Who Was to Blame for the Subprime Crisis?

Anytime something bad happens, it doesn't take long before people start to assign blame. It could be as simple as a bad trade or an investment that no one thought would bomb. Some companies have banked on a product they launched that just never took off, putting a huge dent in their bottom lines. But some events have such a devastating effect that they end up having an effect on the overall economy. That's what happened with the subprime mortgage market, which led to the Great Recession. But who do you blame?

When it comes to the subprime mortgage crisis, there was no single entity or individual at whom we could point the finger. Instead, this mess was the collective creation of the world's central banks, homeowners, lenders, credit rating agencies, underwriters, and investors. Read on to find out more about each individual player and what role they played in the crisis.

Key Takeaways

  • The subprime mortgage crisis was the collective creation of the world's central banks, homeowners, lenders, credit rating agencies, underwriters, and investors. 
  • Lenders were the biggest culprits, freely granting loans to people who couldn't afford them because of free-flowing capital following the dotcom bubble.
  • Borrowers who never imagined they could own a home were taking on loans they knew they may never be able to afford.
  • Investment banks, ratings agencies, and hedge funds also had a role to play in the subprime mess.
  • Investors hungry for big returns bought mortgage-backed securities at ridiculously low premiums, fueling demand for more subprime mortgages.

The Subprime Mess: An Overview

Before we look at the key players and components that led to the subprime mortgage crisis, it's important to go back a little further and examine the events that led up to it.

In early 2000, the economy was at risk of a deep recession after the dotcom bubble burst. Before the bubble burst, tech company valuations rose dramatically, as did investment in the industry. Junior companies and startups that didn't produce any revenue yet were getting money from venture capitalists, and hundreds of companies went public. This situation was compounded by the September 11 terrorist attacks in 2001. Central banks around the world tried to stimulate the economy as a response. They created capital liquidity through a reduction in interest rates.  In turn, investors sought higher returns through riskier investments.

Enter the subprime mortgage. Lenders took on greater risks, too, approving subprime mortgage loans to borrowers with poor credit, no assets, and—at times—no income. These mortgages were repackaged by lenders into mortgage-backed securities (MBS) and sold to investors who received regular income payments just like coupon payments from bonds. But consumer demand drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed the following summer.

The Great Recession

The subprime mortgage crisis didn't just hurt homeowners, it had a ripple effect on the global economy leading to the Great Recession which lasted between 2007 and 2009. This was the worst period of economic downturn since the Great Depression.

After the housing bubble burst, many homeowners found themselves stuck with mortgage payments they just couldn't afford. Their only recourse was to default. This led to the breakdown of the mortgage-backed security market, which were blocks of securities backed by these mortgages, sold to investors who were hungry for great returns. Investors lost money, as did banks, with many teetering on the brink of bankruptcy.

Homeowners who defaulted ended up in foreclosure. And the downturn spilled into other parts of the economy—a drop in employment, more decreases in economic growth as well as consumer spending. The U.S. government approved a stimulus package to bolster the economy by bailing out the banking industry. But who was to blame? Let's take a look at the key players.

The Biggest Culprit: The Lenders

Most of the blame is on the mortgage originators or the lenders. That's because they were responsible for creating these problems. After all, the lenders were the ones who advanced loans to people with poor credit and a high risk of default. Here's why that happened.

When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors looked for riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their own investment returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were—rates were low, the economy was healthy, and people were making their payments. Who could have foretold what actually happened?

Despite being a key player in the subprime crisis, banks tried to ease the high demand for mortgages as housing prices rose because of falling interest rates.

Partner In Crime: Homebuyers

We should also mention the homebuyers who were far from innocent in their role in the subprime mortgage crisis. Many of them played an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages such as 2/28 and interest-only mortgages. These products offered low introductory rates and minimal initial costs such as no down payment. Their hopes lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in another spending. However, instead of continuing to appreciate, the housing bubble burst, taking prices on a downward spiral with it.

When their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created with the fall of housing prices. They were, therefore, forced to reset their mortgages at higher rates they couldn't afford, and many of them defaulted. Foreclosures continued to increase through 2006 and 2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression there was no risk to these mortgages and the costs weren't that high. But at the end of the day, many borrowers simply took on mortgages they couldn't afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable.

Exacerbating the situation, lenders and investors who put their money into securities backed by these defaulting mortgages ended up suffering. Lenders lost money on defaulted mortgages as they were increasingly left with property worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.

Investment Banks Worsen the Situation

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more, and the snowball began to build.

A lot of the demand for these mortgages came from the creation of assets pooling mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize them into bonds, which were sold to investors through CDOs.

Rating Agencies: Possible Conflicts of Interest

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the AAA-rating given to the higher quality tranches. If the ratings were more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad.

Moreover, some have pointed to the conflict of interest of rating agencies which receive fees from a security's creator and their ability to give an unbiased assessment of risk. The argument is rating agencies were enticed to give better ratings to continue receiving service fees, or they ran the risk of the underwriter going to a different agency.

Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is they were simply bringing bonds to market based on market demand.

Fuel to the Fire: Investor Behavior

Just as the homeowners are to blame for their purchases gone wrong, much of the blame must also be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums instead of Treasury bonds. These enticingly low rates are what ultimately led to such a huge demand for subprime loans.

In the end, it is up to the individual investors to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the AAA CDO ratings at face value.

Don't Forget the Hedge Funds

Another party added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem.

To illustrate, there is a hedge fund strategy best described as credit arbitrage. It involves purchasing subprime bonds on credit and hedging the positions with credit default swaps. This amplified demand for CDOs. By using leverage, a fund could purchase many more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.

Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls.

The Bottom Line

There may have been a mix of factors and participants that precipitated the subprime mess, but it was ultimately human behavior and greed that drove the demand, supply, and investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future.

Article Sources
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