Background information
Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. The word Subprime refers to the credit-worthiness of the borrower (being less than ideal) and does not refer to the interest rate of the loan. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody's or other rating firms, albeit for an "alternative" means.
The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,[10] with over 7.5 million first-lien subprime mortgages outstanding.[11]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.[12] By January of 2008, the delinquency rate had risen to 21%.[13]
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.[14]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.[15] 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.[16]
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.[17] An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.[18]
Understanding the causes and risks of the subprime crisis
The reasons for this crisis are varied and complex.[19] Understanding and managing the ripple effect through the world-wide economy poses a critical challenge for governments, businesses, and investors. Due to innovations in securitization, the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgement by either the borrower or the lender; inappropriate mortgage incentives, and rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. There are three 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, owing to innovations in securitization, credit risk is now shared more broadly with investors, because the rights to these 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 the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. Further, the MBS investor has the right to cash flows related to the mortgage payments. To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create separate legal entities, called special-purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively sell the mortgage assets (i.e., banking accounts receivable, which are the rights to receive the mortgage payments) to these SPE. In turn, the SPE then sells the MBS to the investors. The mortgage assets in the SPE become the collateral.
- Asset price risk: CDO valuation is complex and related "fair value" accounting for such "Level 3" assets is subject to wide interpretation. This valuation fundamentally derives from the collectibility of subprime mortgage payments, which is difficult to predict owing to lack of precedent and rising delinquency rates. Banks and institutional investors have recognized substantial losses as they revalue their CDO assets downward. Most CDOs require that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows, collateral ratings, or market values. For deals with market value tests, if the valuation falls below certain levels, the CDO may be required by its terms to sell collateral in a short period of time, often at a steep loss, much like a stock brokerage account margin call. If the risk is not legally contained within an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types of assets, as well, to satisfy the terms of the deal. In addition, credit rating agencies have downgraded over U.S. $50 billion in highly-rated CDO and more such downgrades are possible. Since certain types of institutional investors are allowed to only carry higher-quality (e.g., "AAA") assets, there is an increased risk of forced asset sales, which could cause further devaluation.[20]
- Liquidity risk: A related risk involves the commercial paper market, a key source of funds (i.e., liquidity) for many companies. Companies and SPE called 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.[21] 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.[22]
Understanding the effect on corporations and investors
- related loss
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.[23]
- 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.[24]
- 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.[25]
Causes of the crisis
a) The housing downturn
Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent.[26]
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%.[27] 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.[28]
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 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"[29], and corporations like General Motors produced commercials with the same theme.
Overbuilding during the boom period, increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available. Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981.[30] Further, a record of nearly four million unsold existing homes were available.[31]
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.[32]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[33] 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.
b) 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.[13]
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.[34]
Misrepresentation of loan application data is another contributing factor. In a January 13, 2008New York Times, George Mason University economics professor Tyler Cowen[36] column in the 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. [35]
c) 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 [37] , 9% in 1996 [38], 13% ($160 billion) in 1999 [37] , and 20% ($600 billion) in 2006.[38][39] 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.[40]
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.[41]
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.[42]
[edit] Role of securitization
Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment.[43] 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.[44] The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006.[40] 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. [45]
d) Role of mortgage brokers
Mortgage brokers don't lend their own money. There is not a direct correlation between loan performance and compensation. They have big financial incentives for selling complex, adjustable rate mortgages (ARM's), since they earn higher commissions. [46]
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. [47]
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. [48]
e) 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. [49] 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."[50] 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. [51]
f) 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.[52] [53] Economist Robert KuttnerGlass-Steagall Act as contributing to the subprime meltdown. [54]Savings and Loan crisis[55] has criticized the repeal of the A taxpayer-funded government bailout related to mortgages during the may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans.
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.[56]
In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.[57]
g) Role of credit rating agencies
Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings are theoretically due to the multiple, independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play.
h) 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 dotcom 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.[58][59] 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.[60]
A potential 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.[58]
i) Effects
Company  | Business Type | Loss (Billion $) |
|---|---|---|
 Citigroup | investment bank | $24.1 bln [61] [62] [63] |
| Merrill Lynch | investment bank | $22.5 bln [64] [65] |
 UBS AG | investment bank | $18.7 bln [66] [67] |
| Morgan Stanley | investment bank | $10.3 bln [68] [69] |
 Crédit Agricole | bank | $4.8 bln [70] |
 HSBC | bank | $17.2 bln [71][72] |
| Bank of America | bank | $9.4 bln [73] |
 CIBC | bank | $3.2 bln [74] |
 Deutsche Bank | investment bank | $3.1 bln [75] [76] |
| Barclays Capital | investment bank | $3.1 bln [77] |
| Bear Stearns | investment bank | $2.6 bln [78] [79] |
| RBS | bank | $3.5 bln [80][81][82] |
| Washington Mutual | savings and loan | $2.4 bln [83] [84] |
| Swiss Re | re-insurance | $1.07 bln [85] |
| Lehman Brothers | investment bank | $2.1 bln [86] [87] |
| LBBW | bank | $1.1 bln [88] |
| JP Morgan Chase | investment bank | $2.9 bln [89] [69] |
| Goldman Sachs | investment bank | $1.5 bln [90] [68] |
| Freddie Mac | mortgage GSE | $3.6 bln [91] [92] |
| Credit Suisse | bank | $3.7 bln [93] |
| Wells Fargo | bank | $1.4 bln [94] |
| Wachovia | bank | $3.0 bln [95] [96] |
| RBC | bank | $0.360 bln [97] [98] |
| Fannie Mae | mortgage GSE | $0.896 bln [99] |
| MBIA | bond insurance | $3.3 bln [100] |
| Hypo Real Estate | bank | $0.580 bln [101] |
| Ambac Financial Group | bond insurance | $3.5 bln [102] [103] [104] |
| Commerzbank | bank | $1.1 bln [105] |
| Société Générale | investment bank | $3.0 bln [106] [107] |
| BNP Paribas | bank | $0.870 bln [108] [109] |
| WestLB | bank | $1.37 bln [110] [111] |
| American International Group | insurance | $11.1 bln [112][113] |
| BayernLB | bank | $2.8 bln [114] |
| Natixis | bank | $1.75 bln [115] |
| Countrywide | mortgage bank | $1.0 bln [116] |
| DZ Bank | bank | $2.1 bln [117] |
 Fortis | bank | $2.3 bln [118] |
 ICICI Bank | bank | $0.264 bln [119] |
| Business | Type | Date |
|---|---|---|
| New Century Financial | subprime lender | April 2, 2007 |
| American Home Mortgage | mortgage lender | August 6, 2007 |
| Sentinel Management Group | investment fund | August 17, 2007 [120] |
| Ameriquest | subprime lender | August 31, 2007 |
| NetBank | on-line bank | September 30, 2007[121] |
 Terra Securities | securities | November 28, 2007 [122] |
| American Freedom Mortgage, Inc. | subprime lender | January 30, 2007 [123] |
j) 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.[124] 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[125] although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis. dropping about 7% in one day,
Mortgage lenders [126] [127] and home builders [128] [129] 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.[130]
k) Effect on financial institutions
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 March 16, 2008 financial institutions had recognized subprime-related losses or write-downs exceeding U.S. $175 billion.
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.[131]
Other companies from around the world, such as IKB Deutsche Industriebank [132], have also suffered significant losses [133] and scores of mortgage lenders have filed for bankruptcy.[134][135] Various institutions follow-up with merger deals.[136] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.
In addition, Northern Rock and Bear Stearns[137] have required emergency government bailouts.
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.[138]
l) 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 Jan 2008, the 2007 numbers were not yet available.[139] [140]
m) Effect on municipal bond "monoline" insurers
A secondary cause and effect of the crisis relates to the role of municipal bond "monoline" insurance corporations. 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.[141]
n) Effect on home owners
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.[32]However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.[33] 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.[30]
Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels. As MBS and CDO valuation is related to the value of the underlying housing collateral, MBS and CDO losses will continue until housing prices stabilize.[142]
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 chi$ldren" [143].
o) Effect on minorities
There is a disproportionate level of foreclosures in some minority neighborhoods. [144] [145]
About 46% of Hispanics and 55% of blacks 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. [145]
p) Actions to manage the crisis
- 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.[146] 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. [147]
- 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.[148]
- Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.[149] 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.[150]
- The media can help educate the public and parties involved.[19] 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.[151]
- Banks have sought and received additional capital (i.e., cash investments) 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. 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. 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.[152]
- 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.[153]
q) President Bush administration's plan
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 1-800-995-HOPE (sic)" [154]. The correct number is 1-888-995-HOPE.[155]. A refinancing facility called FHA-Secure was also created. [156] 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.[157]
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.[158] 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.[159]
The U.S. Treasury Department is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing ARM increases, rather than working through loans on a case-by-case basis.[160]
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.[9]
r) 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."[13]
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.[161]Federal funds rate was lowered from 5.25% to 2.25% and the discount rate was lowered from 5.75% to 2.5%, through five separate actions.[162][163] 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. Between September 18, 2007 and March 18, 2008, the target for the
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. [164]subprime crisis impact timeline. 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
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.[165] 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.[166]
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.[167] 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.[168]
In March 2008, the Fed also provided funds and guarantees to enable bank J.P. Morgan ChaseBear 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, potentially destabilizing other major financial institutions.[169][170] to purchase
s) 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…[171] | ” |
The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm" [172]. 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" [173].
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.[174]
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" [175].
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.”[176]
As of November 22, 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion.[177] As of December 22, 2007, a leading business periodical estimated subprime defaults between U.S. $200-300 billion.[178] As of March 1, 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350-600 billion.[179]
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." [142
