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In June 2006, new Federal Reserve Chair Ben Bernanke completed a series of rate increases that brought the federal funds rate to 5.25 percent, up from 1 percent in 2004. This marked the fourth rate increase of 2006 and the culmination of 17 consecutive rate hikes since June 2004. The increases were designed to cool an overheating economy and combat inflation, but they had catastrophic consequences for millions of subprime borrowers whose adjustable-rate mortgages were tied to the federal funds rate.
The rate increases triggered massive payment shocks for borrowers who had taken out interest-only loans and payment option ARMs during the low-rate environment of 2003-2005. Many subprime borrowers had been sold mortgages with low "teaser rates" that reset after two or three years, with lenders assuring them they could refinance before rates adjusted. However, with home prices beginning to decline in many markets and underwriting standards remaining loose, these borrowers found themselves unable to refinance. Monthly payments on adjustable-rate subprime mortgages often doubled or tripled as rates reset at the new higher levels.
By December 2006, over 13 percent of subprime loans were delinquent, up from about 10 percent during the housing boom. More than 14 percent of subprime ARMs specifically were delinquent in December 2006, double the rate from two years earlier. Foreclosure initiations surged to 310,000 in the fourth quarter of 2006, compared to an average of 230,000 quarterly for the preceding two years, with subprime mortgages accounting for more than half of new foreclosures. The Fed's rate policy, combined with captured regulators who had permitted predatory lending to flourish unchecked, transformed millions of households' "American Dream" into foreclosure nightmares.