The Subprime Mortgage
Market Meltdown: How Did It Happen?
The U.S. economy appeared strong throughout the
first half of 2007, but many observers saw clouds on the horizon in the form of
trouble brewing in the subprime home mortgage market. Fear of the coming storm
had been intensifying as housing prices dropped, home foreclosures increased,
major subprime mortgage lenders filed for bankruptcy, and investors took losses
on mortgage-backed securities. By the end of the year, many were predicting a
serious economic downturn.
“It's not like a bottle of water,” said Senator
Charles E. Schumer, chairman of the Joint Economic Committee of the U.S.
Congress. “It's much more like a pond where ripples start and can spread
quickly. … The subprime ripple leads to another ripple of lower housing prices
and a credit crunch for banks and financial markets. Another ripple driven by
consumer anxiety causes lower consumer spending, which makes up nearly
two-thirds of our economic growth, and leads to an even larger ripple that may
end up causing a recession.”1
What Are Subprime
Mortgages?
The subprime mortgages at the center of all this
turmoil were made to borrowers who had poor credit histories or who were
considered high credit risks for other reasons. Subprime mortgages are a
relatively recent phenomenon because, prior to the 1980s, usury laws limited
the ability of lenders to charge interest rates that adequately compensated
them for the risks associated with these loans. As a result, subprime mortgage
loans were simply not made before the usury laws were relaxed.
Several new federal laws were passed in the
1980s that, among other things, eliminated interest rate caps and made it
possible for high-risk borrowers to obtain home mortgages. The subprime market
experienced ups and downs in the 1990s, but by the early 2000s it had become an
important part of the broader mortgage market. Loans originated in the subprime
market made up less than 5 percent of mortgage loans in 1994 but increased to
13 percent in 2000 and to more than 20 percent in 2005 and 2006.2 The increase after 2000 accompanied a
rapid rise in home prices in many real estate markets throughout the United
States. Higher prices resulted in larger mortgage loans, which in turn
increased the average risk of new loans, because incomes were not rising as
quickly as home prices.
The emergence of the subprime market was
accompanied by a number of changes in the structure of mortgage lending.
Traditionally, a person who wanted a mortgage loan dealt with a bank or a
savings and loan institution, which granted the loan (or refused to grant it),
financed the loan with deposits, collected the payments, and foreclosed on the
property if the payments weren't made. Today, these activities are much more
likely to be carried out by separate institutions. For example, a majority of
subprime mortgages are originated by mortgage brokers—intermediaries that earn
a fee by bringing borrowers and lenders together. Once the loans are made, the
lenders often resell the resulting mortgages.
Beginning in the 1990s, the securitization of
mortgage loans became quite popular. This practice involves bundling groups of
loans with similar characteristics and selling claims on the cash flows from
these bundles, called mortgage-backed securities (MBSs). Most commonly, MBSs
are sold to institutional investors by investment banks. Investors in
mortgage-backed securities include insurance companies, mutual funds, pension
funds, and hedge funds, among others. The securitization of subprime loans
increased from about 32 percent of all such loans in 1994 to about 78 percent
in 2006.3 This development meant that much of the
relatively high risk associated with subprime loans was spread among a large
number of investors, rather than a relatively small number of lending
institutions.
Over the same period a number of new kinds of
mortgages were developed to supplement the traditional fixed-rate mortgage.
Especially important in the subprime market are various kinds of
adjustable-rate mortgages (ARMs). The interest rate in an ARM changes (resets)
at regular intervals—once a year, for example—in response to changes in some
index, such as the prime rate. Many subprime ARMs are hybrids that start with
low “teaser” rates that remain constant for a certain period, typically two or
three years. After that period is over, the mortgage “resets.” Thereafter, it
is adjusted periodically.
In addition, no-documentation loans appeared in
the early 2000s as housing prices began their rapid rise. With these loans,
lenders do not even ask for verification of the borrower's income.
What Went Wrong?
Many observers touted the benefits of subprime
loans in enabling previously disadvantaged groups, such as those living in poor
or minority neighborhoods, to become homeowners. In addition, lenders initially
earned large profits by charging these borrowers high interest rates and,
because so many of the mortgages were securitized, a relatively large number of
investors earned high returns.
So how did this evidently great idea turn into
an economic disaster? Remember that subprime borrowers are risky
borrowers—they're considered more likely to default on their loans. And that's
just what happened. Beginning in 2006, more and more subprime borrowers fell
behind on their loan payments, and many of them ended up defaulting. This began
a long upward trend in foreclosures that showed little sign of slowing even by
the end of 2010. Several economic conditions contributed to the high rate of
defaults. For one thing, the prime rate of interest, which had been declining
or holding steady since 2001, began to rise in 2004, affecting the rate to
which interest on ARMs was reset. To further complicate the situation, housing
prices, which had been increasing steadily, began to drop in 2006, leaving some
buyers owing more than the current value of their homes.
As a result of the large number of defaults,
subprime lenders found themselves in deep financial trouble, and some top
lenders filed for bankruptcy. Lenders were originating fewer loans and were
finding it difficult to sell those that they had originated. Investment bankers
who had purchased loans and securitized them, also suffered. In order to get
the highest possible prices, they had retained some exposure to the riskiest
parts of the loan bundles that they sold. As the default rates on loans underlying
MBSs increased, the investment bankers suffered losses, as did the investors
who bought the securities.
As investors in other types of fixed-income
securities saw what was happening to the values of securitized subprime
mortgages, they became concerned about the values of similar securitized debt
instruments, such as collateralized loan obligations (CLOs). CLOs are
securitized business loans, which included business loans that had been used to
fund leveraged buyouts and were therefore also quite risky. Investors' concerns
caused prices for CLOs to decline rapidly. In addition, banks and other lenders
began to tighten their credit standards, which made it more difficult for
businesses and individuals to get loans, further contributing to a general
weakening of the economy.
Who's to Blame?
Inevitably, observers looked around for someone
to blame for the subprime crisis. And they came up with a long list of
candidates, from the homebuyers themselves (who should have been more prudent)
to the SEC and the Federal Reserve (who should have been paying closer
attention). Few disagree, though, that those promoting subprime mortgages—such
as mortgage brokers and lenders—must bear at least a part of the blame.
Motivated by the potential to earn a lot of
money in a rapidly expanding market, many of these players turned their backs
on ethical standards. “In the feeding frenzy for housing loans,” according to
one writer, “basic quality controls were ignored in the mortgage business,
while the big Wall Street investment banks that backed these firms looked the
other way.”4 Problems existed at many levels, as a few
examples show:
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Mortgage
lenders did not adequately monitor what the mortgage brokers were doing. In
fact, some allege that they were willing to make virtually any loan that
brokers sent their way. With little oversight, the brokers did not have a
strong incentive to carefully evaluate the ability of borrowers to repay
the mortgages. They filled out the loan paperwork that they submitted to
the lenders without verifying all of the information and, it has been
alleged, in some cases actually misrepresented the facts.
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Appraisers
inflated the market value of houses, causing consumers to take out
mortgages that did not reflect their houses' true value. According to
several national studies, lenders commonly pressured appraisers to value a
property at whatever amount was needed to allow a high-priced sale to
close.5 Willingness to inflate appraisals also made some
appraisers attractive to unscrupulous mortgage brokers, who were an
important source of their business. The attorneys general of several states
filed suit against mortgage and appraisal firms, claiming that they engaged
in this practice.
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Mortgage
companies lured buyers with teaser rates and other loan terms that appeared
favorable but, in the longer run, were not. (Some have called these terms
“toxic.”) Mortgage agreements often included prepayment penalties that
would make it very expensive for buyers to refinance later. Many subprime
buyers weren't experienced or sophisticated enough to fully understand the
terms, but lenders and brokers were interested in pushing through the
loans—not in explaining the loan terms.
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Many
subprime mortgages were “no-doc” loans, which required little or no
documentation of income. These loans, claimed one observer, “were available
to anyone with a pulse.” Opportunities for abuse are obvious—and not
restricted to borrowers. A former employee of Ameriquest Mortgage Corp.
stated that it was “a common and open practice at Ameriquest for account
executives to forge or alter borrower information or loan documents. … I
saw account executives openly engage in conduct such as altering borrowers'
W-2 forms or pay stubs, photocopying borrower signatures and copying them
onto other, unsigned documents, and similar conduct.”6
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As bonds
backed by subprime mortgages became more popular and profitable, investment
banks—eager to bundle more mortgages—loosened their standards. The quality
of the loans being bundled began to slide as the popularity of subprime mortgages
grew, according to the consultants (called due-diligence firms) hired by
the bankers to evaluate loan quality. However, many investment banking
firms overlooked the problem—and, as a result, passed ever-higher risk
along to the investors who bought their mortgage-backed securities.
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Investors
in the MBSs did not fully understand the risks associated with them. The
way in which the mortgages were bundled made it difficult for investors to
value the MBSs. They were so complex that many investors apparently relied
on investment bankers to tell them what they were worth. The investment
bankers apparently did not understand or simply failed to inform investors
of all the risks. Some investors probably also got a bit greedy.
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DISCUSSION QUESTIONS
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7.1
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What were the responsibilities of
the mortgage brokers to borrowers? To lenders? To investors? How well did
they fulfill their responsibilities? Why?
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7.2
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Did some subprime lenders behave
unethically? If so, how? Whose interests did the subprime lenders have a
responsibility to represent? Did they adequately represent those interests?
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7.3
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What motivated the investment
bankers to get involved in the subprime market? Did they behave
appropriately? Why or why not?
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7.4
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Should the borrowers (homeowners)
share in the blame? If so, how?
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7.5
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What about the investors in MBSs?
What could they have done differently?
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7.6
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What can be done to prevent future
blowups like the one that occurred in the subprime market?
BUY ETHICS ESSAY ON SUBPRIME MORTGAGES NOW!
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