Why Did Subprime Loans Become Such a Big Deal?

Monday, May 5th, 2008

Abraham ParkIntelligent people, including my wife, have been asking me questions about the subprime mortgage crisis. The point that seems to stump them is why a relatively small percentage of subprime mortgage defaults has led to a spiraling national credit crisis, how it happened, and where do we go from here. They were good questions, and if you are wondering the same thing, read on…

So what’s the deal with the subprime mortgage meltdown?

Well, imagine that the markets involved are analogous to a house with three stories. Each of the floors represent an industry related to the housing market and each of the upper stories are dependent on the one right below it.

The first floor represents the primary mortgage market (homeowners and their banks or mortgage lenders)

The second level represents the secondary mortgage market (where government-enabled agencies and private lenders by bundled bank mortgages)

The third represents the credit derivatives market (where securities created in the secondary mortgage market are pooled again with other debts and with various risk preferences)

The primary mortgage market is huge, but the second and third levels are just as huge. It makes for a pretty big meltdown when it all starts to unravel.

When did they start lowering standards for homebuyers?

A lot of changes happened about twenty years ago, when the Tax Reform Act of 1986 introduced interest deductions on mortgages for homes, making mortgage debt cheaper than consumer debt for many homeowners. In addition, there was a concerted effort in economic policy to increase the share of homeownership in America. As a result, since 1986, the housing market has experienced 20 years of continued price increases. Even through the recession of 2001, while labor and stock markets weakened, the housing market continued to thrive with high volumes and steady price increases.

And along with the housing boom came the growth of the mortgage lending industry. Subprime lending was made possible because of laws such as the Depository Institutions Deregulation and Monetary Control Act (1980) and the Alternative Mortgage Transaction Parity Act (1982), which gave lenders the ability to charge high rates and fees, as well as variable interest rates and balloon payments.

However, it wasn’t until 1994, when an increase in interest rates caused a drop in prime mortgages, that brokers and mortgage companies turned to the subprime market to maintain the volume. During these times, subprime mortgages were relatively new and the long-term performances of these loans were unknown. In 1995, the size of the subprime loan market was estimated around $65 billion, but by 2007, subprime mortgages accounted for $1.3 trillion out of a total of $10 trillion in outstanding mortgages.

But how could so many lenders originate such huge volumes of mortgages? Where do they get their money?

From the secondary market, or the second floor of our imaginary house analogy. Mortgages, if you think of them as a consumer good, can actually be bundled and sold. And the government (and some private companies) bought them. After the savings and loan crisis of the 1980s, with the infamous “maturity mismatch” problem of lenders using short-term deposits to fund long-term mortgages, mortgages became tougher to acquire. So the government enabled agencies like Ginnie Mae, Fannie Mae, and Freddie Mac, to buy bank mortgages in the secondary mortgage market, which gave mortgage lenders a way to replenish their funds so that they could in turn originate more mortgages.

These government agencies (and some private companies also) then turned around and issued securities based on these mortgage debts as collaterals. And global investors, who wanted to participate in the U.S. housing market, bought a lot of these types of securities. And since 1980, the volume of government-sponsored mortgage-backed securities has risen from $200 billion to over $4 trillion. In addition, private mortgage insurers and mortgage pools (which include nonconforming loans) account for approximately $2 trillion.

The secondary market was an incentive, then, for banks to issue more loans?

Precisely. With the securitization of loans, banks and mortgage lenders effectively became mortgage originating and servicing business, which meant that mortgage lenders profits were based on the volume of mortgage originations. Since there was a huge growing secondary market willing to buy repackaged mortgage products that were ultimately based on these mortgages, the effective size of the mortgage market became much bigger than the size of the mortgage originations.

Then why would the secondary market buy the subprime loans? Don’t they have standards?

From the mid 1990s, the growth in securitization (10% of mortgages securitized in 1980 while 60% securitized now) led to dramatic growth in subprime lending as well, and by 2007, 75% of all subprime mortgages were securitized.

Now, the reason why subprime loans were able to be repackaged and sold in the secondary market , was entirely due to the existence of credit ratings agencies, such as Moody’s and Standard & Poors. Although they provide no guarantees, there is an overwhelming and even reckless reliance by investors on these agencies to give accurate ratings.

Rating agencies measure the credit risk, which is also referred to as default risk. Professional credit risk managers spend theirs careers developing credit risk models, but most models are based on two fundamental concepts: default probability and recovery rate. Together, the default probability and recovery rate give a good measurement of a debt’s quality and are often referred as credit spread. Combining these factors with a measurement of how much the creditor would lose if the counterparty defaulted (credit exposure) on a given debt, companies can calculate the expected loss of any given obligation. Now when the credit rating agency gives a stamp of approval, the tendency is for investors to not look at the quality of the underlying mortgages.

If we go back to our 3-story house, the credit ratings agencies are like the columns that are holding up the building; the foundation on which the columns are grounded are the assumption, based on historical figures, that house prices will continue to rise as they have since 1986. So when the house prices fell….

Then the second floor came crashing down? What a mess!

But the second floor is nothing compared to the third floor. The third floor represents the credit derivatives market, in which securities created in the secondary mortgage market are in turn pooled again with other debts and sold as slices (known as tranches) with various risk preferences. Banks, securities houses, hedge funds, and insurance companies buy these credit derivative instruments, called structured finance products.

Everyone benefited from credit derivatives:

  1. Banks could transfer the credit risk of loans through these derivative products, while keeping the loan on its books
  2. Investors could enhance the credit risk of obligations by isolating the credit risk, pricing it, and transferring it to other investors; and
  3. Investors could diversify their risk with credit derivatives such as collateralized debt obligations (CDOs) or mortgages obligations (CMOs), which bundled together different types of credit risk and sold them as a portfolio product.

The frightening thing is that this third floor, though a relatively new development, is HUGE.

The credit derivatives market has had explosive growth only since the late 1990s. From $170 billion in 1997, currently the global credit derivatives market stands at estimated $20 trillion, surpassing the equity derivatives market and the corporate bond market. The CDO market alone is roughly $3 trillion—CDOs are useful because they can be used to dispose of high risk loans. Japanese banks used CDOs to clear up their loan books in the 1990s, as did Germany’s Dresdner Bank in 2003.

But who is holding this market together? You guessed it – the credit rating agency. It’s practically impossible for the investors in this market to understand or know the credit risk of the underlying securities when the underlying loans are pooled together from many different sources and are repackaged multiple times. So everyone just trusted the credit rating agencies to assign the appropriate risk rating.

How could they put so much trust in the rating agencies?

That is the biggest problem. Investors are interested in high returns, but only if they can trust the risk rating. Much of the global money has shifted away from the US stock market and into the real estate market since 2000 when the internet bubble burst. In the finance world, it’s all about risk-adjusted returns, and people don’t, or can’t, invest if risk can’t be accurately assessed.

So that is why the subprime debacle is a deeper problem than just these mortgages. It has revealed that the risk-pricing system by credit agencies is deeply suspect, which in turn has brought into suspicion not only subprime evaluations, but all other risk-based evaluations in the financial market.

Going back to the 3-story house analogy, imagine if the investors in the third floor realized that the columns have cracks in them (thus, risk of their investments were much higher than once believed). Not only would they want to shut down the third floor, they would want to exercise buyback provisions that permit investors to sell back loans that go bad within a specified period of time.

That’s how you get a case like Bear Sterns. Once everyone realizes that your underlying collateral is worth much less than expected because of the adjustments in credit ratings, the issuer is stuck with bad mortgages and the huge second and third floor activities suddenly freeze.

So what happens next? Are we going to buy a house this summer or not?

The problem was caused by credit rating agencies basing the credit risk of mortgages on the faulty assumption that the housing prices would continue to go up. So when house prices fell against expectations, all those industries we talked about suddenly found themselves on shaky foundations. Consequently, the secondary mortgage market participants are reducing mortgage purchases from the mortgage lenders, which means the mortgage lenders are stuck with bad mortgages. With liquidity dried up, mortgage lenders now have to tighten borrowing standards, which in turn causes house prices to fall even further. Potential disaster can be alleviated if the house prices start to go back up soon again. But I wouldn’t expect the house prices to turn up again any time soon, even though interest rates remain low.

The first order of priority, before expecting the house prices to rise, would be for the government and financial market participants to reevaluate the credit rating agencies, credit risk pricing models, and structured finance products in general. There is also the whole potential legal mess involving the mortgage insurers. It’s going to be a long road back.

As to buying a house, let’s wait.


Related in the Graziadio Business Report

Will the Sub-Prime Meltdown Burst the Housing Bubble? by Peggy J. Crawford, PhD, and Terry Young, PhD

Is the Real Estate Market a House of Cards? by Peggy J. Crawford, PhD, and Terry Young, PhD

The Book Corner Recommends: The Foreclosures.Com Guide to Making Huge Profits Investing in Preforeclosures without Selling Your Soul by Michael Kinsman, CPA, PhD

Topic: America's Financial Crisis, In the News, Real Estate
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San Diego Bankruptcy Lawyer

September 10, 2010 at 8:08 AM

Prof. Park-

As a bankruptcy attorney I see so many people who’s mortgages spiraled out of control and they now face foreclosure. Really, it doesn’t look like it is getting any better. Thanks for the information.


Chandler realtor

September 13, 2010 at 11:15 AM

Great post, I love how you break everything down.

Arizona Golf Course Homes

September 20, 2010 at 3:07 PM

Well its been over two years since this article was published and things don’t seem to be any better now than they were then, maybe even a little worse. I guess we need to just hope for the light at the end of the tunnel. One thing is for certain, we’re closer to it now than we were in May 2008!

Brooklyn Real Estate

November 1, 2010 at 6:52 AM

First off – great info-graphic, great way to give a picture depicting the market.

The economy is still down, as it was in 2008 – However, there are still hopes for the future. There have been some credits given to new home-buyers which is at least an attempt to alleviate this situation. Hopefully, we continue to keep the money moving in the real estate market.

Birmingham Electricians

November 4, 2010 at 12:39 PM

In Birmingham, we haven’t had it as bad as other areas. My friends in Tampa are in completely different situations that us.

Jarl Kubat

November 26, 2010 at 7:51 AM

This whole mortgage debacle has left many families in shambles. Our country is near collapse and the people that are suppose to navigate us through this mess understands it.

H. Tieben

November 29, 2010 at 3:16 AM

Not only subprime loans were the problem, you can see the same now in Europe (Greece, Ireland etc.)

H. Tieben

Anna Holland

February 8, 2011 at 12:28 AM

There really is no solution to that problem.
Of course there are government agencies that help pay mortgages but the government also has to help banks that go bankrupt because they will cripple the economy.

-Anna of Eton Properties

Cornerstone Properties

March 22, 2011 at 1:27 PM

A loan that is made at a higher interest rate than most other loans. Subprime loans are made to borrowers who do not qualify for ordinary loans because of bad credit history or some other reason.

CT Real Estate

May 18, 2011 at 1:56 PM

It is sad, that to this day business, despite record piles of cash, are not hiring more. It is the only way to get the country on its feet again, yet private business can’t get their act together to help not just the USA, but the world. I wonder when this sub-prime mess will ever be behind us.

Bankruptcy Attorney San Diego

August 2, 2011 at 5:09 PM

The relatively small number of mortgage defaults is a huge number for the credit markets to absorb and it is growing. In San Diego, California, for example, mortgage defaults are continuing at the pace they have been for the past year and the pace does not appear to be slowing. Mark, Bankruptcy Attorney in San Diego.

what is mortgage rate today

August 23, 2011 at 2:46 PM

They were trying to get out of their stake but there is a ton of Chinese bank equity sales and Then again, I’ve never understood why ANY small investor would use a high-service brokerage, given their long long record of selling inferior branded products with high costs and poor performance.


September 7, 2011 at 9:57 PM

Interesting post :)


September 26, 2011 at 7:35 PM

Call me wind because I am abolsuelty blown away.

Audra Quinn, Managing Editor

October 3, 2011 at 8:49 AM

Thank you Luther! We are looking into it now. I greatly appreciate you bringing this matter to my attention.

Audra Quinn
Managing Editor


November 12, 2011 at 3:07 PM

You say that the derivatives market took off in the mid 1990s.

Question: Did the derivatives market exist in the US before The Financial Modernization Act of 1999? Or if it did exist was it a dominate source of risk — in the trillions of dollars — to all the other layers in the market?

How did banking deregulation and the rise of the “institutional speculator” play a role in the development of the derivatives market?

If we argue that in the past markets were driven by rational risk taking on the basis of success — or at least cutting your losses before its too late — does not the incentive to bet on market losses encourage an ironic “rationality of unacceptable risk”?

By way of example the documentary, “House of Cards”, depicts a trader who made a killing speculating that the bubble would burst. Hence my question: Would betting money on the probability of loss have been possible ~30-odd years ago?


November 21, 2011 at 1:18 PM

great post with your model you can see where the mass of theft took place
on the second and third floor.

Free Education Aid

December 21, 2011 at 9:15 PM

Well its been over two years since this article was published and things don’t seem to be any better now than they were then, maybe even a little worse. thanks for information..I really like to know more about subprime mortgage crisis.

Free Education Aid

January 3, 2012 at 10:51 PM

very well written, Hopefully some of the negative inventory sitting on the real estate markets will get pushed through soon. There have been some credits given to new home-buyers which is at least an attempt to alleviate this situation.

Reuben Silvester

March 3, 2012 at 6:36 AM

Good day, dear sir, great site! But I am with poor vision,it is hard to read the text with so few linebreaks, otherwise I really aprecciated your post.

Levi Goldberg

March 12, 2012 at 4:48 PM

It’s interesting to read an loan related article which was written BEFORE the financial crises happened. The best sentence in this article was “As to buying a house, let’s wait.”. People who followed that advice probably saved a fortune. Thank you. Best wishes from NYC

pasma training

March 17, 2012 at 2:27 PM

This valuable information means much to me and much more to my colleagues. Thank you;

doncaster locksmiths

March 19, 2012 at 12:50 PM

That is so typical, I can’t feel consumers are doing this but whatever

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March 27, 2012 at 1:35 AM

This good information,thanks!

Pension Release

April 5, 2012 at 4:44 AM

Thank you for this very helpful article. I have found it quite useful.


May 2, 2012 at 10:49 PM

I enjoy what you guys are usually up too. This kind of clever work and reporting! Keep up the terrific works guys I’ve added you guys to my own blogroll.

Lance Hill

May 28, 2012 at 10:08 AM

Very informative. I am just hoping that any non-positive thoughts lying around the real estate markets will be gone soon.

Zimmerman Defense Fund

July 24, 2012 at 8:33 AM

Great post…Shared on FB


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