Subprime mortgage crisis

 

The subprime mortgage crisis is an ongoing economic problem characterized by contracted liquidity in the global credit markets and banking system. An undervaluation of real risk in the subprime market is cascading, rippling and ultimately severely adversely affecting the world economy.

The crisis began with the bursting of the United States housing bubble^[1][2] and high default rates on "subprime" and adjustable rate mortgages (ARM). Loan incentives, such as easy initial terms, in conjunction with an acceleration in rising housing prices encouraged borrowers to assume difficult mortgages on the belief they would be able to quickly refinance at more favorable terms. However, once 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.^[3]

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008.^[4][5] Owing to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.

The widespread dispersion of credit risk and the unclear effect on financial institutions caused reduced lending activity and increased spreads on higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets. The U.S. government also bailed-out key financial institutions, assuming significant additional financial commitments.

The subprime crisis has adversely affected several inputs in the economy, resulting in downward pressure on economic growth. Fewer and more expensive loans tend to result in decreased business investment and consumer spending. The initial leveling off in the housing market has become a downturn in many areas due to a surplus inventory of homes. The reduction and shift in demand versus supply has resulted in a significant decline in new home construction.^[6]

With interest rates on a large number of subprime and other ARM due to adjust upward during the 2008 period, U.S. legislators, the U.S. Treasury Department, and financial institutions are taking action. A systematic program to limit or defer interest rate adjustments was implemented to reduce the effect. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Banks have sought and received over $250 billion in additional funds from investors to offset losses.^[7] The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in several decisions by the U.S. Federal Reserve to cut interest rates and the economic stimulus package passed by Congress and signed by President George W. Bush on 13 February 2008.^[8][9][10] Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.

Background information

 

Subprime lending is the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,^[11] with over 7.5 million first-lien subprime mortgages outstanding.^[12]Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005.^[13] By January 2008, the delinquency rate had risen to 21%^[14] and by May 2008 it was 25%.^[15]

Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007.^[16] During 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings including default notices, auction sale notices and bank repossessions can include multiple notices on the same property.^[17] More homeowners continue to receive foreclosure notices, with one in every 519 households receiving a foreclosure filing in April 2008.^[18]

The U.S. mortgage market is estimated at $12 trillion^[19] with approximately 9.2% of loans either seriously delinquent or in foreclosure through August 2008.^[20]

 

Risks of the subprime crisis

As a result of innovations in securitization, risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. There are four primary categories of risk involved: credit risk, asset price risk, liquidity risk, and counterparty risk. Each of these risk types is described in the background information.

 

Effect on corporations and investors

Average investors and corporations face a variety of risks owing to the inability of mortgage holders to pay. These vary by legal entity. Banks, investment banks, mortgage lenders, real estate investment trusts (REIT), special purpose entities (SPE) and individual investors have all been significantly affected. Many of these entities own or owned mortgage backed securities, which have valuations ultimately tied to the price of housing. Declines in housing prices and uncertainty surrounding future housing prices have resulted in significant losses and stock price reductions. The mechanisms through which the crisis affects each of these entity types is described in the background information.

Causes of the crisis

The reasons for this crisis are varied and complex.^[21] The crisis can be attributed to a number of factors pervasive in both the housing and credit markets. Some of these include: the inability of homeowners to make their mortgage payments; poor judgment by the borrower and/or the lender; speculation and overbuilding during the boom period; risky mortgage products; high personal and corporate debt levels; financial innovation that distributed and perhaps concealed default risks; central bank policies; and regulation (or lack thereof).^[22]

Housing downturn

 

Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent.^[23]

This demand helped fuel housing price increases and consumer spending, reducing housing affordability ^[24]. Between 1997 and 2006, American home prices increased by 124%.^[25] Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade.^[26] A culture of consumerism is a factor "in an economy based on immediate gratification".^[27]

In the early 2000s recession that began in early 2001 and which was exacerbated by the September 11, 2001 terrorist attacks, Americans were asked by the current President, George W. Bush, to spend their way out of economic decline and "get down to Disney World in Florida."^[28] This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop"^[29], and corporations like General Motors produced commercials with the same theme.

Overbuilding during the boom period, increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available. Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981.^[30] Further, a record of nearly four million unsold existing homes were for sale,^[31]including nearly 2.9 million that were vacant.^[32]

This excess supply of home inventory places significant downward pressure on prices. As prices decline, more homeowners are at risk of default and foreclosure. According to the S&P/Case-Shiller price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2 2006 peak^[26] and by May 2008 they had fallen 18.4%.^[33] However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.^[34] The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%.^[35]Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.

Role of borrowers

A variety of factors have contributed to an increase in the payment delinquency rate for subprime ARM borrowers, which recently reached 21%, roughly four times its historical level.^[14]

Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S. (ee United States housing market correction and United States housing bubble), refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts. Other homeowners, facing declines in home market value or with limited accumulated equity, are choosing to stop paying their mortgage. They are essentially "walking away" from the property and allowing foreclosure, despite the impact to their credit rating.^[37]

Misrepresentation of loan application data and mortgage fraud are other contributing factors.^[38] US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005. ^[36]

American Economist Hyman Minsky described three types of speculative borrowing that can contribute to the accumulation of debt that eventually leads to a collapse of asset values:^[39][40]the "hedge borrower" who borrows with the intent of making debt payments from cash flows from other invesments; the "speculative borrower" who borrows based on the belief that they can service interest on the loan but who must continually roll over the principal into new invesments; and the "Ponzi borrower" (named for Charles Ponzi), who relies on the appreciation of the value of their assets (e.g. real estate) to refinance or pay-off their debt but cannot repay the original loan. All of these practices in some form or another contributed to the accumulation of debt that preceded the subprime crisis.

Unfortunately the Mortgage_Forgiveness_Debt_Relief_Act_of_2007 removed incentives for borrowers to remain in their homes. Some have called for this law to be rewritten and retitled the Patriotic Mortgage Repayment Act of 2008. The Patriotic Mortgage Repayment Act of 2008 - If a borrower defaults on a mortgage and the market value of the collateral is insufficient to repay the money borrowed, the Treasury will recover 100% of the residual amount using IRS collection methods and interest schedules. Such a law would prevent the general population from bailing out the speculators that purchased more house than they could reasonably afford.

Role of housing investors and speculators

Speculation in real estate was 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, nearly 40% of home purchases (record levels) were not primary residences. NAR's chief economist at the time, David Lereah, stated that the fall in investment buying was expected in 2006. "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."^[41]

While homes had not traditionally been treated as investments like stocks, 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 the behavior of purchasing condominiums prior to completion, then "flipping" (selling) them for a profit without ever living in the home.^[42]Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.^[43]

Role of financial institutions

A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 ^[44] , 9% in 1996 ^[45], 13% ($160 billion) in 1999 ^[44] , and 20% ($600 billion) in 2006.^[45][46] A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "subprime markup" or "risk premium") declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower and loan characteristics declined overall during the 2001–2006 period, which should have had the opposite effect. The combination is common to classic boom and bust credit cycles.^[47]

In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. These high risk loans included 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. Further, an estimated one-third of ARM 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.^[48]

Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.^[49]

The Center for Responsible Lending, in its report on IndyMac, related testimony that the bank actually made efforts to avoid having income information about some borrowers ^[50]. The Associated Press has reported that a federal grand jury is investigating subprime lenders Countrywide Financial Corp., New Century Financial Corp. and IndyMac Bancorp Inc. and reports also that the FBI is investigating IndyMac for possible fraud. ^[51]. The question, then, is whether banks and other private mortgage originators of subprime and other "nonprime" loans might deliberately have profited or attempted to profit - in moneys, economic benefit or even fraudulent gain - through reducing the amount of information they collected from borrowers.

Judge Leslie Tchaikovsky of the U.S. Bankruptcy Court for the Northern District of California, found on 25 May 2008 that even though a pair of borrowers had, indeed, misrepresented their incomes on a "stated income" home equity loan, National City Bank's "reliance" on these statements of income "was not reasonable based on an objective standard"^[52].

Investment banks are not subject to the same capital reserve regulations as depository banks. Some of the larger investment banks were highly leveraged (i.e., a high ratio of debt to capital reserves). As a result, they were not as capable of absorbing MBS losses. In addition, they were also counterparties to complex credit derivative transactions insuring various types of debt instruments. The combination of MBS losses and leverage rendered their ability to perform their counterparty role less certain. This in turn represented a broader risk to the financial system, resulting in their outright or "arranged" takeovers.^[53]

] Role of securitization

Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment.^[54] There are many parties involved. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Asset securitization began with the structured financing of mortgage pools in the 1970s.^[55] The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006.^[47] Alan Greenspan stated that the securitization of home loans for people with poor credit not the loans themselves was to blame for the current global credit crisis.^[56]

Role of mortgage brokers

Mortgage brokers do not lend their own money. There is not a direct correlation between loan performance and income. They have a financial incentive for selling complex, adjustable rate mortgages (ARMs), since they earn significantly higher commissions. ^[57]

According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the U.S., with subprime and Alt-A loans accounting for 42.7% of brokerages' total production volume. ^[58]

The chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn't do enough to examine whether borrowers could repay. ^[59]

Role of mortgage underwriters

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. ^[60] 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."^[61] 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. ^[62]

Role of government and regulators

Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. ^[63] 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.^[64]Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers^{[65] [66] [67]} and defenders claiming a thirty year history of lending without increased risk.^[68][69][70]Amendments to the CRA in the mid-1990s, dramatically 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. ^{[71] [72] [73]}

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.^[74]

Lawmakers received favorable treatment from financial institutions involved in the subprime industry; see Countrywide Financial political loan scandal, below.

The U.S. Department of Housing and Urban Development helped fuel more of that risky subprime lending.^[75][76]

Role of credit rating agencies

Further information: Role of credit rating agencies in the subprime crisis

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified by various credit enhancements including overcollateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.^[77] On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.^[78]

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower.^[79]

Role 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.^[80] There is significant debate among economists regarding whether this is the optimal strategy.^[81]

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.^[82]

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.^[80] From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.^[83] 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.^[84]

Effects

Effects on stock markets

On 19 July 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.^[85] By 15 August, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Large daily drops became common, with, for example, the KOSPI dropping about 7% in one day, ^[86] although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis.

Mortgage lenders ^{[87] [88]} and home builders ^{[89] [90} fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.^[91]

The crisis has 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".^[92] 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."^[93][94] 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 materials.^[95]

Stock indices worldwide trended downward for several months since the first panic in July-August 2007. All three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market during the summer of 2008. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. Poor economic data on manufacturing contributed to the day's panic, but were eclipsed by the severe developments of the financial crisis. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.

Effect on world economy

When the crisis first came to light, many analysts called it a domestic problem—one that would only affect US housing markets. However, the crisis quickly spread throughout the world. In September 2007, Northern Rock, a British Bank, experienced a bank run after it was revealed that the bank was having trouble raising liquidity. Within one day, customers had withdrawn an estimated £1 billion. This was the first bank run in Britain since 1866.^[96] The Bank of China (the #2 bank in China) announced in August 2007 that it held $9.7 billion dollars of US subprime debt.^[97] In January of 2008, Korean markets fell due to the "selling spree" of shares of US mortgages.^[98] Because of the global economy, and the huge subprime "pool" of mortgages that was bought by investors world wide, the International Monetary Fund (IMF) "says that the worldwide losses stemming from the US subprime mortgage crisis could run to $945 billion."^[99]

Effects on Businesses

 

Many banks, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. Financial institutions from around the world have recognized subprime-related losses and write-downs exceeding U.S. $501 billion.^[100]

Profits at the 8,533 U.S. banks insured by the FDIC declined from $35.2 billion to $646 million (89 percent) during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007, these banks earned approximately $100 billion, down 31 percent from a record profit of $145 billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year, a decline of 46%.^[101][102]

The financial sector began to feel the consequences of this crisis in February 2007 with the $10.5 billion writedown of HSBC, that was the first major CDO or MBO related loss to be reported^[103] since then at least 100 mortgage companies have either shut down, suspended operations or been sold since 2007.^[104] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.^[105] Various institutions follow-up with merger deals.^[106]

In addition, Northern Rock and Bear Stearns^[107] have required emergency assistance from central banks. IndyMac was shut down by the FDIC on 11 July 2008.

The crisis also affected Indian banks which have ventured into USA. ICICI, India's second largest bank, has reported mark-to-market loss of $263 million in its loans and investment exposures. Other state owned banks such as State Bank of India, Bank of India and Bank of Baroda have refused to release their figures.^[108]

As increasing amounts of bad debt are passed on to professional debt collectors, the collection industry is projected to grow by 9.5 percent in 2008 and will continue to experience growth as long as delinquencies continue to mount.^[109]. On September 14th 2008, Lehman Brothers filed for bankruptcy after more than 150 years in business as a consequence of losses stemming from the subprime mortgage crisis.^[110] On September 16, 2008, the Federal Reserve gave an $85 billion loan to the insurer A.I.G. in exchange for an 80% stake; the company had been expected to declare bankruptcy the next day if no intervention occurred.^[111]

Effect on insurance companies

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. As of January 2008, the 2007 numbers were not yet available.^{[112] [113]}

Effect on municipal bond "monoline" 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.^[114] As a result, rating agencies have downgraded several bond insurers--as well as the bonds they insure^[115][116]--some to low speculative grade rating categories.^[117][118] The downgrades further threaten the bond insurers because they become unable to underwrite new business going forward. The downgrades may also require financial institutions holding the bonds to lower their valuation or to sell them, as some entities (such as pension funds) are only allowed to hold the highest-grade bonds. The effect of such a devaluation on institutional investors and corporations holding the bonds (including major banks) has been estimated as high as $200 billion. Regulators are taking action to encourage banks to lend the required capital to certain monoline insurers, to avoid such an impact.^[119] However, rather than recapitalizing insurance units plagued by exposure to subprime related products, some insurers are focused on moving excess capital to previously dormant units that could continue to underwrite new business.^[120]

Effects on Individuals

] Effect on homeowners

 

According to the S&P/Case-Shiller housing price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their mid-2006 peak^[26] and by June 2008 this was approximately 20%.^[121]Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981.^[30]

Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels. As MBS and CDO valuation is related to the value of the underlying housing collateral, MBS and CDO losses will continue until housing prices stabilize.^[80]

As home prices have declined following the rise of home prices caused by speculation and as re-financing standards have tightened, a number of homes have been foreclosed and sit vacant. These vacant homes are often poorly maintained and sometimes attract squatters and/or criminal activity with the result that increasing foreclosures in a neighborhood often serve to further accelerate home price declines in the area. Rents have not fallen as much as home prices with the result that in some affluent neighborhoods homes that were formerly owner occupied are now occupied by renters. In select areas falling home prices along with a decline in the U.S. dollar have encouraged foreigners to buy homes for either occasional use and/or long term investments. Additional problems are anticipated in the future from the impending retirement of the baby boomer generation. It is believed^[who?] that a significant proportion of baby boomers are not saving adequately for retirement and were planning on using their increased property value as a "piggy bank" or replacement for a retirement-savings account. This is a departure from the traditional American approach to homes where "people worked toward paying off the family house so they could hand it down to their children" ^[122].

Effect on minorities

There is a disproportionate level of foreclosures in some minority neighborhoods. ^{[123] [124]}

About 46% of Hispanics and 55% of African Americans who obtained mortgages in 2005 got higher-cost loans compared with about 17% of whites and Asians, according to Federal Reserve data. Other studies indicate they would have qualified for lower-rate loans. ^[124]

Disproportionate default rates across ethnic classes prove that legislation such as the Community_Reinvestment_Act forces banks to make unsound loans. ^[125]

Effect on tenants

Many renters have been forced from their homes by foreclosures due to their landlords defaulting on loans. According to a January study by the Mortgage Bankers Association, one out of every seven Maryland homes that lenders began foreclosure proceedings on last summer was not occupied by the owner. Foreclosure voids any lease agreement, and renters have no legal right to continue renting.^[126]

Effect on jobs in the financial sector

According to Bloomberg, from July 2007 to March 2008 financial institutions laid off more than 34,000 employees.^[104] In April, job cut announcements continued with Citigroup announcing an extra 9,000 layoffs for the remainder of 2008, back in January 2008 Citigroup had already slashed 4,200 positions.^[127]

Also in April, Merrill Lynch said that it planned to terminate 2,900 jobs by the end of the year.^[128] At Bear Stearns there is fear that half of the 14,000 jobs could be eliminated once JPMorgan Chase completes its acquisition.^[104] Also that month, Wachovia cut 500 investment banker positions^[129], Washington Mutual cut its payroll by 3,000 workers^[130] and the Financial Times reported that RBS may cut up to 7,000 job positions worldwide.^[131][132] According to the Department of Labor, from August 2007 until August 2008 financial institutions have slashed over 65,400 jobs in the United States.^[133]

Effect on the financial condition of the U.S. government

 

The U.S. federal government has made significant additional financial commitments through efforts to support the financial system. This includes pledges of up to $200 billion to protect Fannie Mae and Freddie Mac, an $85 billion bridge loan for AIG, and a $29 billion loan guarantee for Bear Stearns. As the crisis has progressed, the Fed has expanded the collateral against which it loans, including higher-risk assets and (in certain cases) equity.^[134] Through June 2008, the Fed had provided approximately $1.2 trillion in loans to various financial institutions through its Term auction facility.^[135] The extent to which the federal government will suffer losses on these investments is not presently clear.^[136]

In addition, an estimated $1.2 trillion reduction in housing prices and slowing of the economy are expected to significantly reduce state and local property tax revenues.^[137]

On 19 September 2008, the U.S. government announced a plan to purchase large amounts of illiquid, risky mortgage backed securities from financial institutions^[138], which is estimated to involve "hundreds of billions" of additional commitments.^[139] The mortgage market is estimated at $12 trillion^[140] with approximately 9.2% of loans either seriously delinquent or in foreclosure through August 2008.^[141]

Actions to manage the crisis

Government Actions

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."^[14]

• 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.^[142][143]

• 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.^[144]

• 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.^[145]

Loan modification/Loss Mitigation/Hope Now Alliance

Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Homeowners have also been encouraged to contact their lenders to discuss alternatives.^[146]

President George W. Bush announced a plan voluntarily and temporarily to freeze the mortgages of a limited number of mortgage debtors holding ARMs.^[147][148] A refinancing facility called FHA-Secure was also created. ^[149] This action is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.^[150]

The Hope Now Alliance released a report in February, 2008 indicating it helped 545,000 subprime borrowers with shaky credit in the second half of 2007, or 7.7 percent of 7.1 million subprime loans outstanding in September 2007. A spokesperson acknowledged that much more must be done.^[151] During February 2008, a program called "Project Lifeline" was announced. Six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for homeowners 90 or more days delinquent on payments. The intent of the program was to encourage more loan adjustments, to avoid foreclosures.^[152]

Corporations, trade groups, and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs. There is some dispute regarding the appropriate measures, sources of data, and adequacy of progress. A report issued in January 2008 showed 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 new foreclosures. Consumer groups claimed the modifications affected less than 1 percent of the 3 million subprime loans with adjustable rates that were outstanding in the third quarter.^[153]

The State Foreclosure Prevention Working Group, a coalition formed by 11 state attorney's general and bank regulators, reported in April 2008 that the increasing pace of foreclosures exceeds the ability of loan servicers to keep up. Seventy percent of subprime mortgage holders are not getting the help required. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. The group has recommended applying a more systematic method of loan modification that can automatically be applied to a large number of struggling homeowners and slowing down the pace of foreclosures. ^[154]

Regulation

Further information: Regulatory responses to the subprime crisis

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.^[155] 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.^[156]

• 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.^[157]

• In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.^[158]

• 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. ^[159]

• 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."^[160]

• UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008.^[161]

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.^[10] 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. Senators McCain and Clinton, meanwhile, proposed eliminating the federal gasoline tax for the summer months instead.^{[162] [163]}

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.^[164] 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 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.
• Enhancements to mortgage disclosures.
• Community assistance to help local governments buy and renovate foreclosed properties.

Government Bailouts

Bear Stearns

On March 16th 2008, J.P. Morgan Chase announced that it would buy Bear Stearns for $236 million or $2 a share^[165], those same shares a year earlier were trading at around $150.^[166] Later, on March 24th 2008 J.P. Morgan Chase increased the offer to $1.2 billion or $10 a share.^[167] In order for deal to go through J.P. Morgan Chase required ^[168] the Fed to issue a nonrecourse loan of $29 billion to Bear Stearns.^[169][170]This means that the loan is collateralized by mortgage debt^[171] and that the government can't go after J.P. Morgan Chase's assets if the mortgage debt collateral becomes insufficient to repay the loan.^[172][173]

The bailout was taken in part to avoid a potential fire sale of nearly U.S. $210 billion of Bear Stearns' MBS and other assets, which could have caused further devaluation in similar securities across the banking system.^[174][175] Chairman of the Fed, Ben Bernanke, defended the bailout by stating that a Bear Stearns' bankruptcy would have affected the real economy^[176]and could have caused a "chaotic unwinding" of investments across the US markets.^[177]

Fannie Mae and Freddie Mac

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), two large government-sponsored enterprises, are the two largest single mortgage backing entities in the United States. Between the two corporations, they back nearly half of the $12 trillion mortgages outstanding as of 2008.^[178] During the mortgage crises, some in the investment community feared the corporations would run out of capital. Both corporations insisted that they were financially solid, with sufficient capital to continue their businesses, but stock prices in both corporations dropped steadily nonetheless.

Due to their size and key role in the US housing market, it had long been speculated that the US Government would take action to bolster both companies in such a situation. On 30 July 2008, this speculation became reality when President Bush signed the Housing and Economic Recovery Act of 2008. While analysts disagreed on the financial need for such a bailout, the investor confidence provided by an explicit government show of support was likely needed in any case.

On 5 September 2008, the Treasury Department confirmed that both Fannie Mae and Freddie Mac would be placed into conservatorship^[179] with the government taking over management of the pair.

 

Lehman Brothers, Merrill Lynch & Co. and AIG

 

On September 15th, a day which has been dubbed Meltdown Monday by some News outlets^[180][181], the 94 year-old Merrill Lynch agreed to sell itself to Bank of America for $50 billion. Also on that day Lehman Brothers, facing a refusal by the federal government to bail it out, filed for Chapter 11 bankruptcy protection ^[182]. Treasury Secretary Hank Paulson cited moral hazard as a reason for not bailing out Lehman Brothers.^[183] Meanwhile Goldman Sachs and JP Morgan Chase tried but failed to raise $70 billion to lend AIG.^[184]

One day later, The Fed found itself forced to bail out insurance giant AIG by providing an emergency loan of $85 billion,^[185] which will be repaid by selling off assets of the company.^[184] After concluding that a disorderly failure of AIG could aggravate the current financial and economic crisis^[186] The Fed decided to intervene. This intervention gave the US government a 79.9 percent equity stake at AIG.^[184]

Emerging plan to bail out financial institutions

On 19 September 2008, the U.S. government announced a plan to purchase large amounts of illiquid, risky mortgage backed securities from financial institutions^[187], which is estimated to involve at minimum, $700 billion of additional commitments. ^[188]This plan also included a ban on short-selling of financial stocks.^[189] The mortgage market is estimated at $12 trillion^[190] with approximately 9.2% of loans either seriously delinquent or in foreclosure through August 2008.^[191]

Financial industry responses

Bank financial health

Major financial institutions had obtained over $260 billion in new capital (i.e., cash investments) as of May, 2008.^[192] Such capital is used to help banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to subprime loan or CDO losses. This capital was raised by issuing such instruments as bonds or preferred stock to investors in exchange for cash. Such capital raising has been advocated by the leaders of the U.S. Federal Reserve and the Treasury Department. ^[193] Well-funded banks are in a better position to loan at favorable interest rates, which offsets the liquidity and uncertainty aspects of the crisis. That banks and securities firms have been able to place such large volumes of debt with investors is an indication to some analysts that these firms will survive the credit crisis.^[194]

Banks have obtained some of this capital from sovereign wealth funds, which are entities that control the surplus savings of developing countries. An estimated U.S. $69 billion has been invested by these entities in large financial institutions over the past year. On 15 January 2008, sovereign wealth funds provided a total of $21 billion to two major U.S. financial institutions. Sovereign wealth funds are estimated to control nearly $2.9 trillion. Much of this wealth is oil and gas related. As they represent the surplus funds of governments, these entities carry at least the perception that their investments have underlying political motives.^[195]

Certain major banks have also reduced their dividend payouts^[196] to increase liquidity and further dividend reductions are expected by some analysts in 2008.^[197] Of the 3,776 U.S. FDIC insured institutions that paid common stock dividends in the first quarter of 2007, almost half (48 percent) paid lower dividends in the first quarter of 2008, including 666 institutions that paid no dividends. Insured institutions paid $14.0 billion in total dividends in the first quarter, down $12.2 billion (46.5 percent) from a year earlier.^[198]

Credit rating agencies

Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.^[199] In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates.^[200]

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 percent 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.^[201]

Former Bear Stearns managers were named in civil lawsuits brought in 2007 by investors, including Barclays Bank PLC, who claimed they had been misled. Barclays claimed that Bear Stearns knew that certain assets in the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear Stearns managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." The lawsuit said Bear Stearns told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting." ^[202]

Law enforcement

The number of FBI agents assigned to mortgage-related crimes increased by 50 percent between 2007 and 2008. ^[203] 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. ^[204] 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.^[203] 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. ^[202]

 

Expectations and forecasts

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm".^[207] Alan Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s".^[208]

On 7 September 2007, the Wall Street Journal reported that Alan Greenspan has said that the current turmoil in the financial markets is in many ways "identical" to the problems in 1987 and 1998.^[209]

The Associated Press described the current climate of the market on 13 August 2007, as one where investors were waiting for "the next shoe to drop" as problems from "an overheated housing market and an overextended consumer" are "just beginning to emerge."MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "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 they "continue to believe conditions will get worse"^[210].

As of 22 November 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion.^[211] As of 22 December 2007, a leading business periodical estimated subprime defaults between U.S. $200–300 billion.^[212] As of 1 March 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350–600 billion.^[213]

On 20 March 2008, the Organization for Economic Cooperation and Development downgraded its economic forecasts for the United States, the Eurozone and Japan for the first half of 2008.^[214]

Alan Greenspan, the former Chairman of the Federal Reserve, stated:^[80]

“

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 of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

”

References

External links

• "Global Credit Crunch.org", World News aggregate on the Global Credit Crunch and Video Documentaries.
• "The US sub-prime crisis in graphics". BBC (21 November 2007).
• "A House of Cards - from fantasy finance to global crash". Gerry Gold & Paul Feldman (2007: London, Lupus Books), ISBN 9780952345435
• "Understanding the Subprime Mortgage Crisis", paper by Yuliya Demyanyk (FRB St. Louis) and Otto Van Hemert (NYU Stern), 10 December 2007.
• "A Catastrophe Foretold", opinion by Paul Krugman in The New York Times, 26 October 2007.
• Sloan, Allan (16 October 2007). "Junk mortgages under the microscope", The Deal, CNN Money. 
• "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison", Carmen M. Reinhart and Kenneth S. Rogoff, 5 February 2008. Analysis by Harvard economists.
• ""The Rise and Fall of Subprime Mortgages"". Federal Reserve Bank of Dallas (2007-11).
• ""From Complacency to Crisis: Financial Risk Taking in the Early 21st Century"". Federal Reserve Bank of Dallas (2007-12).
• "Heading for the rocks: Will financial turmoil sink the world economy?"—a special free report from the Economist Intelligence Unit.
• "The Next Slum", Christopher B. Leinberger, The Atlantic Monthly, March 2008.
• "The next bubble: Priming the markets for tomorrow's big crash", Eric Janszen, Harper's Magazine, February 2008.
• "The Giant Pool of Money", This American Life, 9 May 2008 (episode #355). A plain language examination of the history and origins of the subprime mortgage crisis and credit crunch.
• "The Subprime Meltdown: A Primer" by Dr. Faten Sabry and Dr. Thomas Schopflocher, NERA Insights: Subprime Lending Series, Part I, 21 June 2007.
• "Liar's Poker" by Michael Lewis. While largely a dramatic account of life at Salomon Brothers investment bank in the 1980s, a good description is given of the creation of the market for mortgage-backed securities.
• How to Stop the Foreclosures: A Review of the Policy Proposals by economist Fred Moseley in Dollars & Sense magazine, July/August 2008
• (Mis)Understanding a Banking Industry in Transition by economist William K. Black in Dollars & Sense magazine, November/December 2007