruptcy, which contributed to the need for government bailouts. Some experts believe these shadow institutions had become as important as commercial banks in providing credit to the U.S. economy, but they were not subject to the same regulations. These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.
The losses experienced by financial institutions on their mortgage-related securities impacted their ability to lend, slowing economic activity. Interbank lending dried-up initially and then loans to non-financial firms were affected. Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Effects on global stock markets due to the crisis were dramatic. Between January 1 and October 11, 2008, owners of stocks in U.S. corporations suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries averaged about 40%.
Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine. Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis. A variety of solutions were proposed by government officials, central bankers, economists, and business executives. In the U.S., the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 to address some of the causes of the crisis.
Causes
Overview
The crisis can be attributed to several factors, which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments, overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary and housing policies that encouraged risk-taking and more debt, international trade imbalances, and inappropriate and insufficient government regulation. Excessive consumer housing debt was in turn caused by the mortgage-backed security, credit default swap, and collateralized debt obligation sub-sectors of the finance industry, which were offering irrationally low interest rates and irrationally high levels of approval to subprime mortgage consumers due in part to faulty financial models. Debt consumers were acting in their rational self-interest, because they were unable to audit the finance industry's opaque faulty risk pricing methodology.Among the important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market, government policies aimed at expanding homeownership, speculation by many home buyers, and the predatory lending practices of the mortgage lenders, specifically the adjustable-rate mortgage, 2–28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers. On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.
In its "Declaration of the Summit on Financial Markets and the World Economy," dated November 15, 2008, leaders of the Group of 20 cited the following causes:
Federal Reserve Chair Ben Bernanke testified in September 2010 regarding the causes of the crisis. He wrote that there were shocks or triggers and vulnerabilities that amplified the shocks. Examples of triggers included: losses on subprime mortgage securities that began in 2007 and a run on the shadow banking system that began in mid-2007, which adversely affected the functioning of money markets. Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or repos; deficiencies in corporate risk management; excessive use of leverage ; and inappropriate usage of derivatives as a tool for taking excessive risks. Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed "Too big to fail" institutions, monetary policy, and trade deficits.
During May 2010, Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically; 2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4) Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed. Economists surveyed by the University of Chicago during 2017 rated the factors that caused the crisis in order of importance: 1) Flawed financial sector regulation and supervision; 2) Underestimating risks in financial engineering Mortgage fraud and bad incentives; 4) Short-term funding decisions and corresponding runs in those markets Credit rating agency failures.
The real estate bubble was initially fueled by a global pool of reserves valued at approximately U.S.$70 trillion. A significant portion of these reserves was utilized by investment banks to purchase securities like mortgage-backed securities. MBSes, for example, are derivatives where the issuing banks would secure loans from commercial banks to finance home purchases. To refinance these loans, the banks would seek funding, often drawing on savings from their clients.
MBSes, tied to the real estate sector, became highly attractive financial assets during the housing boom. Both individual investors and financial institutions largely ignored the risks associated with these securities. Their value rose steadily, creating a perception of security and profitability. However, when the housing market faltered, the value of MBSes plummeted, leading to significant financial losses and a cascading crisis.
This misjudgment of risk, combined with excessive reliance on credit and financial engineering, created the conditions for the eventual collapse, illustrating the vulnerabilities of a system heavily dependent on inflated asset values.
Another critical factor in the subprime mortgage crisis was the precarious financial position of major investment banks. The ratio of their leverage ratios was alarmingly low, in some cases reaching 1:40. This meant that for every dollar of equity, these banks owed $40. Such extreme leverage made them highly vulnerable to even minor fluctuations in asset values.
These investment banks poured significant resources into MBSes, gambling heavily on the assumption that real estate prices would continue to rise indefinitely. Commercial banks, in turn, loaned substantial sums to individuals and to investment banks involved in issuing these risky MBSes. However, the investment banks failed to properly assess the future value of these financial assets. It was not just a matter of credit expansion but also of widespread overconfidence and naivety—individuals and institutions alike were convinced that the housing bubble would persist.
The situation was exacerbated by the deregulation of over-the-counter derivatives markets. These markets allowed for the creation and trade of complex financial derivatives, many of which were tied to the real estate sector and, in some cases, to foreign exchange markets. These derivatives often lacked transparency and their behavior was poorly predicted, yet their trade still proliferated in the unregulated OTC markets.
The sheer volume of derivatives became staggering, with their total value exceeding the global GDP by more than tenfold. Many of these derivatives were backed by high-risk assets like MBSes and CDOs, further compounding the instability of the financial system.
The unregulated creation and trade of derivatives, combined with excessive leverage and misplaced confidence in the housing market, were equally significant contributors. These factors created a fragile financial structure that was doomed to collapse once the bubble burst.
Before the subprime crisis, an excessive number of houses were constructed, and resources were disproportionately allocated to the real estate sector. Investment banks issued MBS at unprecedented levels, fueled by the housing boom. Meanwhile, many non-financial corporations prioritized stock buybacks, dividend payments, and speculative investments over reinvesting in productive capital and expanding employment. In some cases, these corporations even incurred debt to finance these financial maneuvers, further diverting resources away from productive sectors.
The globalized nature of the modern economy amplifies the effects of crises. When major economies like the U.S. or China experience downturns, the impact spreads worldwide, leading to business defaults, rising unemployment, and economic contraction. Compounding this is the phenomenon of financialization, where banks and non-financial corporations prioritize investments in financial instruments like stocks, derivatives, and bonds over productive investments.
A significant portion of the funds used to finance MBSes and other home purchases originated from global savings, not solely from central bank credit expansion. These savings came not just from within the United States but from international sources as well, like China and other Asian developing economies.
This shift in economic focus led to a decrease in the production of both capital and consumer goods in Western economies. Outsourcing and risky financial strategies further exacerbated this trend. Credit expansion primarily benefited the real estate sector, leaving other productive parts of the economy underfunded.
The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."