Bill D'AlessandroEntrepreneurship, Investing, Technology

Overview of the Subprime Mortgage Crisis

The effects of the subprime mortgage crisis are all over the news – foreclosures are up, the stock market is down, investment banks are failing, and politicians are making empty promises to fix the problem.

But how did we get here? Why are people defaulting on their mortgage payments? And what effect does this have on the markets and economy?

The explanation begins with a description of a special kind of loan employed by many homeowners with less than perfect credit, or those that may be borrowing more than they can afford – an adjustable rate mortgage (ARM). These mortgages often come with a low introductory “teaser rate” that makes the loan seem cheap. However, after a certain period of time, the loan’s interest rate “resets” to a much higher rate (often higher than the borrower can afford to pay).

So why would a borrower agree to an adjustable rate mortgage, knowing that the higher rate is more than they are able to afford? Many times, these loans are made to people with poor credit, and are the only kind of loan they can get. They’ll often take a short-term view and sign the loan, hoping to be able to refinance before the higher interest rate takes effect.

Another major contributing factor has been the United States housing bubble. In 2005, home prices were higher than they’d ever been, and seemed to have nowhere to go but up, having experienced price appreciation of 10% or more in each of the previous 4 years. Real estate was the hot, “sure thing” investment. Home buyers had no problem signing an ARM, because they assumed that as the price of their home continued to rise, they could either refinance or flip the house before the higher interest rates kicked in.

Just one problem – bubbles burst. By 2006, housing prices had peaked. Throughout the year, they corrected downward, and by the end of the year, had experienced double digit declines in some markets.

By this time, all those ARMs signed in 2005 are beginning to “reset” to much higher interest rates – often more than doubling peoples monthly payments. Faced with payments far too high for their budgets, people normally would sell the house and “buyout” the mortgage with the proceeds. However, real estate prices are substantially lower than they were in 2005 – meaning that selling the home would not net nearly enough to cover the amount of the mortgage it was purchased with (at inflated 2005 prices). So, unable to meet their monthly payments, and unable to sell their homes for enough to buyout their mortgages, this leaves the homeowners only one option – default.

Down ArrowWhen homeowners default on their loans, banks do the only thing they can to recover their money – seize the property pledged as collateral (the home). However, this does not solve the problem. Now the bank is stuck with a home that is a.) very illiquid, and b.) still not worth enough to cover the amount of the loan. So, the bank does the only thing it can – sells the house at auction, usually for a price far lower than what it is worth, in order to recover some of its money. This has the side effect of increasing the supply of houses on the market, which further depresses home prices, creating a vicious cycle.

Though banks have lost millions of dollars in the above manner, it pales in comparison to the billions lost in mortgage backed securities. What is a mortgage backed security? Once a bank has made thousands of mortgage loans, they often package up all the loans together and sell them to investors as bonds. Initially, everyone on Wall Street thought that these bonds were very safe investments (AAA rated, the highest possible) with very little risk of default. After all, home prices were on the rise, and the banks could always seize the valuable real estate collateral if people defaulted. Investors bought these mortgage backed securities by the billions of dollars. Soon however, the forces detailed above began to take effect. Real estate prices began to fall, and homeowners began to default in larger than expected numbers. Quickly, these mortgage backed securities didn’t look quite so safe any more.

As uncertainty about borrowers ability to repay spread across Wall Street, ratings agencies began to downgrade groups of mortgage backed securities (to AA or even lower) – officially indicating that they were now perceived as more risky by the investment community. On Wall Street, when all other things are unchanged, a safe investment is preferred to a risky one. Thus, the newly downgraded mortgage bonds suddenly fetched much less on the open market. Overnight, a bank that thought it was holding $100 billion in safe assets found that those same assets could only be sold for $75 billion – if they could find a buyer at all. As fears spread about just how risky these mortgage bonds might actually be, no investors wanted to touch them until the risks became clear. Because of this, the market for mortgage bonds dried up rapidly, casting the true value of the bonds into even further doubt – after all, if you can’t find a buyer for something, is it really worth anything at all?

So, in summary:

  • The real estate bubble is bursting
  • Homeowners across the country are stuck with mortgages they cannot afford
  • Many are losing their homes as they cannot make their payments
  • Banks have lost billions of dollars through defaults and writedowns on mortgage backed securities

I hope I’ve done a decent job of laying out the reasons behind the current crisis, as well as explaining to the uninitiated how they interacted to cause a large amount of pain for homeowners, mortgage lenders, and investors. Next time, I’ll stray from the purely objective and give my opinions on the predicament of homeowners (they’re getting what they deserve), as well as my thoughts on the proposed “bailout” plans by the leading presidential candidates (unfair, economically unsound, and socialist). Stay tuned.

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Bill D'Alessandro