Subprime Mortgage Crisis: Effect and Timeline

Follow the Timeline of Events as They Happened

The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds and corporations who owned these derivatives. It led to the 2007 banking crisis, the 2008 financial crisis and 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 relationship between interest rates, real estate and the rest of the economy. 

February 21, 2003: Buffett Warns of Financial Weapons of Mass Destruction

Warren Buffett
Warren Buffett, chairman and CEO of Berkshire Hathaway, was the first to warn of the dangers of derivatives. Photo: Alex Wong/Getty Images

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.” (Sources: Ron Hera, “Forget About Housing, The Real Real Cause of the Crisis Was OTC Derivatives,” Business Insider, May 11, 2010. “25 People to Blame for the Financial Crisis,” Time Magazine.) 

June 2004-June 2006: Fed Raised Interest Rates

Greenspan Bernanke
Ben Bernanke (R) flanked by Alan Greenspan (L) speaks after being nominated by U.S President George W. Bush to be Federal Reserve chairman October 24, 2005 in Washington, DC. Photo by Mark Wilson/Getty Images

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. They provided lower monthly payments. As 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 127,000. (Source: “Historical New Home Sales, U.S. Census.) More

August 25-27, 2005: IMF Economist Warns the World's Central Bankers

rajan.jpg
Rajan (on the left) must skillfully guide India's monetary policy. Photo: Getty Images

Dr. Raghuram Rajan was 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 at 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 LTCM crisis. The audience scoffed at Rajan’s warnings, with Former Treasury Secretary Larry Summers even calling him a Luddite. (Source: "Economist Raghuram Rajan Risked Reputation to Predict Credit Crisis," Economic Times, June 9, 2010.) More

December 22, 2005: Yield Curve Inverts

inverted-yield-curve.jpg
An inverted yield curve means that yields on short-term bonds are higher than long-term ones. A recession is imminent!. Photo: GSO Images/Getty Images

Right after Rajan's announcement, investors started buying more Treasurys, pushing yields down. But they were buying more long-term Treasurys (3- to 20-year) than short-term bills (1-month to 2-year). 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 2-year Treasury bill yield to 4.40 percent. But yields on longer-term bonds weren't rising as fast. The 7-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 a recession could occur in two years. They wanted a higher return on the 2-year bill than on the 7-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 2-year Treasury bill returned 4.41 percent, but the yield on the 7-year note had fallen to 4.36 percent. The yield on the 10-year Treasury note had fallen to 4.39 percent.

By January 31, 2006, the 2-year bill yield rose to 4.54 percent, outpacing the 10-year’s 4.49 percent yield. It fluctuated over the next six months, sending mixed signals.

By June 2006, the Fed funds rate was 5.75 percent, pushing up short-term rates. On July 17, 2006, the yield curve seriously inverted. The 10-year note yielded 5.06 percent, less than the 3-month bill at 5.11 percent. More

September 25, 2006: Home Prices Fall for the First Time in 11 Years

house for sale sign
Home sales prices started falling in 2006. Photo: Getty Images

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 percent 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 4-month supply in 2004. Most economists thought it just meant the housing market was cooling off, though. That’s because interest rates were reasonably low, at 6.4 percent for a 30-year fixed-rate mortgage. (Source: “Home Prices: First Drop in 11 Years,” CNN, September 25, 2006.)

November 2006: New Home Permits Fall 28 Percent

homebuilder.jpg
A construction worker uses a saw to cut wood as he builds framing for a new house in a development June 26, 2006 in Richmond, California. A report issued by the U.S. Commerce Department stated that sales of new single-family homes were up 4.6 percent in May. The median price of homes sold in May slipped to $235,300, down 4.3 percent from April. Photo by Justin Sullivan/Getty Images

Slowing demand for housing reduced new home permits 28 percent from the year before. This leading economic indicator came in at 1.535 million, according to the November 17 Commerce Department Real Estate Report.

New home permits are usually 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. More

Background Reading: A Must If You Are the Least Bit Confused So Far

debt.jpg
It's complicated, so keep reading if you want to understand more. Photo: Seb Oliver/Getty Images

 

Interest-only loans made a lot of subprime mortgages possible. That's because 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 they could no longer afford to sell the homes either. Voila! Subprime mortgage mess.

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—and perhaps would have been more careful about whom they made loans to.

Interest rates rule the housing market, as well as the entire financial community. For more, see How Interest Rates Are DeterminedRelationship Between Treasury Notes and Mortgage RatesFederal Reserve and Treasury notes

Before the crisis, real estate made up almost 10 percent to the economy. When the market collapsed, it took a bite out of gross domestic product. Although many economists said that the slowdown in real estate would be contained, that was just wishful thinking.

Fannie and Freddie Programs

housetrap
Many homeowners were trapped by a mortgage that was worth more than the house. Getty Images

Freddie Mac and Fannie Mae developed resources for those crushed by subprime mortgage debts. Find out how to get help if you are a subprime mortgage holder. More

How the Subprime Crisis Created the 2007 Banking Crisis

A bank owned for sale sign
A bank owned for sale sign is posted in front of a foreclosed home May 7, 2009 in Antioch, California. Photo by Justin Sullivan/Getty Images

As home prices fell, bankers lost trust in each other. No one wanted to lend to each other because they would receive mortgage-backed securities as collateral. No one knew what the value of these derivatives once home prices started falling. But if banks don't lend to each other, the whole financial systems starts to collapse. More