With the exclusion of the burst of the dot-com bubble along with the temporary downturn after 9/11, America saw continued expansion of the market during the late 1990s and 2000s. A housing market drove customer spending and made the financial markets a great deal of money. Yet, when the sector began to falter, the market began to falter with it, and a domino effect began that led to a meltdown in the financial sector and national recession. Two individual factors caused the subprime mortgage crisis: a home market that expanded too rapidly to become sustainable and a basic change in the managing of mortgages.
Starting in the 1990s, the USA began experiencing a time of great financial prosperity. The nation had a balanced budget and many consumers were feeling good about the future. These positive feelings spurred consumer spending, forcing a growth in industrial output, which boosted employment and contributed to greater prosperity. The first part of the 2000s saw a reduction in interest rates and people buying houses in record numbers, driving up demand and prices. In many areas, such as California, Arizona and Florida, buyers greatly outnumber sellers and bid for houses over the asking price. Sellers began increasing asking prices in response and double-digit annual value increases became common. Many who did not market their houses borrowed from the equity produced by the inflated value of the houses.
The assumption in the 2000s was that housing prices would grow indefinitely, which makes buyers rush into purchasing and investors and sellers anxious to see gains. Lenders fueled this assumption by developing risky, innovative loan programs to fund this overblown market and enlarge the pool of buyers. A huge proportion of those loans were subprime loansloans especially geared toward buyers with high risk credit and greater debt.
Lenders operate on perceived risk. They judge whether to approve a person for a loan based on the default risk of the applicant. Lenders do not like loan defaults due to the fact that they result in foreclosure, which traditionally costs them money. When home prices rise at a quick pace, as they did at the 2000s, foreclosure is much less costly or as likely, because the homeowner can sell before foreclosure occurs or the lender can stand to eliminate money once in a while on a foreclosed home. This means the lender can afford to take some extra risk with the types of loans it provides.
Lenders began offering subprime loans that featured reduced credit criteria, reduced down payment requirements, let more debt versus income, and started more applications with little to no income verification in exchange for gains from charging higher interest rates. These products enlarged the pool of buyers, which warmed up the industry even more. Adjustable-rate mortgages provided low initial monthly payments for a couple of years that would adjust to a speed more in keeping with the market and let more people get into homes that would otherwise be out of the price range with minimal to no money down. Home buyers with such mortgages expected refinancing to fixed-rate loans before the modification interval and building equity from increasing prices.
Lenders took even more risk in their loans since they changed how they did business. In the past, lenders were restricted in how far they could lend by just how much they had in deposits or may borrow. In the 2000s, most lenders acquired a continuous source of money to lend by bundling loans and selling them at a profit as mortgage-backed securities. These bundles comprised both high- and low-risk loans. The demand in the secondary market for these securities was high, with everyone from insurance companies to mutual and pension funds one of the purchasers. The sale of these loans required the foreclosure threat off the lender’s shoulders, freeing them to create even more loans and continue to fuel the market. A vicious cycle has been born.
The bubble burst when the first wave of foreclosures arrived in 2006 and 2007. Many homeowners did not or could not refinance their adjustable-rate mortgage could not afford the new high corrected payment. The resulting foreclosures began to flood the market and bring prices down. Lenders began to tighten lending criteria, which restricted the pool of buyers and, even when combined with falling home prices, further restricted the ability of homeowners to avoid foreclosure. Eventually, many homeowners were”upside down,” meaning that they owed more than what their houses were worth. A cycle began that eventually affected the whole nation and pressured many lenders out of business, starting with the heavily subprime lenders.