A Brief Overview of the Subprime Crisis Essay Example

by over 35% in less than a decade. As a result, there was widespread expectation that this growth trend would persist.

S&P/Case-Shiller Home Price Index (Source: Bloomberg) The rise of homeownership in the United States was aided by accessible credit and foreign investment during the early 2000s. This was enabled by a record-low Federal funds target rate of 1% and a substantial surge in household debt, which grew to $12 trillion from its previous amount of $4.85 trillion in 1995 (equivalent to 65.5% of GDP).

According to Bloomberg, the US household debt reached 4 trillion by mid-2006, accounting for 93% of GDP. Additionally, M. Bush and J. Katz report in their publication 'Reinvestment Alert' from Woodstock Institute (p. 1) that from 1994 to the third quarter of 2005, the US household debt as a percentage of annual personal disposable income increased from 88% to 126%.

From 1995 to 2005, a significant portion of household debts were used for financing home purchases. During this ten-year period, the total amount of mortgage originations increased remarkably by over 350%, from $640 billion to $2.9 trillion (Source: Mortgage Bankers Association of America, Washington, DC, '1-4 Family Mortgage Originations 1990-2005'). Moreover, outstanding mortgage debts for houses with one to four family members also grew substantially, rising from $3.5 trillion (accounting for 72% of the household debts) in 1995 to $9 trillion.

According to a 2005 report by the US Census Bureau, the mortgage market received $3 trillion in investments, accounting for 75% of the overall market. This information can be found on The US Census Bureau's website at www.census.gov/compendia/statab/2011/tables/11s1191.pdf. Consequently, there was an increase in homeownership rates in the United States. Previously stagnant

around 64% for many years, this rate began rising in the mid-1990s and reached 69% by 2004 as reported by Bloomberg. The growth in homeownership was attributed to an increase in US households, which rose from 98.

Based on data from the U.S. Census Bureau's Current Population Reports and Statistical Abstract of the United States, there was a notable surge in US homeownership between 2008. The number of homeowners grew by 13.9 million, resulting in a total count of 112 million compared to the initial figure of 99 million.

Speculation in the housing market is thought to have contributed to the rise in home prices. In the early 2000s, while the housing market experienced an average annual growth rate of 11.34%, the US stock market remained stagnant following the burst of the dot-com bubble in 2000. Furthermore, due to a low federal fund rate, investors did not find appealing coupons or yields in the bond market. As a result, investors turned their attention towards the housing market for greater investment returns.

The Economist's 16th June 2005 issue reported that over 40% of houses bought in 2005 were not intended as primary residences. Among this percentage, 28% were acquired for investment purposes and 12% were purchased as vacation homes. The following year, the proportion of houses bought for investment purposes increased to nearly 35%. The magazine noted that investors were acquiring properties that would not generate sufficient rental income to cover their monthly mortgage payments. They believed that the value of these investment properties would appreciate over time. Some investors, known as 'flippers', even engaged in purchasing and selling newly constructed properties before completion with hopes of making substantial

profits. In Miami, up to half of the original buyers participated in this practice by reselling new apartments.

In 2005, a source from the Economist stated that properties often change ownership multiple times before being occupied. This information was mentioned in an article titled "In Come the Wave". Furthermore, economists Karl E. Case and Robert J. Shiller noticed a surge in speculative articles about the US housing market during the early 2000s. Some of these articles speculated that there was a significant bubble in the market and warned of its potential collapse.

According to a survey conducted in 2003 by Case and Shiller, the general public did not show significant concern about the housing market bubble despite media coverage. The survey involved 700 homebuyers who bought residential properties in 2002 and revealed that most of them did not perceive the housing market as being in a bubble (K. E. Case & R. J. Shiller, 2004, 'Is There a Bubble in the Housing Market?', Cowles Foundation Paper No.).

In December 2004, the Federal Reserve Bank of New York released an economic policy review discussing concerns regarding the US housing market. They refuted fears of a housing bubble and major decline in weak economic conditions by asserting that the surge in home prices was linked to higher personal income and lower interest rates. Between 1990 and 2003, median household income experienced a roughly 50% growth. Additionally, the average nominal interest rate for 30-year fixed-rate conventional mortgages decreased from just above 10% in 1990 to 5.75% in 2003.

According to McCarthy ; Peach (2004, p. 6), these factors led to a nearly 130% rise in the maximum mortgage amount that a household

with the median income could borrow. Even Case and Shiller, who predicted a bubble in the housing market and potential harm to homeowners in coastal regions of the US if there was a market correction, did not expect a nationwide sharp decline in prices. They believed that certain areas might not even experience declines for several years.

According to Case ; Shiller (2004, pp. 341-342), there was a widely held perspective among government officials, academics, and the general public that home prices in the US were expected to either moderately decrease or not increase at all.

Causes of the Subprime Mortgage Crisis

The subprime mortgage crisis can be attributed to a combination of low interest rates and significant inflows of foreign funds. These factors resulted in an increase in mortgage originations and household debts, which ultimately led to the US housing bubble. The bursting of this bubble was driven by housing speculation.

However, the household lending/mortgage market's expansion cannot be solely attributed to these factors. Instead, it was a result of various interconnected factors including lending/borrowing practices, government policies (both financial and social/economic), financial innovation, and business practices on Wall Street.

In terms of mortgages and lending/borrowing practices, there was a staggering 350% surge in mortgage originations from 1995 to 2005. Furthermore, the total outstanding mortgage debts for 1-to-4 family houses experienced a 165% increase, growing from $3.5 trillion (72% of household debts) in 1995 to $9 trillion.

In 2005, the US experienced a 75% increase in available credit amounting to 3 trillion. This growth occurred despite a mere 14.5% rise in the number of households. The expansion of credit was facilitated through credit easing, enabling individuals with lower credit scores,

known as "subprime" borrowers, to access more credit. However, these borrowers are more likely to face difficulties in making their monthly repayments promptly. Consequently, mortgages provided to this group feature higher interest rates and less advantageous terms intended to mitigate the elevated credit risk.

Subprime mortgage originations increased due to various factors, particularly lending and borrowing practices. Initially, as the housing market became more competitive, mortgage qualifications became more relaxed. This resulted in the creation of new mortgage loans specifically designed for subprime borrowers. These included Stated Income Verified Asset Loans (SIVA), No Income Verified Asset Loan (NIVA), and No Income No Asset Loan (NINA), each with different requirements. Among these options, NINA was the most lenient choice as it did not require income or asset verification. Lenders only considered the borrower's credit score.

Furthermore, in conjunction with relaxed guidelines, the advancement of new financial technology allowed mortgage lenders to swiftly analyze numerous applications online without verifying necessary documentation. First Franklin Financial, a prominent subprime mortgage lender in the United States, pioneered this software engineered by a former NASA employee. By 2005, during the height of the housing market upturn, First Franklin processed a staggering 50,000 subprime loan applications per month, a seven-fold increase from before. Since its launch in 1999, this software facilitated the extension of a remarkable $450 billion worth of loans to subprime borrowers (L.

In his article 'the Subprime Loan Machine' published in the New York Times, Browning (23/03/2007) explores the impact of low down payment loans on housing affordability. Browning suggests that these loans created a misleading perception that buying a house was possible for those unable to afford a significant down payment.

An examination in 2005 uncovered that first-time homebuyers had a median down payment of only 2%, with 43% making no down payment at all (N.).

According to Knox (1/17/2006) in USA Today, 43% of first-time homebuyers did not provide a down payment. In addition, subprime borrowers often received riskier mortgages compared to traditional fixed rate mortgages. These riskier options included Option ARMs and 3/27 ARMs. Option ARMs allowed borrowers to choose their monthly payment amount while 3/27 ARMs had a low interest rate for the initial 3 years before transitioning into a variable rate semiannually or annually for the remaining 27 years. Borrowers with poor credit scores were attracted to these types of ARMs because of their affordable monthly payments but overlooked potential risks like fluctuating interest rates and poor payment management. This could result in significant increases in monthly repayments and mortgage balance, making refinancing difficult. Despite these dangers, mortgage lenders had an incentive to issue more mortgages quickly in order to earn higher commissions. This also motivated individuals with lower credit scores to pursue homeownership through a mortgage.

In 1995, subprime mortgage accounted for 10.2% ($65.28 billion) of the total mortgage originations valued at $640 billion (J). By 2005, this percentage had risen to 21% ($655.2 billion) of the $3.12 trillion mortgage originated that year (J).

According to a study conducted by R. Barth from Auburn University and the Milken Institute in 2008, the collapse of the subprime mortgage market in the U.S. had a significant impact. The study found that the outstanding debt from subprime mortgages increased from $370 billion in 2000 to $1.14 trillion in 2005, tripling during that period (Source: USA Today, http://www).

The

Federal Reserve tightened its monetary policy in 2004 by raising the federal funds target rate, available at data360.org/dsg.aspx?Data_Set_Group_Id=1363. This led to an increase in the rate from 1% to 5% within a span of less than 2 years. Moreover, a housing market slowdown was observed in 2006.

The increase in refinance costs and the rise in foreclosure rates around 2007 can be attributed to mortgage fraud. Risky mortgage and lending practices, characterized by relaxed mortgage qualification guidelines and documentation requirements, created an environment conducive to the flourishing of mortgage fraud activities. Collapsing lending standards and lax tax regulations facilitated this phenomenon. Weak underwriting standards and ineffective management practices allowed mortgage fraud operators to exploit lending institutions without being detected. Mortgage fraud schemes involve the use of material misstatements, misrepresentations, or omissions regarding the property or potential borrower, which underwriters rely on to provide funding, purchase, or insure a loan. Perpetrators of mortgage fraud often deceive lenders about the value of collateral or their qualifications for obtaining a loan, intending to steal the loan proceeds without intention of repayment. (Source: 2009 Financial Crimes Report, The FBI).

According to the FBI (source), mortgage fraud includes various deceptive practices, such as inflated appraisals, stolen or fictitious identities, nominee buyers, false loan applications, fraudulent loan documents, and kickbacks. These activities often result in lenders holding overvalued properties and experiencing significant financial losses. Prior to the subprime crisis, there was a substantial increase in Suspicious Activity Reports (SARS) related to mortgage fraud. The number of mortgage fraud SARS submitted by federally-insured financial institutions increased from 6,396 in FY2003 to 67,190 in FY2009, demonstrating exponential growth of more than tenfold.

The total dollar loss

resulting from mortgage fraud is not available, but losses reported by depository institutions to about US$1.5 billion in FY 2008 and nearly $1.2 billion in the first half of FY 2009 (Source: The Detection and Deterrence of Mortgage Fraud Against Financial Institutions: A White Paper, Produced by the July 13 – 24, 2009 FFIEC Fraud Investigations Symposium).

According to a study, the loss resulting from fraud on mortgage loans made between FY2005 and FY2007 is estimated to be US$112 billion, as noted by the Subprime mortgage crisis – Wikipedia, the free encyclopedia. The chart displays the estimated losses from mortgage fraud between FY2004 and FY2009. The information can be found in the Stats ; Services, Reports ; Publication, Mortgage Fraud Report 2008 by the FBI. Additionally, the text mentions securitization practices, which involve bundling loans or other income generating assets to create bonds that can be sold to investors. This process is a modern version of securitization in the U.S.

Mortgage securitization originated in the 1980s when Government Sponsored Enterprise (GSEs) began combining secure conventional conforming mortgages, selling bonds to investors, and providing guarantees against defaults on the underlying mortgages (Source: Competition and Crisis in Mortgage Securitization, Michael Simkovic). However, as time passed, the US government relaxed regulations on mortgage securitization, allowing private banks to bundle non-conforming mortgages for securitization without guaranteeing the bonds against defaults. Unlike GSE securitization, these bonds transfer both the interest rate risk and default risks to the investors. Despite their higher risk, these subprime non-guaranteed securities remained popular among investors. This was partly due to the significant growth in wealth in emerging economies since the 1990s, which created a global pool of

investors searching for maximum returns.

Approximately $70 trillion in worldwide fixed income investments was created, forming a large pool of money that was constantly seeking a high rate of return. This pool of money doubled in size between 2000 and 2007. However, there were not enough lucrative investments available to satisfy the demand. In response to market needs, investment banks introduced products such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which offered higher yields than those provided by the U.S. (Source: Finance Markets, Financial Crisis Of 2007-2009- Causes And Impact On Global Economy Part II).

According to the Federal Reserve Statistical Release, as of the second quarter of 2011, the total U.S. mortgage debt outstanding is approximately $13.7 trillion.

According to the Securities Industries and Financial Markets Association Statistical Release, the total value of U.S. mortgage-related securities is approximately $8.5 trillion.

Around $7 trillion of the total mortgage market is secured or guaranteed by government sponsored enterprises or government agencies, while approximately $1.5 trillion is pooled by private mortgage conduits, according to the Federal Reserve Statistical Release. Taking into account Credit Default Swaps, the size of mortgage backed securities could reach tens of trillions. Critics argue that the complexity of securitization can hinder investors from effectively assessing risk, especially in competitive markets with multiple securitizers, which can lead to a decline in underwriting standards. Competitive private mortgage securitization is believed to have played a significant role in the U.S. subprime mortgage crisis.

According to Michael Simkovic in "Competition and Crisis in Mortgage Securitization," off-balance sheet treatment and issuer guarantees make the securitizing firm's leverage less transparent, enabling risky capital structures and under-priced credit risk. These off-balance sheet securitizations

were a significant factor in the high leverage ratio of US financial institutions prior to the financial crisis. The information is sourced from "Secret Liens and the Financial Crisis of 2008" published in the American Bankruptcy Law Journal, Volume 83, page.

253, 2009, Michael Simkovic) Credit rating agencies are companies that assign credit ratings for issuers of debt obligations and the debt instruments themselves. The credit rating assigned to the issuer often considers the credit worthiness of the issuer and affects the interest rate applied to the debt obligation. Credit ratings are utilized by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies expand investment options and offer independent, user-friendly measurements of relative credit risk; this typically enhances market efficiency and reduces costs for borrowers and lenders. Consequently, this boosts the overall availability of risk capital in the economy, leading to stronger growth.

According to Wikipedia, the credit rating agency industry is dominated by three major companies: Standard & Poor's, Moody's Investors Services, and Fitch Ratings. Standard & Poor's and Moody's each have a 40% market share, while Fitch Ratings controls 14% of the market. The Financial Crisis Inquiry Commission stated in January 2011 that these three agencies played a crucial role in the financial crisis.

The rating agencies played a crucial role in the marketing and sale of the mortgage-related securities that caused the crisis. Investors heavily relied on their approval, sometimes without question, and there were instances where their use was mandatory or influenced regulatory capital standards. It is undeniable that the rating agencies were integral to the occurrence of this crisis.

According to the FCIC Final Report - Conclusions from January 2011, the

ratings of Credit Rating Agencies had a significant impact on the market. Specifically, their downgrades during 2007 and 2008 caused chaos in both markets and firms. These agencies have faced widespread criticism for their errors in judgment when rating structured products, particularly in giving AAA ratings to structured debt that was later downgraded or defaulted in a large number of cases. The table below displays the quantity and rate of downgrades on Mortgage-Backed Securities (MBS), which ultimately led to the subprime crisis. Additionally, there has been scrutiny regarding Moody's method of rating CDOs.

If default models contain biased default data and underestimate the true level of expected defaults, the default distribution process of Moody's method will produce an inappropriate level of average defaults. Consequently, the perceived default probability of rated tranches from high yield CDOs will be inaccurately biased downwards, providing a false sense of confidence to rating agencies and investors (Source: Wadden IV, William "Biv" (2002). "Interpreting Moody’s Historical Default Rate Data"). The fact that rating agencies have made little effort to address these issues indicates a lack of motivation for providing accurate credit ratings in the modern CRA industry.

The development of an incestuous relationship between financial institutions and credit agencies resulted in banks leveraging the credit ratings among each other and shopping for the best ratings for their CDOs. They would frequently modify loans of different qualities until they met the minimum standards for a desired AAA rating. Typically, the fees for these ratings ranged from $300,000 to $500,000, but sometimes reached up to $1 million. (Source: Wayne, Leslie (15 July 2009).

"Calpers is taking legal action against the ratings of securities" (source: The New

York Times). A significant number of the rated financial products were comprised of lower quality 'BBB' rated loans. However, these products were given an AAA rating when bundled into CDOs. Another factor contributing to this issue is the structure of the Basel II agreement, which allows banks to determine their capital reserve requirements based on credit ratings. As per Basel II guidelines, a securitization with an AAA rating only needs a capital allocation of 0.6%, whereas a BBB rated securitization requires 4%.

The capital requirements for CDOs increased significantly due to multiple downgrades on CDO and MBS portfolios under the Basel II agreements. This led to a capital squeeze during the subprime crisis. Both government regulation and deregulation played a role in the subprime mortgage crisis. The existence of low-quality mortgages raised concerns about the impact of government policies. In 1982, the US Congress passed the Alternative Mortgage Transaction Parity Act, which aimed to promote home ownership through Adjustable Interest Rate Mortgages.

This new system gained popularity and was credited for replacing fixed-rate, amortizing mortgages. While some politicians and financial industries claimed that this system caused a mortgage crisis, the Federal Reserve Economics and independent academic research advise that this claim was not accurate. Around 90% of subprime mortgages issued between 2006 and 2009 were given to lower income families. The following chart demonstrates that from 2006 to 2009, the ARPM increased.

In 1990, Fannie Mae and Freddie Mac acquired 42% of the subprime mortgage load to provide loans for low-income families. This percentage grew to 50% in 2000 and further increased to 52% by 2005. Fannie Mae and Freddie Mac were purchasing $175 billion worth of loans

annually. According to the Financial Crisis Inquiry Commission, if the private sector, specifically Fannie Mae, had not taken excessive risks, the financial crisis could have been averted. However, it is important to note that Fannie Mae and Freddie Mac were not the primary cause of the crisis.

According to research, the primary cause of the crisis is the Community Reinvestment Act (CRA), which encourages banking institutions to assist lower-income borrowers and areas with their credit needs. This law compels banks to engage in high-risk mortgage lending. Central banks play a role in safeguarding the government banking system from failure and managing monetary policy. Their main objective is to ensure currency stability and protect against inflation. This focus on stable prices means that central banks are less concerned about asset price and housing bubbles.

Central Banks aim to minimize the impact of a crisis on the government's economy and they have some control over commercial banks. Critics argue that the actions of the Federal Reserve encourage Moral Hazard, which is when one party prioritizes their own interests over another party's. Some critics believe that the crisis was caused by an excessive emphasis on Moral Hazard. The failure of Long Term Capital Management in September 1998 is a case study in how a restructuring deal and intervention from the Federal Reserve helped prevent bankruptcy. This example can provide insights into the role of the Federal Reserve in responding to financial crises. The Federal Reserve intervened because it was concerned about the potentially catastrophic consequences for global financial markets if the firm were allowed to fail.

The rescue operation led to an increase in regulations on hedge funds, with the Federal

Reserve believing that they were "too big to fail." This meant that any failure could have a significant impact on the financial crisis, as the Federal Reserve had allowed a large amount of funds to be used. The concept of being "too big to fail" encourages financial firms to take on irresponsible risks, making them more vulnerable and the financial markets more fragile. Any failure could have severe consequences for long-term stability. When the economy is stable, individuals are more likely to provide monetary incentives to strengthen their own financial position.

The actions of the Federal Reserve can create challenges for individual firms, which reduces their motivation to maintain their financial well-being and increases the likelihood of future difficulties. In 2000, when the Fed decreased the federal fund rate from 6.5% to 1%, this had an impact on the increase in house prices and contributed to the formation of a housing bubble. The Federal Reserve believed that a low interest rate would promote stability due to the low inflation rate. However, critics argued that the Fed's interest rate policy was incorrect because the actual inflation rate was higher than the measurement used by the Fed.

During 2004-2006, the Federal Reserve increased the federal fund interest rate more than the ARM interest rate, making it difficult for homeowners to afford and increasing the riskiness of housing speculation. From 1997 to 2007, the debt level of financial institutions in the USA increased from 3 trillion to 36 trillion dollars, exceeding the share of gross domestic product. Additionally, the nature of Wall Street firms underwent a significant change. The fall on Wall Street was even more pronounced, with the Dow

Jones Industrial Average experiencing a loss of 504 points, equivalent to 4.42 percent.

There are clear indications that the sell-off will worsen, and the consequences of the two Wall Street banks' collapse are still uncertain. In 2005, the profitability of the U.S. commercial banking industry remained strong but slightly below previous years. Although the asset quality was still good, the pressure on net interest margins decreased the return on assets. Additionally, an increase in equity compared to assets, resulting from accumulating goodwill through recent major mergers, significantly lowered the return on equity.

In 2005, the 10 largest US commercial banks owned 55% of industrial assets. At the same time, many financial institutions and investment banks were issuing a significant amount of debt between 2004 and 2007 to invest in Mortgage-backed securities (MBS). These MBS were based on the belief that housing prices would continue to rise and that debt owners would continue to make their payments. The borrowing to invest had a low interest rate, while the investment itself had a high interest rate. However, when housing prices began to decline, private investors, investment banks, and financial institutions all experienced significant losses in 2007.

Under the net capital rule decided by the SEC in 2004, large investment banks were granted an exemption from a previous regulation that restricted the amount of debt their brokerage units could incur. This exemption allowed the release of millions of dollars that were being held in reserve to protect against investment losses. The funds freed up through the exemption could then be utilized by the banks' parent companies to invest in various financial instruments such as credit derivatives, mortgage-backed securities, and more.

The key institutions benefiting from this rule change were Lehman Brothers, Merrill Lynch, Bear Sterns, Goldman Sachs, and Morgan Stanley, who collectively issued $4.

In 2007, the US had a debt of 1 trillion dollars, which accounted for approximately 30% of the country's GDP. The following year, three major investment banks, Lehman Brothers, Bear Stearns, and Merrill Lynch, declared bankruptcy. Meanwhile, Morgan Stanley and Goldman Sachs Group, the only two independent brokerages left on Wall Street, decided to become commercial banks and subject themselves to the oversight of various federal regulatory agencies. This shift in status for these five largest investment banks demonstrated a decrease in capital holding and a significant increase in leverage between 2005 and present.

The investment banks' leverage ratio from FY End 2002-2008 [pic] witnessed significant changes. The four largest depositor banks aimed to increase their assets to 5.2 trillion, but they encountered losses during the crisis period. Additionally, Wall Street executives received $23.9 billion for short-term risk investment, disregarding their long-term obligations.

Wall Street's top risk managers lacked understanding of the mechanics behind Collateralized Debt Obligations (CDOs). CDOs are designed in a way that minimizes risks for investors by combining various assets to form a diversified product. Such assets include loans, bonds, or mortgages, which are packaged and sold together as a single entity. The fundamental idea is that it is improbable for all the mortgage loans within the CDO to default. This structure allows investors to mitigate risk by owning smaller portions of multiple assets that share similar risk attributes. Consequently, the CDO's ability to distribute risk rests heavily on the quality and nature of the underlying assets.

To create a

mortgage CDO, an underwriter (such as an investment bank) would purchase mortgages in bulk from a mortgage lender using mortgage-backed securities, typically in the form of bonds. The underwriter would then categorize the mortgages into three groups based on their risk profiles: senior, mezzanine, and equity. The senior tranche would have an AAA rating, the mezzanine tranche would have an AA+ rating, and the equity tranche would have a rating lower than AA+. These tranches would be sold to different investors, with the highest-risk tranche offering the highest returns in monthly payouts. As the monthly mortgage payments were made, the investors in the lowest-risk tranche would receive their payment first, followed by the medium-risk investors, and finally the highest-risk investors.

The waterfall effect, also known as the cascade effect, was observed in the US CDO market. By 2007, the market size was estimated to be worth over USD350 billion (as reported by Deutsche Bank in their 2007 publication titled "Global CDO Market: O