Who Was to Blame for the Subprime Crisis?

Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the instance of subprime mortgage woes, there was no single entity or individual to point the finger at. Instead, this mess was the collective creation of the world's central banks, homeowners, lenders, credit rating agencies, underwriters and investors.

The economy was at risk of a deep recession after the dotcom bubble burst in early 2000. This situation was compounded by the September 11 terrorist attacks in 2001. In response, central banks around the world tried to stimulate the economy. They created capital liquidity through a reduction in interest rates. In turn, investors sought higher returns through riskier investments.

Lenders took on greater risks too, and approved subprime mortgage loans to borrowers with poor credit. Consumer demand drove the housing bubble to all-time highs in the summer of 2005, which ultimately collapsed the following summer.

The end result was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who's to blame? Let's take a look at the key players.

Most of the blame is on at the mortgage originators (lenders) for creating these problems. It was the lenders who ultimately lent funds to people with poor credit and a high risk of default.

When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.

In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments. (To learn more, see: Subprime Is Often Subpar.)

We should also mention the homebuyers who were definitely not completely innocent. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages) offering low introductory rates and minimal initial costs, such as "no down payment." Their hope lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in other spending. However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly. (To learn more, read: Why Housing Market Bubbles Pop.)

As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgages at higher rates they couldn't afford, and many of them defaulted. Foreclosures continued to increase through 2006 and 2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression there was no risk to these mortgages and the costs weren't that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn't afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable.

Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy. (For related reading, see: Subprime Lending: Helping Hand Or Underhanded?)

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more, and the snowball began to build. (For more, see: Behind the Scenes of Your Mortgage.)

A lot of the demand for these mortgages came from the creation of assets pooling mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize them into bonds, which were sold to investors through CDOs.

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the "AAA" rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad.

Moreover, some have pointed to the conflict of interest of rating agencies, which receive fees from a security's creator, and their ability to give an unbiased assessment of risk. The argument is rating agencies were enticed to give better ratings to continue receiving service fees, or they ran the risk of the underwriter going to a different agency.

Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is they were simply bringing bonds to market based on market demand.

Just as the homeowners are to blame for their purchases gone wrong, much of the blame also must be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums instead of Treasury bonds. These enticingly low rates are what ultimately led to such huge demand for subprime loans.

In the end, it is up to the individual investors to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the "AAA" CDO ratings at face value.

Another party added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem.

To illustrate, there is a hedge fund strategy best described as "credit arbitrage." It involves purchasing subprime bonds on credit and hedging the positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.

Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. (For more, see: Massive Hedge Fund Failures.)

Overall, it was a mix of factors and participants that precipitated the subprime mess. Ultimately, though, human behavior and greed drove the demand, supply and the investor appetite for these types of loans. Hindsight is always 20/20, and it is now obvious there was a lack of wisdom on the part of many. However, there are countless examples of markets lacking wisdom. It seems to be a fact of life that investors will always extrapolate current conditions too far into the future.

(For related reading, see: The Fuel That Fed the Subprime Meltdown.)