page_title: Subprime crisis background information
section_title: A plain-language overview
hierarchical_section_title: Subprime crisis background information / A plain-language overview
caption_attribution_description: English: Causes of the Housing Bubble Contents 1 Overview 2 Lending Decisions by Institutions 3 Borrowing Decisions by Individuals 4 Transition to the Subprime Mortgage Crisis 5 Additional Sources 6 Caveats 7 Sources 8 Licensing 9 Original upload log Overview See the United States housing bubble and subprime mortgage crisis for in-depth discussion and citations. A brief summary of each vertical "string" of causes is included below. While there are many factors that influenced the housing bubble, fundamentally a bubble is built one transaction at a time. Risky lending decisions were made by institutions and risky borrowing decisions were made by both individuals and institutions. According to the Pew Research Center, “There is a broad public consensus regarding the causes of the current problems with financial institutions and markets: 79 percent say people taking on too much debt has contributed a lot to the crisis, while 72 percent say the same about banks making risky loans.”&#91;1&#93; Lending Decisions by Institutions Banks and investment banks funded the housing boom and also packed mortgages into MBS for sale or their own accounts. Investors demanded MBS, as they were considered safe investments that paid a higher rate of return than treasury bills during the boom period, when defaults were minimal. Credit risk insurance was available through credit default swaps (CDS). Both MBS and CDS are relatively opaque investments and once the bubble burst, their valuation became difficult to determine. Loanable funds (capital) was readily available due to: low interest rates early in the decade; abundant foreign capital flowing into the U.S.; low taxes and deficit spending supporting robust economic growth; and the recent dot-com stock bubble bursting. Credit rating agencies assigned optimistic "AAA" ratings to subprime MBS, which made the investments easier to trade (liquid) and supporting demand for them. Credit rating agencies are paid by those whose instruments they are rating. Rather than using the boom period to build their reserves, banks increased risk as evidenced by higher debt to equity ratios also known as financial leverage, which multiplies profits during a boom but reduces them during a bust. The financial regulations did not cover the shadow banking system, non-bank entities that were assuming increasingly leveraged and important roles in the financial system through MBS and credit default swap (CDS) derivatives. Non-banks did not have the same leverage restrictions as commercial banks. Incentive structures on Wall Street tended to be short-term rather than multi-year. Bankers received over $26 billion in bonuses during 2006. For decades, GSE-Government Sponsored Entities (Ginnie Mae, Fannie Mae &amp; Freddie Mac) have purchased mortgage from a variety of mortgage companies and banks and sold bonds. These bonds represent the first mortgage-backed securities (MBS). These loans are referred to as "qualifying" or "prime" when they meet the GSE underwriting standards. The GSEs have missions that included helping provide housing to lower-income Americans by purchasing mortgages from originating firm. A small percentage of these loans are non-prime. A variety of politicians supported this mission both formally and informally.&#91;2&#93; Borrowing Decisions by Individuals In a competitive lending environment, mortgage brokers developed a variety of "innovative" mortgage products that were increasingly high-risk to the lending institutions and to borrowers. These included adjustable-rate mortgages and interest-only payment terms. Many homeowners were encouraged to purchase high-risk mortgages due to the belief that increasing home values would enable them to pay for the property. The American Dream as recently interpreted includes a house with several bedrooms, a yard, and a picket fence. This is reinforced widely in the culture, through television and movies. America is a consumption-oriented culture, with a negative savings rate. During the housing boom, many made significant profits through speculation or heard stories of massive home appreciation. The housing bubble developed for over a decade, with housing prices peaking in June-July 2006. Between 1997 and 2006, American home prices increased by 124%. Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences. With such an upward trend, housing seemed a safe investment, particularly after the dot-com bust. American household debt relative to income increased to record levels, to nearly 140% during 2008. Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."&#91;3&#93; Transition to the Subprime Mortgage Crisis thumb|A diagram of the elements of the subprime crisis Once housing prices began to fall in June-July 2006, homeowners were often stuck with mortgages they could not afford or refinance. Delinquencies and foreclosures increased dramatically. As mortgage payments fell, the money flowing into MBS decreased during 2007. Many financial institutions suffered enormous losses, with hundreds of mortgage companies and several major financial institutions going bankrupt. Due to uncertainty regarding the financial condition of many financial institutions and banks dramatically increasing lending standards, loanable funds liquidity became less available. This is further described in the second subprime crisis diagram at right. Additional Sources Comprehensive discussions of housing bubbles and the crisis are at: Blackburn - The Subprime Crisis Economist - The Global Housing Boom Other Specific contributing causes: Rating Agencies: Financial Times - We Must Not Rely on Only the Rosiest Ratings The outdated regulatory regime and discussion of causes: Gelinas - Stormproofing the Economy - City Journal Bubble psychology and other causes: Samuelson-Good Times Breed Bad Times-Newsweek Caveats The main diagram helps illustrate how the housing bubble was built. It does not illustrate the ripple effect through the housing market, financial markets, and economy, which is shown as a thumbnail diagram. The diagram does not assign relative importance and key factors are not included. Some factors are critical to the housing market or the financial markets; some are critical to both. Experts disagree on which factors matter most. The many elements of the diagram interact and provide feedback on each other to varying degrees. This is a very simplistic representation. It would take a rather complex computer simulation to show the interaction of the two meta markets--the housing market and the financial market. Sources The letters from Fed Chairman Bernanke provide a helpful explanation of the subject.&#91;4&#93; &#91;5&#93; Further, several cover stories and in-depth articles appeared in the Economist&#91;6&#93; &#91;7&#93; &#91;8&#93; and Business Week.&#91;9&#93; Former Federal Reserve Chairman Greenspan wrote an Op Ed piece for the Wall Street Journal that summarizes the crisis from a variety of angles.&#91;10&#93; Economist Joseph Stiglitz summarized his views on the causes of the crisis.&#91;11&#93;
context_page_description: It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.
context_section_description: The following is excerpted (with some modifications) from former U.S. President George W. Bush's Address to the Nation on September 24, 2008: Other additions are sourced later in the article or in the main article.
  The problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad.  This large influx of money to U.S. banks and financial institutions — along with low interest rates — made it easier for Americans to get credit.  Easy credit — combined with the faulty assumption that home values would continue to rise — led to excesses and bad decisions.
  Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.  Both individuals and financial institutions increased their debt levels relative to historical norms during the past decade significantly.
  Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or refinance their homes before the adjustments occurred were unable to refinance. As a result, many mortgage holders began to default as the adjustments began.
  These widespread defaults (and related foreclosures) had effects far beyond the housing market. Home loans are often packaged together, and converted into financial products called "mortgage-backed securities". These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value.
  Credit rating agencies gave them high-grade, safe ratings. Two of the leading sellers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put the financial system at risk.
  The decline in the housing market set off a domino effect across the U.S. economy. When home values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their mortgages.  Investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold.
  Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not sell. They ran out of the money needed to meet their immediate obligations and faced imminent collapse. Other banks found themselves in severe financial trouble. These banks began holding on to their money, and lending dried up, and the gears of the American financial system began grinding to a halt.
caption: Factors Contributing to Housing Bubble - Diagram 1 of 2
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