Recession and Subprime Lending

Mortgage Subprime Crisis – Mortgage lending to high-risk borrowers, along with soaring home prices, resulted in a period of financial market turbulence that spanned from 2007 to 2010.

Subprime Crisis Of 2007–10

The subprime crisis of 2007–10 resulted from previous development of mortgage lending, including to borrowers who would have previously been unable to obtain mortgages, which both made a significant contribution to and was helped facilitate by quickly rising home prices. Historically, potential homeowners who had below-average credit histories made little down payments or requested high-payment loans and had a tough time obtaining mortgages.

Lenders frequently declined such mortgage requests unless they were protected by government insurance. In the face of restricted credit choices, certain high-risk households might get small-sized mortgages secured by the Federal Housing Administration. Home ownership varied about 65 percent during the time, foreclosure process rates were low, and home development and house prices were mostly influenced by changes in mortgage rates and income.

High-risk mortgages became accessible in the early and mid-2000s from lenders that financed mortgages by restructuring them into groups that were sold on the open market. New financial instruments were developed to distribute these risks, with personal mortgage-backed securities (PMBS) accounting for the majority of subprime mortgage funding. The least sensitive of these assets were thought to be low risk because they were protected with financial innovations or because other assets would bear any losses on the underpinning mortgages first (DiMartino and Duca 2007). More first-time homebuyers were able to acquire mortgages as a result (Duca, Muellbauer, and Murphy 2011), and ownership increased.

The increasing demand drove up property prices, especially in places where housing was scarce. This fuelled anticipation for even greater house price increases, driving up housing demand and prices even more (Case, Shiller, and Thompson 2012). Initially, investors who purchased PMBS gained because growing housing values shielded them from losses. When high-risk mortgage customers were unable to make repayments, they either traded their properties at a profit and paid off their debts, or drew more against rising market prices. Because such periods of growing property values and greater mortgage availability were relatively unusual, and the longer-run sustainability of new mortgage products was unknown, the riskiness of PMBS may not have been fully appreciated. The risk was “off the radar screen” on a practical level since many indicators of mortgage loan integrity available at the time were predicated on prime, instead of new mortgage products.

When house values crested, mortgage and selling properties became less attractive options for resolving mortgage debt, and mortgage failure rates for creditors and borrowers began to rise. New Century Financial Corp., a major subprime mortgage lender, declared bankruptcy in April 2007. Several subprime lenders folded shortly after, and a considerable number of PMBS and PMBS-backed assets were rated to high risk.

Because bond funding for subprime mortgages dried up, bankers quit making subprime and other riskier non prime mortgages. This reduced demand for housing, resulting in falling house prices that spurred anticipation of future reductions, thus lowering demand for homes. Prices plummeted so precipitously that it became difficult for distressed borrowers to sell their houses in order to fully repay entire mortgages, even if they had made a significant down payment.

As a result, Fannie Mae and Freddie Mac, two government-sponsored firms, sustained significant losses and were acquired by the federal government in the spring of 2008. Previously, in order to satisfy federally mandated goals of increasing ownership, Fannie Mae and Freddie Mac issued loans to support the acquisition of subprime lender securities, which eventually lost value. Furthermore, the two government firms faced losses on defaulting prime mortgages, which they had previously purchased, guaranteed, and packaged into quality mortgage-backed securities sold to investors.

Steps To Resolve The Crisis

The administration made many efforts to mitigate the harm. One series of activities was designed to persuade lenders to modify payments and other terms on distressed mortgages or refinance “underwater” mortgages (loans that exceed the market value of properties) rather than aggressively pursue foreclosure. This lowered the number of repossessions, the sale of which might further depress housing prices.

In addition, Congress granted temporary tax subsidies for purchasers, which stimulated housing demand and slowed the decline in home values in 2009 and 2010. To help with mortgage finance, Congress doubled the large limit of loans that FHA will cover. Because FHA loans require minimal down payments, the agency’s proportion of new bond mortgages increased from less than 10% to more than 40%.

After lowering simple interest rates to 0 percent by early 2009, the Federal Reserve took additional efforts to cut lengthier interest rates and encourage economic growth (Bernanke 2012). This included purchasing huge amounts of long-term Treasury bonds and mortgage-backed securities, which were used to support prime mortgages. To further cut interest rates and boost confidence in the economy, the Federal Reserve committed to acquiring long-term assets until the labor market recovered significantly and to maintaining short-term interest rates low until unemployment levels fell, as long as inflation stayed low (Bernanke 2013; Yellen 2013).

These and other housing policy efforts, along with a decreased backlog of unsold properties following years of minimal new development, contributed to housing market stabilization by 2012. (Duca 2014). Around that time, global house prices and home building began to rise, home construction began to rise from its downtrend, and foreclosure rates began to decline from recession highs. By mid-2013, the percentage of properties in foreclosure had fallen to pre-recession levels, indicating that the long-awaited rebound in property activity was well begun.

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