Subprime Crisis and its impact on India
Subprime Mortgage Crisis[/b]
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 through 2007 and 2008. The crisis began with the bursting of the US housing bubble 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.
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. $435 billion as of July 17, 2008. 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.[8] 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.[9] 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.[10][11][12] Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
The term subprime lending refers to 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, with over 7.5 million first-lien subprime mortgages outstanding.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.[15] By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.
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. 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. More homeowners continue to receive foreclosure notices, with one in every 519 households receiving a foreclosure filling in April, 2008.
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. An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.
The reasons for this crisis are varied and complex. 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. 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: 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.
[/list]
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.
[/list]
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. 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.
[/list]
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.
[/list]
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. 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.
[/list]
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.
[/list]
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]
[/list]
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.
[/list]
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.
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%. 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.
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 and "Get down to Disney World in Florida." This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop", and corporations like General Motors produced commercials with the same theme.
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. Further, a record of nearly four million unsold existing homes were for sale, including nearly 2.9 million that were vacant.
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.[39]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[40] 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.
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.
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.
Mortgage fraud by borrowers from US Department of the Treasury
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."
US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005.
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. 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.
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.
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.
Critics note that the Bankruptcy Abuse Prevention and Consumer Protection Act did nothing to curtail the predatory practices of credit card companies, such as exorbitant interest rates, rising and often hidden fees, and targeting minors and the recently bankrupt for new cards. The bill's critics pointed out that these practices are themselves significant contributors to the growth of consumer bankruptcies.
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. 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. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. 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.
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.
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.
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.
Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting.
In 2007, 40 percent of all subprime loans were generated by automated underwriting. An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation." Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown.
Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. A taxpayer-funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumersand defenders claiming a thirty year history of lending without increased risk.
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.
In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.
Lawmakers received favorable treatment from financial institutions involved in the subprime industry; see Countrywide Financial political loan scandal, below.
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 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. On June 11, 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. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers.
As of July 2008, Standard & Poors (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS abd CDOs of ABS originally rated by S&P. Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation.
Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy.
Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf.
A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation.. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[76] 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. ”
Effect on stock markets[/b]
On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time. 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
Subprime Mortgage Crisis[/b]
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 through 2007 and 2008. The crisis began with the bursting of the US housing bubble 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.
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. $435 billion as of July 17, 2008. 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.[8] 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.[9] 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.[10][11][12] Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
Background information
The term subprime lending refers to 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, with over 7.5 million first-lien subprime mortgages outstanding.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.[15] By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.
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. 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. More homeowners continue to receive foreclosure notices, with one in every 519 households receiving a foreclosure filling in April, 2008.
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. An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.
The reasons for this crisis are varied and complex. 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. 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: 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.
[/list]
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.
[/list]
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. 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.
[/list]
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.
[/list]
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. 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.
[/list]
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.
[/list]
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]
[/list]
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.
[/list]
Causes of the crisis
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.
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%. 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.
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 and "Get down to Disney World in Florida." This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop", and corporations like General Motors produced commercials with the same theme.
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. Further, a record of nearly four million unsold existing homes were for sale, including nearly 2.9 million that were vacant.
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.[39]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[40] 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.
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.
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.
Mortgage fraud by borrowers from US Department of the Treasury
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."
US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005.
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. 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.
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.
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.
Critics note that the Bankruptcy Abuse Prevention and Consumer Protection Act did nothing to curtail the predatory practices of credit card companies, such as exorbitant interest rates, rising and often hidden fees, and targeting minors and the recently bankrupt for new cards. The bill's critics pointed out that these practices are themselves significant contributors to the growth of consumer bankruptcies.
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. 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. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. 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.
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.
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.
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.
Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting.
In 2007, 40 percent of all subprime loans were generated by automated underwriting. An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation." Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown.
Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. A taxpayer-funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumersand defenders claiming a thirty year history of lending without increased risk.
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.
In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.
Lawmakers received favorable treatment from financial institutions involved in the subprime industry; see Countrywide Financial political loan scandal, below.
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 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. On June 11, 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. The proposal would, among other things, prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available, prohibit credit rating agencies from structuring the same products that they rate, and require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. The last proposed requirement is designed to facilitate "unsolicited" ratings of structured securities by rating agencies not compensated by issuers.
As of July 2008, Standard & Poors (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A;" 466 of those downgrades of "triple-A" securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS abd CDOs of ABS originally rated by S&P. Since certain types of institutional investors are allowed to only carry investment-grade (e.g., "BBB" and better) assets, there is an increased risk of forced asset sales, which could cause further devaluation.
Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy.
Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf.
A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation.. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[76] 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. ”
Effects
Effect on stock markets[/b]
On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time. 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