Knowledge@Wharton Finance and Investment Research Article

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The subprime mortgage crisis is a tremor that turned into an earthquake, threatening this year to plunge the U.S. economy into its first recession since 2001. Who is to blame? Wall Street alchemists, overeager borrowers and aggressive lenders who all let their eye for opportunity trump their nose for risk.

In this special report, prepared by writer Jeff Brown, Knowledge@Wharton looks at the crisis in depth, asking seven Wharton faculty members what caused it, how the immediate effects can be minimized, and what should be done to prevent a similar crisis in the future.

The results presented here include video interviews with the faculty members, a timeline describing key points in the crisis, an interactive feature demonstrating the cascade of events that fell like a line of dominos toward disaster, a glossary, and an op-ed piece and two articles. One of the articles examines the causes of the crisis and remedies that have been tried and proposed. The second explores the response by the Federal Reserve. In addition, we provide links to stories we have published on the subject over the past 18 months.

The crisis had its roots in the U.S. housing boom that began early in the decade. Low interest rates allowed home buyers to take out larger loans, giving them money to bid up home prices. At the same time, advances in loan securitization and automated mortgage underwriting made it easy and profitable for Wall Street to convert newly issued mortgages into securities that could be sold to investors.

Wall Street alchemists found new ways to turn risky mortgages -- subprime loans originally designed for borrowers with low income or poor credit -- into securities that looked almost risk-free. Investors were eager to buy these securities, which promised higher yields than U.S Treasury bonds and other "safe" holdings.

But cracks began to appear in 2006. Most subprime loans carried adjustable interest rates, and growing numbers of borrowers were falling behind after annual interest-rate resets pushed up their monthly payments. By the summer of 2007, prices of securities based on subprime loans were in freefall, as investors worried they would not get the interest and principal payments promised. Surprised about the depth of this problem, investors started to lose confidence in many other types of securities based on various forms of debt. Lenders became reluctant to lend.

Worried that this credit crunch would stall the economy, the Federal Reserve began a series of interest-rate cuts and initiated new lending programs to brokerage houses and commercial and investment banks, accepting risky mortgage-backed securities as collateral for the first time. Congress and President Bush approved an economic stimulus package early in 2008, and Washington was thrown into a debate over whether to help the estimated two million homeowners at risk of foreclosure.

While the credit crunch is showing signs of easing, debate is likely to continue for some time. How can borrowers and lenders be helped without encouraging risky behavior in the future? Should the system for turning loans into securities be modified? Is the patchwork of regulatory agencies pieced together since the 1930s equipped to handle today's financial and economic issues?

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