The collapse of the subprime mortgage market in late 2006 set in
motion a chain reaction of economic and financial adversity that
has since spread to nearly all sectors of the economy, as well as
to global financial markets, has created depression-like conditions
in the housing market, and has led the American economy to the
brink of recession. In response, many in Congress and the executive
branch have proposed a number of new federal spending and credit
programs that would greatly expand the role of government in the
economy while doing little to alleviate the distress caused by the
How the Problem Started
These problems had their origin in the mid-1990s when mortgage
lenders reduced the previously strict financial qualifications
needed to acquire a mortgage to buy a house by offering
credit-impaired households mortgage loans, albeit at higher
interest rates to compensate for the greater risk. Despite the many
different forms these mortgages would ultimately assume -- no down
payment, interest only, negative amortization, etc. -- they were
designated "subprime" because of the checkered credit histories of
the households using them. 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
As a consequence, the availability of risky loans soared from
the late 1990s through 2006. In 2001, newly originated subprime,
Alt-A, and home equity lines (seconds) totaled $330 billion and
amounted to 15 percent of all residential mortgages. Just three
years later, in 2004, these mortgages accounted for almost $1.1
trillion in new loans, equal to 37 percent of the total. Their
volume peaked in 2006 when they reached $1.4 trillion and 48
percent of the total. Over a similar period, the volume of
mortgage-backed securities (MBS) collateralized by subprime
mortgages increased from $18.5 billion in 1995 to $507.9 billion in
In turn, the looser lending standards allowed previously
unqualified borrowers to become homeowners, and the homeownership
rate soared from the 64 percent range of the 35 years prior to 1995
to an all time high of 69 percent in 2004. While most celebrated
this accomplishment, the consequence of lending to riskier
borrowers under diminished underwriting standards led to an
escalation in the number of loan defaults beginning in 2006,
followed by an escalation in the number of foreclosures. Because
many of these loans had been repackaged into mortgage-backed
securities, the growing default problem soon spread to investors in
the national and international financial markets where these
instruments were sold.
The first to suffer was the housing market, where new
construction and the sales of both new and existing homes plunged.
This was soon followed by a decline in home values, which in turn
worsened the financial problems in the mortgage market by reducing
the value of the collateral securing these loans. As many subprime
borrowers now found themselves owning a house worth less than the
debt owed on it, the incentive to default increased, and by the end
of 2007, more than 17 percent of subprime borrowers had fallen
behind in their loan payments.
Implications for the economy
After reaching the more than 1.7 million new units started in
2005, single-family housing starts in February 2008 fell to a
seasonally adjusted annual rate of 707,000 units, less than half
the level of production two years earlier. On a year-over-year
basis, the decline in starts was 40.4 percent. Sales of new homes
fell precipitously over the same period. After reaching 1,283,000
units in 2005, they fell in February 2008 to a seasonally adjusted
annual rate of 590,000, less than half the level of 2005 and down
29.8 percent from February 2007. For existing homes, sales
peaked in 2005 at 7,076,000 units, fell to 6.4 million in 2006, and
by February 2008 had fallen to a seasonally adjusted annual rate of
5 million, nearly 30 percent below the peak levels of sales during
After two years of declining activity in the housing market,
many are hopeful that the bottom has been reached and that the
market will soon revive, but this seems unlikely. The subprime
default and foreclosure problems first emerged at a time 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 confront unemployment, tightened
credit standards will exclude many from homeownership, and the
number of subprime mortgages resetting to higher payments will be
greater than the number that reset in 2006 and 2007.
As a consequence, the homeownership rate is likely to fall from
its record levels near 69 percent to something closer to the
long-term historic norm of 64 percent. This trend in turn implies a
greater number of lost homes coming onto the market at a time when
sales are depressed. 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 a costly exercise to prop up the inflated an
unsustainable market that characterized 2004 to 2006.
In response to the threat of a financial market panic that could
contribute to a severe recession, as well as to the growing number
of borrowers who might soon lose their homes, both Congress and the
Administration began to take a number of steps to address the
problems. Regrettably, they all involved expansion of existing
federal programs and the creation of many new ones, often at very
substantial cost to the taxpayer.
Notwithstanding the constituent and lobbyist pressure to do
something costly and do it quickly, the history of government
intervention in housing markets and the economy has not been one of
notable success. Many of the proposals now on the table hold the
promise of carrying on that tradition and doing so, as noted, at
great cost to the taxpayer.
Many in Congress and the Administration are calling for more
regulation, yet a much more intensive system of federal regulations
of the industry in the past contributed to the catastrophic
collapse of the savings and loan industry in the late 1980s and
early 1990s. Thanks to a burdensome system of intense federal
regulations, the S&L industry -- then the most important source
of mortgage credit -- was technically insolvent because the market
value of its mortgage loan portfolio was less than the value of the
deposits financing it. Although Congress belatedly responded by
reducing the regulatory burden it had earlier imposed on the
industry, that effort was too late, and by the end of the 1980s,
the S&L industry was teetering on the brink of collapse.
And collapse it did. In the late 1980s, more than 1,000 S&Ls
became insolvent and filed for bankruptcy. By 1995, there were only
1,645 S&Ls in operation compared to 3,234 in 1986, and the
industry's share of the mortgage market fell from 44 percent in
1970 to 21 percent by 1990. Because the value of the insolvent
S&Ls' assets was less than that of their deposits, the Federal
Savings and Loan Insurance Corporation (FSLIC) had to cover the
loss between what the assets were worth and what was owed to the
federally insured depositors. The losses quickly exceeded the
reserves of the FSLIC (which was subsequently merged into the
Federal Deposit Insurance Corporation), and the final cost of the
debacle to the taxpayers totaled approximately $130 billion.
A Bigger Fannie Mae
Another response to the current problem has been to expand the
powers (and market share and profits) of the two major
government-sponsored enterprises (GSEs): Fannie Mae and Freddie
Mac. Until recently, the Bush Administration and some in Congress
were working to diminish their role as a consequence of
mismanagement, the concentration of risk, and misbehavior over the
past decade or more. Despite the presumed intense federal oversight
of these two GSEs, both of them found themselves mired in
allegations of massive accounting fraud in the early part of this
decade. More recently, and again despite federal
oversight, both have suffered major losses -- almost $9 billion in
the second half of 2007 -- from bad mortgage investments in their
most recent fiscal year.
Others see a bigger role for the Federal housing Administration
(FHA), but FHA loans experienced a higher default rate than
subprime loans from 2003 through 2006, and more than 14 percent of
FHA borrowers are now behind in their payments.
As recent history reveals, there is little reason to have much
confidence in a relief effort that relies upon a suspect process
implemented by suspect institutions. While only a few of these
proposals have been acted on, the threat of a worsening economy and
the prospect of an upcoming presidential and congressional election
may encourage many members of both parties to succumb to the
temptation of a massive bailout. As noted, the history of such
government intervention in housing markets has not been one of
notable success. Many of the proposals now on the table would
simply carry on that tradition.
Will history Repeat Itself?
Among the many risks now confronting the nation is that
substantial expansion of the federal government's scope will be
both ineffective and permanent. While many know that the advent of
the New Deal during the Great Depression of the 1930s led to a
substantial and permanent increase in the scope of the federal
government, few know that the process of federal expansion was well
underway before Franklin Roosevelt took office in 1932.
Following the stock market collapse in October 1929, the
Republican Administration of President Herbert Hoover attempted to
spend its way out of the depression, increasing federal spending by
47 percent between 1929 and 1932, Hoover's last year in office. As
a result, the federal share of GDP increased from 3.4 percent in
1930 to 6.9 percent in 1932. By 1940, spending had increased to 9.8
percent of GDP while the level of government spending doubled.
Indeed, many of the federal programs now being considered for
expanded action -- Fannie Mae, a resurrected Home Owners Loan
Corporation, FHA, Federal Home Loan Bank Board -- were created during
the Great Depression for much the same purpose.
While this point of nostalgia has excited many of the current
advocates of federal expansion, ordinary citizens and taxpayers
should take note that, despite all this spending and government
bureaucracy-building, the number of Americans with jobs in 1940 was
less than the number with jobs in 1929. And despite the New Deal's
focus on the problems of the housing market, the homeownership rate
in 1940 was the lowest since that data series had been created -- and
even below that of 1890 (47.6 percent vs. 43.6 percent).
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
Edward Vincent Murphy, "Subprime Mortgages: Primer on Current
Lending and Foreclosure Practices," Congressional Research Service
Report for Congress, March 19, 2007, pp. 2 and 3.
Darryl E. Getter, Mark Jickling, Marc Labonte, and Edward Vincent
Murphy, "Financial Crisis? The Liquidity Crunch of August 2007,"
Congressional Research Service Report for Congress,
September 21, 2007, p. 4.
"New Residential Construction in February 2007," U.S.
Census Bureau News, U.S. Department of Commerce, March 18, 2008,
"New Residential Sales in February 2008," U.S. Census
Bureau News, U.S. Department of Commerce, March 26, 2008, Table
James R. Hagerty, "Fannie, Freddie Shares Suffer Hit As
Mortgage-Default Fears Mount," The Wall Street Journal,
March 11, 2008, p. A3.
National Delinquency Survey, from the Mortgage Bankers
Association, Q407, Data as of December 31, 2007, Mortgage
Bankers Association, March 2008.