The Heritage Foundation

Executive Summary #2127 on Economy

April 22, 2008

April 22, 2008 | Executive Summary on Economy

Executive Summary: The Subprime Mortgage Market Collapse: A Primeron the Causes and Possible Solutions

The collapse of the subprime mortgage market in late 2006 set in motion a chain reaction of economic and financial adversity that has spread to global financial markets, created depression-like condi­tions in the housing market, and pushed the U.S. economy to the brink of recession. In response, many in Congress and the executive branch have proposed new federal spending and credit pro­grams that would greatly expand the role of govern­ment in the economy but do little to alleviate the distress caused by the financial crisis that has spread rapidly to nearly all sectors of the economy.

The Financial Crisis. These problems origi­nated in the mid-1990s, when mortgage lenders relaxed the previously strict financial qualifications for obtaining a mortgage to buy a house by offering mortgage loans to credit-impaired households, albeit at higher interest rates to compensate for the greater risk. Despite the many different forms that these mortgages would ultimately assume (e.g., no down payment, interest-only, and negative amorti­zation), they were designated "subprime" because of the borrowers' checkered credit histories. Despite the risk associated with these subprime mortgages, many mortgage lenders further relaxed their under­writing standards and in the process introduced even more risk into the system, some of it motivated by fraud and misrepresentation.

Looser lending standards enabled previously unqualified borrowers to become homeowners, and the homeownership rate soared from the 64 percent range of the 35 years before 1995 to an all-time high of 69 percent in 2004. While most celebrated this accomplishment, lending to riskier borrowers under diminished underwriting standards led to an escalating number of loan defaults and foreclosures beginning in 2006. Because many of these loans had been repackaged into mortgage-backed securities, the growing default problem soon spread to inves­tors in national and international financial markets where these instruments were sold.

The first to suffer was the housing market when new construction and sales of new and existing homes plunged. This was soon followed by a decline in home values, which worsened the mort­gage market's financial problems by reducing the value of the collateral securing these loans. As many subprime borrowers found themselves owning houses worth less than the debt owed on them, their incentive to default increased. By the end of 2007, more than 17 percent of subprime borrowers had fallen behind on their loan payments.

Many hope that the housing market has reached bottom and will soon revive, but this seems unlikely. The subprime default and foreclosure problems first emerged when the economy was healthy, most borrowers were employed, and hous­ing values were stable or rising. In 2008, home prices and sales are falling, some borrowers may soon be unemployed, tightened credit standards will exclude many from homeownership, and the number of subprime mortgages resetting to higher payments will be much greater than the number that reset in 2006 or 2007.

As a consequence, the homeownership rate will likely fall from its record levels near 69 percent to something closer to the historic norm of 64 percent. This trend implies that a greater number of lost homes will come onto the market at a time when sales are already depressed.

Proposed Solutions: Good and Bad. Under the circumstances, government policies should focus on cost-effective ways to facilitate the transition to a sustainable housing market of fewer homeowners and/or lower home prices, as opposed to costly exercises to prop up the inflated and unsustainable market of the sort that existed from 2004 to 2006.

One way to do this might be to encourage cre­ation of a privately funded version of the Resolution Trust Corporation that helped to wind down the portfolios of the dead and dying savings and loan industry during the catastrophic collapse of the real estate market in the late 1980s and early 1990s. Capitalized by financial institutions looking to sell off portions of their troubled mortgage portfolios (an ownership share of the entity would be a pre­requisite for using it), the corporation would be tasked with choosing the most cost-effective way to deal with each troubled mortgage, ranging from foreclosure to restructuring. A new private entity, the Private National Mortgage Acceptance Com­pany (PennyMac) has already been created to do just that. More will be needed and should be encouraged.

This approach would be superior to many of the costly plans that Congress and the Administration have been discussing, all of which would expand existing federal programs to some degree and/or create new ones, often at substantial taxpayer expense. While only a few of these proposals have been acted on, the threat of a worsening economy and upcoming presidential and congressional elec­tions may encourage members of both parties to succumb to the temptation of a massive bailout. As this report reveals, the history of such government intervention in housing markets is not marked by much success. Many of the current proposals prom­ise to carry on this tradition of failure.

Conclusion. Among the many risks confronting the United States is that many of the proposed relief measures would substantially and permanently expand the scope of the federal government while doing little to address the current financial crisis. Few will remember that, while the New Deal of the 1930s substantially and permanently increased the scope of the federal government, the process was well underway before Franklin Roosevelt took office in 1932. Following the stock market collapse in October 1929, the Hoover Administration attempted to spend its way out of the Great Depres­sion, increasing federal spending by 47 percent between 1929 and 1932. As a result, federal spend­ing as a percentage of GDP increased from 3.4 per­cent in 1930 to 6.9 percent in 1932 and reached 9.8 percent by 1940. During that period, many of the federal programs now being buffed up for expanded action-Fannie Mae, Home Owners' Loan Corpora­tion, FHA, FHLBB-were created for much the same purpose.

While this point of nostalgia has excited many advocates of an expanded federal government, ordi­nary citizens and taxpayers should note that, despite all of the new government spending and bureaucracy, fewer Americans had jobs 1940 than in 1929. Furthermore, the homeownership rate of 43.6 percent in 1940 was the lowest recorded by the Census Bureau, even below the 47.6 percent rate of 1890.

Ronald D. Utt, Ph.D., is Herbert and Joyce Morgan Senior Research Fellow in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

Ronald D. Utt, Ph.D. Herbert and Joyce Morgan Senior Research Fellow

Related Issues: Economy