ISSUES AND ETHICS IN FINANCE (FIN657)

US Subprime Mortgage Crisis 2007

The US subprime crisis is the largest crisis in the history and it was turning point in
the US economy and global culture. The subprime mortgage crisis was rise in home
foreclosures, started in the United States in late 2006 and became a global financial crisis
during 2007 and 2008. There were some millions of the homes that were closed down but no
one was there to buy them. The crisis began with the bursting of the housing bubble in the
U.S. and high default rates on subprime and other adjustable rate mortgages (ARM) made to
higher-risk borrowers with lower income or lesser credit history than prime borrowers. Loan
incentives and a long-term trend of rising housing prices encouraged borrowers to assume
mortgages, believing they would be able to refinance at more favourable terms later.
However, once housing prices started to drop in 2006-2007, it became more difficult to
refinancing. ARM interest rates reset higher that makes defaults and foreclosure activity
increased dramatically. The industries that were hit the hardest were the banking industry, real
estate and the construction.

The mortgage lending market is divided in two sectors prime and subprime. Prime
borrowers are marked by high income, strong credit rating and sound savings while subprime
mortgages are named for the borrowers that the mortgages are given to subprime for those
who have struggled to meet those standards. People who are approved of subprime mortgages
historically have low credit scores, no savings, blemished credit history and problems with
debt. They often have tremendous difficulty getting approval on a mortgage, also considered
riskier by the lending institutions and are generally assessed at higher interest rates than
normal.

How subprime mortgage crisis happen

The subprime mortgage market emerged and flourished in the 1990’s. The new trend
of extending loans or credit to borrowers with less than perfect profiles was adopted in 1990’s
and continued until 2005, resulting in increased homeownership recording 64.1 % in 1993
and 68.9% in 2005 (Carpenter,2008). The expansion of the sub-prime market improved the
access of credit and resulted in the boom in the real estate market. This led to the expansion of
credit to those borrowers whose credit was blemished. This period was also backed by strong
overall housing market with increasing value of the home prices. Though this trend did not
continue and in 2006 the housing market began to slow down, which resulted in rising late
mortgage payments, foreclosures and defaults. This resulted in the collapse of the US
subprime mortgage market and had impact on the borrowers, investors, financial institutions,
securitization, and mortgage broker which led to more involved government regulation.

In 2007, the US economy experienced the worst mortgage crisis ever that led to panic
and financial challenges all over the world. The primary cause of the mortgage crisis was
excessive borrowing and unfeasible financial projection. The projection relied on the
assumption that the local prices only increased. Subprime borrowers defaulted as a result of
change of mortgage interest rates. The unfolding of the mortgage crisis can be illustrated
through an analysis of the issues that culminated to the crisis. Other factors that intensified the
crisis are fraud and greed.

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In the early 2000s, interest rates on house payments were quite low. More and more
people that struggling credit were able to qualify for subprime mortgages with manageable
rates. This sudden increase in subprime mortgages was due in part to the Federal Reserve's
decision to significantly lower the Federal funds rate to spur growth. People who couldn't
afford homes or get approved for loans before were suddenly qualifying for subprime loans
and choosing to buy which make American home ownership rose exponentially.

Real estate purchases rose for subprime borrowers and for Americans as well. As
prices rose and people expected a continuation of that, investors who got burned by the
bubble of the early 2000s and needed a replacement in their portfolio started investing in real
estate. While the housing prices rising rapidly, the number of subprime mortgages given out
was rising even more. By 2005, some began to fear that this was a housing bubble.

From 2004 until 2006, the Federal Reserve has raised the interest rate over a dozen
times in attempt to slow down and avoid more serious inflation. End of 2004, the interest rate
was 2.25% and by mid-2006 it rise to 5.25% but this was unable to stop the inevitable, the
bubble burst. In 2005 and 2006 the housing market crash back down to earth and make
subprime mortgage lenders begin laying thousands of employees off, filing for bankruptcy or
shutting down entirely.

The subprime mortgage crisis or the Great Recession, has many parties that share
blame for it. For one are lenders who were selling these as mortgage-backed securities. After
the lenders approved and gave out the loan, then the loan would be sold to an investment bank
which then bundle this mortgage with other similar mortgage for other parties to invest in, and
the lender as a result have more money to use for home loans.

It is a continuous process that had worked in the past, but the housing bubble saw an
unusually large number of subprime mortgages that approved for people who struggled with
credit and income. Loans became more expensive and the borrowers found themselves unable
to pay it off when the Fed began raising interest rates over and over

Lenders were give away so many risky loans at once assuming that housing prices
would continue to rise and interest rates would stay low. Investment banks also seem to had
similar motives, getting bolder with their mortgage backed securities investments. The banks
and the lenders started to force the people to get the maximum amount of loans that they
could ensure the alone and they could not be repaid.

Though these parties has took advantage of people with bad credit in need of a place
to live, homebuyers and the distinctly American pursuit of owning a home also played a small
role in this. Their dream to upward mobility and owning larger homes led the people to riskier
with their own real estate investments, and lenders were all too ready to help them.

Another party that create the mess was the hedge fund industry. It not only pushing
rates lower, but also aggravated the problem by fuelling the market volatility that caused
investor losses. The failures of a few investment managers also contributed to the problem.
Credit arbitrage was a hedge fund strategy which involves purchasing subprime bonds on
credit and hedging the positions with credit default swaps. This amplified demand for CDOs
by using leverage, a fund could purchase a lot more CDOs and bonds than it could with
existing capital alone, pushing subprime interest rates lower and further fuelling the problem.
Leverage was involved and set the stage for a spike in volatility, which is exactly what
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happened as soon as investors realized the true, lesser quality of subprime CDOs. There’s
losses and many hedge funds shut down their operation as they ran out of money in the face
of margin calls because they use a significant amount of leverage.

Risks Involve In The Subprime Crisis

There are three primary risk categories involved in the subprime crisis:

1) Credit risk

The credit risk would be assumed by the bank originating the loan. Due 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 is a repacking of existing debt, and MBS collateral has made up a
large proportion of issuance in recent years. In exchange for purchasing the MBS,
third-party investors receive a claim on the mortgage assets, which become collateral
in the event of default. MBS investor has the right to cash flows related to the
mortgage payments. In order to manage their risk, mortgage originators such as 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 will sell the mortgage assets to these SPE and then SPE will sells the MBS
to the investors. The mortgage assets in the SPE become the collateral.

2) Asset price risk

CDO valuation is complex and related to fair value accounting. Due to lack of
precedent and rising delinquency rates, this valuation fundamentally derives from the
collectability of subprime mortgage payments is difficult to predict. Banks and
institutional investors have recognized substantial losses as they revalue their CDO
assets downward.
Most CDOs require a number of tests to be satisfied on a periodic basis, such
as tests of interest cash flows, market values or collateral ratings. For deals with
market value tests, if the valuation falls below certain levels, the CDO 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 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. Certain types of
institutional investors are allowed to only carry higher-quality assets, there is an
increased risk of forced asset sales, which could cause further devaluation.

3) Liquidity risk

A related risk involves the commercial paper market, a key source of funds for
many companies. Companies and SPE called structured investment vehicles (SIV)
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often obtain short-term loans by pledging mortgage assets, issuing commercial paper
or CDO as collateral. Investors provide cash in exchange for the commercial paper,
receiving money-market interest rates.
However, the value of the mortgage asset collateral linked to subprime loans
and the ability of many companies to issue such paper has been significantly affected.
In addition, the interest rate that charged by investors to provide loans for commercial
paper has increased substantially above historical levels.

Effects of the Subprime Mortgage Crisis

During the subprime mortgage crisis, home prices has fell tremendously as the
housing bubble completely burst. This has crushed many of the recent homeowners, who
were seeing interest rates on their mortgage rise rapidly as the value of the home deteriorated.
People are unable to pay their mortgage on a monthly payment and also unable to sell the
home without taking a massive loss. So many of them had no choice because the banks
foreclosed on their houses and make homeowners were left in ruins, and many suburbs turned
into ghost towns. Even homeowners with good credit who qualified for standard mortgages
struggled with the steadily rising interest rates.

At the time these homes were foreclosed upon, they had cratered in value which meant
banks were also losses on real estate. Investors effected as well, as the value of the mortgage-
backed securities they were investing was in tumbled. People still buying homes even as the
bubble began to burst in 2006 into early 2007 which was made more difficult because loans
were still being given out and taken as sales slumped.

Investment banks who bought and sold these loans that were being defaulted on
started failing and lenders no longer had the money to continue giving them out. When 2008,
the economy was in complete freefall. Government help to bailed out some institutions while
other banks, who had gotten so involved in the mortgage business, were not so lucky.

Action to manage the subprime crisis

Homeowners and lenders both may benefit from avoiding foreclosure, which is a
lengthy process and costly. Most of the lenders have taken action to reach out to homeowners
to provide more favourable mortgage terms such as loan modification or refinancing. Home
owners have also been encouraged to contact their lenders to discuss alternatives.

Loan modification programs has been introduced to assist a corporations, trade

groups, consumer advocates and types of homeowners. There is also 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.

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Credit rating agencies also help to evaluate and report on the risk involved with
various investment alternatives. This 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.

Regulators and legislators are take action regarding lending practices, tax policies,
bankruptcy protection, credit counseling, affordable housing, the licensing and qualifications
of lenders and education by creating regulations and guidelines that can 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 to identify solutions
and apply pressure to the various parties involved.

The media also has a big role in helping to educate the public and parties involved. 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.

Banks have sought and received additional capital such as 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.

President George W. 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. He also announced a plan to voluntarily and temporarily freeze the
mortgages of a limited number of mortgage debtors holding ARMs.

A refinancing facility called FHA-Secure was also created as a part of an ongoing

collaborative effort between the US Government and private industry to help some subprime
borrowers called the Hope Now Alliance. In February 2008, the Hope Now Alliance released
a report 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.

During February 2008, a program called "Project Lifeline" was announced and the
intent of the program was to encourage more loan adjustments, to avoid foreclosures. Six of
the largest U.S. lenders, in partnership with the Hope Now Alliance has agreed to defer
foreclosure actions for 30 days, for homeowners 90 or more days delinquent on payments.
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.

The Federal Reserve Chairman, Ben Bernanke, has signals towards making interest
rate cuts and in early 2008, they make an efforts to support market liquidity and functioning
and the pursuit of macroeconomic objectives through monetary policy. Tougher regulatory
standards are also proposed. Additionally, a freeze of interest payments on certain subprime
loans is announced. On January 22, 2008, the Fed also slashed a key interest rate (the federal

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funds rate) by 75 basis points to 3.5%, the biggest cut since 1984, followed by another cut of
50 basis points on January 30th.

Central banks have conducted open market operations to ensure member banks have
access to funds liquidity. These are effectively short-term loans to member banks
collateralized by government securities. They also have lowered the interest rates charged to
member banks for short-term loans. 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 assets to helps lenders, SPE, and SIV avoid selling mortgage-backed assets
at a steep loss and second is the available funds stimulate the general economic activity and
commercial paper market.

Central banks around the world also have begun coordinated efforts of their own to
increase liquidity in their own currencies to stabilize foreign exchange rates and prevent the
probable significant global consequences a run on the American dollar would cause. It is the
first time the American, European, and Japanese central banks have taken such actions
together. As of August 10, 2007, the United States Federal Reserve has injected a combined
43 billion USD, the European Central Bank (ECB) 156 billion euros (214.6 billion USD), and
the Bank of Japan 1 trillion Yen (8.4 billion USD) while smaller amounts have come from the
central banks of Australia, and Canada.

The US Government took several steps intended to lessen the damage. One set of
actions was aimed at encouraging lenders to rework payments and other terms on troubled
mortgages or to refinance “underwater” mortgages which loans exceeding the market value of
homes rather than aggressively seek foreclosure. This is to reduced repossessions whose
subsequent sale could further depress house prices. Congress also passed temporary tax
credits for homebuyers that increased housing demand and eased the fall of house prices in
2009 and 2010. The Congress greatly increased the maximum size of mortgages that FHA
would insure to buttress the funding of mortgages because FHA loans allow for low down
payments, the agency’s share of newly issued mortgages jumped from under ten percent to
over fourty percent.

The Federal Reserve had lowered short-term interest rates to nearly 0 percent by early
2009 and took additional steps to lower longer-term interest rates and stimulate economic
activity. This is including buy large quantities of long-term treasury bonds and mortgage-
backed securities that funded prime mortgages. The Federal Reserve committed itself to
purchasing long-term securities to further lower interest rates and to encourage confidence
needed for economic recovery until the job market substantially improved and to keeping
short-term interest rates low until unemployment levels declined, so long as inflation
remained low. These moves and other housing policy actions along with a reduced backlog of
unsold homes following several years of little new construction helped stabilize housing
markets by 2012. National house prices and home construction began rising, home
construction rose off its lows, and also foreclosure rates resumed falling from recession highs.
In 2013, the percent of homes entering foreclosure had declined to pre-recession levels and
the long-awaited recovery in housing activity was solidly underway.

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