What Caused the Subprime Mortgage Crisis?

The subprime mortgage crisis was caused by hedge funds, banks and insurance companies. The first two created mortgage-backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing.  When the Federal Reserve raised the fed funds rate, it sent adjustable mortgage interest rates skyrocketing. That sent home prices plummeting,  and borrowers defaulting. Derivatives then spread the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the Great Depression

Hedge Funds Played a Key Role in the Crisis

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Photo: Laurence Mouton/Getty Images

Hedge funds are always under tremendous pressure to outperform the market. They created demand for mortgage-backed securities by pairing them with guarantees called credit default swaps. What could go wrong? Nothing, until the Fed started raising interest rates. Those with adjustable-rate mortgages couldn't make these higher payments. Demand fell, and so did housing prices. When they couldn't sell their homes, either, they defaulted. No one could price, or sell, the now-worthless securities. And AIG almost went bankrupt trying to cover the insurance.

The subprime mortgage crisis was also caused by deregulation. In 1999, the banks were allowed to act as hedge funds. They also invested depositors' funds in outside hedge funds. That's what caused the Savings and Loan Crisis in 1989. Many lenders spent millions of dollars to lobby state legislatures to relax laws. Those laws would have protected borrowers from taking on mortgages they really couldn't afford. More

Derivatives Drove the Subprime Crisis

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Derivatives drove demand for collateral to support them, in this case mortgages. Photo: PeopleImages.com/Getty Images

Banks and hedge funds made so much money selling mortgage-backed securities, they soon created a huge demand for the underlying mortgages. That's what caused mortgage lenders to continually lower rates and standards for new borrowers.

Mortgage-backed securities allow lenders to bundle loans into a package and resell them. In the days of conventional loans, this allowed banks to have more funds to lend. With the advent of interest-only loans, this also transferred the risk of the lender defaulting when interest rates reset. As long as the housing market continued to rise, the risk was small.

The advent of interest-only loans combined with mortgage-backed securities created another problem. They added so much liquidity in the market that it created a housing boom. More

Subprime and Interest-Only Mortgages Don't Mix

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Interest-only loans made homeownership more affordable. Unfortunately, many people didn't realize they weren't paying off the loan. Photo: Dave and Les Jacobs/Getty Images

Subprime borrowers are those who have poor credit histories and are therefore more likely to default. Lenders usually charge higher interest rates to provide more return for the greater risk. Generally, that makes it too expensive for many subprime borrowers to make monthly payments.

The advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them. It increased the risk to lenders, however, because the initial rates usually reset after one, three or five years. But the rising housing market comforted lenders, who assumed the borrower could resell the house at the higher price rather than default. More

Two Myths About What Caused the Crisis

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Prior to the CRA, banks "redlined" poor neighborhoods, and wouldn't lend to anyone there, no matter how good their score. Photo: Steve Debenport/Getty Images

Fannie Mae and Freddie Mac were government-sponsored enterprises that participated in the mortgage crisis. They may have even made it worse. But they didn't cause it. Like many other banks, they got caught up in the practices that created it. For more, see Did Fannie and Freddie Cause the Subprime Crisis?

Another myth is that the Community Reinvestment Act created the crisis. That's because it pushed banks to lend more to poor neighborhoods. That was its mandate when it was created in 1977.

In 1989, FIRREA strengthened the CRA by publicizing banks' lending records. It prohibited them from expanding if they didn't comply with CRA standards. In 1995, President Clinton called on regulators to strengthen the CRA even more.

But, the law did not require banks to make subprime loans. It didn't ask them to lower their lending standards. They did that to create additional profitable derivatives. 

Collateralized Debt Obligations

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Banks repackaged debt into bundles they could resell. Photo: Michael A. Keller/Fuse Fuse

The risk was not just confined to mortgages. All kinds of debt was repackaged and resold as collateralized debt obligations. As housing prices declined, many homeowners who had been using their homes as ATM machines found they could no longer support their lifestyle. Defaults on all kinds of debt started to slowly creep up. Holders of CDOs included not only lenders and hedge funds. They also included corporations, pension funds and mutual funds. That extended the risk to individual investors.

The real problem with CDOs was that buyers did not know how to price them. One reason was they were so complicated and so new. Another was that the stock market was booming. Everyone was under so much pressure to make money that they often bought these products based on nothing more than word of mouth. More

Then a Little Downturn in Real Estate Prices Triggered Disaster

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New houses are up for auction after new-home sales tumbled to the lowest mark in 12 years during December and prices fell sharply, where a recent housing boom has been taking place January 28, 2008 in Rancho Cucamonga, California. Photo: David McNew/Getty Images

Every boom has its bust. In 2006, housing prices started to decline. When subprime borrowers couldn't sell their houses at a higher price, they were forced to default. They couldn't find anyone to negotiate a settlement. Banks had repackaged and sold their loans. ​ More

Next: How the Subprime Mess Spread to the Banking Industry

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IndyMac Bank was shut down three hours early on a Friday after customers withdrew $1.9 billion. Its subprime mortgages caused the second-largest U.S. bank failure ever. Photo by David McNew/Getty Images

Many of the purchasers of CDOs were banks. As defaults started to mount, banks were unable to sell these CDOs, and so had less money to lend. Those that who had funds did not want to lend to banks that might default. By the end of 2007, the Fed had to step in as a lender of last resort. The crisis had come full circle. Instead of lending too freely, banks lent too little, causing the housing market to decline further. More