Subprime mortgage crisis. Credit crisis. Bank collapse. Government bailout. Phrases like these frequently appeared in the headlines throughout the fall of 2008. This period ranks among the most devastating in U.S. financial market history. Those who lived through these events will likely never forget the turmoil.
So what happened, exactly, and why? Read on to learn how the explosive growth of the subprime mortgage market, which began in 1999, played a significant role in setting the stage for the turmoil that would unfold just nine years later in the 2008 house market crash and the 2008 stock market crash.
- The stock market and housing market crashes of 2008 trace their origins to the unprecedented growth of the subprime mortgage market that began in 1999.
- Fannie Mae and Freddie Mac made home loans accessible to borrowers who had low credit scores and a higher risk of defaulting on loans.
- These "subprime borrowers" were allowed to take out adjustable-rate mortgages with low starting rates that would increase after a few years.
- Financial firms sold these subprime loans to large commercial investors in pools of mortgages known as mortgage-backed securities.
- By the fall of 2008, borrowers were defaulting on subprime mortgages in high numbers; the collapse of the financial markets and the global Great Recession ensued.
Unprecedented Growth and Consumer Debt
Subprime mortgages are mortgages made to borrowers with less-than-perfect credit and less-than-adequate savings. An increase in subprime borrowing began in 1999 as the U.S. government-sponsored mortgage lender Federal National Mortgage Association (widely referred to as Fannie Mae) began a concerted effort to make home loans more accessible to those with lower credit and savings than lenders typically required.
The idea was to help everyone attain the American dream of homeownership. Since these borrowers were considered high risk, their mortgages had unconventional terms that reflected that risk, such as higher interest rates and variable payments. While many saw great prosperity as the subprime market began to explode, others began to see red flags and potential danger for the economy.
Robert R. Prechter Jr., the founder of Elliott Wave International, consistently argued that the out-of-control mortgage market was a threat to the U.S. economy because the whole industry was dependent on ever-increasing property values.
As of 2002, Fannie Mae and another government-sponsored mortgage lender, Freddie Mac, had extended more than $3 trillion worth of mortgage credit. In his 2002 book, Conquer the Crash, Prechter stated, "confidence is the only thing holding up this giant house of cards."
The role of both Fannie Mae and Freddie Mac is to repurchase mortgages from the lenders who originated them and make money when mortgage notes are paid. Thus, ever-increasing mortgage default rates led to a crippling decrease in revenue for these two companies.
Among the most potentially harmful of the mortgages offered to subprime borrowers were the interest-only ARM and the payment option ARM. Both wereadjustable-rate mortgages (ARMS). These mortgage types allow the borrower to make much lower initial payments than would be due under a fixed-rate mortgage. After a period of time, often only two or three years, these ARMs reset, often at higher rates. The payments then fluctuate as frequently as monthly, sometimes resulting in much larger payments than those the borrower paid initially.
In the up-trending market (and growing housing bubble) that existed from 1999 through 2005, these mortgages were virtually risk-free. Borrowers could end up with positive equity despite their low mortgage payments because their homes had increased in value since the purchase date. If they could not afford the higher payments after their mortgage rates reset, they could just sell the homes for a profit.
However, many argued that these creative mortgages were a disaster waiting to happen in the event of a housing market downturn, which would put owners in a negative equity situation and make it impossible to sell.
Increased Consumer Debt
To compound the potential mortgage risk, total consumer debt, in general, continued to grow at an astonishing rate. In 2004, consumer debt hit $2 trillion for the first time.
Insatiable investor demand for mortgage-related investments drove the predatory home loan private lending that led up to the 2008 crash.
The Rise of Mortgage-Related Investment Products
With the run-up in housing prices, the mortgage-backed securities (MBS) market became popular with commercial investors. An MBS is a pool of mortgages grouped into a single security. Investors benefit from the premiums and interest payments made toward the individual mortgages that the security contains.
This market is highly profitable as long as home prices continue to rise and homeowners continue to make their mortgage payments. The risks, however, became all too real as housing prices began to plummet and homeowners in droves began to default on their mortgages. At the time, few people realized how volatile and complicated this secondary mortgage market had become.
Credit Default Swaps
Another popular investment vehicle during this time was the credit derivative, known as a credit default swap (CDS). CDSs were designed to be a method of hedging against a company's creditworthiness, similar to insurance. But unlike the insurance market, the CDS market was unregulated. This meant that there was no requirement that the issuers of CDS contracts maintain enough money in their reserves to pay out under a worst-case scenario (such as an economic downturn). In early 2008, this spelled potential disaster for American International Group (AIG), one of the nation's leading financial companies, when it couldn't meet claims and announced huge losses in its portfolio of underwritten CDS contracts.
The amount of bailout money AIG received from the U.S. federal government in 2008, which the company repaid with interest by 2013.
The Markets Begin to Decline
By March 2007, Bear Stearns had failed due to huge losses resulting from underwriting many of the investment vehicles linked to the subprime mortgage market. It became evident that the market was in trouble and the subprime mortgage crisis was looming. Homeowners defaulted at high rates as the creative variations of subprime mortgages reset to higher payments as home prices declined.
Homeowners were upside down—they owed more on their mortgages than their homes were worth—and could no longer just flip their way out of making the new, higher payments. Instead, they lost their homes to foreclosure and often filed for bankruptcy in the process. The subprime meltdown was taking its toll on homeowners and the real estate market.
Despite this apparent mess, the financial markets continued higher into Oct. 2007, with the Dow Jones Industrial Average (DJIA) reaching a closing high of 14,164 on Oct. 9, 2007. The turmoil eventually caught up, and by Dec. 2007 the United States had fallen into a recession. By early July 2008, the Dow Jones Industrial Average would trade below 11,000 for the first time in over two years. That would not be the end of the decline.
Many borrowers who obtained adjustable-rate subprime mortgages with low initial rates received no information from lenders about the details of such loans and found themselves trapped with unaffordable loan obligations when rates rose.
Lehman Brothers Collapses
On Sept. 6, 2008, with the financial markets down nearly 20% from the Oct. 2007 peaks, the government announced its takeover of Fannie Mae and Freddie Mac. This was a necessary step due to losses from heavy exposure to the collapsing subprime mortgage market.
One week later, on Sept. 14, major investment banking firm Lehman Brothers succumbed to its own overexposure to the subprime mortgage market. It announced the largest bankruptcy filing in U.S. history at that time. The next day, markets plummeted and the Dow closed down 499 points at 10,917.
The collapse of Lehman led to the net asset value of the Reserve Primary Fund falling below $1 per share on Sept. 16, 2008. Investors were informed that for every $1 invested, they were entitled to only 97 cents. This drop was due to the holding of commercial paper issued by Lehman and was only the second time in history that a money market fund's share value had "broken the buck."
Panic ensued in the money market fund industry, resulting in massive redemption requests. On the same day, Bank of America (BAC) announced it was buying Merrill Lynch, the nation's largest brokerage company. Additionally, the credit rating for American International Group was downgraded due to the aforementioned credit derivative contracts that they'd underwritten.
The Government Starts Bailouts
On Sept. 18, 2008, talk of a government bailout began, sending the Dow up 410 points. The next day, Treasury Secretary Henry Paulson proposed that a Troubled Asset Relief Program (TARP) involving as much as $1 trillion be made available to buy up toxic debt and ward off a complete financial meltdown.
Also on this day, the Securities and Exchange Commission (SEC) initiated a temporary ban on short-selling the stocks of financial companies to stabilize the markets. The markets surged on the news and investors sent the Dow up 456 points to an intraday high of 11,483, finally closing up 361 at 11,388.
These highs would prove to be of historical importance as the financial markets were about to undergo three weeks of complete turmoil.
Financial Turmoil Escalates
The Dow would plummet 3,600 points from its Sept. 19, 2008 intraday high of 11,483 to the Oct. 10, 2008 intraday low of 7,882. The following is a recap of the major U.S. events that unfolded during this historic three-week period.
Sept. 21, 2008
Goldman Sachs and Morgan Stanley, the last two of the major investment banks still standing, converted from investment banks to bank holding companies to gain better ability to obtain bailout funding.
Sept. 25, 2008
After a 10-day bank run, the Federal Deposit Insurance Corporation (FDIC) seized Washington Mutual, then the nation's largest savings and loan, which had been heavily exposed to subprime mortgage debt. Its assets were transferred to JPMorgan Chase (JPM).
Sept. 28, 2008
The TARP bailout plan stalled in Congress.
Sept. 29, 2008
The Dow declined 774 points (6.98%), at the time the largest point drop in history.
Oct. 3, 2008
A reworked $700 billion TARP plan, renamed the Emergency Economic Stabilization Act of 2008, passed a bipartisan vote in Congress.
Oct. 6, 2008
The Dow closed below 10,000 for the first time since 2004.
Oct. 22, 2008
President Bush announced that he would host an international conference of financial leaders on Nov. 15, 2008.
The Housing Market Then vs. Now
In 2008, the housing market bubble burst when subprime mortgages, a huge consumer debt load, and crashing home values converged. Homeowners began defaulting on the home loans.
Currently, high mortgage rates and the threat of a recession are worrisome. However, while home prices peaked and started dropping through 2022, the potential for a crash and foreclosures isn't completely consistent with the situation in 2008. Today, more homeowners have solid credit, large amounts of home equity, and low mortgage rates that are locked in.
What Caused the Financial Crisis of 2008?
The growth of predatory mortgage lending, unregulated markets, a massive amount consumer debt, the creation of "toxic" assets, the collapse of home prices, and more contributed to the financial crisis of 2008.
How Much Did Housing Prices Drop in 2008?
From July 2006 to January 2009, the national median house price dropped by 29%.
How Long Did the 2008 Housing Market Crisis Last?
Different geographic areas recover at different speeds. However, in general, the recovery began in 2011, more than 3 years after the housing crisis began. Home prices had fully recovered by 2012.
The Bottom Line
While good intentions were likely the catalyst leading to the decision to expand the subprime mortgage market back in 1999, many unfortunate (and foreseeable) repercussions resulted and imperiled the economy in 2008.
The growth of the subprime mortgage market along with its various new and questionable investment vehicles, combined with the explosion of consumer debt and dropping home prices were harbingers of the future financial turmoil of 2008. The ensuing Great Recession might have been minimized or perhaps avoided if more responsible lending practices and financial policies had been in place or implemented sooner.