The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds, and corporations who owned these derivatives. The ensuing 2007 banking crisis and the 2008 financial crisis produced the worst recession since the Great Depression.
Here's the timeline from the early warning signs in 2003 to the collapse of the housing market in late 2006. Keep reading to understand the relationships among interest rates, real estate, and the rest of the economy.
February 21, 2003: Buffett Warns of Financial Weapons of Mass Destruction
The first warning of the danger of mortgage-backed securities and other derivatives came on February 21, 2003. That's when Warren Buffett wrote to his shareholders, “In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
June 2004-June 2006: Fed Raised Interest Rates
By June 2004, housing prices were skyrocketing. The Federal Reserve Chairman Alan Greenspan started raising interest rates to cool off the overheated market. The Fed raised the fed funds rate six times, reaching 2.25 percent by December 2004. It raised it eight times in 2005, rising two full points to 4.25 percent by December 2005. In 2006, the new Fed Chair Ben Bernanke raised the rate four times, hitting 5.25 percent by June 2006.
Disastrously, this raised monthly payments for those who had interest-only and other subprime loans based on the fed funds rate. Many homeowners who couldn't afford conventional mortgages took interest-only loans as they provided lower monthly payments. When home prices fells, many found their homes were no longer worth what they paid for them. At the same time, interest rates rose along with the fed funds rate. As a result, these homeowners couldn't pay their mortgages nor sell their homes for a profit. Their only option was to default. As rates rose, demand slackened. By March 2005, new home sales peaked at 1,431,000.
August 25-27, 2005: IMF Economist Warns the World's Central Bankers
Dr. Raghuram Rajan was the chief economist at the World Bank in 2005. He presented a paper entitled, "Has Financial Development Made the World Riskier?" at the annual Economic Policy Symposium of central bankers in Jackson Hole, Wyoming. Rajan’s research found that many big banks were holding derivatives to boost their own profit margins. He warned, "The inter-bank market could freeze up, and one could well have a full-blown financial crisis," similar to the Long-Term Capital Management crisis.
December 22, 2005: Yield Curve Inverts
Right after Rajan's announcement, investors started buying more Treasurys, pushing yields down, but they were buying more long-term Treasurys, maturing between three to 20 years, than short-term bills, with terms ranging from one month to two years. That meant the yield on long-term Treasury notes was falling faster than on short-term notes.
By December 22, 2005, the yield curve for U.S. Treasurys inverted. The Fed was raising the fed funds rate, pushing the two-year Treasury bill yield to 4.40 percent, but yields on longer-term bonds weren't rising as fast. The seven-year Treasury note yielded just 4.39 percent.
This meant that investors were investing more heavily in the long term. The higher demand drove down returns. Why? They believed that a recession could occur in two years. They wanted a higher return on the two-year bill than on the seven-year note to compensate for the difficult investing environment they expected would occur in 2007. Their timing was perfect.
By December 30, 2005, the inversion was worse. The two-year Treasury bill returned 4.41 percent, but the yield on the seven-year note had fallen to 4.36 percent. The yield on the ten-year Treasury note had fallen to 4.39 percent.
By January 31, 2006, the two-year bill yield rose to 4.54 percent, outpacing the seven-year’s 4.49 percent yield. It fluctuated over the next six months, sending mixed signals.
By June 2006, the fed funds rate was 5.25 percent, pushing up short-term rates. On July 17, 2006, the yield curve seriously inverted. The ten-year note yielded 5.07 percent, less than the three-month bill at 5.11 percent.
September 25, 2006: Home Prices Fall for the First Time in 11 Years
The National Association of Realtors reported that the median prices of existing home sales fell 1.7 percent from the prior year. That was the largest such decline in 11 years. The price in August 2006 was $225,000. That was the biggest percentage drop since the record 2.1 percent decline in the November 1990 recession.
Prices fell, because the unsold inventory was 3.9 million, 38 percent higher than the prior year. At the current rate of sales of 6.3 million a year, it would take 7.5 months to sell that inventory. That was almost double the four-month supply in 2004. Most economists thought it just meant that the housing market was cooling off, though, because interest rates were reasonably low, at 6.4 percent for a 30-year fixed-rate mortgage.
November 2006: New Home Permits Fall 28 Percent
Slowing demand for housing reduced new home permits 28 percent from the year before. This leading economic indicator came in at 1.57 million.
New home permits are issued about six months before construction finishes and the mortgage closes. This means that permits are a leading indicator of new home closes. A slump in permits means that new home closings will continue to be in a slump for the next nine months. No one at the time realized how far subprime mortgages reached into the stock market and the overall economy.
At that time, most economists thought that as long as the Federal Reserve dropped interest rates by summer, the housing decline would reverse itself. What they didn't realize was the sheer magnitude of the subprime mortgage market. It had created a "perfect storm" of bad events.
Interest-only loans made a lot of subprime mortgages possible. Homeowners were only paying the interest and never paying down principal. That was fine until the interest rate kicker raised monthly payments. Often the homeowner could no longer afford the payments. As housing prices started to fall, many homeowners found that they could no longer afford to sell the homes either.
Mortgage-backed securities repackaged subprime mortgages into investments. That allowed them to be sold to investors. It helped spread the cancer of subprime mortgages throughout the global financial community.
The repackaged subprime mortgages were sold to investors through the secondary market. Without it, banks would have had to keep all mortgages on their books.
Interest rates rule the housing market, as well as the entire financial community. In order to understand interest rates and the role it plays, know how interest rates are determined and what the relationship between Treasury notes and mortgage rates is, and have a good basic understanding of the Federal Reserve and Treasury notes.
Before the crisis, real estate made up almost 10 percent of the economy. When the market collapsed, it took a bite out of the gross domestic product. Although many economists said that the slowdown in real estate would be contained, that was just wishful thinking.
How the Subprime Crisis Created the 2007 Banking Crisis
As home prices fell, banks lost trust in each other. They were afraid to lend to each other because if they could receive mortgage-backed securities as collateral. Once home prices started falling, they couldn't price the value of these assets, but if banks don't lend to each other, the whole financial system starts to collapse.
Frequently Asked Questions (FAQs)
What is a subprime mortgage?
A subprime mortgage can be any home loan intended for borrowers with impaired credit. They often have adjustable rates. Banks independently decide which borrowers don't qualify for prime mortgages, but a credit score below 660 will usually land a borrower in the "subprime" category.
How large was the U.S. subprime mortgage market in 2007?
In the second quarter of 2007, the subprime mortgage market made up roughly 14 percent of the total mortgage industry. That was the peak rate of the era. As the crisis took a hit on financial markets, the number of new subprime mortgages quickly declined.