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The United States subprime mortgage crisis was a nationwide financial crisis that occurred between 2007 and 2010, and contributed to the U.S. financial crisis.[1][2] It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies, foreclosures, and the devaluation of housing-related securities. Declines in residential investment preceded the Great Recession and were followed by reductions in household spending and then business investment. Spending reductions were more significant in areas with a combination of high household debt and larger housing price declines.[3]

The housing bubble preceding the crisis was financed with mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which initially offered higher interest rates (i.e. better returns) than government securities, along with attractive risk ratings from rating agencies. While elements of the crisis first became more visible during 2007, several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.[4]

There were many causes of the crisis, with commentators assigning different levels of blame to financial institutions, regulators, credit agencies, government housing policies, and consumers, among others.[5] Two proximate causes were the rise in subprime lending and the increase in housing speculation. The percentage of lower-quality subprime mortgages originated during a given year rose from the historical 8% or lower range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S.[6][7] A high percentage of these subprime mortgages, over 90% in 2006 for example, had an interest rate that increased over time.[4] Housing speculation also increased, with the share of mortgage originations to investors (i.e. those owning homes other than primary residences) rising significantly from around 20% in 2000 to around 35% in 2006–2007. Investors, even those with prime credit ratings, were much more likely to default than non-investors when prices fell.[8][9][10] These changes were part of a broader trend of lowered lending standards and higher-risk mortgage products,[4][11] which contributed to U.S. households becoming increasingly indebted. The ratio of household debt to disposable personal income rose from 77% in 1990 to 127% by the end of 2007.[12]

When U.S. home prices declined steeply after peaking in mid-2006, it became more difficult for borrowers to refinance their loans. As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms globally, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending.[6] Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe.

The crisis had severe, long-lasting consequences for the U.S. and European economies. The U.S. entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly 6% of the workforce. The number of jobs did not return to the December 2007 pre-crisis peak until May 2014.[13] U.S. household net worth declined by nearly $13 trillion (20%) from its Q2 2007 pre-crisis peak, recovering by Q4 2012.[14] U.S. housing prices fell nearly 30% on average and the U.S. stock market fell approximately 50% by early 2009, with stocks regaining their December 2007 level during September 2012.[15] One estimate of lost output and income from the crisis comes to "at least 40% of 2007 gross domestic product".[16] Europe also continued to struggle with its own economic crisis, with elevated unemployment and severe banking impairments estimated at €940 billion between 2008 and 2012.[17] As of January 2018, U.S. bailout funds had been fully recovered by the government, when interest on loans is taken into consideration. A total of $626B was invested, loaned, or granted due to various bailout measures, while $390B had been returned to the Treasury. The Treasury had earned another $323B in interest on bailout loans, resulting in an $87B profit.[18]

The Economist reported in March 2010: "Bear Stearns and Lehman Brothers were non-banks that were crippled by a silent run among panicky overnight "repo" lenders, many of them money market funds uncertain about the quality of securitized collateral they were holding. Mass redemptions from these funds after Lehman's failure froze short-term funding for big firms."[145]

Securitization – the bundling of bank loans to create tradeable bonds – started in the mortgage industry in the 1970s, when Government Sponsored Enterprises (GSEs) began to pool relatively safe, conventional, "conforming" or "prime" mortgages, create "mortgage-backed securities" (MBS) from the pool, sell them to investors, guaranteeing these securities/bonds against default on the underlying mortgages.[6][146] This "originate-to-distribute" model had advantages over the old "originate-to-hold" model,[147] where a bank originated a loan to the borrower/homeowner and retained the credit (default) risk. Securitization removed the loans from a bank's books, enabling the bank to remain in compliance with capital requirement laws. More loans could be made with proceeds of the MBS sale. The liquidity of a national and even international mortgage market allowed capital to flow where mortgages were in demand and funding short. However, securitization created a moral hazard – the bank/institution making the loan no longer had to worry if the mortgage was paid off[148] – giving them incentive to process mortgage transactions but not to ensure their credit quality.[149][150] Bankers were no longer around to work out borrower problems and minimize defaults during the course of the mortgage.[151]

With the high down payments and credit scores of the conforming mortgages used by GSE, this danger was minimal.[152] Investment banks however, wanted to enter the market and avoid competing with the GSEs.[148] They did so by developing mortgage-backed securities in the riskier non-conforming subprime and Alt-A market. Unlike the GSEs[153] the issuers generally did not guarantee the securities against default of the underlying mortgages.[6]

What these "private label" or "non-agency" originators did do was to use "structured finance" to create securities. Structuring involved "slicing" the pooled mortgages into "tranches", each having a different priority in the monthly or quarterly principal and interest stream.[154][155] Tranches were compared to "buckets" catching the "water" of principal and interest. More senior buckets didn't share water with those below until they were filled to the brim and overflowing.[156] This gave the top buckets/tranches considerable creditworthiness (in theory) that would earn the highest "triple A" credit ratings, making them salable to money market and pension funds that would not otherwise deal with subprime mortgage securities.

To use up the MBS tranches lower in payback priority that could not be rated triple-A and that a con

With the high down payments and credit scores of the conforming mortgages used by GSE, this danger was minimal.[152] Investment banks however, wanted to enter the market and avoid competing with the GSEs.[148] They did so by developing mortgage-backed securities in the riskier non-conforming subprime and Alt-A market. Unlike the GSEs[153] the issuers generally did not guarantee the securities against default of the underlying mortgages.[6]

What these "private label" or "non-agency" originators did do was to use "structured finance" to create securities. Structuring involved "slicing" the pooled mortgages into "tranches", each having a different priority in the monthly or quarterly principal and interest stream.[154][155] Tranches were compared to "buckets" catching the "water" of principal and interest. More senior buckets didn't share water with those below until they were filled to the brim and overflowing.[156] This gave the top buckets/tranches considerable creditworthiness (in theory) that would earn the highest "triple A" credit ratings, making them salable to money market and pension funds that would not otherwise deal with subprime mortgage securities.

To use up the MBS tranches lower in payback priority that could not be rated triple-A and that a conservative fixed income market would not buy, investment banks developed another security – known as the collateralized debt obligation (CDO). Although the CDO market was smaller, it was crucial because unless buyers were found for the non-triple-A or "mezzanine" tranches, it would not be profitable to make a mortgage-backed security in the first place.[157][158] These CDOs pooled the leftover BBB, A-, etc. rated tranches, and produced new tranches – 70%[159] to 80%[160] of which were rated triple A by rating agencies. The 20–30% remaining mezzanine tranches were sometimes bought up by other CDOs, to make so-called "CDO-Squared" securities which also produced tranches rated mostly triple A.[161]

This process was later disparaged as "ratings laundering"[162] or a way of transforming "dross into gold"[163] by some business journalists, but was justified at the time by the belief that home prices would always rise.[164][165] The model used by underwriters, rating agencies and investors to estimate the probability of mortgage default was based on the history of credit default swaps, which unfortunately went back "less than a decade, a period when house prices soared".[166]

In addition the model – which postulated that the correlation of default risks among loans in securitization pools could be measured in a simple, stable, tractable number, suitable for risk management or valuation[166] – also purported to show that the mortgages in CDO pools were well diversified or "uncorrelated". Defaults on mortgages in Orlando, for example, were thought to have no effect on – i.e. were uncorrelated with – the real estate market across the country in Laguna Beach. When prices corrected (i.e. the bubble collapsed), the resulting defaults were not only larger in number than predicted but far more correlated.[166]

Still another innovative security criticized after the bubble burst was the synthetic CDO. Cheaper and easier to create than original "cash" CDOs, synthetics did not provide funding for housing, rather synthetic CDO-buying investors were in effect providing insurance (in the form of "credit default swaps") against mortgage default. The mortgages they insured were those in "cash" CDOs the synthetics "referenced". So instead of providing investors with interest and principal payments from MBS tranches, payments were the equivalent of insurance premiums from the insurance "buyers".[167] If the referenced CDOs defaulted, investors lost their investment, which was paid out to the insurance buyers.[168]

Unlike true insurance, credit default swaps were not regulated to insure that providers had the reserves to pay settlements, or that buyers owned the property (MBSs) they were insuring, i.e. were not simply making a bet a security would default.[169] Because synthetics "referenced" another (cash) CDO, more than one – in fact numerous – synthetics could be made to reference the same original, multiplying the effect if a referenced security defaulted.[170][171] As with MBS and other CDOs, triple A ratings for "large chunks"[172] of synthetics were crucial to the securities' success, because of the buyer/investors' ignorance of the mortgage security market and trust in the credit rating agencies ratings.[173]

Securitization began to take off in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.[99] In the mid-2000s as the housing market was peaking, GSE securitization market share declined dramatically, while higher-risk subprime and Alt-A mortgage private label securitization grew sharply.[6] As mortgage defaults began to rise, it was among mortgages securitized by the private banks. GSE mortgages – securitized or not – continued to perform better than the rest of the market.[6][174] Picking up the slack for the dwindling cash CDO market[175] synthetics were the dominant form of CDO's by 2006,[176] valued "notionally"[177] at an estimated $5 trillion.[176]

By the autumn of 2008, when the securitization market "seized up" and investors would "no longer lend at any price", securitized lending made up about $10 trillion of the roughly $25 trillion American credit market, (i.e. what "American homeowners, consumers, and corporations owed").[141][142] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.[178]

According to economist A. Michael Spence: "when formerly uncorrelated risks shift and become highly correlated ... diversification models fail." "An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."[179]

Criticizing the argument that complex structured investment securitization was instrumental in the mortgage crisis, Paul Krugman points out that the Wall Street firms issuing the securities "kept the riskiest assets on their own books", and that neither of the equally disastrous bubbles in European housing or US commercial property used complex structured securities. Krugman does agree that it is "arguable is that financial innovation ... spread the bust to financial institutions around the world" and its inherent fragmentation of loans has made post-bubble "cleanup" through debt renegotiation extremely difficult.[138]

The Financial Crisis Inquiry Commission reported in January 2011 that: "From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed – from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the industry's assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980."[70]

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–07, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.[180]

A 2004 U.S. Securi

Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–07, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.[180]

A 2004 U.S. Securities and Exchange Commission (SEC) decision related to the net capital rule allowed US investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004–07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of US nominal GDP for 2007. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001–03 to between 18–20% from 2004 to 2006, due in-part to financing from investment banks.[114][115]

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). These failures augmented the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation.[181][182]

In the years leading up to the crisis, the top four U.S. depository banks moved an estimated $5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or other entities in the shadow banking system. This enabled them to essentially bypass existing regulations regarding minimum capital ratios, thereby increasing leverage and profits during the boom but increasing losses during the crisis. New accounting guidance will require them to put some of these assets back onto their books during 2009, which will significantly reduce their capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion. This effect was considered as part of the stress tests performed by the government during 2009.[183]

Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way round regulation."[184]

The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system – from mortgage brokers to Wall Street risk managers – seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."[60][185]

The incentive compensation of traders was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.[186]

Credit default swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default, or by speculators to profit from default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the protection would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion.[187]:73 CDS are lightly regulated, largely because of the Commodity Futures Modernization Act of 2000. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[188] The monoline insurance companies went out of business in 2008–2009.

When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[189][190] Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill's CDOs. The loss of confidence of trading partners in Merrill Lynch's solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.[191][192]

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."[193]