What Was the Subprime Mortgage Crisis and How Did it Happen?

It may feel like longer to some, but it was just a decade ago that a catastrophic housing crisis destroyed the lives of many Americans, with effects that still exist today.

As we approach the 10-year anniversary of Lehman Brothers' collapse and the Great Recession, we should take a look back at the subprime mortgage crisis. How did it start and who was to blame? What happened, and what is still happening in the wake of it? And what even makes a mortgage subprime?

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.

People who are approved of subprime mortgages historically have low credit scores and problems with debt. There is no exact established number, but a FICO score below 640 is generally seen as subprime for a loan like a mortgage.

People with spotty credit histories like this often have tremendous difficulty getting approval on a mortgage, and as such the monthly payments have much higher interest rates than normal since the lenders view the loan as much riskier.

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.

What Parties Were to Blame for the Crisis?

The subprime mortgage crisis, which guided us into the Great Recession, has many parties that can share blame for it. For one, lenders were selling these as mortgage-backed securities. After the lenders approved and gave out the loan, that loan would be sold to an investment bank. The investment bank would then bundle this mortgage with other similar mortgage for other parties to invest in, and the lender would, as a result of the sale, have more money to use for home loans.

It is a process that had worked in the past, but the housing bubble saw an unusually large number of subprime mortgages approved for people who struggled with credit and income. When the Fed began raising interest rates over and over, those loans became more expensive and the borrowers found themselves unable to pay it off.

Lenders were far too ready to give away so many risky loans at once, seemingly assuming that housing prices would continue to rise and interest rates would stay low. Investment banks seem to have had similar motives, getting bolder with their mortgage-backed securities investments.

Though these parties decidedly took advantage of people with bad credit in need of a place to live, homebuyers and the distinctly American pursuit of owning a home played a small role in this as well. The dream of upward mobility and owning larger homes led people to be riskier with their own real estate investments, and predatory lenders were all too ready to help them.

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.

Subprime Mortgage Crisis and Lehman Brothers

Lehman Brothers was one of the largest investment banks in the world for years. It was also one of the first investment banks to get very involved with investing in mortgages, something that would pay off until it became their downfall.

The plummeting price of real estate and the widespread defaulting on mortgages crushed Lehman Brothers. They were forced to close their subprime lenders, and despite their many attempts to stop the bleeding (such as issuing stock) they continued to take on losses until, on Sept. 15, 2008, Lehman Brothers applied for bankruptcy.

Lehman Brothers was one of the most prominent financial-service firms in the world. Its rapid descent into bankruptcy was a major cause of the 2008 stock market crash.

Subprime Mortgages Today

Subprime mortgages disappeared for a while after this, since they were seen as one of the largest parts of an economic collapse. But they've been somewhat rebranded, as lenders have begun selling "non-prime loans" to borrowers struggling with their credit.

There are also other forms of loans and debt that some economists fear have concerning similarities with the subprime mortgages of the mid-2000s. For example, a 2017 Citi report showed parallels between the subprime mortgage crisis and today's ever-growing student loan debt.

Millennials with student loan debt have been a prime candidate for lenders to offer these non-prime loans to, sparking concerns that financial institutions have failed to learn or are ignoring the lessons from a decade ago.

More from Mortgages

D.R. Horton Reports Strong Earnings, Sees Signs of Moderating Demand

D.R. Horton Reports Strong Earnings, Sees Signs of Moderating Demand

What Is the Prime Rate? Definition, History and Rate in 2018

What Is the Prime Rate? Definition, History and Rate in 2018

How to Invest in Real Estate: Buying vs. Not Buying Property

How to Invest in Real Estate: Buying vs. Not Buying Property

How Is Social Security Calculated? Find Your Benefits

How Is Social Security Calculated? Find Your Benefits

12 Simple Ways to Improve Your Credit Score in 2018

12 Simple Ways to Improve Your Credit Score in 2018