EFFECT OF SUBPRIME

EFFECT OF SUBPRIME





Subprime Introduction

Subprime lending (near-prime, non-prime, or second chance lending) is a

financial term that was popularized by the media during the "credit crunch" of

2007 and involves financial institutions providing credit to borrowers who do

not meet prime underwriting guidelines. Subprime borrowers have a

heightened perceived risk of default, such as those who have a history of loan

delinquency or default, those with a recorded bankruptcy, or those with

limited debt experience.



Although there is no standardized definition, in the US subprime loans

are usually classified as those where the borrower has a FICO score below 680.

Subprime lending encompasses a variety of credit types, including mortgages,

auto loans, and credit cards.



Subprime could also refer to a security for which a return above the

"prime" rate is adhered, also known as C-paper. The term subprime often

correlates with non-conforming loans, or those that do not meet Fannie Mae

or Freddie Mac guidelines. Those guidelines may be the size of the loan, a high

debt-to-income ratio or lack of income documentation provided.



The Wall Street Journal reported in 2006 that 61 percent of all

borrowers receiving subprime loans had credit scores high enough to qualify

for prime conventional loans.



Proponents of subprime lending maintain that the practice extends

credit to people who would otherwise not have access to the credit market









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Background

Subprime lending evolved with the realization of a demand in the

marketplace for loans to high-risk borrowers with imperfect credit. The first

subprime was initiated in 1993. Many companies entered the market when the

prime interest rate was low, and real interest became negative allowing

modest subprime rates to flourish; negative interest rates are hand-outs, the

more you borrow the more you earn.[citation needed] Others entered with the

relaxation of usury laws. Traditional lenders were more cautious and

historically turned away potential borrowers with impaired or limited credit

histories. Statistically, approximately 25% of the population of the United

States falls into this category. Citation needed] In 1998, the Federal Trade

Commission estimated that 10% of new-car financing in the U.S. was provided

by subprime loans, and that $125 billion of $859 billion total mortgage dollars

were subprime.



In the third quarter of 2007, subprime ARMs only represented 6.8% of

the mortgages outstanding in the US, yet they represented 43.0% of the

foreclosures started. Subprime fixed mortgages represented 6.3% of

outstanding loans and 12.0% of the foreclosures started in the same period.





Subprime lenders

To access this increasing market, lenders often take on risks associated

with lending to people with poor credit ratings or limited credit histories. For

example, they would lend money to consumers that have bad credit. The FICO

score indicates to the lender the rate of default. Those with credit scores

below 620 have a much higher default rate than those with credit score above

720. However, if a borrower has sufficient income then he or she may qualify

for a subprime mortgage product. Subprime loans are considered to carry a far

greater risk for the lender due to the aforementioned credit risk characteristics

of the typical subprime borrower. Lenders use a variety of methods to offset

these risks. In the case of many subprime loans, this risk is offset with a higher

interest rate. In the case of subprime credit cards, a subprime customer may

be charged higher late fees, higher over-the-limit fees, yearly fees, or up-front

fees for the card. Late fees are charged to the account, which may drive the

customer over their credit limit, resulting in over-the-limit fees. These higher



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fees compensate the lender for the increased costs associated with servicing

and collecting such accounts, as well as for the higher default rate.





Borrower profiles

Subprime loans can offer an opportunity for borrowers with a less-than-

ideal credit record to become a home owner. Borrowers may use this credit to

purchase homes, or in the case of a cash-out refinance, finance other forms of

spending such as purchasing a car, paying for living expenses, remodeling a

home, or even paying down on a high-interest credit card. However, due to the

risk profile of the subprime borrower, this access to credit comes at the price

of higher interest rates, increased fees and other increased costs. Subprime

lending (and mortgages in particular) provides a method of "credit repair"; if

borrowers maintain a good payment record, they should be able to refinance

into mainstream rates after two to three years. In the United Kingdom, most

subprime mortgages have a two or three-year tie-in, and borrowers may face

additional charges for replacing their mortgages before the tie-in has expired.



Generally, the credit profile keeping a borrower out of a prime loan may

include one or more of the following:



Two or more loan payments paid past 30 days due in the last 12 months, or

one or more loan payments paid past 90 days due the last 36 months;



Judgment, foreclosure, repossession, or non-payment of a loan in the past;



Bankruptcy in the last 5 years;



Relatively high default probability as evidenced by the credit score.



Accuracy of the credit line data obtained by the underwriter.









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Private label credit

In the USA, this group of credit companies includes major banks such as

Wells Fargo, CitiBank, GE Credit, Household Finance, and more. While it is not

certain what percentage of subprime lending involves the private label

branding of the retail chains (i.e. The Gap, Victoria's Secret, Old Navy, and most

furniture and appliance retailers), most national retail chains use some form of

subprime lending as a marketing strategy. Deferred interest programming may

result in high default rates that must be offset by aggressive lending practices.

It is common for a $200,000,000 furniture retailer to have 50% of their long-

term business be derived from the direct result of private label credit

promotions.





Origination, securitization and servicing

Some subprime originators (mortgage companies or brokers) formerly

promoted residential loans with features that could trap low income

borrowers into loans with increasing yield terms that eventually exceed

borrower’s capability to make the payments. Most of these loans were

originated for the purpose of selling them into securitization conduits, which

are special purpose entities (REMICs) that issue Residential Mortgage Backed

Securities (RMBS), bonds, securities and other investment vehicles for resale to

pension funds and other fixed income investors. The same process takes place

for some commercial mortgages (CMBS).



Some of these mortgage originators are owned or controlled by major

financial institutions which provide a "Warehouse" line for their lending. For

example, First Franklin was owned by Merrill Lynch and WMC was owned by

GE. These financial institutions then remain in control of these loans as

"Trustee", "Servicers" and "Controlling Class" of the REMIC trusts in hopes of

deriving significant fees and other income from management of Taxes,

Insurance and Repair Reserve Funds required by the terms of these mortgages.



In most cases, should these loans default, the servicing is passed to

"Special Servicers" who derive "Workout", "Foreclosures" and Real estate

owned (REO) management fees. The Special Servicers are directed by

"Directing Class" or "Controlling Class" which comprise of majority holders of





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the lowest class of REMIC Trust securities also referred to as "First Loss" or "B-

Piece" holders.



The shortfall of loan repayment is usually repaid as a result of

"Repurchase Demand" by Special Servicer on GSE or loan seller to REMIC Trust

also called "Loan Depositor." The purchased collateral at auctions by Special

Servicers is referred to as REO properties which then can be marketed and sold

for market value. Special Servicers usually keep the "Upside" or difference

between auction price and market sale of the collateral. These foreclosure fees

and REO income form a major incentive for Servicers to purchase the

"Servicing Rights" of the REMIC trusts from Trustees who, depending on the

terms of the Pooling and Servicing Agreement (PSA), have the authority to

replace Servicers. It is not uncommon for a predatory Servicer to pay millions

of dollars to procure the "Servicing Rights" of the REMIC trusts in hopes of

successful foreclosures and equity stripping from Borrowers, Guarantors, Loan

Sellers and Investor.



REMIC Trusts are "Passive" or "Pass-Through" Entities under the IRS

code and are not taxed at trust level. However, the bond-holders are expected

to be taxpaying entities and are taxed on interest income distributed by the

REMIC trusts. REMIC trusts are forbidden from any other business activities

and are taxed 100% on any other income they may generate which is referred

to as "Prohibited Income" under IRC 860 Code.









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Types

Subprime mortgages

Like other subprime loans, subprime mortgages are defined by the

financial and credit profile of the consumers to which they are marketed.

According to the U.S. Department of Treasury guidelines issued in 2001,

"Subprime borrowers typically have weakened credit histories that include

payment delinquencies and possibly more severe problems such as charge-

offs, judgments, and bankruptcies. They may also display reduced repayment

capacity as measured by credit scores, debt-to-income ratios, or other criteria

that may encompass borrowers with incomplete credit histories."



Unlike other nations, the US Tax Code allows 100% tax deductibility of all

interest payments and part of principal payments on loans for housing. This

means a tax break of 30% to 50%, not only of the real interest but also of the

inflation part of nominal interest rates. This tax break is what fuelled second

and third mortgages, used to buy cars and other consumer goods. Interest

rates on car purchases are not deductible, but second mortgages are. This tax

give away is what makes America become the most personally indebted nation

in the world. Countries like Brazil that do not use nominal interest rates in

housing loans, and do not give such tax breaks do not have a prime or a sub-

prime housing problem.



Subprime mortgage loans are riskier loans in that they are made to

borrowers unable to qualify under traditional, more stringent criteria due to a

limited or blemished credit history. Subprime borrowers are generally defined

as individuals with limited income or having FICO credit scores below 620 on a

scale that ranges from 300 to 850. Subprime mortgage loans have a much

higher rate of default than prime mortgage loans and are priced based on the

risk assumed by the lender.



Although most home loans do not fall into this category, subprime

mortgages proliferated in the early part of the 21st Century. About 21 percent

of all mortgage originations from 2004 through 2006 were subprime, up from 9

percent from 1996 through 2004, says John Lon ski, chief economist for



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Moody's Investors Service. Subprime mortgages totaled $600 billion in 2006,

accounting for about one-fifth of the U.S. home loan market citation needed]



As with other types of mortgage, various special loan features are

available with subprime mortgages, including:



Interest-only payments, which allow borrowers to pay only interest for a

period of time (typically 5–10 years);



"Pay option" loans, usually with adjustable rates, for which borrowers choose

their monthly payment (full payment, interest only, or a minimum payment

which may be lower than the payment required to reduce the balance of the

loan);



And so-called "hybrid" mortgages with initial fixed rates that sooner or later

convert to adjustable rates.



This last class of mortgages has grown particularly popular among

subprime lenders since the 1990s. Common subprime hybrids include the "2-

28 loan", which offers a low initial interest rate that stays fixed for two years

after which the loan resets to a higher adjustable rate for the remaining life of

the loan, in this case 28 years. The new interest rate is typically set at some

margin over an index, for example, 5% over a 12-month LIBOR. Variations on

the "2-28" include the "3-27" and the "5-25".





Subprime credit cards

Credit card companies in the United States began offering subprime

credit cards to borrowers with low credit scores and a history of defaults or

bankruptcy in the 1990s when usury laws were relaxed. These cards usually

begin with low credit limits and usually carry extremely high fees and interest

rates as high as 30% or more. In 2002, as economic growth in the United States

slowed, the default rates for subprime credit card holders increased

dramatically, and many subprime credit card issuers were forced to scale back

or cease operations.



In 2007, many new subprime credit cards began to sprout forth in the

market. As more vendors emerged, the market became more competitive,

forcing issuers to make the cards more attractive to consumers. Interest rates

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on subprime cards now start at 9.9% but in some cases still range up to 24%

APR.



In some situations, subprime credit cards may help a consumer improve

poor credit scores. Most subprime cards report to major credit reporting

agencies such as Transition and Equifax, but in the case of "secured" cards,

credit scoring often reflects the nature of the card being reported and may or

may not consider it. Issuers of these cards claim that consumers who pay their

bills on time should see positive reporting to these agencies within 90 days.





Proponents

Individuals who have experienced severe financial problems are usually

labeled as higher risk and therefore have greater difficulty obtaining credit,

especially for large purchases such as automobiles or real estate. These

individuals may have had job loss, previous debt or marital problems, or

unexpected medical issues, usually unforeseen and causing major financial

setbacks. As a result, late payments, charge-offs, repossessions and even

bankruptcy or foreclosures may result.



Due to these previous credit problems, these individuals may also be

precluded from obtaining any type of conventional loan. To meet this demand,

lenders have seen that a tiered pricing arrangement, one which allows these

individuals to receive loans but pay a higher interest rate and higher fees, may

allow loans which otherwise would not occur. In 1999, under pressure from

the Clinton administration, Fannie Mae, the nation's largest home mortgage

underwriter, relaxed credit requirements on the loans it would purchase from

other banks and lenders, hoping that easing these restrictions would result in

increased loan availability for minority and low-income buyers. Putting

pressure on the GSE's (Government Sponsored Enterprise) Fannie Mae and

Freddie Mac, the Clinton administration looked to increase their sub-prime

portfolios, including the Department of Housing and Urban Development

expressing its interest in the GSE's maintaining a 50% portion of their portfolios

in loans to low and moderate-income borrowers.



From a servicing standpoint, these loans have a statistically higher rate

of default and are more likely to experience repossessions and charge offs.



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Lenders use the higher interest rate and fees to offset these anticipated higher

costs.



Provided that a consumer enters into this arrangement with the

understanding that they are higher risk, and must make diligent efforts to pay,

these loans do indeed serve those who would otherwise be underserved.

Continuing the example of an auto loan, the consumer must purchase an

automobile which is well within their means, and carries a payment well within

their budgets





Criticism

Capital markets operate on the basic premise of risk versus reward.

Investors taking a risk on stocks expect a higher rate of return than do

investors in risk-free Treasury bills, Guaranteed Investment Certificates, etc.

which are backed by the full faith and credit of the issuing country or

institution. The same goes for loans. Allegedly less creditworthy subprime

borrowers represent a riskier investment, so lenders will charge them a higher

interest rate than they would charge a prime borrower for the same loan.



To avoid high initial mortgage payments, many subprime borrowers took

out adjustable-rate mortgages (or ARMs) that give them a lower initial interest

rate. But with potential annual adjustments of 2% or more per year, these

loans can end up costing much more. So a $500,000 loan at a 4% interest rate

for 30 years equates to a payment of about $2,400 a month. But the same loan

at 10% for 27 years (after the adjustable period ends) equates to a payment of

$4,220. A 6-percentage-point increase in the rate caused slightly more than a

75% increase in the payment. This is even more apparent when the lifetime

cost of the loan is considered (though most people will want to refinance their

loans periodically). The total cost of the above loan at 4% is $864,000, while

the higher rate of 10% would incur a lifetime cost of $1,367,280.



On the other hand, interest rates on ARMs can also go down - in the US,

some interest rates are tied to federal government-controlled interest rates, so

when the Fed cuts rates, ARM rates go down, too. Most subprime ARM loans

are tied to LIBOR (London Interbank Offered Rate - a rate trading system

originating in Britain). ARM interest rates usually adjust once a year or per



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quarter, and the rate is based on a calculation specified in the loan documents.

Also, most ARMs limit the amount of change in a rate.





Mortgage discrimination

Some subprime lending practices have raised concerns about mortgage

discrimination on the basis of race. The NAACP filed a lawsuit in federal court

in Los Angeles against 12 mortgage lenders. The lawsuit accuses the companies

of steering black borrowers into subprime loans. Black and other minorities

disproportionately fall into the category of "subprime borrowers", even when

median income levels were comparable, home buyers in minority

neighborhoods were more likely to get a loan from a subprime lender. Interest

rates and the availability of credit are often tied to credit scores, and the

results of a 2004 Texas Department of Insurance study found that of the 2

million Texans surveyed, "black policyholders had average credit scores that

were 10% to 35% worse than those of white policyholders. Hispanics' average

scores were 5% to 25% worse, while Asians' scores were roughly the same as

whites.









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Subprime mortgage crisis

The subprime mortgage crisis is an ongoing financial crisis triggered by a

dramatic rise in mortgage delinquencies and foreclosures in the United States,

with major adverse consequences for banks and financial markets around the

globe. The crisis, which has its roots in the closing years of the 20th century,

became apparent in 2007 and has exposed pervasive weaknesses in financial

industry regulation and the global financial system.



Many USA mortgages issued in recent years were made to subprime

borrowers, defined as those with lesser ability to repay the loan based on

various criteria. When USA house prices began to decline in 2006-07, mortgage

delinquencies soared, and securities backed with subprime mortgages, widely

held by financial firms, lost most of their value. The result has been a large

decline in the capital of many banks and USA government sponsored

enterprises, tightening credit around the world.





Background

The crisis began with the bursting of the United States housing bubble

and high default rates on "subprime" and adjustable rate mortgages (ARM),

beginning in approximately 2005–2006. Government policies and competitive

pressures for several years prior to the crisis encouraged higher risk lending

practices. Further, an increase in loan incentives such as easy initial terms and

a long-term trend of rising housing prices had encouraged borrowers to

assume difficult mortgages in the belief they would be able to quickly

refinance at more favorable terms. However, once interest rates began to rise

and housing prices started to drop moderately in 2006–2007 in many parts of

the U.S., refinancing became more difficult. Defaults and foreclosure activity

increased dramatically as easy initial terms expired, home prices failed to go up

as anticipated, and ARM interest rates reset higher. Foreclosures accelerated

in the United States in late 2006 and triggered a global financial crisis through

2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were

subject to foreclosure activity, up 79% from 2006.







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Financial products called mortgage-backed securities (MBS), which

derive their value from mortgage payments and housing prices, had enabled

financial institutions and investors around the world to invest in the U.S.

housing market. Major Banks and financial institutions had borrowed and

invested heavily in MBS and reported losses of approximately US$435 billion as

of 17 July 2008. The liquidity and solvency concerns regarding key financial

institutions drove central banks to take action to provide funds to banks to

encourage lending to worthy borrowers and to restore faith in the commercial

paper markets, which are integral to funding business operations.

Governments also bailed out key financial institutions, assuming significant

additional financial commitments.



The risks to the broader economy created by the housing market

downturn and subsequent financial market crisis were primary factors in

several decisions by central banks around the world to cut interest rates and



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governments to implement economic stimulus packages. These actions were

designed to stimulate economic growth and inspire confidence in the financial

markets. Effects on global stock markets due to the crisis have been dramatic.

Between 1 January and 11 October 2008, owners of stocks in U.S. corporations

had suffered about $8 trillion in losses, as their holdings declined in value from

$20 trillion to $12 trillion. Losses in other countries have averaged about 40%.

Losses in the stock markets and housing value declines place further

downward pressure on consumer spending, a key economic engine. Leaders of

the larger developed and emerging nations met in November 2008 to

formulate strategies for addressing the crisis.









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Mortgage market

Subprime lending is the practice of lending, mainly in the form

of mortgages for the purchase of residences, to borrowers who do

not meet the usual criteria for borrowing at the lowest prevailing

market interest rate. These criteria pertain to the borrower's credit

score, credit history and other factors. If a borrower is delinquent in

making timely mortgage payments to the loan servicer (a bank or

other financial firm), the lender can take possession of the residence

acquired using the proceeds from the mortgage, in a process called

foreclosure.



The value of USA subprime mortgages was estimated at $1.3

trillion as of March 2007, with over 7.5 million first-lien subprime

mortgages outstanding. Between 2004-2006 the share of subprime

mortgages relative to total originations ranged from 18%-21%,

versus less than 10% in 2001-2003 and during 2007. In the third

quarter of 2007, subprime ARMs making up only 6.8% of USA

mortgages outstanding also accounted for 43% of the foreclosures

which began during that quarter. By October 2007, approximately

16% of subprime adjustable rate mortgages (ARM) were either 90-

days delinquent or the lender had begun foreclosure proceedings,

roughly triple the rate of 2005. By January 2008, the delinquency

rate had risen to 21%. And by May 2008 it was 25%.



The value of all outstanding residential mortgages, owed by

USA households to purchase residences housing at most four

families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion

as of midyear 2008. During 2007, lenders had begun foreclosure

proceedings on nearly 1.3 million properties, a 79% increase over

2006. This increased to 2.3 million in 2008, an 81% increase vs. 2007.



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As of August 2008, 9.2% of all mortgages outstanding were either

delinquent or in foreclosure. Between August 2007 and October

2008, 936,439 USA residences completed

foreclosure









Credit risk

Credit risk arises because a borrower has the option of defaulting on the

loan he/she owes. Traditionally, lenders (who were primarily thrifts) bore the

credit risk on the mortgages they issued. Over the past 60 years, a variety of

financial innovations have gradually made it possible for lenders to sell the

right to receive the payments on the mortgages they issue, through a process

called securitization. The resulting securities are called mortgage backed

securities (MBS) and collateralized debt obligations (CDO). Most American

mortgages are now held by mortgage pools, the generic term for MBS and

CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of

midyear 2008, $6.6 trillion were held by mortgage pools and $3.4 trillion by

traditional depository institutions.



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This "originate to distribute" model means that investors holding MBS and

CDOs also bear several types of risks, and this has a variety of consequences.

There are four primary types of risk:









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Name Description

Credit Risk the risk that the homeowner or borrower will be unable or

unwilling to pay back the loan

Asset price the risk that assets (MBS in this case) will depreciate in value,

risk resulting in financial losses, markdowns and possibly margin

calls

Liquidity risk the risk that a business entity will be unable to obtain financing,

such as from the commercial paper market

Counterparty The risk that a party to a contract will be unable or unwilling to

risk uphold their obligations.

The aggregate effect of these and other risks has recently been

called systemic risk, which refers to when formerly

uncorrelated risks shift and become highly correlated,

damaging the entire financial system

When homeowners default, the payments received by MBS and CDO

investors decline and the perceived credit risk rises. This has had a significant

adverse effect on investors and the entire mortgage industry. The effect is

magnified by the high debt levels (financial leverage) households and

businesses have incurred in recent years. Finally, the risks associated with

American mortgage lending have global impacts, because a major

consequence of MBS and CDOs is a closer integration of the USA housing and

mortgage markets with global financial markets.



Investors in MBS and CDOs can insure against credit risk by buying credit

defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers

of CDS would have to pay their counterparties increased. This created

uncertainty across the system, as investors wondered if CDS issuers would

honor their commitment





Causes

He reasons proposed for this crisis is varied and complex. The crisis can

be attributed to a number of factors pervasive in both housing and credit

markets, factors which emerged over a number of years. Causes proposed

include the inability of homeowners to make their mortgage payments, poor

judgment by borrowers and/or lenders, speculation and overbuilding during

the boom period, risky mortgage products, high personal and corporate debt

levels, financial products that distributed and perhaps concealed the risk of



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mortgage default, monetary policy, international trade imbalances, and

government regulation (or the lack thereof).Ultimately, though, moral hazard

lay at the core of many of the causes



In its "Declaration of the Summit on Financial Markets and the World

Economy," dated 15 November 2008, leaders of the Group of 20 cited the

following causes



During a period of strong global growth, growing capital flows, and

prolonged stability earlier this decade, market participants sought higher yields

without an adequate appreciation of the risks and failed to exercise proper due

diligence. At the same time, weak underwriting standards, unsound risk

management practices, increasingly complex and opaque financial products,

and consequent excessive leverage combined to create vulnerabilities in the

system. Policy-makers, regulators and supervisors, in some advanced

countries, did not adequately appreciate and address the risks building up in

financial markets, keep pace with financial innovation, or take into account the

systemic ramifications of domestic regulatory actions.





Boom and bust in the housing market

Low interest rates and large inflows of foreign funds created easy credit

conditions for a number of years prior to the crisis, fueling a housing market

boom and encouraging debt-financed consumption. The USA home ownership

rate increased from 64% in 1994 (about where it had been since 1980) to an

all-time high of 69.2% in 2004. Subprime lending was a major contributor to

this increase in home ownership rates and in the overall demand for housing,

which drove prices higher.



Between 1997 and 2006, the price of the typical American house

increased by 124%. During the two decades ending in 2001, the national

median home price ranged from 2.9 to 3.1 times median household income.

This ratio rose to 4.0 in 2004 and 4.6 in 2006. This housing bubble resulted in

quite a few homeowners refinancing their homes at lower interest rates, or

financing consumer spending by taking out second mortgages secured by the

price appreciation. USA household debt as a percentage of annual disposable

personal income was 127% at the end of 2007, versus 77% in 1990



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While housing prices were increasing, consumers were saving less and

both borrowing and spending more. A culture of consumerism is a factor "in an

economy based on immediate gratification." Starting in 2005, American

households have spent more than 99.5% of their disposable personal income

on consumption or interest payments. If imputations mostly pertaining to

owner-occupied housing are removed from these calculations, American

households have spent more than their disposable personal income in every

year starting in 1999. Household debt grew from $705 billion at year-end 1974,

60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally

to $14.5 trillion in midyear 2008, 134% of disposable personal income. During

2008, the typical USA household owned 13 credit cards, with 40% of

households carrying a balance, up from 6% in 1970









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This credit and house price explosion led to a building boom and

eventually to a surplus of unsold homes, which caused U.S. housing prices to

peak and begin declining in mid-2006. Easy credit, and a belief that house

prices would continue to appreciate, had encouraged many subprime

borrowers to obtain adjustable-rate mortgages. These mortgages enticed

borrowers with a below market interest rate for some predetermined period,

followed by market interest rates for the remainder of the mortgage's term.

Borrowers who could not make the higher payments once the initial grace

period ended would try to refinance their mortgages. Refinancing became

more difficult, once house prices began to decline in many parts of the USA.

Borrowers who found themselves unable to escape higher monthly payments

by refinancing began to default.



As more borrowers stop paying their mortgage payments, foreclosures

and the supply of homes for sale increase. This places downward pressure on

housing prices, which further lowers homeowners' equity. The decline in

mortgage payments also reduces the value of mortgage-backed securities,

which erodes the net worth and financial health of banks. This vicious cycle is

at the heart of the crisis.





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By September 2008, average U.S. housing prices had declined by over

20% from their mid-2006 peak. This major and unexpected decline in house

prices means that many borrowers have zero or negative equity in their



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homes, meaning their homes were worth less than their mortgages. As of

March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners

— had negative equity in their homes, a number that is believed to have risen

to 12 million by November 2008. Borrowers in this situation have an incentive

to "walk away" from their mortgages and abandon their homes, even though

doing so will damage their credit rating for a number of years.



Increasing foreclosure rates increases the inventory of houses offered

for sale. The number of new homes sold in 2007 was 26.4% less than in the

preceding year. By January 2008, the inventory of unsold new homes was 9.8

times the December 2007 sales volume, the highest value of this ratio since

1981. Furthermore, nearly four million existing homes were for sale, of which

almost 2.9 million were vacant. This overhang of unsold homes lowered house

prices. As prices declined, more homeowners were at risk of default or

foreclosure. House prices are expected to continue declining until this

inventory of unsold homes (an instance of excess supply) declines to normal

levels. [Citation needed]



Economist Muriel Routine wrote in January 2009 that subprime

mortgage defaults triggered the broader global credit crisis, but were just one

symptom of multiple debt bubble collapses: "This crisis is not merely the result

of the U.S. housing bubble’s bursting or the collapse of the United States’

subprime mortgage sector. The credit excesses that created this disaster were

global. There were many bubbles, and they extended beyond housing in many

countries to commercial real estate mortgages and loans, to credit cards, auto

loans, and student loans. There were bubbles for the securitized products that

converted these loans and mortgages into complex, toxic, and destructive

financial instruments. And there were still more bubbles for local government

borrowing, leveraged buyouts, hedge funds, commercial and industrial loans,

corporate bonds, commodities, and credit-default swaps..." It is the bursting of

the many bubbles that he believes are causing this crisis to spread globally and

magnify its impact









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EFFECT OF SUBPRIME



Speculation

Speculation in residential real estate has been a contributing factor.

During 2006, 22% of homes purchased (1.65 million units) were for investment

purposes, with an additional 14% (1.07 million units) purchased as vacation

homes. During 2005, these figures were 28% and 12%, respectively. In other

words, a record level of nearly 40% of homes purchases were not intended as

primary residences. David Leech, NAR's chief economist at the time, stated

that the 2006 decline in investment buying was expected: "Speculators left the

market in 2006, which caused investment sales to fall much faster than the

primary market.



Housing prices nearly doubled between 2000 and 2006, a vastly

different trend from the historical appreciation at roughly the rate of inflation.

While homes had not traditionally been treated as investments subject to

speculation, this behavior changed during the housing boom. For example, one

company estimated that as many as 85% of condominium properties

purchased in Miami were for investment purposes. Media widely reported

condominiums being purchased while under construction, then being "flipped"

(sold) for a profit without the seller ever having lived in them. Some mortgage

companies identified risks inherent in this activity as early as 2005, after

identifying investors assuming highly leveraged positions in multiple

properties.



Nicole Galina’s of the Manhattan Institute described the consequences

of failing to respond to the shifting treatment of a home from conservative

inflation hedge to speculative investment. For example, individuals investing in

equities have margin (borrowing) restrictions and receive warnings regarding

the risk to principal; there are no such requirements for home buyers. While

stock brokers are prohibited from telling an investor that a stock or bond

investment cannot lose money, it was not illegal for mortgage brokers to do so.

Equity investors are well-aware of the need to diversify their financial holdings,

but for many homeowners the home represented both a leveraged and

concentrated risk. Further, in the U.S. capital gains on stocks are taxed more

aggressively than housing appreciation, which has large exemptions. These

factors all enabled speculative behavior.





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EFFECT OF SUBPRIME



Economist Robert Sheller argues that speculative bubbles are fueled by

"contagious optimism, seemingly impervious to facts, that often takes hold

when prices are rising. Bubbles are primarily social phenomena; until we

understand and address the psychology that fuels them, they're going to keep

forming." Keynesian economist Hyman Minsk described three types of

speculative borrowing that contribute to rising debt and an eventual collapse

of asset values.



The "hedge borrower," who expects to make debt payments from cash flows

from other investments;



The "speculative borrower," who borrows believing that he can service the

interest on his loan, but who must continually roll over the principal into new

investments;



The "Penza borrower," who relies on the appreciation of the value of his assets

to refinance or pay off his debt, while being unable to repay the original loan.





High-risk mortgage loans and lending/borrowing practices

Lenders began to offer more and more loans to higher-risk borrowers,

including illegal immigrants. Subprime mortgages amounted to $35 billion (5%

of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999, [66] and

$600 billion (20%) in 2006. A study by the Federal Reserve found that the

average difference between subprime and prime mortgage interest rates (the

"subprime markup") declined from 280 basis points in 2001, to 130 basis

points in 2007. In other words, the risk premium required by lenders to offer a

subprime loan declined. This occurred even though the credit ratings of

subprime borrowers, and the characteristics of subprime loans, both declined

during the 2001–2006 period, which should have had the opposite effect. The

combination of declining risk premier and credit standards is common to

classic boom and bust credit cycles.



In addition to considering higher-risk borrowers, lenders have offered

increasingly risky loan options and borrowing incentives. In 2005, the median

down payment for first-time home buyers was 2%, with 43% of those buyers

making no down payment whatsoever. By comparison, China has down





24

EFFECT OF SUBPRIME



payment requirements that exceed 20%, with higher amounts for non-primary

residences.



Growth in mortgage loan fraud based upon US Department of the

Treasury Suspicious Activity Report Analysis.



One high-risk option was the "No Income, No Job and no Assets" loans,

sometimes referred to as Ninja loans. Another example is the interest-only

adjustable-rate mortgage (ARM), which allows the homeowner to pay just the

interest (not principal) during an initial period. Still another is a "payment

option" loan, in which the homeowner can pay a variable amount, but any

interest not paid is added to the principal. An estimated one-third of ARMs

originated between 2004 and 2006 had "teaser" rates below 4%, which then

increased significantly after some initial period, as much as doubling the

monthly

payment









Mortgage underwriting practices have also been criticized, including

automated loan approvals that critics argued were not subjected to

appropriate review and documentation. In 2007, 40% of all subprime loans

resulted from automated underwriting. The chairman of the Mortgage Bankers



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EFFECT OF SUBPRIME



Association claimed that mortgage brokers, while profiting from the home loan

boom, did not do enough to examine whether borrowers could repay.

Mortgage fraud by borrowers increased.





Securitization practices

Securitization, a form of structured finance, involves the pooling of

financial assets, especially those for which there is no ready secondary market,

such as mortgages, credit card receivables, student loans. The pooled assets

serve as collateral for new financial assets issued by the entity (mostly GSEs

and investment banks) owning the underlying assets. The diagram at left

shows how there are many parties involved.



Securitization, combined with investor appetite for mortgage-backed

securities (MBS), and the high ratings formerly granted to MBSs by rating

agencies, meant that mortgages with a high risk of default could be originated

almost at will, with the risk shifted from the mortgage issuer to investors at

large. Securitization meant that issuers could repeatedly relend a given sum,

greatly increasing their fee income. Since issuers no longer carried any default

risk, they had every incentive to lower their underwriting standards to increase

their loan volume and total profit.



The traditional mortgage model involved a bank originating a loan to the

borrower/homeowner and retaining the credit (default) risk. With the advent

of securitization, the traditional model has given way to the "originate to

distribute" model, in which the credit risk is transferred (distributed) to

investors through MBS and CDOs. Securitization created a secondary market

for mortgages, and meant that those issuing mortgages were no longer

required to hold them to maturity. Asset securitization began with the creation

of private mortgage pools in the 1970s. Securitization accelerated in the mid-

1990s. The total amount of mortgage-backed securities issued almost tripled

between 1996 and 2007, to $7.3 trillion. The securitized share of subprime

mortgages (i.e., those passed to third-party investors via MBS) increased from

54% in 2001, to 75% in 2006. Alan Greenspan has stated that the current

global credit crisis cannot be blamed on mortgages being issued to households







26

EFFECT OF SUBPRIME



with poor credit, but rather on the securitization of such mortgages.









American homeowners, consumers, and corporations owed roughly $25

trillion during 2008. American banks retained about $8 trillion of that total

directly as traditional mortgage loans. Bondholders and other traditional

lenders provided another $7 trillion. The remaining $10 trillion came from the

securitization markets. The securitization markets started to close down in the

spring of 2007 and nearly shut-down in the fall of 2008. More than a third of

the private credit markets thus became unavailable as a source of funds.



Investment banks sometimes placed the MBS they originated or

purchased into off-balance sheet entities called structured investment vehicles

or special purpose entities. Moving the debt "off the books" enabled large

financial institutions to circumvent capital requirements, thereby increasing

profits but augmenting risk. Investment banks and off-balance sheet financing

vehicles are sometimes referred to as the shadow banking system and are not



27

EFFECT OF SUBPRIME



subject to the same capital requirements and central bank support as

depository banks.



Some believe that mortgage standards became lax because

securitization gave rise to a form of moral hazard, whereby each link in the

mortgage chain made a profit while passing any associated credit risk to the

next link in the chain. At the same time, some financial firms retained

significant amounts of the MBS they originated; thereby retaining significant

amounts of credit risk and so were less guilty of moral hazard. Some argue this

was not a flaw in the securitization concept per se, but in its implementation.



According to Nobel laureate Dr. A. Michael Spence, "systemic risk

escalates in the financial system when formerly uncorrelated risks shift and

become highly correlated. When that happens, then insurance and

diversification models fail. There are two striking aspects of the current crisis

and its origins. One is that systemic risk built steadily in the system. The second

is that this buildup went either unnoticed or was not acted upon. That means

that it was not perceived by the majority of participants until it was too late.

Financial innovation, intended to redistribute and reduce risk, appears mainly

to have hidden it from view. An important challenge going forward is to better

understand these dynamics as the analytical underpinning of an early warning

system with respect to financial instability





Inaccurate credit ratings

Credit rating agencies are now under scrutiny for having given

investment-grade ratings to CDOs and MBSs based on subprime mortgage

loans. These high ratings were believed justified because of risk reducing

practices, including over-collateralization (pledging collateral in excess of debt

issued), credit default insurance, and equity investors willing to bear the first

losses. However, there are also indications that some involved in rating

subprime-related securities knew at the time that the rating process was

faulty. Emails exchanged between employees of rating agencies, dated before

credit markets deteriorated and put in the public domain by USA Congressional

investigators, suggest that some rating agency employees suspected that lax

standards for rating structured credit products would result in major problems.

For example, one 2006 internal Email from Standard & Poor's stated that



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EFFECT OF SUBPRIME



"Rating agencies continue to create and [sic] even bigger monster—the CDO

market. Let's hope we are all wealthy and retired by the time this house of

cards

falters









High ratings encouraged investors to buy securities backed by subprime

mortgages, helping finance the housing boom. The reliance on agency ratings

and the way ratings were used to justify investments led many investors to

treat securitized products — some based on subprime mortgages — as

equivalent to higher quality securities. This was exacerbated by the SEC's

removal of regulatory barriers and its reduction of disclosure requirements, all

in the wake of the Enron scandal.





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EFFECT OF SUBPRIME



Critics allege that the rating agencies suffered from conflicts of interest,

as they were paid by investment banks and other firms that organize and sell

structured securities to investors. On 11 June 2008, the SEC proposed rules

designed to mitigate perceived conflicts of interest between rating agencies

and issuers of structured securities. On 3 December 2008, the SEC approved

measures to strengthen oversight of credit rating agencies, following a ten-

month investigation that found "significant weaknesses in ratings practices,"

including conflicts of interest.



Between Q3 2007 and Q2 2008, rating agencies lowered the credit

ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt

they had to lower the value of their MBS and acquire additional capital so as to

maintain capital ratios. If this involved the sale of new shares of stock, the

value of the existing shares was reduced. Thus ratings downgrades lowered the

stock prices of many financial firms.



In December 2008 economist Arnold Kling testified at congressional

hearings on the collapse of Freddie Mac and Fannie Mae. Kling said that a high-

risk loan could be “laundered” by Wall Street and return to the banking system

as a highly rated security for sale to investors, obscuring its true risks and

avoiding capital reserve requirements.





Government policies

Both government action and inaction has contributed to the crisis. Some

are of the opinion that the current American regulatory framework is

outdated. Then President George W. Bush stated in September 2008:



"Once this crisis is resolved, there will be time to update our financial

regulatory structures. Our 21st century global economy remains regulated

largely by outdated 20th century laws. The Securities and Exchange

Commission (SEC) has conceded that self-regulation of investment banks

contributed to the crisis.



Increasing home ownership was a goal of the Clinton and Bush

administrations. There is evidence that the Federal government leaned on the

mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower

lending standards. Also, the U.S. Department of Housing and Urban



30

EFFECT OF SUBPRIME



Development's (HUD) mortgage policies fueled the trend towards issuing risky

loans.



In 1995, the GSEs began receiving government incentive payments for

purchasing mortgage backed securities which included loans to low income

borrowers. Thus began the involvement of the GSE with the subprime market.[

Subprime mortgage originations rose by 25% per year between 1994 and 2003,

resulting in a nearly ten-fold increase in the volume of subprime mortgages in

just nine years. The relatively high yields on these securities, in a time of low

interest rates, were very attractive to Wall Street, and while Fannie and

Freddie generally bought only the least risky subprime mortgages, these

purchases encouraged the entire subprime market. In 1996, HUD directed the

GSE that at least 42% of the mortgages they purchased should have been

issued to borrowers whose household income was below the median in their

area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to

2006 Fannie Mae and Freddie Mac combined purchases of subprime securities

rose from $38 billion to around $175 billion per year before dropping to $90

billion, thus fulfilling their government mandate to help make home buying

more affordable. During this time, the total market for subprime securities

rose from $172 billion to nearly $500 billion only to fall back down to $450

billion.



By 2008, the GSE owned, either directly or through mortgage pools they

sponsored, $5.1 trillion in residential mortgages, about half the amount

outstanding. The GSE have always been highly leveraged, their net worth as of

30 June 2008 being a mere US$114 billion. When concerns arose in September

2008 regarding the ability of the GSE to make good on their guarantees, the

Federal government was forced to place the companies into a conservatorship,

effectively nationalizing them at the taxpayers' expense.



Liberal economist Robert Suttner has suggested that the repeal of the

Glass-Seagull Act by the Gramm-Leach-Bliley Act of 1999 may have contributed

to the subprime meltdown, but this is controversial. The Federal government

bailout of thrifts during the savings and loan crisis of the late 1980s may have

encouraged other lenders to make risky loans, and thus given rise to moral

hazard.





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EFFECT OF SUBPRIME



Economists have also debated the possible effects of the Community

Reinvestment Act (CRA), with detractors claiming that the Act encouraged

lending to uncreditworthy borrowers. and defenders claiming a thirty year

history of lending without increased risk. Detractors also claim that

amendments to the CRA in the mid-1990s, raised the amount of mortgages

issued to otherwise unqualified low-income borrowers, and allowed the

securitization of CRA-regulated mortgages, even though a fair number of them

were subprime.



Federal Reserve Governor Randall Kroszner, says the CRA isn't to blame

for the subprime mess:



"First, only a small portion of subprime mortgage originations are

related to the CRA. Second, CRA-related loans appear to perform comparably

to other types of subprime loans. Taken together… we believe that the

available evidence runs counter to the contention that the CRA contributed in

any substantive way to the current mortgage crisis."



Kroszner added:



"Only 6% of all the higher-priced loans were extended by CRA-covered

lenders to lower-income borrowers or neighborhoods in their CRA assessment

areas, the local geographies that are the primary focus for CRA evaluation

purposes.



FDIC Chairman Sheila Bair also disputes that the CRA was a problem:



"Let me ask you: where in the CRA does it say: make loans to people who can't

afford to repay? Nowhere! And the fact is, the lending practices that are

causing problems today were driven by a desire for market share and revenue

growth ... pure and simple.





Policies of central banks

Central banks manage monetary policy and may target the rate of

inflation. They have some authority over commercial banks and possibly other

financial institutions. They are less concerned with avoiding asset price

bubbles, such as the housing bubble and dot-com bubble. Central banks have

generally chosen to react after such bubbles burst so as to minimize collateral



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EFFECT OF SUBPRIME



damage to the economy, rather than trying to prevent or stop the bubble

itself. This is because identifying an asset bubble and determining the proper

monetary policy to deflate it are matters of debate among economists.



Some market observers have been concerned that Federal Reserve

actions could give rise to moral hazard. A Government Accountability Office

critic said that the Federal Reserve Bank of New York's rescue of Long-Term

Capital Management in 1998 would encourage large financial institutions to

believe that the Federal Reserve would intervene on their behalf if risky loans

went sour because they were “too big to fail.



A contributing factor to the rise in house prices was the Federal

Reserve's lowering of interest rates early in the decade. From 2000 to 2003,

the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.

This was done to soften the effects of the collapse of the dot-com bubble and

of the September 2001 terrorist attacks, and to combat the perceived risk of

deflation. The Fed believed that interest rates could be lowered safely

primarily because the rate of inflation was low; it disregarded other important

factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of

Dallas, said that the Fed's interest rate policy during the early 2000s was

misguided, because measured inflation in those years was below true inflation,

which led to a monetary policy that contributed to the housing bubble.





Financial institution debt levels and incentives

Many financial institutions, investment banks in particular, issued large

amounts of debt during 2004–2007, and invested the proceeds in mortgage-

backed securities (MBS), essentially betting that house prices would continue

to rise, and that households would continue to make their mortgage

payments. Borrowing at a lower interest rate and investing the proceeds at a

higher interest rate is a form of financial leverage. This is analogous to an

individual taking out a second mortgage on his residence to invest in the stock

market. This strategy proved profitable during the housing boom, but resulted

in large losses when house prices began to decline and mortgages began to

default. Beginning in 2007, financial institutions and individual investors

holding MBS also suffered significant losses from mortgage payment defaults





33

EFFECT OF SUBPRIME



and the resulting decline in the value of MBS.









A 2004 SEC ruling allowed USA investment banks to issue substantially

more debt, which was then used to purchase MBS. Over 2004-07, the top five

US investment banks each significantly increased their financial leverage (see

diagram), which increased their vulnerability to the declining value of MBSs.

These five institutions reported over $4.1 trillion in debt for fiscal year 2007,

about 30% of USA nominal GDP for 2007. Further, the percentage of subprime

mortgages originated to total originations increased from below 10% in 2001-

2003 to between 18-20% from 2004-2006, due in-part to financing from

investment banks.



Three investment banks either went bankrupt (Lehman Brothers) or were sold

at fire sale prices to other banks (Bear Stearns and Merrill Lynch) during

September 2008. The failure of 3 of the 5 large USA investment banks

augmented the instability in the global financial system. The remaining two

investment banks, Morgan Stanley and Goldman Sachs, opted to become

commercial banks, thereby subjecting themselves to more stringent

regulation.

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EFFECT OF SUBPRIME



The New York State Comptroller's Office has said that in 2006, Wall

Street executives took home bonuses totaling $23.9 billion. "Wall Street

traders were thinking of the bonus at the end of the year, not the long-term

health of their firm. The whole system—from mortgage brokers to Wall Street

risk managers—seemed tilted toward taking short-term risks while ignoring

long-term obligations. The most damning evidence is that most of the people

at the top of the banks didn't really understand how those [investments]

worked.



Investment banker incentive compensation was focused on fees

generated from assembling financial products, rather than the performance of

those products and profits generated over time. Their bonuses were heavily

skewed towards cash rather than stock and not subject to "claw-back"

(recovery of the bonus from the employee by the firm) in the event the MBS or

CDO created did not perform. In addition, the increased risk (in the form of

financial leverage) taken by the major investment banks was not adequately

factored into the compensation of senior executives.





Credit default swaps

Credit defaults swaps (CDS) are financial instruments used as a hedge

and protection for debt holders, in particular MBS investors, from the risk of

default. As the net worth of banks and other financial institutions deteriorated

because of losses related to subprime mortgages, the likelihood increased that

those providing the insurance would have to pay their counterparties. This

created uncertainty across the system, as investors wondered which

companies would be required to pay to cover mortgage defaults.



Like all swaps and other financial derivatives, CDS may either be used to

hedge risks (specifically, to insure creditors against default) or to profit from

speculation. The volume of CDS outstanding increased 100-fold from 1998 to

2008, with estimates of the debt covered by CDS contracts, as of November

2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008,

there was no central clearinghouse to honor CDS in the event a party to a CDS

proved unable to perform his obligations under the CDS contract. Required

disclosure of CDS-related obligations has been criticized as inadequate.

Insurance companies such as American International Group (AIG), MBIA, and



35

EFFECT OF SUBPRIME



Ambac faced ratings downgrades because widespread mortgage defaults

increased their potential exposure to CDS losses. These firms had to obtain

additional funds (capital) to offset this exposure. AIG's having CDSs insuring

$440 billion of MBS resulted in its seeking and obtaining a Federal government

bailout.



Like all swaps and other pure wagers, what one party loses under a CDS,

the other party gains; CDSs merely reallocate existing wealth. Hence the

question is which side of the CDS will have to pay and will it be able to do so.

When investment bank Lehman Brothers went bankrupt in September 2008,

there was much uncertainty as to which financial firms would be required to

honor the CDS contracts on its $600 billion of bonds outstanding. Merrill

Lynch's large losses in 2008 were attributed in part to the drop in value of its

unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased

offering CDS on Merrill's CDOs. The loss of confidence of trading partners in

Merrill Lynch's solvency and its ability to refinance its short-term debt led to its

acquisition by the Bank of America.



Economist Joseph Stieglitz summarized how credit default swaps contributed

to the systemic meltdown: "With this complicated intertwining of bets of great

magnitude, no one could be sure of the financial position of anyone else-or

even of one's own position. Not surprisingly, the credit markets froze.





Inflow of funds due to trade deficits

In 2005, Ben Bernanke addressed the implications of the USA's high and

rising current account (trade) deficit, resulting from USA imports exceeding its

exports. Between 1996 and 2004, the USA current account deficit increased by

$650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the

USA to borrow large sums from abroad, much of it from countries running

trade surpluses, mainly the emerging economies in Asia and oil-exporting

nations. The balance of payments identity requires that a country (such as the

USA) running a current account deficit also have a capital account (investment)

surplus of the same amount. Hence large and growing amounts of foreign

funds (capital) flowed into the USA to finance its imports. Foreign investors

had these funds to lend, either because they had very high personal savings

rates (as high as 40% in China), or because of high oil prices. Bernanke referred



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EFFECT OF SUBPRIME



to this as a "savings glut" that may have pushed capital into the USA, a view

differing from that of mainstream economists, who view such capital as having

been pulled into the USA by its high consumption levels. In other words, a

nation cannot consume more than its income unless it sells assets to

foreigners, or foreigners are willing to lend to it.



Regardless of the push or pull view, a "flood" of funds (capital or

liquidity) reached the USA financial markets. Foreign governments supplied

funds by purchasing USA Treasury bonds and thus avoided much of the direct

impact of the crisis. USA households, on the other hand, used funds borrowed

from foreigners to finance consumption or to bid up the prices of housing and

financial assets. Financial institutions invested foreign funds in mortgage-

backed securities. USA housing and financial assets dramatically declined in

value after the housing bubble burst









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EFFECT OF SUBPRIME



Impact

Financial market impacts, 2007

The crisis began to affect the financial sector in February 2007, when

HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-

related MBS by $10.5 billion, the first major subprime related loss to be

reported. During 2007, at least 100 mortgage companies either shut down,

suspended operations or were sold. Top management has not escaped

unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week

of each other in late 2007. As the crisis deepened, more and more financial

firms either merged, or announced that they were negotiating seeking merger

During 2007, the crisis caused panic in financial markets and encouraged

investors to take their money out of risky mortgage bonds and shaky equities

and put it into commodities as "stores of value".



Financial speculation in commodity futures following the collapse of the

financial derivatives markets has contributed to the world food price crisis and

oil price increases due to a "commodities super-cycle.Financial speculators

seeking quick returns have removed trillions of dollars from equities and

mortgage bonds, some of which has been invested into food and raw Partners



Mortgage defaults and provisions for future defaults caused profits at

the 8533 USA depository institutions insured by the FDIC to decline from $35.2

billion in 2006 Q4 billion to $646 million in the same quarter a year later, a

decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance

since 1990. In all of 2007, insured depository institutions earned approximately

$100 billion, down 31% from a record profit of $145 billion in 2006. Profits

declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of

46%.





Financial market impacts, 2008

As of August 2008, financial firms around the globe have written down

their holdings of subprime related securities by US$501 billion. The IMF

estimates that financial institutions around the globe will eventually have to

write off $1.5 trillion of their holdings of subprime MBSs. About $750 billion in



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EFFECT OF SUBPRIME



such losses had been recognized as of November 2008. These losses have

wiped out much of the capital of the world banking system. Banks

headquartered in nations that have signed the Basel Accords must have so

many cents of capital for every dollar of credit extended to consumers and

businesses. Thus the massive reduction in bank capital just described has

reduced the credit available to businesses and households.









When Lehman Brothers and other important financial institutions failed

in September 2008, the crisis hit a key point. During a two day period in

September 2008, $150 billion were withdrawn from USA money market funds.

The average two day outflow had been $5 billion. In effect, the money market

was subject to a bank run. The money market had been a key source of credit

for banks (CDs) and nonfinancial firms (commercial paper). The TED spread

(see graph above), a measure of the risk of interbank lending, quadrupled

shortly after the Lehman failure. This credit freeze brought the global financial

system to the brink of collapse. The response of the USA Federal Reserve, the

European Central Bank, and other central banks was immediate and dramatic.

During the last quarter of 2008, these central banks purchased US$2.5 trillion



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EFFECT OF SUBPRIME



of government debt and troubled private assets from banks. This was the

largest liquidity injection into the credit market, and the largest monetary

policy action, in world history. The governments of European nations and the

USA also raised the capital of their national banking systems by $1.5 trillion, by

purchasing newly issued preferred stock in their major banks





Indirect economic effects

The subprime crisis has had a number of adverse effects on the overall

American economic situation. USA GDP was expected to contract at a 5.5%

annual rate during Q4 2008. USA employers slashed 2.6 million jobs during

2008, the most since 1945. There have been significant job losses in the

financial sector, with over 65,400 jobs lost in the USA as of September 2008.

The unemployment rate climbed to 7.2% in December 2008, the highest level

in 16 years.



Declining house prices have reduced household wealth and the

collateral for home equity loans, which is placing downward pressure on

consumption. The tightening of credit has caused a major decline in the sale of

motor vehicles. Between October 2007 and October 2008, Ford sales were

down 33.8%, General Motors sales were down 15.6%, and Toyota sales had

declined 32.3%. There is an ongoing global automobile industry crisis, and calls

for some form of government intervention.



Members of USA minority groups received a disproportionate number of

subprime mortgages, and so have experienced a disproportionate level of the

resulting foreclosures. Minorities have also born the brunt of the dramatic

reduction in subprime lending. House-related crimes such as arson have

increased. Many renters became innocent victims, by being evicted from their

residences without notice, because their landlords' property has been

foreclosed. In October 2008, Tom Dart, the elected Sheriff of Cook County,

Illinois, criticized mortgage lenders for the adverse consequences their actions

had on tenants, and announced that he was suspending all foreclosure

evictions









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EFFECT OF SUBPRIME







Responses

Various actions have been taken since the crisis became apparent in

August 2007. In September 2008, major instability in world financial markets

increased awareness and attention to the crisis. Various agencies and

regulators, as well as political officials, began to take additional, more

comprehensive steps to handle the crisis.



To date, various government agencies have committed or spent trillions

of dollars in loans, asset purchases, guarantees’, and direct spending





Legislative and regulatory responses





Federal Reserve Bank

The central bank of the USA, the Federal Reserve, in partnership with

central banks around the world, has taken several steps to address the crisis.

Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the

Federal Reserve's response has followed two tracks: efforts to support market

liquidity and functioning and the pursuit of our macroeconomic objectives

through monetary policy. The Fed has:



Lowered the target for the Federal funds rate from 5.25% to 2%, and the

discount rate from 5.75% to 2.25%. This took place in six steps occurring

between 18 September 2007 and 30 April 2008;



Undertaken, along with other central banks, open market operations to ensure

member banks remain liquid. These are effectively short-term loans to

member banks collateralized by government securities. Central banks have

also lowered the interest rates (called the discount rate in the USA) they

charge member banks for short-term loans;



Used the Term Auction Facility (TAF) to provide short-term loans

(liquidity) to banks. The Fed increased the monthly amount of these auctions

throughout the crisis, raising it to $300 billion by November 2008, up from $20





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EFFECT OF SUBPRIME



billion at inception. A total of $1.6 trillion in loans to banks were made for

various types of collateral by November 2008.



Finalized, in July 2008, new rules for mortgage lenders;



In October 2008, the Fed expanded the collateral it will lend against to include

commercial paper, to help address continued liquidity concerns. By November

2008, the Fed had purchased $271 billion of such paper, out of a program limit

of $1.4 trillion.



In November 2008, the Fed announced the $200 billion Term Asset-Backed

Securities Loan Facility (TALF). This program supported the issuance of asset-

backed securities (ABS) collateralized by loans related to autos, credit cards,

education, and small businesses. This step was taken to offset liquidity

concerns.



In November 2008, the Fed announced a $600 billion program to purchase the

MBS of the GSE, to help lower mortgage rates





Regulation

Regulators and legislators have contemplated taking action with respect

to lending practices, bankruptcy protection, tax policies, affordable housing,

credit counseling, education, and the licensing and qualifications of lenders.

Regulations or guidelines can influence the transparency and reporting

required of lenders and the types of loans they choose to issue. Congressional

committees are also conducting hearings to help identify solutions and apply

pressure to the various parties involved.



On 31 March 2008, a sweeping expansion of the Fed's regulatory powers

was proposed, that would expand its jurisdiction over nonbank financial

institutions, and its authority to intervene in market crises.



Responding to concerns that lending was not properly regulated, the House

and Senate are both considering bills to further regulate lending practices.



Countrywide's VIP program has led ethics experts and key senators to

recommend that members of Congress be required to disclose information

about the mortgages they take out.



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EFFECT OF SUBPRIME



No depository banks (e.g., investment banks and mortgage companies) are not

subject to the same capital requirements as depository banks. Many

investment banks had limited capital to offset declines in their holdings of

MBSs, or to support their side of credit default insurance contracts.



Nobel prize winner Joseph Stieglitz has recommended that the USA adopt

regulations restricting leverage, and preventing companies from becoming

"too big to fail.



British Prime Minister Gordon Brown and Nobel laureate A. Michael Spence

have argued for an "early warning system" to help detect a confluence of

events leading to systemic risk. Dr. Ram Charan has also argued for risk

management early warning systems at the corporate board level.



On 18 September 2008, UK regulators announced a temporary ban on short-

selling the stock of financial firms.



The Australian government will invest AU$4 billion in mortgage backed

securities issued by nonbank lenders, in an attempt to maintain competition in

the mortgage market. However this is considered a drop in the ocean in

regards to total lending.



Fed Chairman Ben Bernanke stated there is a need for "well-defined

procedures and authorities for dealing with the potential failure of a

systemically important non-bank financial institution.



Alan Greenspan has called for banks to have a 14% capital ratio, rather than

the historical 8-10%. Major U.S. banks had capital ratios of around 12% in

December 2008 after the initial round of bailout funds. The minimum capital

ratio is regulated.



Economists Nouriel Roubini and Lasse Pederson recommended in January 2009

that capital requirements for financial institutions be proportional to the

systemic risk they pose based on an assessment by regulators. Further, each

financial institution would pay an insurance premium to the government based

on its systemic risk









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EFFECT OF SUBPRIME



Economic Stimulus Act of 2008

On 13 February 2008, President Bush signed into law an economic

stimulus package costing $168 billion, mainly taking the form of income tax

rebate checks mailed directly to taxpayers.Checks were mailed starting the

week of 28 April 2008. However, this rebate coincided with an unexpected

jump in gasoline and food prices. This coincidence led some to wonder

whether the stimulus package would have the intended effect, or whether

consumers would simply spend their rebates to cover higher food and fuel

prices. Some Congressmen even contemplated a second round of tax rebates

to ensure that the American economy would indeed be stimulated. Secretary

of the Treasury Henry Paulson strongly opposed such initiative.





Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 included six separate

major acts intended to restore confidence in the American mortgage industry.

The Act



Insures $300 billion in mortgages, that will assist an estimated 400,000

borrowers;



Creates a new Federal regulator to ensure the safe and sound operation

of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan Banks;



Raises the ceiling on the dollar value of the mortgages the government

sponsored enterprises (GSEs) may purchase;



Lends money to mortgage bankers to help them refinance the

mortgages of owner-occupants at risk of foreclosure. The lender reduces the

amount of the mortgage (typically taking a significant loss), in exchange for

sharing in any future appreciation in the selling price of the house via the

Federal Housing Administration. The refinancing must have fixed payments for

a term of 30 years;



Requires that lenders disclose more information about the products they

offer and the deals they close;









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Failures and government bailouts of financial firms

Northern Rock, encountering difficulty obtaining the credit it required to

remain in business, was nationalized on 17 February 2008. As of 8 October 8

2008, United Kingdom taxpayer liability arising from this takeover had risen to

£87 billion ($150 billion).



Bear Stearns was acquired by J.P. Morgan Chase in March 2008 for $1.2

billion. The sale was conditional on the Fed's lending Bear Sterns US$29 billion

on a nonrecourse basis.



IndyMac Bank, America's leading Alt-A originator in 2006 with

approximately $32 billion in deposits was placed into conservatorship by the

FDIC on July 11, 2008, citing liquidity concerns. A bridge bank, IndyMac Federal

Bank, FSB, was established under the control of the FDIC.



The GSEs Fannie Mae and Freddie Mac were both placed in

conservatorship in September 2008.The two GSE's guarantee or hold mortgage

backed securities(MBS), mortgages and other debt with a Notional value of

more than $5 trillion.



Merrill Lynch was acquired by Bank of America in September 2008 for $50

billion.



Scottish banking group HBOS agreed on 17 September 2008 to an

emergency acquisition by its UK rival Lloyds TSB, after a major decline in

HBOS's share price stemming from growing fears about its exposure to British

and American MBSs. The UK government made this takeover possible by

agreeing to waive its competition rules.



Lehman Brothers declared bankruptcy on 15 September 2008, after the

Secretary of the Treasury Henry Paulson, citing moral hazard, refused to bail it

out.



AIG received an $85 billion emergency loan in September 2008 from the

Federal Reserve. Which AIG is expected to repay by gradually selling off its

assets. In exchange, the Federal government acquired a 79.9% equity stake in

AIG.







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EFFECT OF SUBPRIME



Washington Mutual (WaMu) was seized in September 2008 by the USA

Office of Thrift Supervision (OTS). Most of WaMu's untroubled assets were to

be sold to J.P. Morgan Chase.



British bank Bradford & Bingley was nationalized on 29 September 2008

by the UK government. The government assumed control of the bank's £50

billion mortgage and loan portfolio, while its deposit and branch network are

to be sold to Spain's Group Santander.



In October 2008, the Australian government announced that it would

make AU$4 billion available to nonbank lenders unable to issue new loans.

After discussion with the industry, this amount was increased to AU$8 billion.



In November 2008, the U.S. government announced it was purchasing

$27 billion of preferred stock in Citigroup, a USA bank with over $2 trillion in

assets, and warrants on 4.5% of its common stock. The preferred stock carries

an 8% dividend. This purchase follows an earlier purchase of $25 billion of the

same preferred stock using TARP funds.





Emergency Economic Stabilization Act of 2008

As of June 30, 2008, residential mortgages owed by USA households

totaled US$10.6 trillion. As of August 2008, 9.2% of these mortgages were

either seriously delinquent or in foreclosure.



On 19 September 2008, the U.S. Federal government announced a plan,

requiring Congressional approval, to purchase from financial institutions large

amounts of mortgage backed securities (MBSs) and collateralized debt

obligation (CDOs) backed by subprime mortgages. The estimated cost of this

plan was at least $700 billion. The plan also banned short-selling the stocks of

financial firms. On 29 September 2008, the House of Representatives rejected

a revised version of the plan. On 1 October 2008, the U.S. Senate approved an

amended version of the plan, which was ratified by the House on October 3

and immediately signed into law by President Bush. After the law was passed,

the the U.S. Treasury instead primarily used the first $350 billion of bailout

funds to buy preferred stock in banks instead of troubled mortgage assets.







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EFFECT OF SUBPRIME



A Congressional Oversight Panel (COP) chaired by Harvard Professor

Elizabeth Warren was created to monitor the implementation of the law. COP

issued its first report on 10 December 2008, which was primarily a series of

questions and answers. In an interview, Warren stated that banks cannot be

stabilized unless foreclosures are addressed.



For a summary of U.S. government financial commitments and

investments related to the crisis, see CNN - Bailout Scorecard





Lending industry action

Both lenders and borrowers may benefit from avoiding foreclosure,

which is a costly and lengthy process. Some lenders have offered troubled

borrowers more favorable mortgage terms (i.e., refinancing, loan modification

or loss mitigation). Borrowers have also been encouraged to contact their

lenders to discuss alternatives.



Corporations, trade groups, and consumer advocates have begun to cite

data on the numbers and types of borrowers assisted by loan modification

programs. There is some disagreement regarding the data, and the adequacy

of measures taken to date. A report January 2008 report stated that mortgage

lenders modified 54,000 loans and established 183,000 repayment plans in the

third quarter of 2007, a period in which there were 384,000 foreclosures were

initiated. Consumer groups claimed these modifications affected less than 1%

of the 3 million ARM subprime mortgages outstanding as of the third quarter.



The State Foreclosure Prevention Working Group, a coalition of state

attorney generals and bank regulators from 11 states, reported in April 2008

that loan servicers could not keep up with the rising number of foreclosures.

70% of subprime mortgage holders are not getting the help they need. Nearly

two-thirds of loan workouts require more than six weeks to complete under

the current "case-by-case" method of review. In order to slow the growth of

foreclosures, the Group has recommended a more automated method of loan

modification that can be applied to large blocks of struggling borrowers.



In December 2008, the U.S. FDIC reported that more than half of

mortgages modified during the first half of 2008 were delinquent again, in

many cases because payments were not reduced or mortgage debt was not



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EFFECT OF SUBPRIME



forgiven. This is further evidence that case-by-case loan modification is not

effective as a policy tool.



On October 5, 2008, the Bank of America, following on a legal

settlement with several states, announced a more aggressive and systematic

program intended to help an estimated 400,000 borrowers keep their homes.

The program will limit payments as a fraction of household income, and reduce

mortgage balances.



In November 2008, Fannie Mae, Freddie Mac and their network of

mortgage service providers announced a streamlined loan modification

program and foreclosure suspension, designed to help keep borrowers in their

homes.



Several Australian lenders have amended their policies for higher risk

mortgage types. These changes have been relatively minor, with the exception

of those nonconforming lenders that lend to credit impaired and subprime

borrowers. It remains to be seen if this trend will continue, or if Australian

lenders will eventually stop offering riskier loan products





Hope Now Alliance

President George W. Bush announced a plan to voluntarily and

temporarily freeze the mortgages of a limited number of mortgage debtors

holding ARMs. A refinancing facility called FHA-Secure was also created. These

actions are part of the Hope Now Alliance, an ongoing collaborative effort

between the US Government and private industry to help certain subprime

borrowers. In February 2008, the Alliance reported that during the second half

of 2007, it had helped 545,000 subprime borrowers with shaky credit, or 7.7%

of 7.1 million subprime loans outstanding as of September 2007. A

spokesperson for the Alliance acknowledged that much more must be done.



During February 2008, a program called "Project Lifeline" was

announced. Six of the largest USA lenders, in partnership with the Hope Now

Alliance, agreed to defer foreclosure actions for 30 days for borrowers 90 or

more days delinquent on their mortgage payments. The intent of the program

was to reduce foreclosures by encouraging loan adjustments.





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Bank capital replenishment from private sources

As of May 2008, major financial institutions had obtained over $260

billion in new capital, taking the form of bonds or preferred stock sold to

private investors in exchange for cash. This new capital has helped banks

maintain required capital ratios (an important measure of financial health),

which have declined significantly due to losses on subprime loans or CDO

investments. Raising additional capital has been advocated by the leadership

of the U.S. Federal Reserve and the Treasury Department. Well-capitalized

banks are in a better position to lend at favorable interest rates, and to offset

the falling liquidity and rising uncertainty in credit markets. Banks have

obtained some of their new capital from the sovereign wealth funds of

developing countries, which may have political implications.



Certain major banks have also reduced their dividend payouts to

stabilize their financial position. Of the 3776 FDIC insured institutions that paid

a dividend on their common stock in the first quarter of 2007, almost half

(48%) paid a lower dividend in the first quarter of 2008, and 666 institutions

reduced their dividend to zero. Insured institutions paid $14.0 billion in total

dividends in the first quarter of 2008, down $12.2 billion (46.5%) from the first

quarter of 2007.



Steven Pearlstein has advocated government guarantees for new

preferred stock, to encourage investors to provide private capital to the banks





Litigation

Litigation related to the subprime crisis is underway. A study released in

February 2008 indicated that 278 civil lawsuits were filed in federal courts

during 2007 related to the subprime crisis. The number of filings in state courts

was not quantified but is also believed to be significant. The study found that

43% of the cases were class actions brought by borrowers, such as those that

contended they were victims of discriminatory lending practices. Other cases

include securities lawsuits filed by investors, commercial contract disputes,

employment class actions, and bankruptcy-related cases. Defendants included

mortgage bankers, brokers, lenders, appraisers, title companies, home

builders, servicers, issuers, underwriters, bond insurers, money managers,

public accounting firms, and company boards and officers. Former Bear



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EFFECT OF SUBPRIME



Stearns managers were named in civil lawsuits brought in 2007 by investors,

including Barclays Bank PLC, who claimed they had been misled.



An important issue related to the restructuring of mortgage loans

involves the contractual rights of investors who purchased related MBS.

Investor permission is often required to modify the underlying mortgages,

resulting in a "case-by-case" loan modification regime. This presents a

challenge for banks and governments who are attempting to limit foreclosures

by helping large groups of homeowners re-negotiate the terms of their

mortgages efficiently. A class-action lawsuit was filed in December 2008 that

may have significant implications





Law enforcement

The number of Federal Bureau of Investigation (FBI) agents assigned to

mortgage-related crimes increased by 50% between 2007 and 2008. In June

2008, the FBI stated that its mortgage fraud caseload has doubled in the past

three years to more than 1,400 pending cases. Between 1 March and 18 June

2008, 406 people were arrested for mortgage fraud in an FBI sting across the

country. People arrested include buyers, sellers and others across the wide-

ranging mortgage industry.



On 8 March 2008, the FBI began a probe of Countrywide for possible

fraudulent lending practices, securities fraud.



On 19 June 2008, two former Bear Stearns managers were arrested by

the FBI, and were the first Wall Street executives arrested related to the

subprime lending crisis. They were suspected of misleading investors about the

risky subprime mortgage market.



On July 16, 2008, an unnamed US Government official said that the FBI is

investigating Indy Mac for possible fraud. It is not clear if the investigation

began before the bank was taken over by the FDIC upon its $32 billion collapse.



On 23 September 2008, in response to concerns about the bailouts of so

many firms, two government officials stated that the Federal Bureau of

Investigation was looking into the possibility of fraud by mortgage financing

companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer



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EFFECT OF SUBPRIME



American International Group, bringing to 26 the number of corporate lenders

under investigation.





Ethics investigation

On 18 June 2008, a Congressional ethics panel started examining

allegations that Democrat Senators Christopher Dodd of Connecticut (the

sponsor of a major $300 billion housing rescue bill) and Kent Conrad of North

Dakota received preferential loans by troubled mortgage lender Countrywide

Financial Corp.





Executive compensation reform

Banks and executives are under pressure to reduce bonuses, as much of

the profits recognized by major banks were wiped out by subsequent losses

during the crisis. The extent of risk taken was not properly factored into bonus

computations. Several executives have foregone bonuses in light of what

turned out to be poor performance. However, few firms had "claw back"

provisions to recapture the bonuses, which were based on short-term profits

rather than long-term value creation. Credit Suisse bank announced it will

begin paying bonuses out of a fund containing troubled assets on its books, in

place of cash. Gains or losses on the fund will affect employee bonuses. This

approach was praised as "monstrously clever" by one analyst





Effect on the financial condition of USA governmental units

The Federal government's efforts to support the global financial system

have resulted in significant new financial commitments, totaling $7 trillion by

November, 2008. These commitments can be characterized as investments,

loans, and loan guarantees, rather than direct expenditures. In many cases, the

government purchased financial assets such as commercial paper, mortgage-

backed securities, or other types of asset-backed paper, to enhance liquidity in

frozen markets.As the crisis has progressed, the Fed has expanded the

collateral against which it is willing to lend to include higher-risk assets









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The extent to which the Federal government is at risk because of these

investments and guarantees remains to be seen. The upshot has been a US$1

trillion increase in the national debt of the USA during FY 2008, compared to

an average increase of US$550 billion during the previous five years. The total

debt reached $10 trillion in September 2008



In addition, state and local government property tax collections are expected

to decline because of an estimated $1.2 trillion reduction in housing prices,

and a slowing of the overall American economy. This expectation is affecting

the ability of state governments to finance their operations through bond

sales. Finding themselves unable to borrow, the states of California and

Massachusetts have requested that the Fed lend them the amounts they

would have borrowed elsewhere under normal conditions.









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EFFECT OF SUBPRIME



Expectations and forecasts

We have been concerned for some time about the risks in asset-backed

bonds, particularly bonds that are backed by home equity loans, automobile

loans or credit card debt (we own no asset-backed bonds). It seems to us that

securitization (or the creation of these asset-backed bonds) eliminates the

incentive for the originator of the loan to be credit sensitive... With

securitization, the dealer (almost) does not care as these loans can be laid off

through securitization. Thus, the loss experienced on these loans after

securitization will no longer be comparable to that experienced prior to

securitization (called a moral hazard)... This is not a small problem. There is

$1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the

U.S.... Who is buying these bonds? Insurance companies, money managers and

banks – in the main – all reaching for yield given the excellent ratings for these

bonds. What happens if we hit an air pocket?



Stifel Nicolaus, writing in MarketWatch, has claimed that the problem

mortgages are not confined to the subprime niche: "the rapidly increasing

scope and depth of the problems in the mortgage market suggest that the

entire sector has plunged into a downward spiral similar to the subprime woes

whereby each negative development feeds further deterioration," calling it a

"vicious cycle" and adding that lenders "continue to believe conditions will get

worse".



On 19 May, 2008, Nouriel Roubini, a professor at New York University

and head of Roubini Global Economics, was quoted as saying that if the

economy slips into recession "then you have a systemic banking crisis like we

haven't had since the 1930s".



Because debt instruments backed by subprime mortgages were

purchased worldwide, the International Monetary Fund (IMF) "says that

worldwide losses stemming from the USA subprime mortgage crisis could run

to $945 billion.



As of February 2009, analysts were predicting that Alt-A loans, offered to

those with good credit but less steady income than prime borrowers,



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EFFECT OF SUBPRIME



represent the next wave of delinquencies and foreclosures. Rating agency

Moody's expects the delinquency rate to increase to over 20%, compared with

the historical average of below 1%. Analysts at Goldman Sachs estimate write-

downs on the $1.3 trillion of total Alt-A debt at $600 billion, almost as much as

expected subprime losses. Add in option ARMs, many of which are essentially

the same as Alt-A, and the potential impact climbs towards $1 trillion.



Francis Fukuyama has argued that the crisis represents the end of

Reaganism in the financial sector, which was characterized by lighter

regulation, pared-back government, and lower taxes. Significant financial

sector regulatory changes are expected as a result of the crisis.



Fareed Zakaria believes that the crisis may force Americans and their

government to live within their means. Further, some of the best minds may

be redeployed from financial engineering to more valuable business activities,

or to science and technology.



Roger Altman wrote that "the crash of 2008 has inflicted profound

damage on [the U.S.] financial system, its economy, and its standing in the

world; the crisis is an important geopolitical setback...the crisis has coincided

with historical forces that were already shifting the world's focus away from

the United States. Over the medium term, the United States will have to

operate from a smaller global platform -- while others, especially China, will

have a chance to rise faster.



The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman

of the Federal Reserve System from 1986 to January 2006. Senator Chris Dodd

claimed that Greenspan created the "perfect storm". Greenspan has remarked

that there is a one-in-three chance of recession from the fallout. When asked

to comment on the crisis, Greenspan spoke as follows



The current credit crisis will come to an end when the overhang of

inventories of newly built homes is largely liquidated, and home price deflation

comes to an end. That will stabilize the now-uncertain value of the home

equity that acts as a buffer for all home mortgages, but most importantly for

those held as collateral for residential mortgage-backed securities. Very large

losses will, no doubt, be taken as a consequence of the crisis. But after a period





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Mortgage loan

A mortgage loan is a loan secured by real property through the use of a

note which evidences the existence of the loan and the encumbrance of that

realty through the granting of a mortgage which secures the loan. However,

the word mortgage alone, in everyday usage, is most often used to mean

mortgage loan.



A home buyer or builder can obtain financing (a loan) either to purchase

or secure against the property from a financial institution, such as a bank,

either directly or indirectly through intermediaries. Features of mortgage loans

such as the size of the loan, maturity of the loan, interest rate, method of

paying off the loan, and other characteristics can vary considerably.





Mortgage loan basics



Basic concepts and legal regulation

According to Anglo-American property law, a mortgage occurs when an

owner (usually of a fee simple interest in realty) pledges his interest as security

or collateral for a loan. Therefore, a mortgage is an encumbrance on property

just as an easement would be, but because most mortgages occur as a

condition for new loan money, the word mortgage has become the generic

term for a loan secured by such real property.



As with other types of loans, mortgages have an interest rate and are

scheduled to amortize over a set period of time; typically 30 years. All types of

real property can, and usually are, secured with a mortgage and bear an

interest rate that is supposed to reflect the lender's risk.



Mortgage lending is the primary mechanism used in many countries to

finance private ownership of residential property. For commercial mortgages

see the separate article. Although the terminology and precise forms will differ

from country to country, the basic components tend to be similar:









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Property: the physical residence being financed. The exact form of ownership

will vary from country to country, and may restrict the types of lending that are

possible.



Mortgage: the security created on the property by the lender, which will

usually include certain restrictions on the use or disposal of the property (such

as paying any outstanding debt before selling the property).



Borrower: the person borrowing who either has or is creating an ownership

interest in the property.



Lender: any lender, but usually a bank or other financial institution.



Principal: the original size of the loan, which may or may not include certain

other costs; as any principal is repaid, the principal will go down in size.



Interest: a financial charge for use of the lender's money.



Foreclosure or repossession: the possibility that the lender has to foreclose,

repossess or seize the property under certain circumstances is essential to a

mortgage loan; without this aspect, the loan is arguably no different from any

other type of loan.



Many other specific characteristics are common to many markets, but

the above are the essential features. Governments usually regulate many

aspects of mortgage lending, either directly (through legal requirements, for

example) or indirectly (through regulation of the participants or the financial

markets, such as the banking industry), and often through state intervention

(direct lending by the government, by state-owned banks, or sponsorship of

various entities). Other aspects that define a specific mortgage market may be

regional, historical, or driven by specific characteristics of the legal or financial

system.



Mortgage loans are generally structured as long-term loans, the periodic

payments for which are similar to an annuity and calculated according to the

time value of money formulae. The most basic arrangement would require a

fixed monthly payment over a period of ten to thirty years, depending on local

conditions. Over this period the principal component of the loan (the original





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EFFECT OF SUBPRIME



loan) would be slowly paid down through amortization. In practice, many

variants are possible and common worldwide and within each country.



Lenders provide funds against property to earn interest income, and

generally borrow these funds themselves (for example, by taking deposits or

issuing bonds). The price at which the lenders borrow money therefore affects

the cost of borrowing. Lenders may also, in many countries, sell the mortgage

loan to other parties who are interested in receiving the stream of cash

payments from the borrower, often in the form of a security (by means of a

securitization). In the United States, the largest firms securitizing loans are

Fannie Mae and Freddie Mac, which are government sponsored enterprises.



Mortgage lending will also take into account the (perceived) riskiness of

the mortgage loan, that is, the likelihood that the funds will be repaid (usually

considered a function of the creditworthiness of the borrower); that if they are

not repaid, the lender will be able to foreclose and recoup some or all of its

original capital; and the financial, interest rate risk and time delays that may be

involved in certain circumstances.





Mortgage loan types

There are many types of mortgages used worldwide, but several factors

broadly define the characteristics of the mortgage. All of these may be subject

to local regulation and legal requirements.



1) Interest: interest may be fixed for the life of the loan or variable, and

change at certain pre-defined periods; the interest rate can also, of

course, be higher or lowe

2) Term: mortgage loans generally have a maximum term, that is, the

number of years after which an amortizing loan will be repaid. Some

mortgage loans may have no amortization, or require full repayment of

any remaining balance at a certain date, or even negative amortization.

3) Payment amount and frequency: the amount paid per period and the

frequency of payments; in some cases, the amount paid per period may

change or the borrower may have the option to increase or decrease the

amount paid.







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4) Prepayment: some types of mortgages may limit or restrict prepayment

of all or a portion of the loan, or require payment of a penalty to the

lender for prepayment



The two basic types of amortized loans are the fixed rate mortgage (FRM)

and adjustable rate mortgage (ARM) (also known as a floating rate or variable

rate mortgage). In many countries, floating rate mortgages are the norm and

will simply be referred to as mortgages; in the United States, fixed rate

mortgages are typically considered "standard." Combinations of fixed and

floating rate are also common, whereby a mortgage loan will have a fixed rate

for some period, and vary after the end of that period.



In a fixed rate mortgage, the interest rate, and hence periodic payment,

remains fixed for the life (or term) of the loan. In the U.S., the term is usually

up to 30 years (15 and 30 being the most common), although longer terms

may be offered in certain circumstances. For a fixed rate mortgage, payments

for principal and interest should not change over the life of the loan, although

ancillary costs (such as property taxes and insurance) can and do change.



In an adjustable rate mortgage, the interest rate is generally fixed for a

period of time, after which it will periodically (for example, annually or

monthly) adjust up or down to some market index. Common indices in the U.S.

include the Prime Rate, the London Interbank Offered Rate (LIBOR), and the

Treasury Index ("T-Bill"); other indices are in use but are less popular.









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EFFECT OF SUBPRIME



Adjustable rates transfer part of the interest rate risk from the lender to

the borrower, and thus are widely used where fixed rate funding is difficult to

obtain or prohibitively expensive. Since the risk is transferred to the borrower,

the initial interest rate may be from 0.5% to 2% lower than the average 30-

year fixed rate; the size of the price differential will be related to debt market

conditions, including the yield curve.



Additionally, lenders in many markets rely on credit reports and credit

scores derived from them. The higher the score, the more creditworthy the

borrower is assumed to be. Favorable interest rates are offered to buyers with

high scores. Lower scores indicate higher risk for the lender, and higher rates

will generally be charged to reflect the (expected) higher default rates.



A partial amortization or balloon loan is one where the amount of

monthly payments due are calculated (amortized) over a certain term, but the

outstanding principal balance is due at some point short of that term. This

payment is sometimes referred to as a "balloon payment" or bullet payment.

The interest rate for a balloon loan can be either fixed or floating. The most

common way of describing a balloon loan uses the terminology X due in Y,

where X is the number of years over which the loan is amortized, and Y is the

year in which the principal balance is due.



Other loan types:

1) Assumed mortgage

2) Balloon mortgage

3) Blanket loan

4) Bridge loan

5) Budget loan

6) Buydown mortgage

7) Commercial loan

8) Endowment mortgage

9) Equity loan

10) Flexible mortgage

11) Foreign National mortgage

12) Graduated payment mortgage loan

13) Hard money loan



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14) Jumbo mortgages

15) Offset mortgage

16) Package loan

17) Participation mortgage

18) Reverse mortgage

19) Repayment mortgage

20) Seasoned mortgage

21) Term loan or Interest-only loan

22) Wraparound mortgage

23) Negative amortization loan

24) Non-conforming mortgage





Loan to value and downpayments

Upon making a mortgage loan for purchase of a property, lenders

usually require that the borrower make a downpayment, that is, contribute a

portion of the cost of the property. This downpayment may be expressed as a

portion of the value of the property (see below for a definition of this term).

The loan to value ratio (or LTV) is the size of the loan against the value of the

property. Therefore, a mortgage loan where the purchaser has made a

downpayment of 20% has a loan to value ratio of 80%. For loans made against

properties that the borrower already owns, the loan to value ratio will be

imputed against the estimated value of the property.



The loan to value ratio is considered an important indicator of the

riskiness of a mortgage loan: the higher the LTV, the higher the risk that the

value of the property (in case of foreclosure) will be insufficient to cover the

remaining principal of the loan.





Value: appraised, estimated, and actual

Since the value of the property is an important factor in understanding

the risk of the loan, determining the value is a key factor in mortgage lending.

The value may be determined in various ways, but the most common are:



Actual or transaction value: this is usually taken to be the purchase price

of the property. If the property is not being purchased at the time of

borrowing, this information may not be available.

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Appraised or surveyed value: in most jurisdictions, some form of

appraisal of the value by a licensed professional is common. There is often a

requirement for the lender to obtain an official appraisal.



Estimated value: lenders or other parties may use their own internal

estimates, particularly in jurisdictions where no official appraisal procedure

exists, but also in some other circumstances.





Equity or homeowner's equity

The concept of equity in a property refers to the value of the property

minus the outstanding debt, subject to the definition of the value of the

property. Therefore, a borrower who owns a property whose estimated value

is $400,000 but with outstanding mortgage loans of $300,000 is said to have

homeowner's equity of $100,000.





Payment and debt ratios

In most countries, a number of more or less standard measures of

creditworthiness may be used. Common measures include payment to income

(mortgage payments as a percentage of gross or net income); debt to income

(all debt payments, including mortgage payments, as a percentage of income);

and various net worth measures. In many countries, credit scores are used in

lieu of or to supplement these measures. There will also be requirements for

documentation of the creditworthiness, such as income tax returns, pay stubs,

etc; the specifics will vary from location to location. Many countries have lower

requirements for certain borrowers, or "no-doc" / "low-doc" lending standards

that may be acceptable in certain circumstances.





Standard or conforming mortgages

Many countries have a notion of standard or conforming mortgages that

define a perceived acceptable level of risk, which may be formal or informal,

and may be reinforced by laws, government intervention, or market practice.

For example, a standard mortgage may be considered to be one with no more

than 70-80% LTV and no more than one-third of gross income going to

mortgage debt.





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A standard or conforming mortgage is a key concept as it often defines

whether or not the mortgage can be easily sold or securitized, or, if non-

standard, may affect the price at which it may be sold. In the United States, a

conforming mortgage is one which meets the established rules and procedures

of the two major government-sponsored entities in the housing finance market

(including some legal requirements). In contrast, lenders who decide to make

nonconforming loans are exercising a higher risk tolerance and do so knowing

that they face more challenge in reselling the loan. Many countries have

similar concepts or agencies that define what are "standard" mortgages.

Regulated lenders (such as banks) may be subject to limits or higher risk

weightings for non-standard mortgages. For example, banks in Canada face

restrictions on lending more than 75% of the property value; beyond this level,

mortgage insurance is generally required (as of April 2007, there is a proposal

to raise this limit to 80%).









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Repaying the capital

There are various ways to repay a mortgage loan; repayment depends on

locality, tax laws and prevailing culture





Capital and interest

The most common way to repay a loan is to make regular payments of

the capital (also called principal) and interest over a set term. This is commonly

referred to as (self) amortization in the U.S. and as a repayment mortgage in

the UK. A mortgage is a form of annuity (from the perspective of the lender),

and the calculation of the periodic payments is based on the time value of

money formulas. Certain details may be specific to different locations: interest

may be calculated on the basis of a 360-day year, for example; interest may be

compounded daily, yearly, or semi-annually; prepayment penalties may apply;

and other factors. There may be legal restrictions on certain matters, and

consumer protection laws may specify or prohibit certain practices.



Depending on the size of the loan and the prevailing practice in the

country the term may be short (10 years) or long (50 years plus). In the UK and

U.S., 25 to 30 years is the usual maximum term (although shorter periods, such

as 15-year mortgage loans, are common). Mortgage payments, which are

typically made monthly, contain a capital (repayment of the principal) and an

interest element. The amount of capital included in each payment varies

throughout the term of the mortgage. In the early years the repayments are

largely interest and a small part capital. Towards the end of the mortgage the

payments are mostly capital and a smaller portion interest. In this way the

payment amount determined at outset is calculated to ensure the loan is

repaid at a specified date in the future. This gives borrowers assurance that by

maintaining repayment the loan will be cleared at a specified date, if the

interest rate does not change.









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Interest only

The main alternative to capital and interest mortgage is an interest only

mortgage, where the capital is not repaid throughout the term. This type of

mortgage is common in the UK, especially when associated with a regular

investment plan. With this arrangement regular contributions are made to a

separate investment plan designed to build up a lump sum to repay the

mortgage at maturity. This type of arrangement is called an investment-backed

mortgage or is often related to the type of plan used: endowment mortgage if

an endowment policy is used, similarly a Personal Equity Plan (PEP) mortgage,

Individual Savings Account (ISA) mortgage or pension mortgage. Historically,

investment-backed mortgages offered various tax advantages over repayment

mortgages, although this is no longer the case in the UK. Investment-backed

mortgages are seen as higher risk as they are dependent on the investment

making sufficient return to clear the debt.



Until recently it was not uncommon for interest only mortgages to be

arranged without a repayment vehicle, with the borrower gambling that the

property market will rise sufficiently for the loan to be repaid by trading down

at retirement (or when rent on the property and inflation combine to surpass

the interest rate).





No capital or interest

For older borrowers (typically in retirement), it may be possible to

arrange a mortgage where neither the capital nor interest is repaid. The

interest is rolled up with the capital, increasing the debt each year.



These arrangements are variously called reverse mortgages, lifetime

mortgages or equity release mortgages, depending on the country. The loans

are typically not repaid until the borrowers die, hence the age restriction. For

further details, see equity release.





Interest and partial capital

In the U.S. a partial amortization or balloon loan is one where the

amount of monthly payments due are calculated (amortized) over a certain

term, but the outstanding capital balance is due at some point short of that

term. In the UK, a part repayment mortgage is quite common, especially where

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the original mortgage was investment-backed and on moving house further

borrowing is arranged on a capital and interest (repayment) basis.





Foreclosure and non-recourse lending

In most jurisdictions, a lender may foreclose the mortgaged property if

certain conditions - principally, non-payment of the mortgage loan - obtain.

Subject to local legal requirements, the property may then be sold. Any

amounts received from the sale (net of costs) are applied to the original debt.

In some jurisdictions, mortgage loans are non-recourse loans: if the funds

recouped from sale of the mortgaged property are insufficient to cover the

outstanding debt, the lender may not have recourse to the borrower after

foreclosure. In other jurisdictions, the borrower remains responsible for any

remaining debt. In virtually all jurisdictions, specific procedures for foreclosure

and sale of the mortgaged property apply, and may be tightly regulated by the

relevant government; in some jurisdictions, foreclosure and sale can occur

quite rapidly, while in others, foreclosure may take many months or even

years. In many countries, the ability of lenders to foreclose is extremely

limited, and mortgage market development has been notably slower.









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Credit card

A credit card is part of a system of payments named after the small

plastic card issued to users of the system. It is a card entitling its holder to buy

goods and services based on the holders promise to pay for these goods and

services. The issuer of the card grants a line of credit to the consumer (or the

user) from which the user can borrow money for payment to a merchant or as

a cash advance to the user. A credit card is different from a charge card, where

a charge card requires the balance to be paid in full each month. In contrast,

credit cards allow the consumers to 'revolve' their balance, at the cost of

having interest charged. Most credit cards are issued by local banks or credit

unions, and are the same shape and size as specified by the ISO 7810 standard.





How credit cards work

Credit cards are issued after an account has been approved by the credit

provider, after which cardholders can use it to make purchases at merchants

accepting that card.



When a purchase is made, the credit card user agrees to pay the card

issuer. The cardholder indicates his/her consent to pay, by signing a receipt

with a record of the card details and indicating the amount to be paid or by

entering a Personal identification number (PIN). Also, many merchants now

accept verbal authorizations via telephone and electronic authorization using

the Internet, known as a 'Card/Cardholder Not Present' (CNP) transaction.



Electronic verification systems allow merchants to verify that the card is

valid and the credit card customer has sufficient credit to cover the purchase in

a few seconds, allowing the verification to happen at time of purchase. The

verification is performed using a credit card payment terminal or Point of Sale

(POS) system with a communications link to the merchant's acquiring bank.

Data from the card is obtained from a magnetic stripe or chip on the card; the

latter system is in the United Kingdom and Ireland commonly known as Chip

and PIN, but is more technically an EMV card.



Other variations of verification systems are used by ecommerce

merchants to determine if the user's account is valid and able to accept the



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charge. These will typically involve the cardholder providing additional

information, such as the security code printed on the back of the card, or the

address of the cardholder.



Each month, the credit card user is sent a statement indicating the

purchases undertaken with the card, any outstanding fees, and the total

amount owed. After receiving the statement, the cardholder may dispute any

charges that he or she thinks are incorrect (see Fair Credit Billing Act for details

of the US regulations). Otherwise, the cardholder must pay a defined minimum

proportion of the bill by a due date, or may choose to pay a higher amount up

to the entire amount owed. The credit provider charges interest on the

amount owed if the balance is not paid in full (typically at a much higher rate

than most other forms of debt). Some financial institutions can arrange for

automatic payments to be deducted from the user's bank accounts, thus

avoiding late payment altogether as long as the cardholder has sufficient

funds.









Interest charges

Credit card issuers usually waive interest charges if the balance is paid in

full each month, but typically will charge full interest on the entire outstanding

balance from the date of each purchase if the total balance is not paid.



For example, if a user had a $1,000 transaction and repaid it in full

within this grace period, there would be no interest charged. If, however, even

$1.00 of the total amount remained unpaid, interest would be charged on the

$1,000 from the date of purchase until the payment is received. The precise

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EFFECT OF SUBPRIME



manner in which interest is charged is usually detailed in a cardholder

agreement which may be summarized on the back of the monthly statement.

The general calculation formula most financial institutions use to determine

the amount of interest to be charged is APR/100 x ADB/365 x number of days

revolved. Take the Annual percentage rate (APR) and divide by 100 then

multiply to the amount of the average daily balance (ADB) divided by 365 and

then take this total and multiply by the total number of days the amount

revolved before payment was made on the account. Financial institutions refer

to interest charged back to the original time of the transaction and up to the

time a payment was made, if not in full, as RRFC or residual retail finance

charge. Thus after an amount has revolved and a payment has been made, the

user of the card will still receive interest charges on their statement after

paying the next statement in full (in fact the statement may only have a charge

for interest that collected up until the date the full balance was paid...i.e. when

the balance stopped revolving).



The credit card may simply serve as a form of revolving credit, or it may

become a complicated financial instrument with multiple balance segments

each at a different interest rate, possibly with a single umbrella credit limit, or

with separate credit limits applicable to the various balance segments. Usually

this compartmentalization is the result of special incentive offers from the

issuing bank, to encourage balance transfers from cards of other issuers. In the

event that several interest rates apply to various balance segments, payment

allocation is generally at the discretion of the issuing bank, and payments will

therefore usually be allocated towards the lowest rate balances until paid in

full before any money is paid towards higher rate balances. Interest rates can

vary considerably from card to card, and the interest rate on a particular card

may jump dramatically if the card user is late with a payment on that card or

any other credit instrument, or even if the issuing bank decides to raise its

revenue.









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Benefits to customers

Because of intense competition in the credit card industry, credit card

providers often offer incentives such as frequent flyer points, gift certificates,

or cash back (typically up to 1 percent based on total purchases) to try to

attract customers to their programs.



Low interest credit cards or even 0% interest credit cards are available.

However, services are available which alert credit card holders when their low

interest period is due to expire. Most such services charge a monthly or annual

fee.





Detriments to customers

Credit cards with low introductory rates are limited to a fixed term,

usually between 6 and 12 months after which a higher rate is charged. As all

credit cards assess fees and interest, some customers become so encumbered

with their credit debt service that they are driven to bankruptcy.





Grace period

A credit card's grace period is the time the customer has to pay the

balance before interest is charged to the balance. Grace periods vary, but

usually range from 20 to 40 days depending on the type of credit card and the

issuing bank. Some policies allow for reinstatement after certain conditions are

met.



Usually, if a customer is late paying the balance, finance charges will be

calculated and the grace period does not apply. Finance charges incurred

depend on the grace period and balance; with most credit cards there is no

grace period if there is any outstanding balance from the previous billing cycle

or statement (i.e. interest is applied on both the previous balance and new

transactions). However, there are some credit cards that will only apply finance

charge on the previous or old balance, excluding new transactions.









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Benefits to merchants

For merchants, a credit card transaction is often more secure than other

forms of payment, such as checks, because the issuing bank commits to pay

the merchant the moment the transaction is authorized, regardless of whether

the consumer defaults on the credit card payment (except for legitimate

disputes, which are discussed below, and can result in charges back to the

merchant). In most cases, cards are even more secure than cash, because they

discourage theft by the merchant's employees and reduce the amount of cash

on the premises. Prior to credit cards, each merchant had to evaluate each

customer's credit history before extending credit. That task is now performed

by the banks which assume the credit risk.



For each purchase, the bank charges the merchant a commission

(discount fee) for this service and there may be a certain delay before the

agreed payment is received by the merchant. The commission is often a

percentage of the transaction amount, plus a fixed fee. In addition, a merchant

may be penalized or have their ability to receive payment using that credit card

restricted if there are too many cancellations or reversals of charges as a result

of disputes. Some small merchants require credit purchases to have a

minimum amount (usually between $5 and $10) to compensate for the

transaction costs, though this is strictly prohibited by credit card companies

and must be reported to the consumer's credit card issuer.



In some countries, for example the Nordic countries, banks guarantee

payment on stolen cards only if an ID card is checked and the ID card

number/civic registration number is written down on the receipt together with

the signature. In these countries merchants therefore usually ask for ID. Non-

Nordic citizens, who are unlikely to possess a Nordic ID card or driving license,

will instead have to show their passport, and the passport number will be

written down on the receipt, sometimes together with other information.

Some shops use the card's PIN for identification, and in that case showing an ID

card is not necessary.









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Detriments to merchants

Merchants are charged many fees for the privilege of accepting credit cards.

The merchant may be charged a discount rate of 1%-3%+ of each transaction

obtained through a credit card. Usually, the merchant will also pay a flat per-

item charge of $0.05 - $0.50 for each transaction. Thus in some instances of

very low value transactions, use of credit cards may actually cause the

merchant to lose money on the transaction





Parties involved

Cardholder: The holder of the card used to make a purchase; the

consumer.



Card-issuing bank: The financial institution or other organization that

issued the credit card to the cardholder. This bank bills the consumer for

repayment and bears the risk that the card is used fraudulently. American

Express and Discover were previously the only card-issuing banks for their

respective brands, but as of 2007, this is no longer the case.







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Merchant: The individual or business accepting credit card payments for

products or services sold to the cardholder



Acquiring bank: The financial institution accepting payment for the products or

services on behalf of the merchant.



Independent sales organization: Resellers (to merchants) of the services of the

acquiring bank.



Merchant account: This could refer to the acquiring bank or the independent

sales organization, but in general is the organization that the merchant deals

with.



Credit Card association: An association of card-issuing banks such as Visa,

MasterCard, Discover, American express, etc. that set transaction terms for

merchants, card-issuing banks, and acquiring banks.



Transaction network: The system that implements the mechanics of the

electronic transactions. May be operated by an independent company, and

one company may operate multiple networks. Transaction processing

networks include: Carnet, Nabisco, Omaha, Paymentech, NDC Atlanta, Nova,

TSYS, Concord EFSnet, and VisaNet.



Affinity partner: Some institutions lend their names to an issuer to

attract customers that have a strong relationship with that institution, and get

paid a fee or a percentage of the balance for each card issued using their

name. Examples of typical affinity partners are sports teams, universities,

charities, professional organizations, and major retailers.



The flow of information and money between these parties — always through

the card associations — is known as the interchange, and it consists of a few

steps.









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Transaction steps

Authorization: The cardholder pays for the purchase and the merchant

submits the transaction to the acquirer (acquiring bank). The acquirer verifies

the credit card number, the transaction type and the amount with the issuer

(Card-issuing bank) and reserves that amount of the cardholder's credit limit

for the merchant. An authorization will generate an approval code, which the

merchant stores with the transaction.



Batching: Authorized transactions are stored in "batches", which are

sent to the acquirer. Batches are typically submitted once per day at the end of

the business day. If a transaction is not submitted in the batch, the

authorization will stay valid for a period determined by the issuer, after which

the held amount will be returned back to the cardholder's available credit (see

authorization hold). Some transactions may be submitted in the batch without

prior authorizations; these are either transactions falling under the merchant's

floor limit or ones where the authorization was unsuccessful but the merchant

still attempts to force the transaction through. (Such may be the case when

the cardholder is not present but owes the merchant additional money, such

as extending a hotel stay or car rental.)



Clearing and Settlement: The acquirer sends the batch transactions

through the credit card association, which debits the issuers for payment and

credits the acquirer. Essentially, the issuer pays the acquirer for the

transaction.



Funding: Once the acquirer has been paid, the acquirer pays the

merchant. The merchant receives the amount totaling the funds in the batch

minus the "discount rate," which is the fee the merchant pays the acquirer for

processing the transactions.



Chargebacks: A chargeback is an event in which money in a merchant

account is held due to a dispute relating to the transaction. Chargebacks are

typically initiated by the cardholder. In the event of a chargeback, the issuer

returns the transaction to the acquirer for resolution. The acquirer then

forwards the chargeback to the merchant, who must either accept the

chargeback or contest it.





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Secured credit cards

A secured credit card is a type of credit card secured by a deposit

account owned by the cardholder. Typically, the cardholder must deposit

between 100% and 200% of the total amount of credit desired. Thus if the

cardholder puts down $1000, they will be given credit in the range of $500–

$1000. In some cases, credit card issuers will offer incentives even on their

secured card portfolios. In these cases, the deposit required may be

significantly less than the required credit limit, and can be as low as 10% of the

desired credit limit. This deposit is held in a special savings account. Credit card

issuers offer this because they have noticed that delinquencies were notably

reduced when the customer perceives something to lose if the balance is not

repaid.



The cardholder of a secured credit card is still expected to make regular

payments, as with a regular credit card, but should they default on a payment,

the card issuer has the option of recovering the cost of the purchases paid to

the merchants out of the deposit. The advantage of the secured card for an

individual with negative or no credit history is that most companies report

regularly to the major credit bureaus. This allows for building of positive credit

history.



Although the deposit is in the hands of the credit card issuer as security

in the event of default by the consumer, the deposit will not be debited simply

for missing one or two payments. Usually the deposit is only used as an offset

when the account is closed, either at the request of the customer or due to

severe delinquency (150 to 180 days). This means that an account which is less

than 150 days delinquent will continue to accrue interest and fees, and could

result in a balance which is much higher than the actual credit limit on the

card. In these cases the total debt may far exceed the original deposit and the

cardholder not only forfeits their deposit but is left with an additional debt.



Most of these conditions are usually described in a cardholder

agreement which the cardholder signs when their account is opened.



Secured credit cards are an option to allow a person with a poor credit

history or no credit history to have a credit card which might not otherwise be

available. They are often offered as a means of rebuilding one's credit. Secured



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credit cards are available with both Visa and MasterCard logos on them. Fees

and service charges for secured credit cards often exceed those charged for

ordinary non-secured credit cards, however, for people in certain situations,

(for example, after charging off on other credit cards, or people with a long

history of delinquency on various forms of debt), secured cards can often be

less expensive in total cost than unsecured credit cards, even including the

security deposit.



Sometimes a credit card will be secured by the equity in the borrower's

home. This is called a home equity line of credit (HELOC).





Prepaid "credit" cards

A prepaid credit card is not a credit card,since no credit is offered by the

card issuer: the card-holder spends money which has been "stored" via a prior

deposit by the card-holder or someone else, such as a parent or employer.

However, it carries a credit-card brand (Visa, MasterCard, American Express or

Discover) and can be used in similar ways just as though it were a regular credit

card.



After purchasing the card, the cardholder loads the account with any

amount of money, up to the predetermined card limit and then uses the card

to make purchases the same way as a typical credit card. Prepaid cards can be

issued to minors (above 13) since there is no credit line involved. The main

advantage over secured credit cards (see above section) is that you are not

required to come up with $500 or more to open an account. With prepaid

credit cards you are not charged any interest but you are often charged a

purchasing fee plus monthly fees after an arbitrary time period. Many other

fees also usually apply to a prepaid card.



Prepaid credit cards are sometimes marketed to teenagers for shopping online

without having their parents complete the transaction.



Because of the many fees that apply to obtaining and using credit-card-

branded prepaid cards, the Financial Consumer Agency of Canada describes

them as "an expensive way to spend your own money". The agency publishes a

booklet, "Pre-paid cards", which explains the advantages and disadvantages of

this type of prepaid card.



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Credit Card Security

Credit card security relies on the physical security of the plastic card as

well as the privacy of the credit card number. Therefore, whenever a person

other than the card owner has access to the card or its number, security is

potentially compromised. Merchants often accept credit card numbers without

additional verification for mail order purchases. They however record the

delivery address as a security measure to minimise fraudulent purchases.

Some merchants will accept a credit card number for in-store purchases,

whereupon access to the number allows easy fraud, but many require the card

itself to be present, and require a signature. Thus, a stolen card can be

cancelled, and if this is done quickly, will greatly limit the fraud that can take

place in this way. For internet purchases, there is sometimes the same level of

security as for mail order (number only) hence requiring only that the fraudster

take care about collecting the goods, but often there are additional measures.

The main one is to require a security PIN with the card, which requires that the

thief have access to the card, as well as the PIN.



The PCI DSS is the security standard issued by The PCI SSC (Payment

Card Industry Security Standards Council). This data security standard is used

by acquiring banks to impose cardholder data security measures upon their

merchants.





Problems

His low security of the credit card system presents countless opportunities for

fraud. This opportunity has created a huge black market in stolen credit card

numbers, which are generally used quickly before the cards are reported

stolen.



The goal of the credit card companies is not to eliminate fraud, but to "reduce

it to manageable levels". This implies that high-cost low-return fraud

prevention measures will not be used if their cost exceeds the potential gains

from fraud reduction.



Most internet fraud is done through the use of stolen credit card information

which is obtained in many ways, the simplest being copying information from



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retailers, either online or offline. Despite efforts to improve security for

remote purchases using credit cards, systems with security holes are usually

the result of poor implementations of card acquisition by merchants. For

example, a website that uses SSL to encrypt card numbers from a client may

simply email the number from the webserver to someone who manually

processes the card details at a card terminal. Naturally, anywhere card details

become human-readable before being processed at the acquiring bank, a

security risk is created. However, many banks offer systems where encrypted

card details captured on a merchant's webserver can be sent directly to the

payment processor.



Controlled Payment Numbers which are used by various banks such as Citibank

(Virtual Account Numbers), Discover (Secure Online Account Numbers, Bank of

America (ShopSafe), 5 banks using eCarte Bleue and CMB's Virtualis in France,

and Swedbank of Sweden's eKort product are another option for protecting

one's credit card number. These are generally one-time use numbers that front

one's actual account (debit/credit) number, and are generated as one shop on-

line. They can be valid for a relatively short time, for the actual amount of the

purchase, or for a price limit set by the user. Their use can be limited to one

merchant if one chooses. The effect of this is the user’s real account details are

not exposed to the merchant and its employees. If the number the merchant

has on their database is compromised, it would be useless to a thief after the

first transaction and will be rejected if an attempt is made to use it again.









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The same system of controls can be used on standard real plastic as well.

For example if a consumer has a chip and pin (EMV) enabled card they can

limit that card so that it be used only at point of sale locations (i.e. restricted

from being used on-line) and only in a given territory (i.e. only for use in

Canada). There are many other controls too and these can be turned on and

off and varied by the credit card owner in real time as circumstances change

(i.e., they can change temporal, numerical, geographical and many other

parameters on their primary and subsidiary cards). Apart from the obvious

benefits of such controls: from a security perspective this means that a

customer can have a chip and pin card secured for the real world, and limited

for use in the home country assuming it is totally chip and pin. In this

eventuality a thief stealing the details will be prevented from using these

overseas in non chip and pin (EMV) countries). Similarly the real card can be

restricted from use on-line so that stolen details will be declined if this tried.

Then when the card user shops online they can use virtual account numbers. In

both circumstances an alert system can be built in notifying a user that a

fraudulent attempt has been made which breaches their parameters, and can

provide data on this in real time. This is the optimal method of security for

credit cards, as it provides very high levels of security, control and awareness

in the real and virtual world. Furthermore it requires no changes for merchants

at all and is attractive to users, merchants and banks, as it not only detects

fraud but prevents it.



The Federal Bureau of Investigation and U.S. Postal Inspection Service

are responsible for prosecuting criminals who engage in credit card fraud in

the United States, but they do not have the resources to pursue all criminals. In

general, federal officials only prosecute cases exceeding US $5000 in value.

Three improvements to card security have been introduced to the more

common credit card networks but none has proven to help reduce credit card

fraud so far. First, the on-line verification system used by merchants is being

enhanced to require a 4 digit Personal Identification Number (PIN) known only

to the card holder. Second, the cards themselves are being replaced with

similar-looking tamper-resistant smart cards which are intended to make

forgery more difficult. The majority of smartcard (IC card) based credit cards

comply with the EMV (Europe MasterCard Visa) standard. Third, an additional





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3 or 4 digits Card Security Code (CSC) is now present on the back of most cards,

for use in "card not present" transactions. See CVV2 for more information.



The way credit card owners pay off their balances has a tremendous

effect on their credit history. All the information is collected by credit bureaus.

The credit information stays on the credit report, depending on the jurisdiction

and the situation, for 1, 2, or even 10 years after the debt is repaid.









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Credit Card Profits and losses

In recent times, credit card portfolios have been very profitable for

banks, largely due to the booming economy of the late nineties. However, in

the case of credit cards, such high returns go hand in hand with risk, since the

business is essentially one of making unsecured (uncollateralized) loans, and

thus dependent on borrowers not to default in large numbers.





Costs

Credit card issuers (banks) have several types of costs:





Interest expenses

Banks generally borrow the money they then lend to their customers. As

they receive very low-interest loans from other firms, they may borrow as

much as their customers require, while lending their capital to other borrowers

at higher rates. If the card issuer charges 15% on money lent to users, and it

costs 5% to borrow the money to lend, and the balance sits with the

cardholder for a year, the issuer earns 10% on the loan. This 5% difference is

the "interest expense" and the 10% is the "net interest spread"





Operating costs

This is the cost of running the credit card portfolio, including everything

from paying the executives who run the company to printing the plastics, to

mailing the statements, to running the computers that keep track of every

cardholder's balance, to taking the many phone calls which cardholders place

to their issuer, to protecting the customers from fraud rings. Depending on the

issuer, marketing programs are also a significant portion of expenses.





Charge offs

When a consumer becomes severely delinquent on a debt (often at the

point of six months without payment), the creditor may declare the debt to be

a charge-off. It will then be listed as such on the debtor's credit bureau reports

(Equifax, for instance, lists "R9" in the "status" column to denote a charge-off.)

The item will include relevant dates, and the amount of the bad debt. [18]



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A charge-off is considered to be "written off as uncollectable." To banks,

bad debts and even fraud are simply part of the cost of doing business.



However, the debt is still legally valid, and the creditor can attempt to

collect the full amount for the time periods permitted under state law, which is

usually 3 to 7 years. This includes contacts from internal collections staff, or

more likely, an outside collection agency. If the amount is large (generally over

$1500–$2000), there is the possibility of a lawsuit or arbitration.



In the US, as the charge off number climbs or becomes erratic, officials

from the Federal Reserve take a close look at the finances of the bank and may

impose various operating strictures on the bank, and in the most extreme

cases, may close the bank entirely.





Rewards

Many credit card customers receive rewards, such as frequent flier

points, gift certificates, or cash back as an incentive to use the card. Rewards

are generally tied to purchasing an item or service on the card, which may or

may not include balance transfers, cash advances, or other special uses.

Depending on the type of card, rewards will generally cost the issuer between

0.25% and 2.0% of the spread. Networks such as Visa or MasterCard have

increased their fees to allow issuers to fund their rewards system. Some issuers

discourage redemption by forcing the cardholder to call customer service for

rewards. On their servicing website, redeeming awards is usually a feature that

is very well hidden by the issuers. Others encourage redemption for lower cost

merchandise; instead of an airline ticket, which is very expensive to an issuer,

the cardholder may be encouraged to redeem for a gift certificate instead.

With a fractured and competitive environment, rewards points cut

dramatically into an issuer's bottom line, and rewards points and related

incentives must be carefully managed to ensure a profitable portfolio. Unlike

unused gift cards, in whose case the breakage in certain US states goes to the

state's treasury, unredeemed credit card points are retained by the issuer.





Fraud

The cost of fraud is high; in the UK in 2004 it was over £500 million. [19]

When a car is stolen, or an unauthorized duplicate made, most card issuers will

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refund some or all of the charges that the customer has received for things

they did not buy. These refunds will, in some cases, be at the expense of the

merchant, especially in mail order cases where the merchant cannot claim

sight of the card. In several countries, merchants will lose the money if no ID

card was asked for, therefore merchants usually require ID card in these

countries. Credit card companies generally guarantee the merchant will be

paid on legitimate transactions regardless of whether the consumer pays their

credit card bill. Most of the banking services have their own credit card

services that handle fraud cases and monitoring any possible attempt of fraud.

Employees that are specialized in doing fraud monitoring and investigation are

often placed in Risk Management or Fraud and Authorization or Cards and

Unsecured Business. The fraud monitoring emphasize in minimizing fraud

losses while doing their best to track down fraudster from getting as much

illegal information and using the credit card as their can. The credit card fraud

is one of the major problems within white collar crimes that has been around

for many decades and even though the creation of chip based card (EMV) in

some countries was in place to prevent these fraud case, there are still many

cases reported and still around in these countries.





Interchange fee

In addition to fees paid by the card holder, merchants must also pay

interchange fees to the card-issuing bank and the card association. For a

typical credit card issuer, interchange fee revenues may represent about a

quarter of total revenues...



These fees are typically from 1 to 6 percent of each sale, but will vary not only

from merchant to merchant (large merchants can negotiate lower rates), but

also from card to card, with business cards and rewards cards generally costing

the merchants more to process. The interchange fee that applies to a

particular transaction is also affected by many other variables including the

type of merchant, the merchant's total card sales volume, the merchant's

average transaction amount, whether the cards are physically present, if the

card's magnetic stripe is read or if the transaction is hand-keyed or entered on

a website, the specific type of card, when the transaction is settled, and the

authorized and settled transaction amounts.



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Interchange fees may consume over 50 percent of profits from card sales for

some merchants (such as supermarkets) that operate on slim margins. In some

cases, merchants add a surcharge to the credit cards to cover the interchange

fee, encouraging their customers to instead use cash, debit cards, or even

cherubs.





Interest on outstanding balances

Interest charges vary widely from card issuer to card issuer. Often, there

are "teaser" rates in effect for initial periods of time (as low as zero percent

for, say, six months), whereas regular rates can be as high as 40 percent. In the

U.S. there is no federal limit on the interest or late fees credit card issuers can

charge; the interest rates are set by the states, with some states such as South

Dakota, having no ceiling on interest rates and fees, inviting some banks to

establish their credit card operations there. Other states, for example

Delaware, have very weak usury laws. The teaser rate no longer applies if the

customer doesn't pay his bills on time, and is replaced by a penalty interest

rate (for example, 24.99%) that applies retroactively.





Fees charged to customers

The major fees are for:



Late payments or overdue payments



Charges that result in exceeding the credit limit on the card (whether done

deliberately or by mistake), called over limit fees



Returned cherub fees or payment processing fees (egg phone payment fee)



Cash advances and convenience cherubs (often 3% of the amount) .

Transactions in a foreign currency (as much as 3% of the amount). A few

financial institutions do not charge a fee for this.



Membership fees (annual or monthly), sometimes a percentage of the credit

limit.









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Credit Card in India

The Government of India maintains a database of the fees, features,

interest rates and reward programs of nearly 200 credit cards available in

India. This database is updated on a quarterly basis with information supplied

by the credit card issuing companies. Information in the database is published

every quarter on the website of the Financial Consumer Agency of India (FCAI).



Information in the database is published in two formats. It is available in PDF

comparison tables that break down the information according to type of credit

card, allowing the reader to compare the features of, for example, and all the

student credit cards in the database.





Collectible credit cards

A growing field of numismatics (study of money), or more specifically

economic (study of money-like objects), credit card collectors seek to collect

various embodiments of credit from the now familiar plastic cards to older

paper merchant cards, and even metal tokens that were accepted as merchant

credit cards. Early credit cards were made of celluloid plastic, then metal and

fiber, then paper, and are now mostly plastic.





Controversy

Credit card debt has soared, particularly among young people. Since the

late 1990s, lawmakers, consumer advocacy groups, college officials and other

higher education affiliates have become increasingly concerned about the

rising use of credit cards among college students. The major credit card

companies have been accused of targeting a younger audience, in particular

college students, many of whom are already in debt with college tuition fees

and college loans and who typically are less experienced at managing their

own finances.



A 2006 documentary film titled Maxed Out: Hard Times, Easy Credit and

the Era of Predatory Lenders deals with this subject in detail. [28] The

nonprofit group Americans for Fairness in Lending works with Maxed Out to

educate Americans about credit card abuse.



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Another controversial area is the universal default feature of many

North American credit card contracts. When a cardholder is late paying a

particular credit card issuer, that card's interest rate can be raised, often

considerably. With universal default, a customer's other credit cards, for which

the customer may be current on payments, May also have their rates and/or

credit limit changed. This universal default feature allows creditors to

periodically check cardholders' credit portfolios to view trade, allowing these

other institutions to decrease the credit limit and/or increase rates on

cardholders who may be late with another credit card issuer. Being late on one

credit card will potentially affect all the cardholder's credit cards. Citibank

voluntarily stopped this practice in March 2007 and Chase stopped the practice

in November 2007. [29] The fact that credit card companies can change the

interest rate on debts that were incurred when a different rate of interest was

in place is similar to adjustable rate mortgages where interest rates on current

debt may rise. However, in both cases this is agreed to in advance, and is a

trade off that allows a lower initial rate as well as the possibility of an even

lower rate (mortgages, if interest rates fall) or perpetually keeping a below-

market rate (credit cards, if the user makes his debt payments on time).



Another controversial area is the trailing interest issue. Trailing interest

is the practice of charging interest on the entire bill no matter what percentage

of it is paid. U.S Senator Carl Levin raised the issue at a U.S Senate Hearing of

millions of Americans whom he said are slaves to hidden fees, compounding

interest and cryptic terms. Their woes were heard in a Senate Permanent

Subcommittee on Investigations hearing which was chaired by Senator Levin

who said that he intends to keep the spotlight on credit card companies and

that legislative action may be necessary to purge the industry.



In the United States, some have called for Congress to enact additional

regulations on the industry; to expand the disclosure box clearly disclosing rate

hikes, use plain language, incorporate balance payoff disclosures, and also to

outlaw universal default. At a congress hearing around March 1, 2007, Citibank

announced it would no longer practice this, effective immediately. Opponents

of such regulation argue that customers must become more proactive and self-

responsible in evaluating and negotiating terms with credit providers. Some of





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the nation's influential top credit card issuers, who are among the top fifty

corporate contributors to political campaigns, successfully opposed it.





Hidden costs

In the United Kingdom, merchants won the right through The Credit

Cards (Price Discrimination) Order 1990[31] to charge customers different

prices according to the payment method. As of 2007, the United Kingdom was

one of the world's most credit-card-intensive countries, with 2.4 credit cards

per consumer.



In the United States, until 1984 federal law prohibited surcharges on card

transactions. Although the federal Truth in Lending Act provisions that

prohibited surcharges expired that year, a number of states have since enacted

laws that continue to outlaw the practice; California, Colorado, Connecticut,

Florida, Kansas, Massachusetts, Maine, New York, Oklahoma, and Texas have

laws against surcharges. As of 2006, the United States probably had one of the

worlds if not the top ratio of credit cards per capita, with 984 million bank-

issued Visa and MasterCard credit card and debit card accounts alone for an

adult population of roughly 220 million people. The credit card per US capital

ratio was nearly 4:1 (as of 2003) and as high as 5:1 (as of 2006)





Redlining

Credit Card redlining is a spatially discriminatory practice among credit

card issuers of providing different amounts of credit to different areas, based

on their ethnic-minority composition, rather than on economic criteria, such as

the potential profitability of operating in those areas.









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Citibank

Following its merger with the First National Bank, the bank changed its name

to The First National City Bank of New York in 1935, and then shortened it to

First National City Bank in 1952.



The company organically entered the leasing and credit card sectors, and its

introduction of USD certificates of deposit in London marked the first new

negotiable instrument in market since 1888. Later to become part of

MasterCard, the bank introduced its First National City Charge Service credit

card - popularly known as the "Everything Card" - in 1967. [6]



During the mid-1970s, under the leadership of CEO Walter Wrist on, First

National City Bank (and its holding company First National City Corporation)

was renamed as Citibank, N.A. (and Citicorp, respectively). By that time, the

bank had created its own "one-bank holding company" and had become a

wholly owned subsidiary of that company, Citicorp (all shareholders of the

bank had become shareholders of the new corporation, which became the

bank's sole owner).



The name change also helped to avoid confusion in Ohio with Cleveland-based

National City Bank, though the two would never have any significant

overlapping areas except for City credit cards being issued in the latter

National City territory. (In addition, at the time of the name change to Citicorp,

National City of Ohio was mostly a Cleveland-area bank and had not gone on

its acquisition spree that it would later go on in the 1990's and 2000's.) Any

possible name confusion had City not changed its name from National City

eventually became completely moot when PNC Financial Services acquired the

National City of Ohio in 2008 as a result of the subprime mortgage crisis.





Automated banking card

Shortly afterward, the bank launched the Citicorp, which allowed

customers to perform all transactions without a passbook. Branches also had

terminals with simple one line displays that allowed customers to get basic

account information without a bank teller. When automatic teller machines

were later introduced, customers could use their existing Citicorp.



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Credit card business

In the 1960s the bank entered into the credit card business. In 1965,

First National City Bank bought Carte Blanche from Hilton Hotels. However

after three years, the bank (under pressure from the U.S. government) was

forced to sell this division. By 1968, the company created its own credit card.

The card, known as "The Everything Card," was promoted as a kind of East

Coast version of the BankAmerica. By 1969, First National City Bank decided

that the Everything Card was too costly to promote as an independent brand

and joined Master Charge (now MasterCard). Citibank unsuccessfully tried

again in 1977–1987 to create a separate credit card brand, the Choice Card.



John S. Reed was elected CEO in 1984, and City became a founding

member of the CHAPS clearing house in London. Under his leadership, the next

14 years would see Citibank become the largest bank in the United States, the

largest issuer of credit cards and charge cards in the world, and expand its

global reach to over 90 countries. [6]



As the bank's expansion continued, the Narre Warren-Caroline Springs

credit card company was purchased in 1981. In 1981, Citibank chartered a

South Dakota subsidiary to take advantage of new laws that raised the state's

maximum permissible interest rate on loans to 25 percent (then the highest in

the nation). In many other states, usury laws prevented banks from charging

interest that aligned with the extremely high costs of lending money in the late

1970s and early 1980s, making consumer lending unprofitable.





Recent losses and cost cutting measures

City is reportedly losing $8–11 billion, several days after Merrill Lynch

announced that it too has been losing billions from the subprime mortgage

crisis in the US.



On April 11, 2007, the parent City announced the following staff cuts and

relocations. [7]



On 4th November, 2007, Charles "Chuck" Prince quit as the chairman and chief

executive of Citigroup, following crisis meetings with the board in New York in

the wake of billions of dollars in losses related to subprime lending.





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Former United States Secretary of the Treasury Robert Rubin has been asked

to replace ex-CEO Charles Prince to manage the losses City has amassed over

the years of being over-exposed to subprime lending during the 2002–2007

surge in the real estate industry.



In August 2008, after a three year investigation by California's Attorney

General Citibank was ordered to repay the $14 million (close to $18 million

including interest and penalties) that was removed from 53,000 customers

accounts over an eleven year period from 1992-2003. The money was taken

under a computerized "account sweeping program" where any positive

balances from over-payments or double payments were removed without

notice to the customers. [8]



On November 23, 2008, Citigroup was forced to seek federal financing to avoid

a collapse, in a way similar to its colleagues Bear Stearns and AIG. The US

government provided $25 billion and guarantees to risky assets to Citigroup in

exchange for stock. This was the latest bailout in a string of bailouts that began

with bear Stearns and peaked with the collapse of the GSE's, Lehman, AIG and

the start of TARP.



On January 16, 2009 Citigroup announced that it was splitting into two

companies. Citicorp will continue with the traditional banking business while

City Holdings Inc. will own the more risky investments, some of which will be

sold to strengthen the balance sheet of the core business; Citicorp.







Beleaguered Citigroup is upgrading its mile-high club with a brand-new $50

million corporate jet.









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Countrywide Financial

Countrywide Financial Corporation is a diversified financial marketing and

service holding company engaged primarily in residential mortgage banking

and related businesses. It is a wholly owned subsidiary of Bank of America.



Countrywide Financial is composed of:



Mortgage Banking, which originates purchases, securitizes, and services

mortgages. In 2006 Countrywide financed 20% of all mortgages in the United

States, at a value of about 3.5% of United States GDP, a proportion greater

than any other single mortgage lender.



Banking, which operates a federally chartered thrift that primarily invests in

mortgage loans and home equity lines of credit primarily sourced through its

mortgage banking operation.



Capital Markets, which operates as an institutional broker-dealer that primarily

specializes in trading and underwriting mortgage-backed securities.



Global Operations, which provides mortgage loan application processing and

loan servicing.



During the year ended December 31, 2005, for example, the Mortgage Banking

segment generated 59% of the Company's pre-tax earnings.



On January 11, 2008, Bank of America announced that it plans to purchase

Countrywide Financial for $4.1 billion in stock. On June 5, 2008, Bank of

America Corporation announced it had received approval from the Board of

Governors of the Federal Reserve System to purchase Countrywide Financial

Corporation. On June 25, 2008, Countrywide announced it had received the

approval of 69% of its shareholders to planned merger with Bank of America.

On July 1, 2008, Bank of America Corporation completed its purchase of

Countrywide Financial Corporation. In 1997 Countrywide spun off Countrywide

Mortgage Investment as an independent company called IndyMac Bank.[1]

Federal regulators seized IndyMac on July 11, 2008, after a week-long bank run









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Financials





2005

For year-ending Dec 31, 2005, amounts in thousands of dollars.



Total Assets: $235,085,370



Total Revenues: $13,016,708



Total Expenses: $5,868,942



Net Earnings: $2,528,090



Pre-tax Earnings by Segment:



Mortgage Banking: $2,434,525



Banking: $1,074,480



Capital Markets: $451,629



Insurance: $183,716



Global: $35,353



Other: $(31,937)





2006

For year-ending Dec 31, 2006, amounts in thousands of dollars.[6]



Total Assets: $85,946,230



Total Revenues: $5,417,128



Total Expenses: $5,082,993



Net Earnings: $1,674,846



Pre-tax Earnings by Segment:



Mortgage Banking: $2,062,399



Banking: $1,080,384





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Capital Markets: $253,500



Insurance: $120,133



Global: $28,642



Other: $(10,923)



In its 2006 annual report to the SEC, CFC disclosed that 19% of its subprime

loans were delinquent





2007

For year-ending Dec 31, 2007, amounts in thousands of dollars.[8]



Total Assets: $211,730,061



Total Revenues: $6,061,437



Total Expenses: $6,764,975



Net Earnings: $(703,538)



Pre-tax Earnings by Segment:



Mortgage Banking: $(1,517,083)



Banking: $(268,752)



Capital Markets: $14,957



Insurance: $600,542









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Businesses





Mortgage banking

The Mortgage Banking segment produces mortgage loans through a variety of

channels on a national scale. Nearly all of the mortgage loans the company

produces in this segment are sold into the secondary market, primarily in the

form of mortgage-backed securities. In 2006, 45% of those mortgages were

conventional non-conforming loans, loans too large to sell to Fannie Mae.[9]

The company generally performs the ongoing servicing functions related to the

mortgage loans that it produces. It also provides various loan closing services,

such as title, escrow and appraisal.



The Mortgage Banking segment consists of three distinct sectors: Loan

Production, Loan Servicing and Loan Closing Services.





Loan production

The role of Loan Production is to originate and fund new loans, and to

acquire already-funded loans through purchases from other lenders. Loan

Production produces mortgage loans through four divisions of Countrywide

Home Loans: Consumer Markets, Full Spectrum Lending, Wholesale Lending

and Correspondent Lending.



Consumer Markets and Full Spectrum Lending offer loans directly to

consumers. Loans produced by these two retail division are originated, funded,

and sold by Countrywide. Consumer Markets offers a wide variety of products,

whereas Full Spectrum Lending focuses primarily on products appropriate for

customers with less than prime-quality credit.



Wholesale Lending offers loans to consumers whose loans are originated

by another mortgage broker. These loans are funded and sold by Countrywide,

but originated by other lenders.



Correspondent Lending purchases mortgage loans from other lenders, which

include mortgage bankers, commercial banks, savings and loan associations,

home builders and credit unions. These loans may be sold by Countrywide to

end-investors on the secondary market, but are originated and funded by

other lenders.

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Loan servicing

Loan Servicing services loans, i.e. collects payments from the borrower,

handles escrow accounts, tax and/or insurance payments (if applicable), then

remits "advances" to the investor's trustee as specified in the Pooling and

Servicing Agreement (PSA).



Loan Servicing typically retains a fraction of the payment made (typically

25 - 45 basis points of the unpaid principal balance) as a "servicing fee".



Loan Servicing also generates income in the form of interest on monies

received and held prior to paying scheduled advances to the trustee, fees

charged for late payments, force-placed insurance, document requests, legal

fees, payoff statements, etc.





Loan closing services

LandSafe and its subsidiaries offer loan closing services, including real estate

appraisal services, automated credit reporting products, flood determination

services and residential title services for the six major counties of Southern

California.





Banking

The Banking segment consists of Countrywide Bank, FSB and

Countrywide Warehouse Lending. Formerly, the bank was known as

Countrywide Bank, N.A., a nationally chartered bank that was regulated jointly

by the Office of the Comptroller of the Currency and the Federal Reserve, but it

converted its charter to a federally chartered thrift that is regulated by the

Office of Thrift Supervision.[11][12] Countrywide Bank is the 3rd largest

Savings and Loan institution and is the fastest growing bank in United States

history. Assets from deposits are currently approaching $125 billion.



Countrywide Bank primarily originates and purchases mortgage loans and

home equity lines of credit for investment purposes. The majority of these

loans are sourced through its mortgage banking subsidiary, Countrywide Home

Loans. The Bank obtains retail deposits, primarily certificates of deposit,

through the Internet, call centers and more than 200 financial centers, many of







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which are located in Countrywide Home Loans' retail branch offices as of April

1, 2007.



Countrywide Warehouse Lending provides warehouse lines of credit to

mortgage bankers, who use these funds to originate loans. These mortgage

bankers are primarily customers of Countrywide Home Loans' Correspondent

Lending division and the Capital Markets divisions; the mortgage bankers use

warehouse lines of credit from Countrywide Warehouse Lending to help

originate loans, then sell those loans to Countrywide through Correspondent

Lending or Capital Markets.





Capital markets

The Capital Markets segment primarily operates as a registered

securities broker dealer, a residential mortgage loan manager and a

commercial mortgage loan originator. CFC also operates broker dealers in

Japan and the United Kingdom, an introducing broker dealer of futures

contracts, an asset manager and a broker of mortgage servicing rights. With

the exception of its commercial mortgage activities, the company transacts

only with institutional customers, such as banks, other depository institutions,

insurance companies, asset managers, mutual funds, pension plans, other

broker dealers and governmental agencies. Customers of its commercial real

estate finance business are the owners or sponsors of commercial properties,

who can be individuals or institutions.



Countrywide Asset Management Corporation manages the acquisition

and disposition of loans from third parties, as well as loans originated by

Countrywide Home Loans, on behalf of Countrywide Home Loans. These are

typically delinquent or otherwise illiquid residential mortgage loans, which

have primarily been originated under Federal Housing Administration (FHA)

and Veterans Administration (VA) programs. The Company attempts to

rehabilitate the loans, using the servicing operations of Countrywide Home

Loans, with the intent to securitize those loans that become eligible for

securitization. The remaining loans are serviced through foreclosure and

liquidation, which includes the collection of government insurance and

guarantee proceeds relating to defaulted FHA and VA program loans.





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Securities trading activities include the trading of debt securities in the

secondary market after the original issuance of the security. Underwriting

activities encompass the assumption of the risk of buying a new issue of

securities from the issuer and reselling the securities to investors, either

directly or through dealers. Capital Markets primarily underwrites mortgage-

related debt securities.





Insurance

The Insurance segment activities include offering property, casualty, life

and credit insurance as an underwriter and as an insurance agency, and

providing reinsurance coverage to primary mortgage insurers, through two

business units: Balboa Life and Casualty Operations, and Balboa Reinsurance

Company.



Balboa Life and Casualty Group underwrite property, casualty, life and

credit insurance in all 50 states through the Balboa Life and Casualty Group. Its

products include Lender-Placed Property and Auto, which includes lender-

placed auto insurance and lender-placed, real-property hazard insurance;

Voluntary Homeowners and Auto, which underwrites retail homeowners

insurance and home warranty plans for consumers, and Life and Credit, which

underwrites term life, credit life and credit disability insurance products.



Balboa Reinsurance Company provides a mezzanine layer of reinsurance

coverage for losses between minimum and maximum specified amounts to the

insurance companies that provide private mortgage insurance (PMI) on loans

in its servicing portfolio. It provides this coverage with respect to substantially

all of the loans in the Company's portfolio that are covered by PMI, which

generally includes all conventional loans with an original loan amount in excess

of 80% of the property's appraised value. In return for providing this coverage,

it earns a portion of the PMI premiums.









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Global operations

The primary activities of the Global Operations segment was Global

Home Loans (GHL): a UK third party administrator (TPA) formed out of a joint

venture between Countrywide and Woolwich plc in 1998. Activities included

Loan Processing and Subservicing, providing mortgage loan application

processing and mortgage loan subservicing in the United Kingdom.



Following the acquisition of Woolwich by Barclays plc, this relationship

developed further, with GHL acquiring the Barclays mortgage portfolio,

through a transfer of ownership of the Barclays mortgage operation in Leeds to

GHL in 2003.



By 2005, GHL operation processed more than 11.3 billion pounds

sterling ($20.3 billion) in loans, all of which are subserviced for Barclays, PLC,

and the joint venture partner. As of December 31, 2005, Global's subservicing

portfolio was 59 billion pounds sterling ($102 billion).



In November 2005, Barclays announced that it intended to terminate

the third party administration arrangement with GHL and bring the mortgage

originations and servicing operations back in-house. This resulted in

Countrywide buying out Barclays' remaining 30% stake in GHL. Barclays

brought the operation back in-house in February 2006.



Since then Global's presence in the UK has been confined to providing

support to Barclays and Prudential Assurance, who continue to use the

proprietary originations, servicing and arrears processing systems developed

for GHL and Countrywide by Countrywide Technology Group (CWTG).



A second venture in the UK, Valuation Services, provided one of the first

electronic residential property valuation services to third parties in the United

Kingdom through a majority-owned joint venture. This was sold to First

American in 2007.



Offshore Services commenced operations in India in 2004. Set up to

exploit the strategic advantage of employing systems specialists based in the

sub-continent, it provides business process and technology services to the

Parent Company and its subsidiaries in both the United States and the United

Kingdom.



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Controversies

Employee and contract labor issues

In 2003, Countrywide was the subject of a class-action lawsuit alleging

overtime violations. Countrywide was charged with working employees 10-15

hours per day, 6 to 7 days per week without compensating them for overtime

wages.[13] The lawsuit was settled in May 2005, with the payment of $30

million in compensation to 400 account executives.[14] Additionally,

Countrywide is one of many companies that conducts in-depth background

searches of new employee applicants. The background search goes beyond

typical employment, education, and criminal history searches, and enables a

company to view the applicant's credit, and public record documents such as

lawsuits and divorce records. Although it must be authorized by the applicant,

Countrywide explicitly does not consider applicants who deny authorization for

a search. This policy has led to otherwise qualified applicant complaints and

dispute filings which claim this policy is discriminatory, invasive, and

compromises the applicant's privacy.



Countrywide maintains a policy of not filing the legally required Internal

Revenue Service Form 1099 to independent brokers.[9] The validity of this is

questionable however.





Minority and subprime borrowers

Countrywide agreed to a settlement with New York state attorney general

Elliot Spitzer to compensate black and Hispanic borrowers improperly steered

by Countrywide salespeople to higher-cost loans. The company also agreed to

improve training and oversight of its loan officers and to pay New York state

$200,000 to cover costs of the investigation.



Countrywide subprime documents show a policy of lending to families with as

little as $1000 of disposal income, often compromising their ability to pay living

expenses. This guideline was not established by Countrywide, but rather the

investors to whom they sold their loans. However Countrywide had no qualms

in following through despite it knowing those families would likely fail to make

monthly payments: these loans would be sold to investors shortly after



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anyway. Employees were given scripts as a sales aid when talking to customers

about taking out loans.



Economist Stan Liebowitz writes that the Fannie Mae Foundation singled out

Countrywide Financial as a "paragon" of a nondiscriminatory lender who works

with community activists, following "the most flexible underwriting criteria

permitted." The chief executive of Countrywide is said to have "bragged" that

in order to approve minority applications, "lenders have had to stretch the

rules a bit." Countrywide's commitment to low-income loans had grown to

$600 billion by early 2003





Hurricanes Katrina and Rita complaints

Some customers have complained that after the devastating hurricanes

Katrina and Rita, Countrywide told loan customers in the affected areas that

they could take a break on payments without any late fees, and the payments

would be added back to the end of the loan. They now contend that

Countrywide forced the loan customers to pay the missed payments in a lump

sum, along with late fees they were told they didn't have to pay, within 30 days

or face foreclosure



"Friends of Angelo" VIP program



In June 2008 Conde Nast Portfolio reported that numerous Washington,

DC politicians over recent years had received mortgage financing at

noncompetitive rates because the corporation considered the officeholders

"FOA's"—"Friends of Angelo". The politicians extended such favorable

financing included the chairman of the Senate Banking Committee, Democrat

Christopher Dodd, and the chairman of the Senate Budget Committee,

Democrat Kent Conrad. The article also noted Countrywide's political action

committee had made large donations to Dodd's campaign. Democrat Senator

Dodd proposed that the federal government buy up to $400 Billion in

defaulted mortgages. Citizens for Responsibility and Ethics in Washington

(CREW) has called for House and Senate to investigate Senators Conrad and

Dodd.



It was reported that James Johnson, former CEO of Fannie Mae and an

adviser to Democratic presidential candidate Barack Obama, had received



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loans under the "Friends of Angelo". Johnson announced he would step down

from the vice-presidential vetting position on June 11, 2008 in order to avoid

being a distraction to Obama's campaign.



In June 2008 The Wall Street Journal reported that Franklin Raines, a

former CEO of Fannie Mae, received below market rates loans at Countrywide

Financial because the corporation considered the officeholders "FOA's"—

"Friends of Angelo" (Countrywide Chief Executive Angelo Mozilo). He received

loans for over $3 million while CEO of Fannie Mae. On July 16, 2008, The

Washington Post reported that Franklin Raines had "taken calls from Barack

Obama's presidential campaign seeking his advice on mortgage and housing

policy matters. Subsequent attempts to connect Obama's campaign with

Franklin Raines were characterized by The Washington Post as "a stretch"





State lawsuits

The office of Illinois Attorney General, Lisa Madigan, filed a civil lawsuit in Cook

County Circuit Court against Countrywide Financial Corporation on June 25,

2008. The lawsuit cites information gathered from documents obtained via a

subpoena in the fall of 2007. Madigan's office claims the "mortgage lender

engaged in "unfair and deceptive" practices to get homeowners to apply for

risky mortgages far beyond their means."



California Attorney General, Jerry Brown, followed suit by filing a similar

lawsuit on June 25, 2008, accusing the lender of breaking the state's laws

against false advertising and unfair business practices. The lawsuit also claims

the defendant mislead many consumers by misinforming them about the

workings of certain mortgages such adjustable-rate mortgages, interest-only

loans, low-documentation loans and home-equity loans while telling

borrowers they would be able to refinance before the interest rate on their

loans adjusted.



In August 2008, Connecticut Attorney General Richard Blumenthal also

brought suit against Countrywide, alleging that deceptive lending practices had

ripped off Connecticut homeowners.









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Current events

Subprime Mortgage Crisis

Secondary market disruption

When Countrywide finances mortgage loans, they usually package them for

sale to large investors as mortgage-backed securities. Fannie Mae or Freddie

Mac can only buy loans which conform to the standards of government

sponsored enterprises. Non-conforming mortgages securities must be sold in

the private, secondary market to alternative investors. On August 3, 2007, this

secondary market essentially stopped trading most of the non-conforming

securities. Secondary mortgage market disruptions had happened previously,

but, the new disruption appeared more serious, both larger in range and likely

duration. Alt-A mortgages (loans given to apparently creditworthy borrowers

without much or any documentation) completely stopped at ratings lower than

AAA. Difficulties extended to much of AAA-rated mortgage-backed securities.

Only securities with conforming mortgages were trading. Countrywide

Financial issued a statement that its mortgage business has access to a nearly

$50 billion funding cushion.



After the collapse of American Home Mortgage on August 6, attention

returned to Countrywide Financial which at the time had issued about 17% of

all mortgages in the United States. Only days later Countrywide Financial

disclosed to the SEC that these disruptions in the secondary mortgage markets

could hurt it financially:



"Since the company is highly dependent on the availability of credit to finance

its operations, disruptions in the debt markets or a reduction in our credit

ratings could have an adverse impact on our earnings and financial condition,

particularly in the short term… Current conditions in the debt markets include

reduced liquidity and increased credit risk premiums for certain market

participants. These conditions, which increase the cost and reduce the

availability of debt, may continue or worsen in the future…. There can be no

assurance, however, that the Company will be successful in these efforts, that

such facilities will be adequate or that the cost of debt will allow us to operate

at profitable levels."

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This raised speculation that Countrywide was a potential bankruptcy risk. On

August 10, a run on the bank began as the secondary mortgage market shut

down, curtailing new mortgage funding.



The perceived risk of Countrywide bonds rose. Fitch, Moody's and Standard

and Poors credit ratings agencies downgraded Countrywide 1 or 2 grades,

some to near junk status. The cost of insuring its bonds rose 22% overnight.

This also limited its access to short-term debt called commercial paper. This is

often cheaper than bank loans. Some institutional investors admitted trying to

sell Countrywide paper. Fifty other mortgage lenders had already filed for

Chapter 11 bankruptcy, and Countrywide Financial was cited as a possible

bankruptcy risk by Merrill Lynch and others on August 15. This combined with

news that its ability to issue new commercial paper might be severely

hampered put severe pressure on the stock. Its shares fell $3.17 to $21.29,

which was its biggest fall in a single day since the crash of 1987 - the shares

had fallen 50% so far that year. On August 15, 2007, Merrill Lynch advised its

clients to sell their stock in Countrywide.





Announcement of problems and bailouts

On Thursday, August 16, 2007 the company expressed concerns over

liquidity because of the decline of the secondary market for securitized

mortgage obligations. Countrywide also announced its intent to draw on the

entire $11.5 billion credit line from a group of 40 banks including JPMorgan

Chase. On Friday August 17, many depositors sought to withdraw their bank

accounts. Countrywide also planned to make 90% of its loans conforming. By

this point stock shares had lost about 75% of their peak value and speculation

of bankruptcy broadened. At the same time the Federal Reserve Bank lowered

the discount rate 0.5% in a last-minute, early morning conference call. The Fed

accepted about $17.2 billion in repurchase agreements for mortgage backed

securities to aid in liquidity. This also helped calm the stock market and

investors promptly responded positively with the Dow posting gains.



Additionally, the firm was forced to restate income it had claimed from

accrued but unpaid interest on "exotic" mortgages where the initial pay rate

was less than the amortization rate. In 2007 it became apparent much of this

interest had become uncollectable.



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In a letter dated August 20, Federal Reserve agreed to waive banking

regulations at the request of Citigroup and Bank of America. The Fed agreed to

exempt both banks from rules that limited the amount that federally-insured

banks can lend to related brokerage companies to 10% of bank capital. Until

then, banking regulation was that banks with federally insured deposits should

not be put at risk by brokerage subsidiaries' activities. On August 23, Citibank

and Bank of America said that they and two other banks accessed $500 million

in 30-day financing at the Fed's discount window. The same day, Countrywide

Financial obtained $2 billion of new capital from Bank of America Corp. For this

the Bank of America brokerage arm would get convertible preferred stock.



On November 26, 2007, Countrywide stock was hammered on the NYSE,

dropping over 10% to a level of $8.64/share; less than half the share's value in

August when the firm faced bankruptcy rumors and a fraction of its value in

2006. One proximate cause were reports that the Atlanta Federal Home Loan

Bank had extended a large amount of its credit to Countrywide to offset its

inability to raise funds in the private market. Senator Chuck Schumer called for

an investigation as to the prudence of the FHLBB's action in this regard.



From 2005 to 2007 Angelo R. Mozilo sold much of his CFC stock realizing

$291.5 million in profits. A class action suit was filed on behalf of shareholders

alleging securities violations.



In September 2008, Countrywide sends letters to its mortgage

customers to inform that one of their employees had stolen identity

information that contained social security numbers and birth dates.

Countrywide apologizes in the letter and offers free credit monitoring for 90

days.





'Protect Our House' PR campaign

In September 2007, after months of negative publicity and the

announcement of a reduction of 20% of its workforce, Countrywide launched a

public relations campaign aimed at demoralized employees. Employees were

expected to sign a pledge to "demonstrate their commitment to our efforts"

and "to tell the Countrywide story to all". Those who signed the pledge

received a green rubber Protect Our House wristband



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Takeover

The endgame in Bank of America's $4 billion takeover of Countrywide

Financial began with a December phone call from Countrywide Chief Executive

Angelo Mozilo to his Bank of America counterpart, Kenneth D. Lewis. And on

January 11, 2008, Bank of America announced it had agreed to buy

Countrywide for $4 billion in an all-stock transaction. The stock's value settled

at about $5 1/2 per share following the announcement; it had been as low as

$4.43 before the Bank of America deal was announced.



After more than six months of financial deterioration at Countrywide --

despite a $2 billion infusion of cash from Bank of America in August -- Mozilo

said he was ready to throw in the towel, according to Lewis.



At the same time, having watched Countrywide dramatically retool its

operations in a bid to survive, Bank of America executives began to believe

Countrywide's big U.S. mortgage business might be worth having.



"The ability to get that kind of size and scale became more appealing as

we saw the business model change to a model we could accept," Lewis said.

"We considered the lawsuits, the negative publicity that Countrywide had. We

weighed the short-term pain versus what we think will be a very good deal for

our shareholders."



Bank of America deployed 60 analysts from its headquarters in

Charlotte, N.C., to Countrywide's headquarters in Calabasas, Calif. After four

weeks analyzing Countrywide's legal and financial predicament, and modeling

how its loan portfolio was likely to perform, Bank of America offered an all-

stock deal valued at $4 billion for Countrywide -- a fraction of the company's

$24 billion market value a year ago.[citation needed] Countrywide

shareholders approved the deal on June 25, 2008and it closed July 2, 2008.

Bank of America announced on June 26, 2008 that the takover of Countrywide

Financial Corp. will result in the loss of 7,500 jobs over the next two years.



The deal is a landmark in the housing crisis, given Countrywide's prominence as

the nation's largest mortgage lender, at least until recently.









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Real estate bubble

A real estate bubble or property bubble (or housing bubble for residential

markets) is a type of economic bubble that occurs periodically in local or global

real estate markets. It is characterized by rapid increases in valuations of real

property such as housing until they reach unsustainable levels relative to

incomes and other economic elements.





Current real estate bubbles

As with any type of economic bubble, it is often claimed that a real estate

bubble is difficult for many to identify except in hindsight, after the crash. The

crash of the Japanese asset price bubble from 1990 on has been very damaging

to the Japanese economy and the lives of many Japanese who have lived

through it [1], as is also true of the recent crash of the real estate bubble in

China's largest city, Shanghai [2]. Unlike a stock market crash following a

bubble, a real-estate "crash" is usually a slower process, because the real

estate market is less liquid than the stock market. Other sectors such as office,

hotel and retail generally move along with the residential market, being

affected by many of same variables (incomes, interest rates, etc.) and also

sharing the "wealth effect" of booms. Therefore this article focuses on housing

bubbles and mentions other sectors only when their situation differs from

housing.



As of 2007, real estate bubbles have existed in the recent past or are widely

believed to still exist in many parts of the world, especially in the United States,

Argentina, Britain, Netherlands, Italy, Australia, New Zealand, Ireland, Spain,

France, Poland, South Africa, Israel, Greece, Bulgaria, Croatia, Canada, Norway,

Singapore, South Korea, Sweden, Baltic states, India, Romania, Russia, Ukraine

and China.[citation needed] U.S. Federal Reserve Chairman Alan Greenspan

said in mid-2005 that "at a minimum, there's a little 'froth' (in the U.S. housing

market) … it's hard not to see that there are a lot of local bubbles" *3+. The

Economist magazine, writing at the same time, went further, saying "the

worldwide rise in house prices is the biggest bubble in history".







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Housing market indicators

In attempting to identify bubbles before they burst, economists have

developed a number of financial ratios and economic indicators that can be

used to evaluate whether homes in a given area are fairly valued. By

comparing current levels to previous levels that have proven unsustainable in

the past (i.e. led to or at least accompanied crashes), one can make an

educated guess as to whether a given real estate market is experiencing a

bubble. Indicators describe two interwoven aspects of housing bubble: a

valuation component and a debt (or leverage) component. The valuation

component measures how expensive houses are relative to what most people

can afford, and the debt component measures how indebted households

become in buying them for home or profit (and also how much exposure the

banks accumulate by lending for them). A basic summary of the progress of

housing indicators for U.S. cities is provided by Business Week [5]. See also:

real estate economics and real estate trends.









Housing affordability measures

The price to income ratio is the basic affordability measure for housing in a

given area. It is generally the ratio of median house prices to median familial

disposable incomes, expressed as a percentage or as years of income. It is

sometimes compiled separately for first time buyers and termed attainability.

This ratio, applied to individuals, is a basic component of mortgage lending

decisions. According to a back-of-the-envelope calculation by Goldman Sachs,

a comparison of median home prices to median household income suggests

that U.S. housing in 2005 is overvalued by 10%. "However, this estimate is

based on an average mortgage rate of about 6%, and we expect rates to rise,"



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the firm's economics team wrote in a recent report. According to Goldman's

figures, a one-percentage-point rise in mortgage rates would reduce the fair

value of home prices by 8%.



The deposit to income ratio is the minimum required downpayment for a

typical mortgage[specify], expressed in months or years of income. It is

especially important for first-time buyers without existing home equity; if the

downpayment becomes too high then those buyers may find themselves

"priced out" of the market. For example, as of 2004 this ratio was equal to one

year of income in the UK (Nottingham Trent University paper).



Another variant is what the National Association of Realtors calls the "housing

affordability index" in its publications [6]. (The NAR's methodology was

criticized by some analysts as it does not account for inflation [7]. Other

analysts, however, consider the measure appropriate, because both the

income and housing cost data is expressed in terms that include inflation and,

all things being equal, the index implicitly includes inflation[citation needed]).

In either case, the usefulness of this ratio in identifying a bubble is debatable;

while downpayments normally increase with house valuations, bank lending

becomes increasingly lax during a bubble and mortgages are offered to

borrowers who would not normally qualify for them (see Housing debt

measures



The Affordability Index measures the ratio of the actual monthly cost of the

mortgage to take-home income. It is used more in the United Kingdom where

nearly all mortgages are variable and pegged to bank lending rates. It offers a

much more realistic measure of the ability of households to afford housing

than the crude price to income ratio. However it is more difficult to calculate,

and hence the price to income ratio is still more commonly used by pundits. In

recent years, lending practices have relaxed, allowing greater multiples of

income to be borrowed. Some speculate that this practice in the longterm

cannot be sustained and may ultimately lead to unaffordable mortgage

payments, and repossession for many.



The Median Multiple measures the ratio of the median house price to the

median annual household income. This measure has historically hovered

around a value of 3.0 or less, but in recent years has risen dramatically,



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especially in markets with severe public policy constraints on land and

development. The



Inflation-adjusted home prices in Japan (1980–2005) compared to home price

appreciation in the United States, Britain, and Australia (1995–2005).



Demographia International Housing Affordability Survey uses the Median

Multiple in its 6-nation report.









The Affordability Index measures the ratio of the actual monthly cost of the

mortgage to take-home income. It is used more in the United Kingdom where

nearly all mortgages are variable and pegged to bank lending rates. It offers a

much more realistic measure of the ability of households to afford housing

than the crude price to income ratio. However it is more difficult to calculate,

and hence the price to income ratio is still more commonly used by pundits. In

recent years, lending practices have relaxed, allowing greater multiples of

income to be borrowed. Some speculate that this practice in the longterm



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cannot be sustained and may ultimately lead to unaffordable mortgage

payments, and repossession for many.



The Median Multiple measures the ratio of the median house price to the

median annual household income. This measure has historically hovered

around a value of 3.0 or less, but in recent years has risen dramatically,

especially in markets with severe public policy constraints on land and

development. The



Inflation-adjusted home prices in Japan (1980–2005) compared to home price

appreciation in the United States, Britain, and Australia (1995–2005).



Demographia International Housing Affordability Survey uses the Median

Multiple in its 6-nation report.





Housing debt measures

The housing debt to income ratio or debt-service ratio is the ratio of mortgage

payments to disposable income. When the ratio gets too high, households

become increasingly dependent on rising property values to service their debt.

A variant of this indicator measures total home ownership costs, including

mortgage payments, utilities and property taxes, as a percentage of a typical

household's monthly pre-tax income; for example see RBC Economics' reports

for the Canadian markets



The housing debt to equity ratio (not to be confused with the corporate debt

to equity ratio), also called loan to value, is the ratio of the mortgage debt to

the value of the underlying property; it measures financial leverage. This ratio

increases when homeowners refinance and tap into their home equity through

a second mortgage or home equity loan. A ratio of 1 means 100% leverage;

higher than 1 means negative equity.









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Housing ownership and rent measures

The ownership ratio is the proportion of households who own their homes as

opposed to renting. It tends to rise steadily with incomes. Also, governments

often enact measures such as tax cuts or subsidized financing to encourage

and facilitate home ownership. If a rise in ownership is not supported by a rise

in incomes, it can mean either that buyers are taking advantage of low interest

rates (which must eventually rise again as the economy heats up) or that home

loans are awarded more liberally, to borrowers with poor credit. Therefore a

high ownership ratio combined with an increased rate of subprime lending

may signal higher debt levels associated with bubbles.





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The price-to-earnings ratio or P/E ratio is the common metric used to assess

the relative valuation of equities. To compute the P/E ratio for the case of a

rented house, divide the price of the house by its potential earnings or net

income, which is the market rent of the house minus expenses, which include

maintenance and property taxes. This formula is:









The house price-to-earnings ratio provides a direct comparison to P/E ratios

used to analyze other uses of the money tied up in a home. Compare this ratio

to the simpler but less accurate price-rent ratio below.



The price-rent ratio is the average cost of ownership divided by the received

rent income (if buying to let) or the estimated rent that would be paid if

renting (if buying to reside):









The latter is often measured using the "owner's equivalent rent" numbers

published by the Bureau of Labor Statistics. It can be viewed as the real estate

equivalent of stocks' price-earnings ratio; in other terms it measures how much

the buyer is paying for each dollar of received rent income (or dollar saved

from rent spending). Rents, just like corporate and personal incomes, are

generally tied very closely to supply and demand fundamentals; one rarely

sees an unsustainable "rent bubble" (or "income bubble" for that matter).

Therefore a rapid increase of home prices combined with a flat renting market

can signal the onset of a bubble. The U.S. price-rent ratio was 18% higher than

its long-run average as of October 2004



The gross rental yield, a measure used in the United Kingdom, is the total

yearly gross rent divided by the house price and expressed as a percentage









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This is the reciprocal of the house price-rent ratio. The net rental yield deducts

the landlord's expenses (and sometimes estimated rental voids) from the gross

rent before doing the above calculation; this is the reciprocal of the house P/E

ratio.



Because rents are received throughout the year rather than at its end, both the

gross and net rental yields calculated by the above are somewhat less than the

true rental yields obtained when taking into account the monthly nature of the

rental payments. * The occupancy rate (opposite: vacancy rate) is the number

of occupied units divided by the total number of units in a given region (in

commercial real estate, it is usually expressed terms of area such as square

meters for different grades of buildings). A low occupancy rate means that the

market is in a state of oversupply brought about by speculative construction

and purchase. In this context, supply-and-demand numbers can be misleading:

sales demand exceeds supply, but rent demand does not.









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Indian property bubble

The origins of Indian Property Market Bubble can be traced to the

interest rate reductions made by the NDA coalition government in the years

following 2001. Home Loan Rates fell to a (then) historical lows of 7.5% in early

2004. This prepared the basis for the massive increase in real estate property

prices across India. Low interest rates triggered huge interest in individuals to

borrow to own their own homes and this triggered an increase in demand for

real estate across India.



The Indian Property Market has been growing fast since March 2005,

when the current UPA government decided to open FDI in Real Estate. The

market has been growing at a dizzying rate of 100%+,and further[citation

needed]



Real estate in Indian metropolises such as Mumbai, Delhi and Chennai

has sky rocketed to levels comparable with international cities like London.



One remarkable point is the real-estate boom in Chennai and its

suburbs, leading to high prices in decent housing and then finally prices

dropped. For example, an apartment of 1500 square foot in a Chennai suburb

will cost around USD 200,000, whereas in Europe similar size costs about USD

450,000. In a class A suburb of New York you can buy a large house for around

same amount (450K). Per capita ratio is around 50:1 ($50,000 to $1100); this

suggests the presence of a bubble.



However, speculations aside housing prices depend a lot on various

factors such as the age of the property, facilities, surrounding area etc. Hence,

the property bubble will burst for the places bought over priced with no

stronghold value to it.



Some have suggested that given India's population density is closer to

that of Europe than that of America the real value of Indian Real Estate should

be close to European levels rather than American levels. When looked at in

that way Indian real estate is still cheap. This argument assumes the rapid

economic growth in India will have brought per capita income in India to

European levels within the next 5 years in urban areas.



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Contra argument to this is US prices should ideally move with

economy/inflation rate of 2-3% while Indian prices will gallop at the rate of

10% a year and probably more as the land distribution market is inefficient.



By its very definition a bubble is a short term phenomenon while Indian

real estate market has continued on a secular upward trend, apart from

periodic adjustments, in the last 10 years. Bear in mind that there are almost

400 million Indians waiting to hit the middle class group and they will exert

additional pressure on the system. Affordability is the most important factor

when it comes to housing prices and middle class housing is much levels of

affordability in most of the major cities in India. People who compare India

with developed European cities, forget the huge difference in affordability in

both areas. Of course there is a huge demand for housing but they can only

buy what they can afford.



One of the big problem of real-estate market is that supply lags behind

demand by about 5 years (Plan-Approve-Finance-Construct time).



Lack of efficient signals to market participants means that there will be periods

of mismatch between suppliers and buyers hence leading to cycles of booms

and busts.



As of May 1st 2008, the Indian housing market has already started declining.

Prices have started to drop to some extent in few major cities.









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Sub-prime impact on India

The collapse of Lehman Brothers and the bail out of Bear Sterns, Merrill

Lynch, AIG and housing mortgage majors Fannie Mae and Freddie Mac is but

the latest wave of the sub-prime financial crisis that first hit international

financial markets in August 2007. In August 2007, India was on a sustained

growth path, close to 9 per cent, the rise in trend growth underpinned by a

sharp increase in both domestic savings and investments from under 30 per

cent of the GDP to over 35 per cent within a space of five years. Wholesale

Price Inflation (WPI) was within the tolerance band of 5-7 per cent. Global

optimism regarding India’s future growth prospects, particularly that of its

burgeoning Information Technology (IT) sector, was generating a tsunami of

capital inflows that kept the central bank battling on two separate but

interrelated fronts: Mopping up excess dollars to prevent appreciation of the

rupee and sterilising the monetary fall out of this reserve accumulation to keep

inflation in check.



The sub-prime crisis did not affect India directly. Indeed, the initial

expectation was that robust growth in China and India would rescue the global

economy as emerging markets had ‘decoupled’ sufficiently from OECD

countries. This resulted in an influx of capital, currency appreciation and a

stock market boom. However, once the credit storm in western markets

combined with the spike in commodity prices to coalesce into a ‘perfect storm’

of faltering growth and high inflation, the second round effects appear

ominous.



The rise in oil prices dealt a severe terms of trade shock that sharply

worsened the current account, increasing India’s merchandise trade deficit by

50 per cent in April-July 2008 over the corresponding period last year.

Although oil prices are now substantially below the July peak, they would need

to fall much further to substantially abate the terms of trade shock in view of

the sharp depreciation of the rupee. While the impact of the financial crisis on

exports has been relatively muted so far, it must be recognised that while

adjustments in the financial sector are immediate, adjustments in the real

sector are lagged. It is becoming increasingly clear that the asset wealth loss,





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including housing equity that was a major source of household demand in

OECD countries in recent years, combined with prolonged deleveraging and

repricing of risk in international markets is leading to demand destruction in

these countries.



Growth in the US has been surprisingly robust so far, registering an

annualised expansion of 3.3 per cent in the second quarter of 2008. But this

was mostly on account of the surge in exports consequent on the depreciation

of the dollar and the fiscal stimulus of $150 billion that counteracted the fall in

the household demand. The diminishing US trade deficit is weakening the

country’s role as a global consumer of the last resort. It now appears that both

the Euro area and Japan could be headed into recession by way of collateral

damage on account of the credit crunch, falling housing prices and contraction

of the US trade deficit and demand. It is these fears that seem to have turned

the tide in favour of the dollar and against commodity prices. As the impact of

the fiscal stimulus and the resurgence of US competitiveness on account of the

appreciating dollar runs out of steam, the decline in household demand and

consumer confidence on account of the continuing housing crisis is widely

expected to drive US growth lower in subsequent quarters. The real test of the

‘decoupling hypothesis’ would be if, given the downturn and crisis in the US,

Europe and Japan, capital were to flow back into emerging markets instead of

the traditional haven, namely US treasuries.



While India is not as dependent on external markets as several other

developing countries, notably China, this cannot but have a dampening effect

on export growth as the US accounts for 15 per cent of India’s merchandise

exports (compared to 20 per cent in the case of both Brazil and China), while

western Europe accounts for another 23 per cent. The dependence on OECD,

and particularly on the US market, and on services exports, through which

India mostly plugs its yawning merchandise trade deficit, is even greater. Of

India’s trade deficit of $90 billion in 2007-08, 40 per cent was covered by IT-

related invisibles exports to the US and Europe. While the falling rupee could

make non-import intensive Indian merchandise exports more competitive,

since banking, financial services and insurance (BFSI) are at the centre of the

credit storm in western markets, there is likely to be shrinkage in both job





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opportunities and export revenues in what is the largest outsourcing vertical of

India’s IT sector.



The combination of current account and inflationary pressures has put

the Indian rupee under pressure since capital flows other than FDI are drying

up as a consequence of the credit freeze and repricing of risk in western capital

markets. There was a net outflow of $3.7 billion of FII from India during April-

August 2008. The reduction in capital flows may have made monetary

management easier, but the reduction is so sharp that the rupee is coming

under heavy pressure, having dipped below Rs 46 to the dollar, even as RBI’s

foreign exchange reserves have fallen by $20 billion between March 31 and

September 5, 2008. The reversal in FII flows has sharply reduced market

capitalisation on account of the stock market’s dependence on FII flows.

Although the current account deficit is eminently fundable in view of the large

stock of foreign currency reserves, rupee depreciation at this point will only

feed inflationary pressures. Fiscal pressures have moreover led international

credit agencies to consider downgrading India’s credit rating from investment

to speculative grade. Should this occur, the rupee would come under even

greater pressure through rebalancing of currency portfolios.



Savings and investment, widely credited for the rise in trend growth over

the last few years, are both likely to be adversely affected. The Economic

Advisory Council to the PM estimated in July 2008 that the commodity terms

of trade shock could administer an additional fiscal shock of up to 4.5 per cent,

thereby sharply lowering savings. Although oil prices have fallen sharply since

this estimate was made, this would undo only some of the damage especially

in view of the depreciating rupee.



While the domestic savings investment gap over the last few years was

modest, ranging from 1 to 1.5 per cent of the GDP, Indian companies and

public sector enterprises had become increasingly dependent on cheap

overseas finance for investment, possibly as a result of monetary tightening at

home and rupee appreciation. External commercial borrowings as a

percentage of gross capital formation of the corporate and public sectors rose

sharply from 3.2 per cent in 2005-06 to 12 per cent in 2006-07 and is likely to

be even higher in 2007-08. The dependence on foreign investment, net of





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mplications for the outsourcing world

The link between the sub-prime mortgage crisis in the US and the global

outsourcing economy stems from the fact that many mortgage companies

have outsourced their operations to outsourcing countries. With the closure of

these units, outsourcing contracts were automatically cancelled.Many back

office operations were shelved as a result, and billing rates, employee makeup

and strength, pay structure and profits were all drastically altered. As Deutsche

Bank, Germany's biggest bank, rightly points out, global economic growth is

taking a direct hit as a result of this crisis. WNS (Holdings), India’s second-

largest BPO, has reported that the US subprime lending crisis would have a

“material adverse impact” on its financial performance. The Bank of China, one

of Asia’s biggest banks, also disclosed considerable exposure to the US

impasse. IT major TCS has raised its billing rates by 3 to 4% for existing clients

and by 5% for new clients because of rising wages and rupee appreciation

against the dollar. And technology giant Infosys has declared that the impact of

the subprime crisis will be close to a $1 million this year. The list continues…



So is the situation very bleak? Not so, according to industry experts

across the world. Only a handful of companies in outsourcing countries like

India are facing considerable exposure to the mortgage industry and the

impact will be confined to this number. Big players are in liaison with large

mortgage firms that have the capacity to tide over subprime problems. But

there is a more prominent silver lining in all this. Companies like IT forerunner

Infosys are taking the crisis in their stride, in spite of losses amounting to

around a million dollars and having to reassign employees who have lost jobs

in their BPO wing. Why the optimism? The possibilities of these large mortgage

firms withstanding the crisis and consolidating are very high. The result – more

outsourcing contract and that too of higher scope! Outsourcing economies

would win more business from the US when the subprime crisis curbed

spending there and companies are driven to cheaper service providers in other

countries. So this brief deadlock would actually work to the advantage of

outsourcing countries!



But the proposal of the Indian Industry body PHD Chamber (PHDCCI) is

worth consideration here to avoid future impasses like this: To overcome such

situations, the BPO segment should increasingly go for balancing their risks by



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taking up projects outside the US and focusing on e-governance and wiring

companies.





Impact of subprime crunch on the Software industry:

R&D budget cuts: this is typical everytime there’s a downturn: large

corporations cut R&D budgets (which I find dumb since downturns are

excellent times for innovation and fostering one’s competitive advantage

through information systems; but well, I’m not in charge here). End result:

software sales aimed at R&D departments (eg. Dassault Systèmes’ CATIA) are

likely to suffer temporarily.





Impact on subprime crunch on IT consulting:

Severe shortcuts are expected in IT consulting, especially in banking /

insurance where uncertainties are likely to remain higher for a short period of

time (a few months). Such redundancies will have a positive impact on the

software industry where finding skilled developers has become nothing less

than a nightmare. Last and not least, the subprime crunch is very likely to

accelerate the ongoing IT & BPO offshoring trend.





Impact on Venture Capital:

On the one hand, venture capitalists may suffer from limited partners

(financial institutions in general + wealthy individuals and families) appearing

less eager to increase VC-managed funds. On the other hand, venture

capitalists invest in private equity that isn’t correlated with either the fixed

income market (high tech startups never raise debt).









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