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This is only a snippet and includes the general layout of the problem in laymen's terms.
American home ownership blossomed from 45% to 65% a decade after WWII due to a variety of factors. One of these was the introduction of long-term fixed mortgages. These mortgages allowed a burgeoning middle class with with good credit and a 20% down payment to build equity that used to be only available to the wealthy. This down payment was possible for many due to a high general savings rate and forced savings accounts by the government.
However home ownership was still out of the reach of many lower income families who could not afford the down payment and minority families who were occasionally discriminated against by the banks even if they qualified. One of the reasons for this was that most mortgages were held by institutions called savings and loans. These savings and loans were bound to Regulation Q of the Federal Reserve that limited the interest they could pay and ultimately limited their ability to attract deposits used to finance new mortgages. As a result mortgage institutions were very selective in who they chose and only individuals who posed the least perceived risk to default would qualify for a mortgage.
It was part of this peculiar aspect of mortgages in the United States that led to deregulation. It is not that banks could not provide mortgage loans; they often did and were regulated by Regulation Q as well. However it was the savings and loans, now known as thrifts, that underwent a financial crises in the 1960s. The disintermediation crisis was caused primarily by rising inflation rates. For long-term fixed loans, this was a serious problem, and thrifts found inflation outstripping the returns of their mortgages. To combat this thrifts tacked an inflation premium onto mortgage loans and attempted to raise interest rates on their deposits. However, Regulation Q caps on time deposit rates led many families to invest in market securities that offered better returns. This led to a decrease in deposits and less money to finance new mortgages. It set up a potential crisis: mortgage access was becoming restricted only to the most creditworthy borrowers because the thrifts did not have a large fund pool and the 'reward' for having good credit was a significantly higher interest loan.
The solution to this crisis was a new source for mortgage funding created by the Federal Government: Federal Home Loan Banks provided funding for thrifts so that they could sell new mortgages. Of more importance was the removal of Regulation Q ceilings , which allowed the thrifts to compete with regards to investment returns. The deposit rate ceiling was eliminated gradually and by 1986 was phased out completely. However, thrifts were still suffering; 1300 thrifts failed between 1980-1994, as did 1600 banks. The lifting of Regulation Q ceilings did little good if the banks could not earn the mortgage profits necessary to pay competitive rates.
The foundation for subprime mortgages and also the return to financial health for banks and thrifts was the enactment of the Depository Institutions Deregulatory and Monetary Control Act of 1980. Developed by the administrations of Jimmy Carter and Ronald Reagan when scarcity of credit was at issue , this Act removed the usury laws that prevented mortgages above a certain rate from being made. It was these mortgage rate caps that effectively prevented banks from ever providing mortgages to moderate risk clients because there was no financial incentive to do so.
Section Two: The Development of the Subprime Crisis
The removal of the cap by the Depository Institutions Deregulatory and Monetary Control Act of 1980 effected the genesis of the subprime mortgage security in the United States. However, subprime lending was a niche market until the early 1990s when it expanded from 35 billion dollars in 1994 to 332 billion dollars in 2003 The crisis that arose from this lending did not manifest until 2007 when there was a 70% increase in the number of subprime foreclosures compared to 2006.
The origin of the subprime crisis is not simplistic, it is helpful to differentiate between the factors that brought about the subprime mortgage market with the factors that resulted in the actual subprime crisis. Subprime mortgages are an effective way for a society to build wealth and excessive regulation that unduly affects legitimate subprime lending is not prudent. The following chart illustrates the complexity of the development and outline the narrative that follows:
Many components of the subprime market worked in conjunction to initiate the subprime crisis. Once the conditions for a potential crisis initiated (the housing boom via price appreciation), a synthesis of various factors exacerbated the situation and generated a housing bubble. The crisis is the result of the bust of that bubble.
Part 1A Deregulation
Part 1B Legal Regulations
Part 1C Credit Crunch and Tax Reform
leads to: SMBS's Introduction to Subprime Markets Growth of Subprime Lenders
Part 2: Convergence
Banks/Thrifts: Desire subprime loans for SMBSs and value
Subprime Lenders: Entry into first mortgage markets
Part 3: Result: Increased competition for new market with fewer rules
Part 4: Response: New Financial Instruments
Part 5: The Origins of the Subprime Crisis: The Housing Boom
Part 6A: Conditions Fueling the Boom
- Increased profits
- Low interest rates
- Foreclosure profitability
Part 6B: Conditions Impeding the Boom
- less affordability
- less creditworthy
Part 7: The Breaking Point
The Relaxation of Underwriting Standards based on the Faulty Premise of Housing Appreciation
Part 8: Response: Predatory Lending
Part 9: Culmination: The Boom Goes Bust
Part 10: The Future
Part 11: Composition of the Legal Framework