What Was the Subprime Meltdown? What Happened and Consequences

What Was the Subprime Meltdown?

The subprime meltdown was the sharp increase in high-risk mortgages that went into default beginning in 2007, contributing to the most severe recession in decades. The housing boom of the mid-2000s—combined with low-interest rates at the time—prompted many lenders to offer home loans to individuals with poor credit. When the real estate bubble burst, many borrowers were unable to make payments on their subprime mortgages.

Understanding the Subprime Meltdown

Following the tech bubble and the economic trauma that followed the terrorist attacks in the U.S. on Sept. 11, 2001, the Federal Reserve stimulated the struggling U.S. economy by cutting interest rates to historically low levels. For example, the Federal Reserve lowered the federal funds rate from 6% in January 2001 to as low as 1% by June 2003. As a result, economic growth in the U.S. began to rise. A booming economy led to increased demand for homes and subsequently, mortgages. However, the housing boom that ensued also led to record levels of homeownership in the U.S. As a result, banks and mortgage companies had difficulty finding new homebuyers.

Lending Standards

Some lenders extended mortgages to those who couldn't otherwise qualify to capitalize on the home-buying frenzy. These homebuyers weren't approved for traditional loans because of weak credit histories or other disqualifying credit measures. These loans are called subprime loans. Subprime loans are loans made to borrowers with lower credit scores than what is typically required for traditional loans. Subprime borrowers have often been turned down by traditional lenders. As a result, subprime loans that are granted to these borrowers usually have higher interest rates than other mortgages.

During the early-to-mid 2000s, the lending standards for some lenders became so relaxed; it sparked the creation of the NINJA loan: "no income, no job, no assets." Investment firms were eager to buy these loans and repackage them as mortgage-backed securities (MBSs) and other structured credit products. A mortgage-backed security (MBS) is an investment similar to a fund that contains a basket home loans that pays a periodic interest rate. These securities were bought from the banks that issued them and sold to investors in the U.S. and internationally.

Adjustable Rate Mortgages

Many subprime mortgages were adjustable-rate loans. An adjustable-rate mortgage (ARM) is a type of mortgage loan where the interest rate can change throughout the life of the loan. An adjustable-rate mortgage typically has a fixed interest rate in the early life of the loan whereby the rate can reset or change within a certain number of months or years. In other words, ARMs carry a floating interest rate, called a variable-rate mortgage loan. 

Many of the ARMs had reasonable interest rates initially, but they could reset to a much higher interest rate after a given period. Unfortunately, when the Great Recession began, credit and liquidity dried up–meaning the number of loans issued declined. Also, interest rates began to rise, which reset many of the subprime adjustable-rate mortgages to higher interest rates. The sudden increase in mortgage rates played a major role in the growing number of defaults—or the failure to make the loan payments—starting in 2007 and peaking in 2010. Significant job losses throughout the economy didn't help. As many borrowers were losing their jobs, their mortgage payments were going up at the same time. Without a job, it was nearly impossible to refinance the mortgage to a lower fixed rate.

Meltdown on Wall Street

Once the housing market started to crash, and borrowers were unable to pay their mortgages, banks were suddenly saddled with loan losses on their balance sheets. As unemployment soared across the nation, many borrowers defaulted or foreclosed on their mortgages. 

In a foreclosure situation, banks repossess the home from the borrower. Unfortunately, because the economy was in a recession, banks were unable to resell the foreclosed properties for the same price that was initially loaned out to the borrowers. As a result, banks endured massive losses, which led to tighter lending, leading to less loan origination in the economy. Fewer loans led to lower economic growth since businesses and consumers didn't have access to credit. 

The losses were so large for some banks that they went out of business or were purchased by other banks in an effort to save them. Several large institutions had to take out a bailout from the federal government in what was called the Troubled Asset Relief Program (TARP). However, the bailout was too late for Lehman Brothers—a Wall Street bond firm—which closed its doors after more than 150 years in business.

Once investors in the markets saw that Lehman Brothers was allowed to fail by the federal government, it led to massive repercussions and sell-offs across the markets. As more investors tried to pull money out of banks and investment firms, those institutions began to suffer as well. Although the subprime meltdown began with the housing market, the shockwaves led to the financial crisis, the Great Recession, and massive sell-offs in the markets.  

Assigning Blame for the Subprime Meltdown

Several sources have been blamed for causing the subprime meltdown. These include mortgage brokers and investment firms that offered loans to people traditionally seen as high-risk, as well as credit agencies that proved overly optimistic about non-traditional loans. Critics also targeted mortgage giants Fannie Mae and Freddie Mac, which encouraged loose lending standards by buying or guaranteeing hundreds of billions dollars in risky loans.