The Great Subprime Meltdown of 2007

Abstract

This article is a brief survey of the subprime mortgage market that existed in the United States from 2000 to 2007. It is a story of how a small, inconsequential part of the mortgage market grew into a monster large enough to shake the very foundations of the U.S. financial system. It's a story with some elements that are old (all bull markets share common traits) and some that are new (credit default swaps, mezz CDOs, ABX, etc.) and it's a story that is not over. The article discusses a “virtuous” cycle of rising home prices and “affordability” mortgage products, reasons the 2006 vintage of subprime mortgages are defaulting at higher rates than the 2005 vintage, the delayed response by banking regulators, programs to rescue subprime borrowers, the role of securitization in the growth of the subprime market, the lack of transparency of subprime securities and their Mezz CDO offshoots, and the spillover of the subprime problem to other markets. A “new” subprime industry is evolving from the ashes of the old, but its final shape is not yet known. We know that the industry that prevailed from 2000 to 2007 no longer exists, but we don' know precisely what will take its place. It will be a much smaller industry (at least 50% smaller), it will consist of largely portfolio-based lending by large financial institutions and it will be mainly subprime loans that have few of the layered risk elements that came to dominate the industry in recent years. But as of this writing (September 2007) the industry is struggling to find the right type of loan that borrowers can afford and that will meet the new bank regulations. If and when subprime loans are securitized again, the new loans also will have to accommodate much tougher enhancement levels demanded by the rating agencies and be a product that investors will once again accept. Developing a product that meets all of those constraints will not be easy.