The Fuel That Fed the Subprime Meltdown

The financial crisis of 2007 and 2008 centered on the U.S. housing market, where fallout from the frozen subprime mortgage market spilled over into the credit markets, as well as domestic and global stock markets.

During this meltdown, dozens of mortgage lenders declared bankruptcy in a matter of weeks. The market was filled with concerns about a major global credit crunch, which affected all classes of borrowers. Central banks used emergency clauses to inject liquidity into scared financial markets. The real estate markets plummeted after years of record highs. Foreclosure rates doubled year-over-year during the latter half of 2006 and in 2007.

This article looks at some of the issues that led to the crisis and what it meant for the global economy.

The Path to a Crisis

Was this the case of one group or one company falling asleep at the wheel? Or was it the result of too little oversight, too much greed, or simply not enough understanding? As is often the case when financial markets go awry, the answer was likely: all the above.

Remember, the market was a byproduct of what it was six years before that. Rewind back to late 2001, when fear of global terror attacks after September 11 roiled an already-struggling economy, one that was just coming out of the recession that was induced by the tech bubble of the late 1990s.

In response, during 2001, the Federal Reserve began cutting rates dramatically, and the fed funds rate arrived at 1% in 2003. The goal of a low federal funds rate is to expand the money supply and encourage borrowing, which should spur spending and investing. Spending was encouraged as a way to help spur the economy. It worked, and the economy began to steadily expand in 2002.

Real Estate Begins to Look Attractive

As lower interest rates worked their way into the economy, the real estate market began to work itself into a frenzy as the number of homes sold increased dramatically starting in 2002, along with the prices at which they sold.

At the time, the rate on a 30-year fixed-rate mortgage was at the lowest level seen in nearly 40 years. Eager individuals saw a unique opportunity to gain access to just about the cheapest source of equity available. This was especially true for first-time homebuyers who wanted a place to truly call their own.

Investment Banks and the Asset-Backed Security

If the housing market was only dealt a decent hand (one with low interest rates and rising demand), any problems would have been fairly contained. Unfortunately, it was dealt a fantastic hand, thanks to the new financial product that was spun on Wall Street: the mortgage-backed security (MBS).

Just like a bond, home loans were purchased from the issuing banks and packaged into a single investment product before being sold to investors. They became so popular that they were spread far and wide, being included in pension funds, hedge funds, and international governments. But, as we saw post-crisis, the investments were only as sound as the mortgages that backed them up. So when mortgagors defaulted, these assets became more worthless.

A Simple Idea Leads to Big Problems

The asset-backed security (ABS) wasn't a new idea. in fact, it was around for decades. A simple investment principle lies at its core:

• Take a bunch of assets with predictable and similar cash flows (like an individual's home mortgage)
• Bundle them into a managed package that collects all of the individual payments (the mortgage payments)
• Use the money to pay investors a coupon on the managed package

This creates an ABS for which the underlying real estate acts as collateral.

Another big plus was that credit rating agencies such as Moody's and Standard & Poor's put their AAA or A+ stamp of approval on many of these securities, signaling their relative safety as an investment. So what does the investor get? They can acquire a diversified portfolio of fixed-income assets that arrive as one coupon payment.

The Government National Mortgage Association (Ginnie Mae) bundled and sold securitized mortgages as ABSs for years. In fact, its AAA ratings had the guarantee that the organization's government backing afforded. Investors gained a higher yield than on Treasuries, and Ginnie Mae used the funding to offer new mortgages.

Widening the Margins

Thanks to an exploding real estate market, an updated form of the ABS was also created, only these ABSs were being stuffed with subprime mortgage loans or loans to buyers with less-than-stellar credit.

Along with their much higher default risks, subprime loans were placed into different risk classes or tranches, each of which came with its own repayment schedule:

• Upper tranches were able to receive AAA ratings—even if they contained subprime loans—because these tranches were promised the first dollars that came into the security
• Lower tranches carried higher coupon rates to compensate for the increased default risk.
• The equity tranche, which was all the way at the bottom, was a highly speculative investment, as it could have its cash flows essentially wiped out if the default rate on the entire ABS crept above a low level, generally in the range of 5% to 7%

Even subprime mortgage lenders had an avenue to sell their risky debt. This enabled them to market this debt even more aggressively. Wall Street picked up their subprime loans, packaged them with others (some quality, some not), and sold them off to investors. The majority of these bundled securities magically became investment grade (A-rated or higher), thanks to the rating agencies, which earned lucrative fees for their work in rating the ABSs.

As a result of this activity, it became very profitable to originate mortgages—even risky ones. It wasn't long before even basic requirements like a down payment and proof of income were being overlooked by mortgage lenders. In fact, mortgages with 125% loan-to-value (LTV) were underwritten and given to prospective homeowners. The logic was that with rising real estate prices (median home prices were rising as much as 14% annually by 2005), a mortgage like this would be above water in less than two years.

Leverage Squared

The reinforcing loop was starting to spin too quickly, but with Wall Street, Main Street, and everyone in between profiting from the ride, who was going to put on the brakes?

Record-low interest rates combined with ever-loosening lending standards. This pushed real estate prices to record highs across most of the United States. Existing homeowners refinanced in record numbers, tapping into recently earned equity that could be had with a few hundred dollars spent on a home appraisal.

Meanwhile, thanks to market liquidity, investment banks and other large investors borrowed more, which increased leverage, to create additional investment products. This included shaky subprime assets.

Collateralized Debt Joins the Fray

The ability to borrow more prompted banks and other large investors to create collateralized debt obligations (CDOs), which essentially scooped up equity and mezzanine (medium-to-low rated) tranches from MBSs and repackaged them yet again, this time into mezzanine CDOs.

By using the same trickle-down payment scheme, most of the mezzanine CDOs could garner an AAA credit rating, landing them in the hands of hedge funds, pension funds, commercial banks, and other institutional investors.

Residential mortgage-backed securities (RMBSs), in which cash flows come from residential debt, and CDOs were effectively removing the lines of communication between the borrower and the original lender. Large investors suddenly controlled the collateral. As a result, negotiations over late mortgage payments were bypassed for the direct-to-foreclosure model of an investor looking to cut their losses.

However, these factors would not have caused the current crisis if:

1. The real estate market continued to boom.
2. Homeowners could actually pay their mortgages.

However, because this did not occur, these factors only helped to fuel the number of foreclosures later on.

Teaser Rates and the ARM

With mortgage lenders exporting much of the risk in subprime lending out the door to investors, they were free to come up with interesting strategies to originate loans with their freed-up capital. Borrowers could be enticed into an initially affordable mortgage in which payments would skyrocket in three, five, or seven years with teaser rates (special low rates that would last for the first year or two of a mortgage) within adjustable-rate mortgages (ARMs).

As the real estate market pushed to its peaks in 2005 and 2006, teaser rates, ARMs, and interest-only loans were increasingly pushed upon homeowners. Fewer borrowers questioned the terms and were enticed by the prospect of refinancing within a few years (at a huge profit, the argument stated), enabling them to make whatever catch-up payments necessary. What borrowers didn't account for in the booming housing market was that any home value decrease would leave the borrower with an untenable combination of a balloon payment and a much higher mortgage payment.

A market as close to home as real estate becomes impossible to ignore when it's firing on all cylinders. Over the space of five years, home prices in many areas literally doubled, and just about anyone who didn't buy or refinance a home considered themselves behind in the race to make money in that market. Mortgage lenders knew this and made an even more aggressive push. New homes couldn't be built fast enough and homebuilders' stocks soared.

The CDO market, which was mainly secured with subprime debt, ballooned to more than $600 billion in issuance during 2006 alone. That was more than 10-times the amount issued just a decade earlier. Although illiquid, these securities were eagerly picked up in the secondary markets, which happily parked them into large institutional funds at their market-beating interest rates.

Cracks Begin to Appear

Cracks began to appear by mid-2006. New home sales stalled and median sale prices halted their climb. While still historically low, interest rates were on the rise, with inflation fears threatening to raise them higher. All of the easy-to-underwrite mortgages and refinances had already been done, and the first of the shaky ARMs, written 12 to 24 months earlier, were beginning to reset.

Default rates began to rise sharply. Suddenly, the CDO didn't look so attractive to investors in search of yield. After all, many of the CDOs had been re-packaged so many times that it was difficult to tell how much subprime exposure was actually in them.

The Crunch of Easy Credit

It wasn't long before the news went from boardroom discussions to major news. Scores of mortgage lenders (with no more eager secondary markets or investment banks to sell their loans into) were cut off from what became the main funding source, forcing them to shut down operations. As a result, CDOs went from illiquid to unmarketable.

In the face of all this financial uncertainty, investors became much more risk-averse and looked to unwind positions in potentially hazardous MBSs, and any fixed-income security not paying a proper risk premium for the perceived level of risk. Investors were casting their votes en masse that subprime risks were not ones worth taking.

Amid this flight to quality, three-month Treasury bills became the new must-have fixed-income product and yields fell a shocking 1.5% in a matter of days. Even more notable than the buying of government-backed bonds (and short-term ones at that) was the spread between similar-term corporate bonds and T-bills, which widened from about 35 basis points to more than 120 basis points in less than a week.

These changes may seem minimal or undamaging to the untrained eye, but in the modern fixed-income markets (where leverage is king and cheap credit is only the current jester), a move of that magnitude has the potential for major damage. This was illustrated by the collapse of several hedge funds.

Many institutional funds were faced with margin and collateral calls from nervous banks, which forced them to sell other assets, such as stocks and bonds, to raise cash. The increased selling pressure took hold of the stock markets, as major equity averages worldwide were hit with sharp declines in a matter of weeks, which effectively stalled the strong market that had taken the Dow Jones Industrial Average (DJIA) to all-time highs in July of 2007.

To help stem the impact of the crunch, the central banks of the U.S., Japan, and Europe helped banks with their liquidity issues and helped to stabilize the financial markets through cash injections of several hundred billion dollars. The Federal Reserve also cut the discount window rate, which made it cheaper for financial institutions to borrow funds from the Fed, add liquidity to their operations, and help struggling assets. All of this helped stabilize the market to some degree.

The Bottom Line

There is nothing inherently wrong or bad about CDOs or other similar vehicles, which can diversify risk and open up capital markets. But a misused or overcooked strategy could lead to disaster. After the 2008 crisis, financial reforms were put in place to tighten up the mortgage market in order to mitigate the risk of another meltdown. These included:

• Tighter lending restrictions
• Ensuring banks pass stress tests
• Prohibiting institutions from making risky investments

Although the Fed's move to raise rates to cool down the economy following the COVID-19 pandemic could slow down the housing market, the economy is better equipped to handle higher lending volumes because mortgages aren't advanced using subprime tactics as they were in the past.