#6 The 2008 Subprime Mortgage & Mortgage-Backed Security Crisis

What do those mean? How about CDO and CDS? What happened in the housing market?

Andrew Bilden

Jun 23, 2023

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Q: What are the terms?

A: Subprime mortgage - a high interest home loan given to people with a low (subprime) credit score (580-619) because there’s a higher risk they won’t pay it back; prime score (660-719).

Mortgage-Backed Security (MBS) - banks or lenders who make loans to people sell the loan to investment banks for a fee. Investment banks buy a lot of loans, create pooled product called MBSs and sell them to investors. Investors and investment banks make money off the interest being paid by the homeowner and have assumed some of the risk.1

Collateralized Debt Obligation (CDO) - similar to MBS, another pool of debt that banks promise to pay to investors in a certain order if there are many defaults.

Credit Default Swaps (CDS) - insurance that people can buy on a loan if it goes bad. Some people bought these to short the market, banking on a bubble bursting.

Q: What happened in the 2008 subprime mortgage and mortgage-backed security crisis?2

A: Defaults on home loans and risky investments in mortgage-backed securities (MBS) led to the loss of wealth for many people.

Since the 1980’s, companies born from the US government like Fannie Mae and Freddie Mac offered subprime mortgages through other banks. The goal was to make housing affordable and achievable for people who wouldn’t find loans at other banks. It came with an implicit government guarantee.

Low interest rates and an improving economy meant there was demand for loans to buy homes. Many lenders lowered their standards by not requiring down payments or proof of income, or acted unethically (predatory). Many people bought houses out of their price range or mortgages they didn’t fully understand.

Investment banks sold mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) to investors, which included people’s retirement account investments. Nobody really paid attention, especially banks and rating agencies.

This made for a risky market.

As more people borrowed for loans, there was an increased demand for homes, and prices went up.

Interest rates rose, and some people who signed contracts with adjustable rates defaulted. These homes went back on the market, but there was less demand. Prices went down. Investors and banks stopped buying loans. Some lenders went bankrupt. The bubble that could now be seen had burst. People had loans that were more expensive than the value of the houses they owned. Investment values dropped.

Because people’s money and homes were at risk, this kicked off a panic and financial crisis that led to government taking stakes in lenders or offering bailouts to banks to stabilize the situation.

Somewhere around 5 million people lost their homes in this crisis, and close to 10 million people lost homes from the crisis and the recession that followed, but the data is not perfect.

There is now more financial and government regulation around sub-prime lending, MBSs and CDOs, which are still legal practices.

There’s much more to cover on the broader 2008 global financial crisis and other crises, like what an inverted yield curve means, but this is the Basic Econ for the mortgage side.

Summary

There was lots of blame to go around for each stakeholder passing off risk and accountability.3

Values don’t just go up, they go down, and speculation gets in the way of fundamentals for decision making.

To reflect: How could private markets improve low-income credit lending? How do Americans think about credit?

I hope you enjoyed!

Basic Econ