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Economics For Beginners: The Subprime Mortgage Crisis

Updated on April 27, 2015

The Great Recession

If you ask 100 people about the Great Recession, you’ll likely get 100 different reasons for what caused it, and why, despite billions in stimulus spending, it’s still lingering. Depending on who you ask, everything from the wars in Iraq and Afghanistan, to the election of Barack Obama, to the wrath of God (seriously, you can't make this stuff up) is to blame.

In this article, we’re going to cover one of the real culprits behind the economic collapse and, how it led to a financial meltdown that we still haven't recovered from. Hopefully, by shedding some light on what actually caused the Great Recession, we can avoid making the same mistakes ever again.

To Get You In A '90s Kind Of Mood

Setting The Stage

To find out what happened, we need to go back a few years… actually quite a few years. We have to go all the way back to the 1990s. That’s right, the same decade that brought us grunge rock and 90210 also brought us an explosion in something called “Subprime Lending”. Basically, subprime lending boils down to loaning money to someone who will have a hard time paying it back.

So why would any bank ever loan money to someone that they knew probably couldn’t afford to repay it? Good question. The answer is, because the Government told them to. Now before you freak out, take a deep breath and relax: the Government actually meant well.

See, a long time ago, banks would set up branches in poor neighborhoods in order to take deposits, but they wouldn't actually lend any money to the people in those neighborhoods. In the late '70s, Congress stepped in and passed a new law called the Community Reinvestment Act (CRA), this law required banks to loan a certain percentage of the money they collected in a community back into that community. Enter President Clinton.

When President Clinton was in office, he wanted to increase home ownership and prosperity for people who, up till that point, hadn’t been able to afford to buy houses or start businesses, so President Clinton pushed for an expansion of the CRA. He thought that, if you could help people buy their own homes and create businesses in those neighborhoods, it would lead to more people achieving the “American Dream”, and he was right… for a little while.

President Clinton Talks About Subprime Lending

The Bubble

With the Government’s focus on home ownership, they started mandating that banks make homes more affordable. While a good idea in theory, they forgot one little detail… banks don’t control the price of homes, the owners selling them do. So since banks couldn’t control the prices of homes (which had been increasing every year), the only other option they had was to make buying those houses easier. How did they do that? They did it by selling “cheap” mortgages, and subprime lending.

Now I know I may have lost some of you there, so let me give you a practical example:

Meet Bob. Bob wants to sell his house. He’s retired now, and he wants to move to Florida and spend his days fishing and golfing. So Bob puts up a “For Sale” sign and waits.

Now, meet Sally. Sally is young, only 25. She’s only been working for a few years, and doesn’t make very much money yet, but she wants to buy Bob’s house.

So Sally talks to Bob, and they agree on a price of $200,000 for the house.

Now Sally doesn’t actually have $200,000. Sally doesn’t have any money saved up, and with student loans, she’s already pretty deep in debt. But Sally really wants to buy Bob’s house, so she goes to the bank to get a loan for the money. This loan is called a Mortgage.

Now normally, to qualify for a mortgage, Sally would have to put up part of the money herself; this is called a Down Payment. Traditionally, the down payment would be anywhere from 10 – 20% of the amount needed; in this case $20,000 - $40,000. However, Sally doesn’t have $20,000 in fact she doesn’t have any money to spend on the down payment.

The Government really wants Sally to be able to buy a home though. They think that everyone who wants a house should be able to buy one. So the Government tells the banks that they need to make mortgages more affordable for people like Sally, even though, they really can’t afford it.

So even though Sally doesn’t qualify for the loan: she has no money to put down, very little income, and no other collateral to offer, the bank tells Sally that she can have the loan with no down payment. This is called a Subprime loan. Sally buys Bob’s house, and everything works out great… for a little while.

This is an example of what happened; only it happened with millions of people. People who couldn’t afford to buy a house were suddenly given access to cheap credit, which lead to an increase in home sales.

Source: Philip Taylor PT, CC: BY, via Flickr
Source: Philip Taylor PT, CC: BY, via Flickr

“Objection: That’s Pure Speculation”

When the banks started offering cheap credit, and lots of people started buying houses, the price of those houses started to skyrocket. It’s called Supply and Demand, and it’s the most basic economic principal there is: when demand increases for an object, the price of that object goes up as well.

With the increase in the value of homes, two things happened: people started building more homes to keep up with demand, and more and more people started buying homes as investments. These two factors played a key part in the disaster.

First, let’s look at the people who bought homes as an investment. They used that same cheap credit (that was designed to help people like Sally), to buy homes and then them sell for a profit. This further increased the demand, and like we just learned, when demand goes up, so do prices.

This worked to make two problems even worse:

First there were the people like Sally, who were looking to buy a house to live in. Because of the rising home prices, they were forced to take out huge mortgages.

Then there were the investors. When people saw how much money was being made in Real Estate Speculation, more and more people decided to get in on the game and try to make a fortune.

Source: JefferyTurner, CC: BY, via Flickr
Source: JefferyTurner, CC: BY, via Flickr

The Burst

I’m sure some of you can already see where this is going, but let’s go back to our example and check on Sally.

Things weren’t looking good for Sally. She still wasn’t making much money, and between her student loan payments, car payments, and living expenses, she just couldn’t afford to keep making her mortgage payments.

Eventually, the bank foreclosed and Sally lost her home.

Now while this is sad for Sally, remember: she wasn’t the only one who bought a house she couldn’t afford. There were millions of people who took advantage of the cheap credit offered by the banks. Now, as those people stated defaulting, the banks started foreclosing and putting those homes back up for sale. We learned earlier about Supply and Demand, and how when demand increases, so do prices. Now it’s time to learn about the other part of that equation: supply.

With all of these foreclosed homes flooding the market, there was a huge increase in supply. So suddenly, there more homes available than there were buyers and whenever supply exceeds demand, prices fall. Just wait… it gets worse.

Remember those investors we talked about? Well when housing prices started plummeting, not only did they not make any money on their investment, but now they were suddenly stuck with those investment properties (and the mortgages on them), with no way to get rid of them.

Then there were the people who bought homes when the prices were high. Because of the collapsing market, their homes were worth less and less; sometimes hundreds of thousands of dollars less than what they owed on them. A lot of people simply decided to walk away and stop paying for their houses, because of this. This added even more homes to an already flooded marketplace and, you guessed it, caused home prices to fall even more.

The Aftermath

When the housing market collapsed, so did the construction companies that were building all of those new homes. When the construction companies collapsed, so did their suppliers. There was a domino effect throughout several sectors of the economy, one that we’re still trying to recover from.

Home ownership is great, for those who can actually afford it, but as we’ve seen time and time again, politics doesn’t always care about economic reality. So did we actually learn our lesson from the Subprime Mortgage Crisis? We can only hope, however, as Shakespeare said: “what’s past is prologue”.

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  • profile image

    Howard Schneider 3 years ago from Parsippany, New Jersey

    Excellent analysis, Shawn. I would also add that mortgages were bought up by banks and packaged into securities. Many of the bad mortgages were packaged together. The bond rating agencies failed to examine any of these properly. All of them were automatically rated AAA because they were being paid fees by these banks and did not do their own research. I wrote a Hub on the financial meltdown. Everyone across the spectrum got greedy and no due diligence was done.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @HSchneider, thanks for taking the time to read my article, I'm glad you enjoyed it. =)

    Yeah, I didn't want to get into CDO's and MBS in the beginners version, but they definitely made a bad situation worse. If you'd like, send my the link to your Hub and I'll add it to this one. I think it'd be valuable for people who want to learn more about the topic.

  • Jed Fisher profile image

    Jed Fisher 3 years ago from Oklahoma

    Nailed it!

    A bubble not unlike Beanie Babies and Pound Puppies and Tickle me Elmos.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @Jed Fisher Thanks, I'm glad you liked the article =)

    For me it was comic books and baseball cards. Although, the whole Steroid Era sorta killed my McGwire & Bonds rookie cards. lol.

  • CHRIS57 profile image

    CHRIS57 3 years ago from Northern Germany

    Nice hub and subprime explanation, but are you sure things started with Bob and Sally and some administration in the 90ties?

    I suspect it all started in the 70ties. At that time the US economy began to live beyond its means. It became a cultural thing to live on credit, to max out credit cards, to have consumer loans to finance your car, no matter if it was and is private household, corporate business or the public hand.

    By the early 90ties, matters got out of control. Large trade deficits started to pile up. At that time it came in very convenient to have a money out of thin air producer called the dot.com business. We all know what happened with the dot.com bubble. It burst, but systemic problems still existed and became larger.

    At that point, i am not sure it was a humanitarian step of Bill Clinton to

    increase home ownership. I think it was sheer necessity to find some way of distributing debt among people. And from here on you step in with your hub :-).

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @CHRIS57, Thanks for taking the time to read my article =)

    There were definitely some large economic problems in the '70s, but this article focused specifically on the Subprime Mortgage Crisis, which is a direct result of the increased focus on the CRA by President Clinton back in the early '90s.

  • Majidsiko profile image

    Majidsiko 3 years ago from Kenya

    Thanks for the hub. I live in Africa where very few countries have banks that give mortgages, so people spend years looking for cheap land and building their houses for years, but i guess in the next 30 or so years it may pay off. So what's the way forward?

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @Majidsiko I'm glad you liked the article =)

    Building yourself is always a great option if you have the skills to do so. There are a lot of emerging markets in Africa, depending on what part you're in.

  • Hackslap profile image

    Harry 3 years ago from Sydney, Australia

    This is an excellent article! .. add this to the fact that banks repackaged the debt obligations into tradable securities (knowing they're worthless) and securitized the risk .... it wasn't really a question of if the bubble would burst ..it was 'when'..

  • thumbi7 profile image

    JR Krishna 3 years ago from India

    Very informative article. Voted up

  • peoplepower73 profile image

    Mike Russo 3 years ago from Placentia California

    If this is just a primer for the meltdown it's good. However, to truly understand the root cause of the financial meltdown, you have to get into the way back machine and go all the way back to 1933 when the Glass-Stegall Act was put in place. One of the biggest factors that caused the great depression of 1929 was that investment companies and deposit banks had merged their operations. Glass-Stegall created a firewall between the two.

    The banks had been trying for many years to get it repealed and congress, little by little chipped away at the act. In 1999, under Clinton, what was left of the act was finally repealed by the Gramm-Leach-Bliley act. Now the firewall was completely removed. This allowed all kinds of exotic investments by banks and investments companies to take place, like in 1929. The details are far too much to but into this comment, but I wrote a hub on it. Congratulations for getting hub of the day. Voting up, useful, and sharing.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @Hackslap Thanks for taking the time to read the article =)

    That's all going to be in the article I'm writing now on the "Great Recession", but it was important to get this one out first, since the Subprime Mortgage Crisis was the "straw that broke the camel's back".

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @peoplepower73 I'm glad you liked the article =)

    Glass-Stegall was definitely the gasoline on the fire, and it made a bad situation much, much worse. I'm going to be going into that one much deeper in the article I'm writing on the Great Recession. I had to get this article out first, since the the Housing Bubble and the Subprime Mortgage Crisis were the vehicles we used to get to the recession.

  • cynthtggt profile image

    cynthtggt 3 years ago from New York, NY

    Yes, the rating agencies have yet to be held accountable in my opinion.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @cynthtggt, Thanks for stopping by. =)

    There is certainly plenty of blame to go around; the most important thing is to get the safeguards back up so that this can't happen again.

  • Thelma Alberts profile image

    Thelma Alberts 3 years ago from Germany

    Congrats on the HOTD! Thanks for sharing this very useful and informative hub.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @Thelma Alberts Thank you very much, I'm glad you liked the article =)

  • rose-the planner profile image

    rose-the planner 3 years ago from Toronto, Ontario-Canada

    Congratulations on HOTD, well deserved! This was a very insightful and interesting article regarding the subprime mortgage crisis. Great perspective! Thank you for sharing. (Voted Up) -Rose

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @rose-the planner Thank you, I'm glad you liked the article =)

  • IslandBites profile image

    IslandBites 3 years ago from Puerto Rico

    Important information, great hub! Congrats!

  • billybuc profile image

    Bill Holland 3 years ago from Olympia, WA

    As an old economics major, I give you a thumbs up for this fine article. More importantly, as a former teacher of creative writing, I give you an A for a finely-written article. Well done and congrats on the HOTD.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @billybuc Thanks for taking the time to read the article, I'm glad you enjoyed it =)

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @IslandBites Thanks for stopping by, I'm glad you liked the article. =)

  • old albion profile image

    Graham Lee 3 years ago from Lancashire. England.

    Hi Shawn. Congratulations. An excellent hub. You have broken down the process into easily understandable sections. I have some experience in the finance field so I can appreciate the overall situation. We have exactly the same situation here in the UK. At the moment we have millions of people stuck in the 'Pay day loan' cycle. Things are indeed extremely difficult for so many of us. On both sides of the water.

    Voted up and all / following.

    Graham.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @old albion Thanks for taking the time to read my article, it's always nice to hear from our friends across the pond. =)

    Yeah, there is a lot of credit out there that's being marketed as "cheap credit" that people are getting caught up in. I'm not really one for trying to read the tea leaves, but if something doesn't change (and soon), we're heading for another depression.

  • Freeway Flyer profile image

    Paul Swendson 3 years ago

    Just a quick question and one simple point. First, can you please reference the piece(s) of legislation passed by the federal government that compelled financial institutions to start issuing subprime loans. (And don't just reference the Community Reinvestment Act. Explain how it forced financial institutions to issue bad loans.) And second, I don't know how you can even begin to talk about the mortgage crisis without talking about mortgage securities.

    One of the basic problems was that the brokers originating the loans did not really care if they were paid back. This is because they would sell these loans off to some type of big financial institution, which would then package a bunch of loans as securities and sell them off to investors. The investors, of course, did not really know what they were buying, partly because they were misled by rating agencies who assured everyone that these were safe investments.

    I don't think that the financial institutions were forced to do anything. They lobbied politicians and assured them that their practices were making homes more affordable for poor people. And the politicians were ignorant enough in general to believe it. Lenders actually preferred subprime loans. They generally had higher interest rates and had high prepayment penalties.

  • peoplepower73 profile image

    Mike Russo 3 years ago from Placentia California

    Freeway Flyer: There was one other key piece to sub-prime loans and that is variable interests rates. They would start out at a very low interest rate (below prime rate) that buyers could afford. After so many months, the loan would reset, to a much higher interest rate, that the buyers could no longer afford. This contributed to a huge foreclosure rate. But by bundling these loans into mortgage backed securities that were rated as AAA rating, the banks could mitigate the risk. They would then sell these packaged loans to investors and bet that they were going down the tubes...and nobody went to jail for fraud, instead, they received huge commissions that were paid for by tax payers money with the TARP bailout.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @Freeway Flyer, Thanks for taking the time to read my article. =)

    I'm going to approve your comment mostly because I want to respond to it here and hopefully prevent any confusion. This article is designed for people with no advanced economic training or education. My entire Economics For Beginners series is just that, for beginners. Your question deals with more advanced economic and political theory and intricacies, and this simply isn't the place for it; to put it another way, you're talking Calculus when I'm teaching simple addition and subtraction.

    In the interests of answering your question however, I will head to the forums to do so now. You can expect a response within the hour. Look for the following thread The CRA and Subprime Lending (or something to that effect based on availability).

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    Hiya peoplepower73,

    As I said in my reply to Freeway Flyer, this conversation is a little too advanced for a Beginners article, so we're moving this conversation to the forums. I invite you, and anyone else who's interested in, what I'm sure will be a captive and intriguing economic debate, to join us there.

  • peoplepower73 profile image

    Mike Russo 3 years ago from Placentia California

    Thanks Shawn, I just wanted to expand on Freeway Flyer's 2nd paragraph to give the readers just a little bit more understanding about the fraud that was perpetrated against the tax payers. But I will let you do that in your series. I look forward to the forum.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    Hiya peoplepower73,

    Here is the URL for the discussion thread if you're interested. =)

    http://hubpages.com/forum/topic/115697

  • stanfrommarietta profile image

    stanfrommarietta 3 years ago

    The only problem I have with your account of the sub-prime mortgage bubble is that you attribute its faults to just Clinton's encouraging lending institutions to loosen up a bit (against racial preferences and lend to groups who can afford it but are not getting loans because of their racial characteristics and the neighborhoods where they want to buy). Nothing in the subprime mortgages was implied by Clinton's position. He did not say lower your lending standards; just don't let race enter into your calculations.

    So, your essay sort of encourages the followers of faux news to blame the Great Recession on democrat Clinton's encouraging lending to blacks: "See what happened when you do that?" The assumption is that all blacks cannot afford home ownership unless you lower your lending standards. And that is false. Back then the economy had raised up a number of blacks who could afford moving up into home ownership. But they weren't getting consideration at the banks.

    None of this account that begins with Clinton's policy takes into account the collateralized debt obligations made by the inventive minds of devious bankers in which mortages from random sections of the country were diced up into little pieces and the pieces assigned at random to new securities to be sold to the gullible, with mixing poor loans with super ones, with the hope that every security is independent of every other one and further every mortgage from widely separated sectors of the economy is independent of every other one in its ability to repay the premiums. All of those assumptions turned out to be false. Once some of the people started to fail to meet their mortgage payments it reflected common faults in the economy at large. And so in any security it was not just one piece from a bad mortgage that started to fail; so did a whole group of them. And that eventually affected even the 'good' mortgages represented in the securities.

    Another element you don't mention were those who were buying homes with subprime loans only to sell them soon after because they were Ponzi buyers hoping to get rich on buying and selling homes, one right after another, because home prices were going up, and up, and up. But the prices eventually reached a level where the prices far outstripped their values or the ability for most buyers to buy safely. So, they would eventually reach a level of price where they couldn't sell their homes and they were now upside down in their mortgages and left holding the bag of their own creation. That's when the bubble burst. And the securitized mortgages were no longer owned by the original banks but by ... whom? Ownership presumably passed to the holders of the securities when the buyers of the securities bought them. But the sliced and diced mortgages were spread all over, and furthermore their titles were not properly registered. How do you claim ownership of just a piece of a mortgage along with numerous other security holders? So there were homeowners who were refusing to vacate their homes until the parties seeking to evict them came up with a clear title. There wasn't any. So home values plummeted. And the housing bubble burst.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 3 years ago from Orlando, FL.

    @stanfrommarietta Thank you for taking the time to read my article =)

    In deference to the time and thought you put into your comment, I'll respond to your concerns on a point-by-point basis. I will say first however that I've already had a great discussion with another Hubber on this topic, you can find it here: http://hubpages.com/forum/topic/115697

    P1. First, and I don't think you did it intentionally, you completely mischaracterized both the CRA and President Clinton's position. The CRA set lending standards based on economic factors, not racial demographics. While the intent of the law may have been to prevent racism in lending practices, the standards for CRA compliance were completely economic. President Clinton's push to expand the CRA, and the existing ambiguity in the way compliance was measured, led directly to banks selling loans that were almost certain to default.

    P2. Again, another mischaracterization, and given your childish use of "faux news", I'm not so certain that this one wasn't intentional. Let me say from the start, that at no point in my article do I mention race. At no point do I allude to, imply, or even hint that there was any sort of racial overtone to Subprime Lending. Your comment displays a brand of racism that I find every bit as insidious and despicable as a burning cross or a noose on a door: this practice of race-baiting simply has no place in civil discourse. I find your comments as distasteful as they are insulting. Grow up!

    P3. COD's and MBS's were a separate issue that helped exacerbate the the problem of Subprime lending, and helped create the Great Recession. This however is an article on Subprime lending and not on the Great Recession. I've also written articles about CDOs and MBS's as well. I cover them separately because I focus on keeping things "user friendly" for people who haven't studied economics.

    P4. Now I'm not so sure that you even bothered to read the entire article, seeing as how I did, actually, cover the effects of speculation and investment on the Subprime Crisis. Again, you're getting into MBO's when that's not what this article was about.

  • Elizabeth Lesar profile image

    Elizabeth Lesar 2 years ago from New York, NY

    Thanks for a focused and succinct article on the U.S. subprime crisis. It just explains the simple mechanics of what happened on the loan level, which was the crux of the whole matter. Folks who want to rant about racism and the declining culture of the U.S. should just start their own blog or something.

  • Shawn McIntyre profile image
    Author

    Shawn McIntyre 2 years ago from Orlando, FL.

    @Elizabeth Lesar Thanks for taking the time to read my article. =)

    The biggest problem- the one I've been dealing with for my entire adult life, is that far too many people can't recognize the difference between a Political issue and an Economic one; the Great Recession was a prime example of that fact.

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