The US Housing Market and the Subprime Mortgage Crisis (B): Impact on the US Economy

The overheating of the housing sector was blamed in part for the Federal Reserve's decision to start increasing interest rates from mid-2004 onward. This led to a decline in home sales which in turn led to a fall in their prices. This decline in home prices and increasing interest rates seriously affected subprime mortgage borrowers – a class of borrowers who on account of their poor credit score were not eligible for prime loans - with several of them defaulting on their mortgage loans (Refer Exhibit I for different types of mortgages). With rising interest rates and declining home prices in 2006, more than two million borrowers failed to make payments on their mortgage loans.

As the subprime mortgage market¹² ($600 billion in 2006), accounted for a significant share of the mortgage market, the high rate of defaults in subprime loans was seen as an indicator of the worsening situation in the housing market. The crisis in the subprime mortgage market led to billions in losses for several mortgage companies, banks and other lenders in the primary market. As a result, the lenders started applying tighter standards for giving loans (Refer Exhibit II for process of mortgage origination). The crisis also affected the secondary mortgage market as investors shied away from Mortgage Backed Securities (MBSs) (Refer Exhibit II for a note on the primary and secondary mortgage markets).