From the late 1990s until the mid 2000s, the U. S. housing market experienced a tremendous boom, which ultimately ended up a disastrous bubble. A major change in how lenders provided mortgages led to more money available to non-prime borrowers. Many of these mortgages had unfavorable terms for the borrowers including high interest rates and unaffordable monthly payments. Soon, borrowers were unable to pay their mortgages and were forced to foreclose on their homes.
A rise in foreclosures caused a ripple effect through financial markets supported by mortgage-backed securities (MBS), culminating in a worldwide financial crisis. The major changes to mortgages that occurred in the 1990s were driven by factors on the supply side of the housing market. Based on continuous historical growth, financial firms, through the use of mortgage brokers, started lending money to borrowers who did not qualify for standard loans. Firms expected high returns from high interest rates and brokers expected high commissions and broker fees.
Additionally, many financial firms began bundling mortgages into MBSs and selling them on the private market, primarily to government-sponsored enterprises (GSE) such as Fannie Mae and Freddie Mac. These GSEs perceived the MBSs as safe due to their high rating from rating agencies and readily bought them. As some firms began to see success with these subprime loans, more suppliers entered the mortgage market, including prominent Wall Street financial firms. Soon a surplus of mortgages flooded the housing market.
Additionally, while supply increased, determinants of demand in the housing market also led to an increase in demand. Many borrowers perceived the housing market as a continuously growing market without a cap and essentially an entirely safe investment. Home-ownership was often called “The American Dream” and many consumers worked towards owning a home.
However, once it became apparent that borrowers were unable to afford the loans they had taken, foreclosure rates of homes skyrocketed and demand quickly fell. With a large increase in supply and a sharp drop in demand, prices of homes drastically fell, in some cases below prices before the burst (Demand” line in Figure 1). After the rise in foreclosures starting in 2006 and into 2007, mortgage lenders took heavy hits to their expected returns.
International banks also experienced unexpected losses and required an influx of cash from state-run banks. After the European Central Bank (ECB) lent $129 billion in response to interest rate spikes, it was revealed that European banks were loaded with MBSs and needed emergency funding. In addition, U. S. banks accepted capital from foreign governments to offset heavy losses from the mortgage crisis, further deepening foreign debt. After the dust had settled from the mortgage crisis, it was clear that its effects had a worldwide reach.