SUBPRIME FINANCIAL MORTGAGE CRISIS The subprime mortgage financial crisis is a phenomenon, nothing less than the global talk throwing a cold reception to 2008. The subprime mortgage is more like an international and Trans continental crisis, but its origin could be traced from the domestic housing markets of the United States of America. This began initially with a sharp rise in home foreclosures the United States during the fall of 2006 and became a global financial crisis within a year. It is an over spilling talk in the newspapers and financial bogs referring to the Sub prime crisis in it’s common parlance as the crisis began with the bursting of the housing bubble in the U.S. The Beginning of Everything: Sub prime Mortgage Loans
In the past five years the private sector expanded its role in the mortgage bond market, specializing new types of mortgages such as “sub-prime lending” to borrowers who do not have good credit histories, level of income etc. The size of the “sub prime mortgage loans” increased over years, the share of sub prime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006 :
1) The Rise of the Mortgage Bond Market
2) Sub prime Mortgage Market Growth
3) The Share of Sub prime Mortgage in the total Mortgage Bond Market
What are the details of these Subprime Mortgage Loans exactly ? To sum up these were the loans to borrowers with poor credit. As you can see above at chart 2, sub prime mortgage loans existed after 1998 and then gained a great share closer to 2006 and 2007. These loans have higher interest rates to compensate the risk posed by the borrowers, most of these loans are ARM’s (Adjustable rate mortgages ), wıth interest only payment options, penalties for paying off the loan early, and low documentation requirements which borrowers need just a little paperwork to borrow the loans. According to First American Loan Performance in 2006 %56 of the loans were “liar loans” which borrowers misrepresent information to obtain the mortgage loans. These borrowers are also called mortgage frauds. The increase in the number of mortgage frauds can be viewed from this chart:
As the interest rates are low and house prices are increasing the sub prime market prospered. Home price appreciation gave borrowers a confidence that even if they fail to pay their debt they can cover this debt by selling their home in appreciated prices. During that period (which home prices are increasing over time) delinquency rates were too low which supports what I stated above. This law delinquency rate masked potential problems in the sub prime market convincing lenders and investors that sub prime loans will face defaults and foreclosures at a low rate. The sub prime mortgage market splitted into parts by ABS (asset backed securities) and CDO’s (collateralized debt obligations). The relationship between the borrower and the lender has been divided among various parties which have its own benefits from its specialized role in the cycle. This cycle will play an important role in the future of mortgage crisis which is now turning into a banking crisis that we are seeing currently in 2008. Excessive underwriting of high-risk mortgages Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting. In 2007, 40 percent of all subprime loans were generated by automated underwriting. An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation." Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown. Government Policies Several critics have commented that the current regulatory framework is outdated. 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. Recently, we've seen how one company can grow so large that its failure jeopardizes the entire financial system." The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree. A taxpayer-funded government bailout related to mortgages during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to un-credit worthy consumers 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 home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages. A study, by a legal firm, of loans made by institutions covered under the CRA reveals the following: The institutions were less likely to make subprime loans, and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.
Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Department's Office of the Comptroller of the Currency, at the insistence of national banks, struck down such attempts as violations of Federal banking laws. The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans. In 1995, Fannie Mae and Freddie Mac began receiving affordable housing credit for purchasing mortgage bank securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. Subprime mortgage loan originations surged by a whopping 25 percent per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years. As of November 2007, Fannie Mae a held a total of $55.9 billion of subprime securities and $324.7 billion of Alt-A securities in their portfolios. As of the 2008Q2 Freddie Mac had $190 billion in Alt-A mortgages. Together they have more than half of the $1 trillion of Alt-A mortgages. The growth in the subprime mortgage market, which included B, C and D paper bought by private investors such as hedge funds, fed a housing bubble that later burst. A September 30, 1999 New York Times article stated, "... the Fannie Mae Corporation is easing the credit requirements on loans... The action... will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough... Fannie Mae... has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people... borrowers whose incomes, credit ratings and savings are not good enough... Fannie Mae is taking on significantly more risk... the government-subsidized corporation may run into trouble... prompting a government rescue... the move is intended in part to increase the number of... home owners who tend to have worse credit ratings..."
Policies of central banks Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the "lenders of last resort" to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy. Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large
financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf. A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. The central bank believed that interest rates could be lowered safely because the rate of inflation was low. The Federal Reserve's inflation figures, however, were flawed. Richard W.
Fisher, President and CEO of the Federal Reserve Bank of Dallas, stated that the Federal Reserve's interest rate policy during this time period was misguided by this erroneously low inflation data, thus contributing to the housing bubble. Institutions were less likely to make subprime loans, and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties. Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Department's Office of the Comptroller of the Currency, at the insistence of national banks, struck down such attempts as violations of Federal banking laws. The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans. In 1995, Fannie Mae and Freddie Mac began receiving affordable housing credit for purchasing mortgage bank securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. Subprime mortgage loan originations surged by a whopping 25 percent per year between 1994 and 2003, resulting in a nearly ten-fold increase in the How the Sub prime Market Collapsed? Everything was going fine, during the early 2000s, interest rates fell, borrowing demand is increased, mortgage lenders were happy that they are expanding their business and making more and more profits, new lenders were entering the market… And the story began, after the increase in US interest rates and decrease in the prices of US housing market the risk of borrowers to default is increased sharply. Defaults and foreclosure activity dramatically increased as ARM interest rates are reset higher. Subprime started to default and could not pay their debts back. But this crisis was not only a two-sided transaction. After sub primes could not pay back their debt, banks has written losses to their accounts. Under you can find some charts which explain the situation: 1) US interest rates
2) US House Price Trends
3) Percentage of home mortgages foreclosure
What are the effects?
In 2007 the crisis affected the financial markets as Dow Jones dropped sharply during August 2007, which the investors started to escape from the market by taking their money out of risky mortgage bonds and putting their money into commodities. A-Institutions: Banks, hedge funds, mortgage lending institutions suffered great losses. As in 2008 the loss is estimated like 280 billion US Dollars. To give an example UBS AG Bank has suffered $37.7 billion, Citibank – $39.1 billion , Merrill Lynch investment bank – $29.1 billion etc. Expected losses in the next periods are even higher
B-Home prices: Another effect of this crisis is on home prices. At the end of 2007 home prices had fallen approximately %8 from their peak in 2006. Also the construction of houses dropped in the same period by the collapse of the industry.
C- Jobs Available: There were also some important effects on jobs available. More than 40000 employees had lost their jobs due to the crisis during 2007 & 2008. There are also some announced layoffs in the industry that the expected number off termination of jobs will increase in the next months:
D- Oil Prices & US Dollar: Another effect of the crisis is surely oil prices and the depreciation of US dollars against other currencies. Nowadays oil prices are the highest of all times, US dollar is hitting recording low against euro and yen. Dollar against Yen chart:
Share Market:
ECONOMIC INDICATOR
SITUATION
IMPACT ON THE SHARE MARKET
1)GDP
GROWTH
BULLISH
DECLINE
BEARISH
2) INFLATION
CONSTANT PRICES
BULLISH
TOO MUCH VARIATION
BEARISH
3) UNEMPLOYMENT
INCREASE
BEARISH
DECREASE
BULLISH
4) EXCHANGE RATE
FAVORABLE
BULLISH
UNFAVORABLE
BEARISH
Miscellaneous effects
Decline in commercial real estate market: Combinations of factors resulting from the subprime mortgage crisis have led to problems in the commercial real estate market. According to the National Association of Realtors (NAR) there is a slowing in commercial real estate due to the tightening credit and slowing growth, the former a direct result of the subprime mortgage crisis. Rise in home-related crime: There is concern that some homeowners are turning to arson as a way to escape from mortgages they can't or refuse to pay. The FBI reports that arson grew 4% in suburbs and 2.2% in cities from 2005 to 2006. Effect on municipal bonds and bond insurers: A secondary cause and effect of the crisis relates to the role of municipal bond "monoline" insurance corporations such as Ambac and MBIA. By insuring municipal bond issues, those bonds achieve higher debt ratings. However, some of these
companies also insured CDOs backed by low-rated tranches of subprime mortgage-backed securities, and as default rates on those MBS have risen, the insurers have suffered significant losses. As a result, rating agencies have downgraded several bond insurers--as well as the bonds they insure some to low speculative grade rating categories. Effect on jobs in the financial sector: According to the Department of Labor, from August 2007 until August 2008 financial institutions have slashed over 65,400 jobs in the United States. Decline in renter security: Many renters have been forced from their homes by foreclosures due to their landlords defaulting on loans. Foreclosure voids any lease agreement, and renters have no legal right to continue renting. RESPONSE TO CRISIS
Legislative and regulatory responses The Federal Reserve
The U.S. central banking system, 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." Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions. The Fed and other central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans. The Fed is using the Term auction facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months. In July 2008, the Fed finalized new rules that apply to mortgage lenders.
Regulation
Regulators and legislators are considering action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings to help identify solutions and apply pressure to the various parties involved.
A sweeping proposal was presented 31 March 2008 regarding the regulatory powers of the U.S. Federal Reserve, expanding its jurisdiction over other types of financial institutions and authority to intervene in market crises. In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices. In the wake of a subprime mortgage crisis and questions about Countrywide’s VIP program, ethics experts and key senators recommend that members of Congress should be required to disclose information about their mortgages. Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital reserve requirements as depository banks. Many of the investment banks had limited capital reserves to address declines in mortgage backed securities or support their side of credit default derivative insurance contracts. Nobel Prize winner Joseph Stiglitz recommends that regulations be established to limit the extent of leverage permitted and not allow companies to become "too big to fail." UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008.
Economic Stimulus Act of 2008
President Bush also signed into law on 13 February 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth. The economic stimulus package included the mailing of rebate checks to taxpayers. Such mailings started the week of 28 April 2008. These mailings, however, coincided with unexpected all-time jumps in food and gasoline prices. This coincidence prompted some to question whether the stimulus package would have the desired effect or whether consumers would just use it to make up for the gap generated by the higher food and fuel prices. Some Congressmen even contemplated legislation for a second round of stimulus rebate checks to ensure the initial intention of the stimulus package had the expected effect. The Treasury Secretary strongly opposed such initiative.
Housing and Economic Recovery Act of 2008
The Housing and Economic Recovery Act of 2008 included six separate major acts designed to restore confidence in the domestic mortgage industry. The Act included: Providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners. Establishing a new regulator to ensure the safe and sound operation of the GSE's (Fannie Mae and Freddie Mac) and Federal Home Loan banks. Raises the dollar limit of the mortgages the government sponsored enterprises (GSE)'s can purchase. Provides loans for the refinancing of mortgages to owner-occupants at risk of foreclosure. The original lender or investor reduces the amount of the original mortgage (typically taking a significant loss) and the homeowner shares any future appreciation with the Federal Housing Administration. The new loans must be 30-year fixed loans.