Subprime mortgage crisis

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Cover of the 20 October 2007 issue of The Economist showing an image related to a Credit crunch caused by the subprime mortgage crisis.
Cover of the 20 October 2007 issue of The Economist showing an image related to a Credit crunch caused by the subprime mortgage crisis. [1]
Cover of the 05 April 2008 issue of The Economist showing an image related to fixing the Credit crunch caused by the subprime mortgage crisis.
Cover of the 05 April 2008 issue of The Economist showing an image related to fixing the Credit crunch caused by the subprime mortgage crisis. [2]
A diagram of the elements of the subprime crisis
A diagram of the elements of the subprime crisis

The subprime mortgage crisis is an ongoing economic problem manifesting itself through liquidity issues in the global banking system owing to foreclosures which accelerated in the United States in late 2006 and triggered a global financial crisis during 2007 and 2008. The crisis began with the bursting of the US housing bubble[3][4] and high default rates on "subprime" and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later. 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 ARM interest rates reset higher. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.[5]

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 U.S. $379 billion as of May 21, 2008[6]. 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 lenders to reduce lending activity or to make loans at 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 the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.

The subprime crisis also places downward pressure on economic growth, because fewer or more expensive loans decrease investment by businesses and consumer spending, which drive the economy. A separate but related dynamic is the downturn in the housing market, where a surplus inventory of homes has resulted in a significant decline in new home construction and housing prices in many areas. This also places downward pressure on growth.[7] 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.[8] 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 February 13, 2008.[9][10][11] Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.


[edit] Background information

The term subprime lending refers to the practice of making loans to borrowers who do not qualify for market interest rates due 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,[12] with over 7.5 million first-lien subprime mortgages outstanding.[13]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.[14] By January 2008, the delinquency rate had risen to 21%[15] and by May 2008 it was 25%.[16]

Number of U.S. Household Properties Subject to Foreclosure Actions by Quarter
Number of U.S. Household Properties Subject to Foreclosure Actions by Quarter

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.[17]A total of nearly 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007, including those with prime, alt-A and subprime loans. This is double the 223,000 properties in the year-ago period and 34% higher than the 333,627 in the prior quarter.[18] This increased to 527,740 during the fourth quarter of 2007, an 18% increase versus the prior quarter. For all of 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.[19] More homeowners continue to receive foreclosure notices, with one in every 519 households receiving a foreclosure filling in April, 2008.[20]

The estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining.[21] An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.[22]

[edit] Understanding the causes and risks of the subprime crisis

The reasons for this crisis are varied and complex.[23] Understanding and managing the ripple effect through the world-wide economy poses a critical challenge for governments, businesses, and investors. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by the borrower and/or the lender; and mortgage incentives such as "teaser" interest rates that later rise significantly. Further, declining home prices have made re-financing more difficult. Due to 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: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is frequently transferred to third-party investors. The rights to mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing MBS or CDO and assuming credit risk, third-party investors receive a claim on the mortgage assets and related cash flows, which become collateral in the event of default.
  • Asset price risk: MBS and CDO asset valuation is complex and related "fair value" or "mark to market" accounting is subject to wide interpretation. The valuation is derived from both the collectibility of subprime mortgage payments and the existence of a viable market into which these assets can be sold, which are interrelated. Rising mortgage delinquency rates have reduced demand for such assets. Banks and institutional investors have recognized substantial losses as they revalue their MBS downward. Several companies that borrowed money using MBS or CDO assets as collateral have faced margin calls, as lenders executed their contractual rights to get their money back. There is some debate regarding whether fair value accounting should be suspended or modified temporarily, as large write-downs of difficult to value MBS and CDO assets may have exacerbated the crisis.[24]
  • Liquidity risk: Many companies rely on access to short-term funding markets for cash to operate (i.e., liquidity), such as the commercial paper and repurchase markets. Companies and structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected.[25] The amount of commercial paper issued as of October 18, 2007 dropped by 25%, to $888 billion, from the August 8 level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels. [26]
  • Counterparty risk: Major investment banks and other financial institutions have taken significant positions in credit derivative transactions, some of which serve as a form of credit default insurance. Due to the effects of the risks above, the financial health of investment banks has declined, potentially increasing the risk to their counterparties and creating further uncertainty in financial markets. The recent demise and bailout of Bear-Stearns was due in-part to its role in these derivatives.[27]

[edit] Understanding the 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. Some general exposures by entity type include:

  • Bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Companies value their mortgage assets (receivables) based on estimates of collections from homeowners. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables.[28] Additionally, a bank's mortgage losses may cause it to reduce lending or seek additional funds from the capital markets, if necessary to maintain compliance with capital reserve regulatory requirements.
  • Mortgage lenders and Real Estate Investment Trusts: These entities face similar risks to banks. In addition, they have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance secured by mortgages. Investors have become reluctant to fund such investments and are demanding higher interest rates. Such lenders are at increased risk of significant reductions in book value owing to asset sales at unfavorable prices and several have filed bankruptcy.[29]
  • Special purpose entities (SPE): Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called structured investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks.[30]
  • Investors: Stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection. Many investors and corporations purchased MBS or CDO as investments and incurred related losses.

[edit] Causes of the crisis

[edit] The housing downturn

Further information: United States housing market correction

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.[31]

This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%.[32] 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.[33]

A culture of consumerism is a factor. 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 with "consumerism... cast as the new patriotism". This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop"[34], and corporations like General Motors produced commercials with the same theme.

Existing Homes Sales, Inventory, and Months Supply, By Quarter
Existing Homes Sales, Inventory, and Months Supply, By Quarter

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.[35] Further, a record of nearly four million unsold existing homes were for sale,[36]including nearly 2.9 million that were vacant.[37]

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 housing price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their 2006 peak.[38]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[39] The price decline in December 2007 versus the year-ago period was 10.4%. As of February 2008, housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.

[edit] 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.[15]

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. (see 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.[40]

Mortgage fraud by borrowers from US Department of the Treasury
Mortgage fraud by borrowers from US Department of the Treasury [41]

Misrepresentation of loan application data is another contributing factor. In a January 13, 2008 column in the New York Times, George Mason University economics professor Tyler Cowen wrote, "There has been plenty of talk about 'predatory lending,' but 'predatory borrowing' may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study. The research was done by BasePoint Analytics, which helps banks and lenders identify fraudulent transactions; the study looked at more than three million loans from 1997 to 2006, with a majority from 2005 to 2006. Applications with misrepresentations were also five times as likely to go into default. Many of the frauds were simple rather than ingenious. In some cases, borrowers who were asked to state their incomes just lied, sometimes reporting five times actual income; other borrowers falsified income documents by using computers."[42]

US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005. [41]

[edit] 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 [43] , 9% in 1996 [44], 13% ($160 billion) in 1999 [43] , and 20% ($600 billion) in 2006.[44][45] 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.[46]

In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. One example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Another example 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 2004–2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[47]

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.[48]

[edit] Role of securitization

Borrowing Under a Securitization Structure
Borrowing Under a Securitization Structure

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.[49] 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.[50] The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006.[46] Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — were to blame for the current global credit crisis. [51]

[edit] 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 big financial incentives for selling complex, adjustable rate mortgages (ARMs), since they earn higher commissions. [52]

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. [53]

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. [54]

[edit] 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. [55] 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."[56] 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. [57]

[edit] Role of government and regulators

Some economists claim that government policy actually encouraged the development of the subprime debacle through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise uncreditworthy consumers.[58] [59] Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. [60] 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.[61]

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.[62]

In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.[63]

[edit] Role of credit rating agencies

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 justified by various credit enhancements including overcollateraliztion (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.[64]

As of April 2008, credit rating agencies had downgraded over U.S. $800 billion in highly-rated CDO and MBS, and more downgrades are expected. Since certain types of institutional investors are allowed to only carry higher-quality (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation.[65]

[edit] 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.[66] There is significant debate among economists regarding whether this is the optimal strategy.[67]

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.[68]

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.[66]. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[69] The central bank was concerned with promoting continued economic expansion after the dot-com bubble, and 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:

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.[70]

[edit] Effects

[edit] Effect on stock markets

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.[71] By August 15, 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, [72][dead link] 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 [73][dead link] [74] and home builders [75] [76][dead link] 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.[77]

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". Most of the recent increases in global food prices have been the result of speculation and the collapse in the value of the US dollar.[78][79]

[edit] Effect on financial institutions

See also: Subprime crisis impact timeline

Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of May 21, 2008 financial institutions had recognized subprime-related losses and write-downs exceeding U.S. $379 billion.[6]

Profits at the 8,533 U.S. banks insured by the FDIC declined from $35.2 billion to $5.8 billion (83.5 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 performance since the fourth quarter of 1991. For all of 2007, these banks earned $105.5 billion, down 27.4 percent from a record profit of $145.2 billion in 2006.[80]

Other companies from around the world, such as IKB Deutsche Industriebank [81], have also suffered significant losses [82][dead link] and scores of mortgage lenders have filed for bankruptcy.[83] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.[84] Various institutions follow-up with merger deals.[85]

In addition, Northern Rock and Bear Stearns[86] have required emergency assistance from central banks.

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.[87]

At least 100 mortgage companies have either shut down, suspended operations or been sold since 2007.[88]

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.[89].

[edit] 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.[90] [91]

[edit] 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, these insurers used premiums to purchase CDO investments and have suffered significant losses, which brings their ability to insure bonds into question. Unless these insurers obtain additional capital, rating agencies may downgrade the bonds they insured or guaranteed. In turn, this may 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.[92]

[edit] Effect on home owners

Further information: United States housing market correction

According to the S&P/Case-Shiller housing price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their 2006 peak.[38]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[39] The price decline in December 2007 versus the year-ago period was 10.4%. 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.[35]

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.[66]

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 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" [93].

[edit] Effect on jobs of the financial sector

According to Bloomberg, from July 2007 to March 2008 financial institutions laid off more than 34,000 employees.[88] 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.[94]

Also in April, Merril Lynch said that it planned to terminate 2,900 jobs by the end of the year.[95] At Bear Stearns there is fear that half of the 14,000 jobs could be eliminated once JP Morgan completes its acquisition.[88] Also that month, Wachovia cut 500 investment banker positions[96], Washington Mutual cut its payroll by 3,000 workers[97] and the Financial Times reported that RBS may cut up to 7,000 job positions worldwide.[98][99]. 40,000 workers in the City of London's financial district are expected to lose their jobs.

[edit] Effect on minorities

There is a disproportionate level of foreclosures in some minority neighborhoods. [100] [101]

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. [101]

[edit] 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.[102]

[edit] Actions to manage the crisis

[edit] 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."[15]

In August 2007, the Federal Open Market Committee announced that "downside risks to growth have increased appreciably," a signal that interest rate cuts might be forthcoming.[103] Between September 18, 2007 and April 30, 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.[104][105] The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank's lending facility via the Discount window.

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. [106] Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed securities. This helps these entities avoid selling the MBS at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline.

The Fed is utilizing 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 addition, term repurchase agreements expected to cumulate to $100 billion were announced, which enhance the ability of financial institutions to sell mortgage-backed and other debt. The Fed indicated that both the TAF and repurchase agreement amounts will continue and be increased as necessary.[107] During March 2008, the Fed also expanded the types of institutions to which it lends money and the types of collateral it accepts for loans.[108]

Fed Chairman Bernanke also delivered a speech March 4, 2008 titled "Reducing Preventable Mortgage Foreclosures." He advocated several solutions, including the reduction of loan principal amounts.[109] This solution was highlighted to address a growing concern that an estimated 8.8 million U.S. homeowners (10%) with negative equity (homes worth less than the mortgage principal) will have a financial incentive to "walk away" from the property, further exacerbating the crisis.[110]

In March 2008, the Fed also provided funds and guarantees to enable bank J.P. Morgan Chase to purchase Bear Stearns, a large financial institution with substantial mortgage-backed securities (MBS) investments that had recently plunged in value. This action 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.[111][112]In addition, Bear had taken on a significant role in the financial system via credit derivatives, essentially insuring against (or speculating regarding) mortgage and other debt defaults. The risk to its ability to perform its role as a counterparty in these derivative arrangements was another major threat to the banking system.[113]

[edit] Loan modification / 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., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives.[114]

President George W. Bush announced a plan voluntarily and temporarily to freeze the mortgages of a limited number of mortgage debtors holding ARMs, declaring "I have a message for every homeowner worried about rising mortgage payments: The best you can do for your family is to call (sic)" [115] the correct number 1-888-995-HOPE.[116]. A refinancing facility called FHA-Secure was also created. [117] This 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.[118]

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.[119] 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.[120]

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.[121][dead link]

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. [122]

[edit] Bank financial health

Major financial institutions had obtained over $260 billion in new capital (i.e., cash investments) as of May, 2008.[123] 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. [124] 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.[125]

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 January 15, 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.[126]

Certain major banks have also reduced their dividend payouts[127] to increase liquidity and further dividend reductions are expected by some analysts in 2008.[128]

[edit] 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.[129] 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.[130]

[edit] 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.[131] 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 help identify solutions and apply pressure to the various parties involved.[132]

A sweeping proposal was presented March 31, 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.[133]

The U.S House passed a bill in early April, 2008 that would offer government insurance on $300 billion in new mortgages to refinance loans for an estimated 500,000 borrowers facing foreclosure and an additional 15 billion to affected states to buy and fix foreclosed homes. [134]

[edit] 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 were not quantified but are 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.[135]

[edit] Media

The media can help educate the public and parties involved.[23] It can also ensure the top subject material experts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions.[136]

[edit] Economic Stimulus Act of 2008

President Bush also signed into law on February 13, 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth.[11] The economic stimulus package included the mailing of rebate checks to taxpayers. Such mailings started the week of April 28, 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.[137] [138]

[edit] Expectations and forecasts

As early as the 2003 Annual Report issued by Fairfax Financial Holdings Limited, Prem Watsa was raising concerns about securitized products:

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. Take the case of an automobile dealer. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. 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? Unlike…[139]

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm" [140]. 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" [141].

On September 7, 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.[142]

The Associated Press described the current climate of the market on August 13, 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."[not in citation given] 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" [143].

Citigroup economists stated in mid-March 2008 regarding the likelihood of a recession that “The self-feeding downturn now in place shows signs of becoming deeply entrenched.”[144]

As of November 22, 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion.[145] As of December 22, 2007, a leading business periodical estimated subprime defaults between U.S. $200–300 billion.[146] As of March 1, 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350–600 billion.[147]

On March 20, 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.[148]

Alan Greenspan, the former Chairman of the Federal Reserve, stated: "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." [66]

[edit] See also

The world housing bubble

[edit] References

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[edit] External links and further reading

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