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Subprime mortgage crisis

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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 financial crisis characterized by contracted liquidity in global credit markets and banking systems. A downturn in the housing market of the United States, risky practices in lending and borrowing, and excessive individual and corporate debt levels have caused multiple adverse effects on the world economy. The crisis, which has roots in the closing years of the 20th century but has become more apparent throughout 2007 and 2008, has passed through various stages exposing pervasive weaknesses in the global financial system and regulatory framework.

The crisis began with the bursting of the United States housing bubble[1][2] and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. For a number of years prior to that, declining lending standards, an increase in loan incentives such as easy initial terms, and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.[3]

Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008.[4][5] In addition, 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 intervene by bailing out defaulting financial corporations in order to encourage lending to worthy borrowers at the expense of taxpayers.

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.[6][7][8] During the week of September 14, 2008 the crisis accelerated, developing into a global financial crisis. Following a series of ad-hoc market interventions to bail out particular firms, a $700 billion proposal was presented to the U.S. Congress in September, 2008. These actions are designed to stimulate economic growth and inspire confidence in the financial markets. On 3 October 2008, President George W. Bush signed the amended version of the bill into law.



[edit] Economic background

Number of U.S. household properties subject to foreclosure actions by quarter.

Number of U.S. household properties subject to foreclosure actions by quarter.

Understanding financial leverage.

Understanding financial leverage.

Further information: Subprime crisis background information

Subprime lending is the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,[9] with over 7.5 million first-lien subprime mortgages outstanding.[10] 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.[11] By January 2008, the delinquency rate had risen to 21%[12] and by May 2008 it was 25%.[13]

The U.S. mortgage market is estimated at $12 trillion[14] with approximately 9.2% of loans either delinquent or in foreclosure through August 2008.[15] Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007.[16] During 2007, nearly 1.3 million properties were subject to foreclosure filings, up 79% versus 2006.[17]

[edit] Understanding the risks of default

Traditionally, banks lent money to homeowners for their mortgage and retained the risk of default, called credit risk. However, due to financial innovations, banks can now sell rights to the mortgage payments and related credit risk to investors, through a process called securitization. The securities the investors purchase are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). This new "originate to distribute" banking model means credit risk has been distributed broadly to investors, with a series of consequential impacts. There are four primary categories of risk involved: credit risk, asset price risk, liquidity risk, and counterparty risk. Each of these risk types is described separately in the background information.

[edit] Understanding the market mechanisms affecting corporations and investors

There is a greater interdependence now than in the past between the U.S. housing market and global financial markets due to MBS. When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain. Investors and businesses holding MBS have been significantly affected. The effect is magnified by the high debt levels maintained by individuals and corporations, sometimes called financial leverage. The mechanisms through which a decline in housing prices affects market participants is described separately in the background information.

[edit] Causes of the crisis

The reasons for this crisis are varied and complex.[18] The crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period of time. Some of these include: the inability of homeowners to make their mortgage payments, poor judgment by the borrower and/or the lender, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovation that distributed and perhaps concealed default risks, central bank policies, and regulation (or lack thereof).[19]

[edit] Boom and bust in the housing market

Further information: United States housing bubble, United States housing market correction

Existing homes sales, inventory, and months supply, by quarter.

Existing homes sales, inventory, and months supply, by quarter.

Common indexes used for adjustable rate mortgages (1996–2006).

Common indexes used for adjustable rate mortgages (1996–2006).

A combination of low interest rates and large inflows of foreign funds help create easy credit conditions for many years leading up to the crisis.[20] Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%.[21]

This demand helped fuel housing price increases and consumer spending.[22] Between 1997 and 2006, American home prices increased by 124%.[23] 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.[24] A culture of consumerism is a factor "in an economy based on immediate gratification".[25][citation needed]

Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline, beginning in the summer of 2006. Easy credit, combined with the assumption that housing prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages (ARMs) they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S., 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.

An estimated 8.8 million homeowners — nearly 10.8% of total homeowners — had zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provided an incentive to "walk away" from the home, despite the credit rating impact.[26]

Increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices had 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.[27] Further, a record of nearly four million unsold existing homes were for sale,[28] including nearly 2.9 million that were vacant.[29]

This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure. According to the S&P/Case-Shiller price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2 2006 peak[24] and by May 2008 they had fallen 18.4%.[30] The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%.[31] Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.

[edit] Speculation

Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences. NAR's chief economist at the time, David Lereah, stated that the fall in investment buying was expected in 2006. "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."[32]

While homes had not traditionally been treated as investments like stocks, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported the behavior of purchasing condominiums prior to completion, then "flipping" (selling) them for a profit without ever living in the home.[33] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.[34]

Keynesian economist Hyman Minsky described three types of speculative borrowing that can contribute to the accumulation of debt that eventually leads to a collapse of asset values:[35][36] the "hedge borrower" who borrows with the intent of making debt payments from cash flows from other investments; the "speculative borrower" who borrows based on the belief that they can service interest on the loan but who must continually roll over the principal into new investments; and the "Ponzi borrower" (named for Charles Ponzi), who relies on the appreciation of the value of their assets (e.g. real estate) to refinance or pay-off their debt but cannot repay the original loan.

The role of speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.[37]

[edit] High-risk loans

“ Subprime is Wall Street's euphemism for junk. ”

—Andy Serwer and Allan Sloan, How Financial Madness Overtook Wall Street, TIME, September 18, 2008

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,[38] 9% in 1996,[39] 13% ($160 billion) in 1999,[38] and 20% ($600 billion) in 2006.[39][40][41] 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.[42]

In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans.

Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[43]

The Center for Responsible Lending, in its report on IndyMac, related testimony that the bank actually made efforts to avoid having income information about some borrowers.[44] The Associated Press has reported that a federal grand jury is investigating subprime lenders Countrywide Financial Corp., New Century Financial Corp. and IndyMac Bancorp Inc. and reports also that the FBI is investigating IndyMac for possible fraud.[45] The question, then, is whether banks and other private mortgage originators of subprime and other "nonprime" loans might deliberately have profited or attempted to profit - in moneys, economic benefit or even fraudulent gain - through reducing the amount of information they collected from borrowers.

Judge Leslie Tchaikovsky of the U.S. Bankruptcy Court for the Northern District of California, found on 25 May 2008 that even though a pair of borrowers had, indeed, misrepresented their incomes on a "stated income" home equity loan, National City Bank's "reliance" on these statements of income "was not reasonable based on an objective standard".[46]

The banking industry provided home loans to undocumented immigrants, viewing it as an untapped resource for growing their own revenue stream.[47][48] Pro-immigrant expert Tim Ready at the University of Notre Dame argued that "It's really important to the economy as a whole and to the real estate market in particular that Latinos be able to purchase a home."[49] Banks, including some major institutions, offered home-mortgage loans to people who don't have Social Security numbers.[50]

[edit] Securitization practices

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.[51] 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.[52]

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006.[42] Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — was to blame for the current global credit crisis.[53]

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.[54]

[edit] Inaccurate credit ratings

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

MBS credit rating downgrades, by quarter.

MBS credit rating downgrades, by quarter.

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses.[citation needed] These high ratings encouraged the flow of investor funds into these securities, helping finance the housing boom. The reliance on ratings by these agencies and the intertwined nature of how ratings justified investment led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities and furthered by SEC removal of regulatory barriers and reduced disclosure requirements in the wake of the Enron scandal.[55] 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.[56] On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.[57]

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower.[58]

[edit] Mortgage fraud

Mortgage fraud by borrowers from US Department of the Treasury.

Mortgage fraud by borrowers from US Department of the Treasury.[59]

Misrepresentation of loan application data and mortgage fraud are other contributing factors.[60] US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411% between 1997 and 2005.[59]

[edit] Flawed oversight by mortgage brokers

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.[61]

The chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but did not do enough to examine whether borrowers could repay.[62]

[edit] Excessive underwriting of high-risk mortgages

Underwriters (working for the actual banks who lend the money, not mortgage brokers) 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% of all subprime loans were generated by automated underwriting.[63] 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."[64] 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.[65]

[edit] Government policies

Several critics have commented that the current regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws. Recently, we've seen how one company can grow so large that its failure jeopardizes the entire financial system."[66] The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.[67][68]

Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree.[69][70] 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.[71] Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers[72][73][74][75] and defenders claiming a thirty year history of lending without increased risk.[76][77][78][79] Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages.[80][81] A study by a legal firm which counsels financial services entities on Community Reinvestment Act compliance found that CRA-covered institutions were less likely to make subprime loans, and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.[82]

Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged

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