Question

QUESTION: CAN YOU EXPLAIN TO ME, IN SIMPLE TERMS, THE SUBPRIME CRISIS?

Answer 1

What Is a Subprime Mortgage?

Subprime mortgages are named for the borrowers that the mortgages are given to. If the prime rate for a mortgage is what is offered to people with good credit and a history of dependability, subprime is for those who have struggled to meet those standards.

How Did the Subprime Mortgage Crisis Start?

How did the U.S. economy get to a point where in 2007, a full-on housing crisis began?

It doesn't happen overnight. In the early-to-mid 2000s, interest rates on house payments were actually quite low. In what looked to be a solid economy after a brief early 2000s recession, more and more people with struggling credit were able to qualify for subprime mortgages with manageable rates, and happily acted on that.

This sudden increase in subprime mortgages was due in part to the Federal Reserve's decision to significantly lower the Federal funds rate to spur growth. People who couldn't afford homes or get approved for loans were suddenly qualifying for subprime loans and choosing to buy, and American home ownership rose exponentially.

Real estate purchases rose not only for subprime borrowers, but for well-off Americans as well. As prices rose and people expected a continuation of that, investors who got burned by the dot com bubble of the early 2000s and needed a replacement in their portfolio started investing in real estate.

Housing prices were rising rapidly, and the number of subprime mortgages given out was rising even more. By 2005, some began to fear that this was a housing bubble. From 2004-2006, the Federal Reserve raised the interest rate over a dozen times in an attempt to slow this down and avoid serious inflation. By the end of 2004, the interest rate was 2.25%; by mid-2006 it was 5.25%.

This was unable to stop the inevitable. The bubble burst. 2005 and 2006 see the housing market crash back down to earth. Subprime mortgage lenders begin laying thousands of employees off, if not filing for bankruptcy or shutting down entirely.

Effects of the Mortgage Crisis---

Home prices fell tremendously as the housing bubble completely burst. This crushed many recent homeowners, who were seeing interest rates on their mortgage rise rapidly as the value of the home deteriorated.

Unable to pay their mortgage on a monthly payment and unable to sell the home without taking a massive loss, many had no choice. The banks foreclosed on their houses. Homeowners were left in ruins, and many suburbs turned into ghost towns. Even homeowners with good credit who qualified for standard mortgages struggled with the steadily rising interest rates.

By the time these homes were foreclosed upon, they had cratered in value. That meant banks were also taking massive losses on real estate. Investors got hit hard as well, as the value of the mortgage-backed securities they were investing in tumbled. This was made more difficult due to people still buying homes even as the bubble began to burst in 2006 into early 2007. Loans were still being given out and taken as sales slumped.

Investment banks who bought and sold these loans that were being defaulted on started failing. Lenders no longer had the money to continue giving them out. By 2008, the economy was in complete freefall.

Some institutions got bailed out by the government. Other banks, who had gotten so involved in the mortgage business, were not so lucky.