What caused the subprime mortgage crisis?

Question by Matty B: What caused the subprime mortgage crisis?
What caused house prices to drop? Thus causing the subprime mortgage crisis?

Best answer:

Answer by fotofarie
banks were willing to write loans for higher amounts to people who they knew would have a hard time paying them off because they could turn around and sell the loan to another party. there was a lack of ‘personal responsibility’ on the part of the banks.
the real estate market could reflect this in the rise of housing prices because of supply and demand. soon, the housing prices became inflated, not representing the ‘actual cost of the house’, loans were made on the inflated amount and when one tried to sell at what they thought was the house value they came up surprisingly short.
so the short answer would be GREED.

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4 Comments → “What caused the subprime mortgage crisis?”

  1. stfukthx2003

    Mar 08, 2014

    Subprime mortgage crisis was caused through the investment banks selling securities called Collateralized Debt Obligations (CDO’s), which are basically debt arrangements with the collateral being pools of mortgages with similar terms (ie thousands of let’s say 25-year mortgages for example). Hedge funds, pension funds, banks or small institutions buy these CDO’s and collect upon the payments made by the homeowners. Now the value of these securities is similar to that of a bond; it’s derived from the interest payments (which are higher because of the risky nature of subprimes). If the homeowners default, there is no value. To further complicate things, these CDO’s are known as “Level 3 assets” which are basically securities which are not publicly traded so you really just don’t know what they’re worth. For a given stock or bond, there’s always the open market to determine the price. That’s why it’s taking so long for the banks to slowly come out with the news of their write-downs and it’s impacting institutions globally. Even Chinese banks are taking hits because they purchased these CDO’s, which are now suddenly worthless.

    So a few banks are taking losses, where’s the crisis? Banks by nature don’t have too much liquid assets lying around, it’s all the money of depositors. If the depositors feel insecure about the bank’s health, they will pull out and exacerbate the issue even more, ala E-trades and Bear Stearns. If we go back to basic economics, there is a banking multiplier, so for every dollar deposited, there’s a multiplier which increases the money circulating in the economy: in actuality the full amount is not actually there to sustain a full withdrawal. Thus there’s the crisis. Small banks can go under, big banks take massive hits, and the US financial system as a whole loses investor confidence, and that’s really all we run on. Confidence.

  2. george w

    Mar 08, 2014

    Greedy Lenders and mindless home buyers who lied their way into debt they could not pay back.

  3. blah

    Mar 08, 2014

    banks lent out money to people who previously could not afford a mortgage, these people took the chance. Sub prime mortagage is simply low interest rates in the beginning, than they jack it up later on. So now these people are un able to pay the interest. Furthermore, housing prices declined, the mortgage is now greater than the value of their house, so they mail the keys to the bank, since there is no point in paying for something which is lower value. The banks used the sub prime mortgage interest revenues to invest in securities, bonds, etc. So now the people who bought these sell them back to the bank due to the fear of the bank not being able to cash out. There are so many houses on the market for sale. When supply exceeds demand, prices fall.

  4. TruthMastaT

    Mar 08, 2014

    Those who study mortgage trends have said that there has been a pretty consistent pattern of a “bust” in mortgages about every 18 years since World War II. We’ve seen problems like this before and we will survive this “crisis.” If you’re looking for a mortgage right now, rates are still very good. The world is not ending (as the politicians who are itching to “help” would have us believe).

    Now to your question… In summary, EVERYONE involved played a part in the mortgage crisis to some extent or another.

    BORROWERS — Rather than living within their means, many borrowers decided that they wanted to have a bigger, more expensive house than they could afford. In order to afford these houses, they often turned to loan products such as “Interest Only” loans. With IO loans, you basically pay the minimum amount possible every month and the principal is never reduced. To complicate matters, some loans featured “zero down” where the borrower had absolutely NO equity in the property. Here is an illustration of a typical problem: A property is worth $ 800,000 at the time of purchase. The borrower takes out an Interest Only loan for $ 800,000 (putting nothing down). Then the property value drops to $ 700,000. Now the borrower has a loan for $ 800,000 for a property that is only worth $ 700,000. The borrower has ZERO equity in the property so guess what… they walk away from the property and the lender ends up taking the loss.

    MORTGAGE COMPANIES (BAD OR POOR UNDERWRITING GUIDELINES) — In an effort to make as many loans as possible (and to sell these loans to foolishly eager investors), many mortgage companies relaxed their guidelines beyond reason. Some loans had a Loan-to-Value (LTV) ratio of 100 (or higher on rare occasion!). If the property was worth $ 100,000, then an LTV meant that $ 100,000 was loaned to the borrower (as stated before, no equity). The lower the LTV, the less risky (and more desirable) the loan is. Another arguably stupid mortgage product was the “80-20” loan. A loan with an LTV of 80 or lower is not considered risky in the mortgage business. Therefore, Mortgage Insurance (MI) is not required for loans with an LTV of 80% or less. (If a borrower has an LTV of 85 and pays it down to 80, then they can drop the MI from the loan.) MI is basically insurance against borrower default. For example, if a borrower defaults on his loan and the lender forecloses and sells the property and loses $ 2000 in the process, then the MI company will cut a check to the lender for $ 2000 to make the lender “whole.” Rather than requiring borrowers to carry MI on their loans (which would have mitigated risk), the mortgage companies allowed the borrowers to take out a second loan on the same property (a “second lien” or Home Equity Line of Credit or HELOC). This HELOC money was then used as the “money down” on the first loan so that MI could be avoided. For example, if the property is worth $ 100,000, the borrower might get a HELOC for $ 20,000 and put that money down on the first loan, thereby lowering the LTV to 80 (thereby exempting them from MI). Another popular loan was an Adjustable Rate Mortgage (ARM) or “Fixed-Adjustable” (where the Interest Rate is fixed for a few years and then starts to adjust (up or down) based on a financial instrument). Borrowers were allegedly given a low “teaser rate” and then (because they bought too much house) couldn’t make the payments with the higher interest rate when the rate adjusted. (It seems hard for me to believe that an interest rate adjustment would be so severe that it would prevent someone from making their payments, but that’s what the borrowers allegedly claim.) Maybe this is too many detailed examples, but suffice it to say that a lot of stupid mortgage products were offered by mortgage companies (and accepted by borrowers).

    INVESTORS — In their quest to make a “fast buck”, investors bought up tons of these mortgages since these riskier “sub-prime” loans brought higher returns (higher interest rates). These investors should have performed a “due diligence” on the loans they bought; but they didn’t. When investors purchase loans, there is usually (if not always) a “buyback” provision. This means that if a loan goes bad and the investor finds that there was some irregularity in the underwriting (the loan decisioning process) that the mortgage company who sold them the loan is required to “buy back” the loan. The problem is that most mortgage companies are “cash poor” (meaning that they borrow the cash that they lend from a “warehouse lender” temporarily until they can sell the loan to an investor and pay back their warehouse lender). So when these loans started going bad (hundreds of millions of dollars worth!), the investors demanded the mortgage companies buy back the loans (according to their agreement). So mortgage companies were now looking at buying millions and millions of dollars worth of loans back when they had little or no money of their own! So what happened? Countless mortgage companies declared bankruptcy. With all of the hullaballoo around bad mortgages, investors decided to stop buying sub-prime mortgages. Since there was nobody buying these mortgages and since mortgage companies don’t have their own cash, mortgage companies found that they could no longer make these sub-prime loans. The sub-prime market dried up almost instantly.

    RATING AGENCIES — The job of rating agencies is to investigate the creditworthiness of investments (many of which included mortgage debt). These agencies did not do their due diligence and ended up giving these investments an artificially high rating. So investors thought the investments were less risky than they were. Investors will always buy investments that have a high return and low risk (but obviously they weren’t low risk).

    THE GOVERNMENT — The government has always put pressure on mortgage companies to make loans to poor and/or minority borrowers. Because these borrowers typically have worse credit and/or less income and/or greater debt, they had to go to the “sub-prime” market to get a mortgage loan. Is it so hard to imagine that a borrower with less income, more debt and bad payment habits will default on a loan (especially when they’ve put little or no money down)? Of course not. But the government continues to “wish away” laws of basic economics and common sense. In order to “do right” by poor people and minorities, the government expected mortgage companies suspend their normal sound underwriting guidelines and business sense. (Obviously, the sub-prime problem goes beyond just poor borrowers, but my point is that the government contributed to the crisis to some extent.) The government is now poised and ready to exacerbate the crisis beyond what it is now by “freezing” interest rate adjustments. Here is an illustration of the problem: Let’s say you have $ 5000 in cash. I’m a bank and I tell you that if you deposit your $ 5000 with me that I will pay you 1% during the first 2 years but then I will pay you 7% after those 2 years. So you deposit your money at the low rate of interest. After two years (when you’re about to get your higher interest rate), the government comes in and says, “Sorry. You’re not getting your 7% as promised. In fact, you can’t take your money out of that bank; you must leave it there and only collect 1% for another 10 years.” What will happen when you have another $ 5000 to deposit? Will you put it in my bank? Absolutely not. Why? Because you don’t know if you’ll really get the return you agreed upon. In the same way, if the government steps in and says to the investor/lender, “Sorry… you’re not getting the return on your money that you negotiated… and you can’t take back your money; you’ve got to leave it at the low rate,” then guess what the investor is going to do. He will never invest in mortgages again! He will take his money to China or municipal bonds or any other vehicle in which he can get a RELIABLE return on his money. If he DOES decide to put money into mortgage debt again, he will demand a higher return to compensate for the greater risk that the government will step in and “help” again. (In other words, Interest Rates on mortgages will go up for EVERYONE!) Thank you Big Government Democrats and George Bush!

    REGIONAL PROBLEMS — Some regions in the USA had events that made the mortgage problems particularly bad. For example, inflated property values in California started deflating. Condos in Florida didn’t sell as thought and many sit vacant. Companies providing jobs in the “rust belt” (such as Michigan) have moved or gone under; thereby leaving the local homeowners with no income with which to make their mortgage payments.

    Sorry for such a long answer. Hope it all makes sense.


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