The most recent collapse of the housing market in the United States was both unforeseen and impactful to almost every investor, in the U.S. and around the world. In hindsight, multiple factors led to its decline, which had devastating effects on the global economy. Prior to the economic downturn, the major force responsible for sowing the seeds of market decay was a flourishing activity of subprime lending.
To understand the subprime lending boom, we must first define the different types of borrowers that exist in the today's housing market. Broadly speaking, homeowners that wish to obtain a mortgage from their lender can be categorized as prime or subprime borrowers. Prime borrowers are those deemed the most credit worthy by lending institutions. Typically, this entails those borrowers who have a credit score greater than 720. From the perspective of lenders, prime borrowers are the least likely to default on their mortgages.
Subprime borrowers, conversely, have a higher credit risk and greater chance of missing their mortgage payments. This type of borrower typically has a credit rating under 720, implying they have had difficulty repaying debt in the past. In order to compensate for this increased risk, mortgage lenders charge a higher interest rate to these borrowers. With the combination of higher interest rate costs and bad credit habits, it should be no surprise that subprime borrowers are 4 to 5 times more likely to default than prime borrowers. The eventual result of mortgage default is usually foreclosure, which is costly to all parties involved. In an attempt to recover unpaid mortgage payments, lenders have the legal ability to sell a home through foreclosure auction.
This graph shows the proportion of subprime mortgages issued in the United States between 1999 and 2008 as a percentage of all mortgage activity. Data: Inside Mortgage Finance, Inside Mortgage Finance Publications, Copyright 2009
In the decades leading up to the crisis, lenders had historically granted only a small fraction of total mortgages to subprime borrowers - about 8 percent. By 2004, this figure had risen to 20 percent. A few major forces caused this ballooning issuance of subprime mortgages during the turn of the century. As the American economy prospered, credit became easier to obtain in all forms. Lending institutions lowered their credit standards, specifically those pertaining to subprime borrowers. Due to the fact that many of these borrowers were inexperienced in matters regarding the mortgage obtainment process, many were subject to predatory lending practices. The combination of an increase in credit availability and predatory lending practices contributed to an over-issuance of loans to borrowers with the greatest potential for mortgage default and subsequent foreclosure.
As a growing portion of borrowers became riskier, mortgage instruments also followed a similar pattern. The most basic type of mortgage has a fixed-rate - in other words, the borrower pays one interest rate for the entire length of the mortgage. Fixed-rate mortgages are relatively safe for homeowners because they are able to better plan for future interest rate costs. The other main type of mortgage loan is known as a variable-rate mortgage. Also known as adjustable-rate mortgages (ARMs), these instruments exist in many different forms; though all share a few key characteristics. In an ARM, borrowers pay a lower primary interest rate for a short entry period of one to three years. After the entry period, a higher index rate is then calculated throughout the mortgage's remaining life.
Variable-rate mortgages are dangerous in the hands of unaware borrowers because these borrowers may fail to look beyond the entry period. In fact, the term 'teaser rate' is an apt synonym for an ARM's primary interest rate because it did just that. A typical ARM was known as a '3/27,' meaning it was a 30-year mortgage with a lower primary interest rate for the first three years and a variable index rate thereafter. In the case of subprime borrowers, it is now evident that many did not account for the possibility of having to pay higher interest rates in the future. Unfortunately, during the same time that subprime borrowers became more involved in the American housing market, more variable-rate mortgages were issued by lenders. In 2003, about one-fifth of all mortgages in the country had adjustable rates. Two years later, this figure had increased to almost 50 percent. This toxic combination of risky borrowers holding risky mortgages was the driving force of the housing market's demise.
One may wonder how it is possible that borrowers holding variable-rate mortgages did not consider the cost of higher future interest rates. Well, the remaining piece of this puzzle has to do with the idea of 'infinite home value appreciation.' In the mid-2000's homeowners often planned their finances with the expectation that their homes would increase in value each year. Between 1999 and 2006, the average price of a single-family home in America doubled. According to the S&P/Case-Shiller Home Price Index, home values grew at a rate of just over 14 percent per year during this seven-year period. Almost all borrowers, both prime and subprime, assumed that a yearly increase in their home's value would offset the possibility of higher future interest rate costs. As is the case of most price bubbles throughout history, no asset can appreciate indefinitely. The consequences of a future drop in home prices would be devastating.
Throughout the first half of the 2000s, the American housing market began to become much riskier. As discussed above, lenders' increased appetite for risk can be seen through the influx of subprime borrowers granted mortgages. Additionally, a greater percentage of these mortgages were variable-rate, increasing the chance that borrowers would not adequately plan for future increases in interest rate costs. Finally, all parties involved shared an irrational belief that home prices would continue to appreciate into infinity. These three factors were most detrimental to the housing market's decline.