There is some debate as to whether the current international economic problems can be blamed primarily on what started out as merely the “subprime crisis” in the United States. However, certainly the conventional wisdom remains that the meltdown in the subprime market was the most crucial factor in what has developed into a financial downturn affecting the entire economy. Therefore, a little history may be helpful in understanding what brought us to this point.

Whether it’s the “subprime crisis,” the “subprime meltdown” or sometimes simply the “subprime mess,” anyone keeping up with the news in even a cursory manner has been inundated for the past two years with references to the “subprime” problems. Originally coined to describe loans made to “persons with blemished or limited credit histories” and carrying “a higher rate of interest than prime loans to compensate for increased credit risk,”1 the term subprime has become a proxy for the complex mortgage and security transactions that fueled the housing market in the United States and beyond – and the resultant woes of consumers, lenders and investors in that market.

How Did We Get to this Point?

Prior to World War II, banks and savings and loan associations made most of the home loans in their communities, utilizing local deposits from local residents. Typically, they made the loans, serviced the loans, took all the risks and made all the decisions, including the ultimate decision about whether to foreclose in the case of a default. As a part of the New Deal, the Federal National Mortgage Association (“Fannie Mae”) was created – with the goal of creating a secondary market for mortgages. The local lender could then sell a mortgage and get needed cash and use the cash to make another loan. Fannie Mae thus took on the credit risk, but could spread the risk through a nationwide portfolio (and also limited its risk by requiring that it would only buy “conforming” mortgages that met certain requirements). Although the term was not used in quite the same way at the time, a loan conforming to Fannie Mae’s “higher standards” would be what we now think of as a “prime” mortgage.

Fannie Mae was a strong addition to the mortgage market and that led in the late 1960s to “Ginnie Mae” – the Government National Mortgage Association. Ginnie Mae was set up to handle government-guaranteed mortgages, such as veteran programs and various federal housing initiatives. The reorganization that established Ginnie Mae also basically privatized Fannie Mae, allowing the market risk to be shifted to private investors.

In its simplest form, a mortgage backed security bundles similar types of mortgages and sells these bundled mortgages to investors (who receive a return on their investment tied to the payments made by the borrowers who mortgaged their homes). In the 1970s, Freddie Mac – the Federal National Mortgage Corporation - allowed this process to expand and provided competition to the privatized Fannie Mae.

These various programs established by the federal government ultimately expanded the availability of “conforming” (i.e., “prime”) mortgage loans and created a major market of investors who wanted to invest their money in what was considered a fairly safe investment – mortgage backed securities. This whole securitization process – turning simple home loans into investment vehicles – spread the risks far beyond the initial lender, provided liquidity to lenders and a relatively safe investment to investors.

The Process of “Securitization”

This private “origination and sell” process for mortgages resulted in the creation of “special purpose entities,” whose sole purpose was to hold the mortgages and issue shares to the investors (who provide the special purpose entities with the money to buy the mortgages). Many times pools of loans were separated into groups, based upon the quality of the loans and the amount of risk (and, correspondingly, the amount of potential return).

So, what started as a government-based, federally guaranteed loan program evolved into a model for the private sector to create and issue its own mortgage-backed securities. Aside from creating a source of further funding for loans and a new market for investors, this whole securitization process did something else – it created a lot of potential revenue for people who neither were borrowing money nor loaning money – originators, brokers, and servicers of the loans and the securities that were created from them. The private sector home mortgage securitizations then mushroomed and took over a majority of the market.2

In short, the whole concept of mortgage-backed securities that had evolved over a period of nearly 70 years made a dramatic shift within the past few years from being tied primarily to conventional, conforming, “prime” loans bundled by the government-established vehicles to having a significant element of lower quality or “subprime” loans being pooled and included in private sector securities. . Compared to Fannie Mae and Freddie Mac that focused on “prime” mortgage lenders, the new “private label” component included a heavy dose of high-fee and high-risk loans.

The Stage is Set

To understand the subprime market, you have to remember what was happening with the economy after September 11, 2001. The Federal Reserve made drastic cuts in interest rates and the federal fund rate dropped to 1 percent in 2003. With interest rates so low, the sales of houses in the U.S. skyrocketed.

Unfortunately, the increase in demand for home mortgages came at a time when the market incentives did not create a particularly cautious approach to lending. Unlike the old days when the local banker that made the loan to the local home owner actually had to worry about getting paid, with the new private securitization process the originator of the loan would typically sell the loan immediately to some nameless, faceless group of investors that would take the mortgage in a package with hundreds or thousands of others. The home mortgage business became “big business” – with big fees from brokering, underwriting, securitizing, rating and servicing new loans.

With that environment, suddenly loans were being made with 125% loan to value ratios, unrealistic assumptions were sometimes made about continued increases in home prices, and loans were often refinanced for the sole purpose of paying off credit card debt for the consumer and creating another fee for the loan originator. “Teaser rates” were given at the beginning of a loan, and interest-only loans were sometimes made. Consumers were willing to overlook the long-term implications of significant rate changes or negative amortization. In short, corners were sometimes cut and loans that might not have historically been considered “subprime” based on the borrower’s credit worthiness were, in fact, below par in terms of overall quality and risk factors.

To complicate matters more, Wall Street figured out ways to take the lower quality loans and make them small pieces of a large pool of mortgages that was, in theory at least, still a high quality investment vehicle when viewed as a whole.

The Meltdown Begins

By the middle of 2007, there was a clear crisis in the industry caused by a variety of factors tied in part to this substantial increase in subprime loans, a stalled housing market and the overall impact on the investment community, which suddenly seemed to recognize the implications of higher rates of default and unexpected risks. The secondary market for mortgage-backed securities began to dry up. Lenders had fewer places to sell new loans they were generating, and their source of funding to make loans became much more limited. A number of home mortgage lenders ended up in bankruptcy or out of business. Housing prices stagnated. And then, all of those adjustable rate mortgages that had been brokered when interest rates were low began to reset at higher rates. Mortgage defaults with some originators doubled from 2006 to 2007.

The meltdown for the home mortgage market (and the private securities market it spawned) had begun – and the overall credit crunch and economic woes spread far beyond the original industry involved. There were significant regulatory and legislative activities in 2007 and 2008 to try to turn the tide, but all of those efforts were dwarfed by the much more massive actions taken in October 2008 that gave rise the Emergency Economic Stabilization Act of 2008 and the Troubled Assets Relief Program.