In 2007, the U.S. economy entered a mortgage crisis that caused panic and financial turmoil around the world. The financial markets became especially volatile, and the effects lasted for several years (or longer). The subprime mortgage crisis was a result of too much borrowing and flawed financial modeling, largely based on the assumption that home prices only go up. Greed and fraud also played important parts.
The American Dream
Owning a home is part of the traditional “American Dream.” The conventional wisdom is that it promotes people taking pride in a property and engaging with a community for the long term. But homes are expensive (at hundreds of thousands of dollars — or more), and many people need to borrow money to buy a home.
In the early 2000s, that dream came into reach for a growing number of people. Mortgage interest rates were low, allowing consumers to get relatively large loans with a lower monthly payment (see how payments are calculated to see how low rates affect payments). In addition, home prices increased dramatically, so buying a home seemed like a sure bet.
Lenders believed that homes made good collateral, so they were willing to lend against real estate and earn revenue while things were good.
Things were good for first-time homebuyers, but existing homeowners also benefited from easy money and low rates.
With home prices skyrocketing, homeowners found enormous wealth in their homes. They had plenty of equity, so why let it sit in the house? Homeowners refinanced and took second mortgages to get cash out of their homes' equity. They spent some of that money wisely (on improvements to the property related to the loan). However, some homeowners used the money for living expenses and other needs, keeping a comfortable standard of living while wages stayed stagnant.
Easy Money Before the Mortgage Crisis
Banks offered easy access to money before the mortgage crisis emerged. Borrowers got into high-risk mortgages such as option-ARMs, and they qualified for mortgages with little or no documentation. Even people with bad credit could qualify as subprime borrowers.
Risky borrowers: Borrowers were able to borrow more than ever before, and individuals with low credit scores increasingly qualified as subprime borrowers. Lenders approved “no documentation” and “low documentation” loans, which did not require verification of a borrower’s income and assets (or verification standards were relaxed).
Risky products: In addition to easier approval, borrowers had access to loans that promised short-term benefits (with long-term risks). Option-ARM loans enabled borrowers to make small payments on their debt, but the loan amount might actually increase if the payments were not sufficient to cover interest costs. Interest rates were relatively low (although not at historic lows), so traditional fixed-rate mortgages might have been a reasonable option during that period.
Fraud: Lenders were eager to fund purchases, but some home buyers and mortgage brokers added fuel to the fire by providing inaccurate information on loan applications. As long as the party never ended, everything was fine. Once home prices fell and borrowers were unable to afford loans, the truth came out.
Where did all of the money for loans come from? There was a glut of liquidity sloshing around the world — which quickly dried up at the height of the mortgage crisis. People, businesses, and governments had money to invest, and they developed an appetite for mortgage-linked investments as a way to earn more in a low-interest-rate environment.
Complicated investments converted illiquid real estate holdings into more cash for banks and lenders.
Secondary markets: Banks traditionally kept mortgages on their books. If you borrowed money from Bank A, you’d make monthly payments directly to Bank A, and that bank lost money if you defaulted. However, banks often sell loans now, and the loan may be split and sold to numerous investors. These investments are extremely complicated, so some investors just rely on rating agencies to tell them how safe the investments are (without really understanding them).
Because the banks and mortgage brokers did not have any skin in the game (they could just sell the loans before they went bad), loan quality deteriorated. There was no accountability or incentive to ensure borrowers could afford to repay loans.
Early Stages of Crisis
Unfortunately, the chickens came home to roost and the mortgage crisis began to intensify in 2007. Home prices stopped rising at breakneck speed, and prices began falling in 2006 as rising interest rates made buying (or refinancing) a home less affordable. Borrowers who bought more homes than they could afford eventually stopped making mortgage payments. To make matters worse, monthly payments increased on adjustable-rate mortgages as interest rates rose.
Homeowners with unaffordable homes faced difficult choices. They could wait for the bank to foreclose, they could renegotiate their loan in a workout program, or they could just walk away from the home and default. Of course, many also tried to increase their income and cut expenses. Some were able to bridge the gap, but others were already too far behind and facing unaffordable mortgage payments that weren’t sustainable.
Traditionally, banks could recover the amount they loaned at foreclosure. However, home values fell to such an extent that banks increasingly took hefty losses on defaulted loans. State laws and the type of loan determined whether or not lenders could try to collect any deficiency from borrowers.
The Plot Thickens
Once people started defaulting on loans in record numbers (and once the word got around that things were bad), the mortgage crisis really heated up. Banks and investors began losing money. Financial institutions decided to reduce their exposure to risk dramatically, and banks hesitated to lend to each other because they didn’t know if they’d ever get paid back. To operate smoothly, banks and businesses need money to flow easily, so the economy came to a grinding halt.
Bank weakness (and fear) caused bank failures. The FDIC ramped up staff in preparation for hundreds of bank failures caused by the mortgage crisis, and some mainstays of the banking world went under. The general public saw these high-profile institutions failing and panic increased. In a historic event, we were reminded that money market funds can “break the buck,” or move away from their targeted share price of $1, in turbulent times.
Other factors contributed to the severity of the mortgage crisis. The U.S. economy softened, and higher commodity prices hurt consumers and businesses. Other complicated financial products started to unravel as well.
Lawmakers, consumers, bankers, and businesspeople scurried to reduce the effects of the mortgage crisis. It set off a dramatic chain of events and will continue to unfold for years to come. The public got to see “how the sausage is made” and was shocked to learn how leveraged the world is.
Key Takeaway for Consumers
The lasting effect for most consumers is that it’s more difficult to qualify for a mortgage than it was in the early-to-mid 2000s. Lenders are required to verify that borrowers have the ability to repay a loan — you generally need to show proof of your income and assets. The home loan process is now more cumbersome, but hopefully, the financial system is healthier than before.