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Subprime mortgage crisis

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The subprime mortgage crisis was the financial shock following the 2007 fall in US house prices, that originated from failure to make payments that were due under the terms of loans secured against the value of their houses on the part of some Americans who had low credit ratings. A resulting loss of confidence in the safety of bonds whose value depended upon such loans caused serious financial problems among banks and other providers of housing loans. The crisis subsequently spread to other financial markets to lead to the global Crash of 2008.

Contents

Introduction

This article is the first of a series of contemporary accounts of economic events and developments during the period from mid 2007 to the end of 2011. The other articles are:-

Crash of 2008 - global financial developments from mid 2007 to the end of 2008
Recession of 2009 - global economic developments from mid 2007 to the end of 2010
Great Recession - an overview of global financial and economic events between mid 2007 and the end of 2011

Overview

"The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.
Paul Krugman New York Times October 13 2008[1].

What came to be known as the subprime mortgages crisis had its origin in repayment defaults by some Americans with low credit ratings who had borrowed money to help pay for house purchases. When house prices were rising, many of them had been able to get the money needed for repayments by further borrowing (because of the increased security that the price increases enabled them to offer). But the sharp fall in the market value of their houses that occurred in 2007 deprived them of that option, and left many of them owing more than their houses were worth - making default a rational, and sometimes unavoidable, recourse.

That, in itself, would have been of little importance to those not directly involved, but for a change that had occurred in the practices of the lenders to those defaulting borrowers and others. Banks and other lenders had ceased to depend mainly upon their depositors to provide the money that they needed and had, in effect, been raising money by selling their subprime lenders' repayment promises. As a result of that practice, documents representing those repayment promises had been passed around the international financial system in a multitude of transactions until they had come to form an important part of the possessions of many organisations.

The damage that was done by the defaults of the subprime borrowers was not only the result of the loss in the value that people attributed to the defaulters' repayment promises. There was also a sudden realisation that the survival of some firms might depend upon other borrowers' promises - and that they, too, might be worthless. The international banking panic that ensued was the result of uncertainty as to who might be in that position. That uncertainty destroyed most businesses' confidence in the ability of other businesses to keep their promises.

The house price boom and bust

Some saw it coming: -

We are buying a lot of housing at rising prices, but home ownership has become a vehicle for borrowing as much as a source of financial security. As a nation we are consuming and investing about 6 percent more than we are producing.....what holds it all together is a massive and growing flow of capital from abroa...this seemingly comfortable pattern can't go on indefinitely...I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change. (Paul Volcker writing in the Washington Post of April 10 2005[2])

- and some didn't: -

Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas. House prices are unlikely to continue rising at current rates. (Ben Bernanke, Testimony before the Joint Economic Committee, October 20, 2005 [3]).

The low interest rates and easy credit of the early 21st century, led to the development of a housing boom in the United States, and the average price of houses there rose by eighty per cent between 2001 and 2006,[4].

In 2007, following subsequent interest rate increases, there was a sharp fall in house prices.

During the boom, a general belief that house prices would continue to rise, had led mortgage lenders to approve loans without taking prudent account of borrowers' ability to pay, and had led borrowers to take out larger loans than they could afford. Inability led to foreclosures, and it was estimated in 2006 that over two million households had either lost their homes or were destined to do so[5]. The fall in prices that occurred in 2007, led to a marked increase in mortgage defaults because many owners of mortgaged houses were no longer able keep up their payments by using them as security for further loans.

That increase in defaults led to financial problems at the government-sponsored enterprises Fannie Mae and Freddie Mac (the major providers of finance to the United States mortgage markets) and at those banks that were also important sources of its finance. An atmosphere of general uncertainty about the value of some mortgage-backed assets developed among other providers of finance to those markets. Operators in the financial markets became reluctant to lend money on the security of those securities, placing other holders of those assets in financial difficulties.

There developed a loss of confidence in organisations that were suspected of being vulnerable to the falling value of their holdings of all mortgage-related assets. By the middle of 2008, US house prices had fallen to 20 per cent below their 2006 peak, there was a further increase in defaults. In July, two highly-respected credit rating agencies (Moodys and Standard and Poor) downgraded hundreds of subprime mortgage-backed securities - often by two or three rating categories, and commenced a review of their rating methods.

Contributory factors

Monetary policy

There is some evidence of a connection between the subprime crisis and the Federal Reserve System's conduct of monetary policy. Since the 1980s, the Bank's monetary policy had successfully stabilised the American economy - and its housing market - by the application of the Taylor rule under which changes to the bank's discount rate had been related to the spare capacity in the economy. During the period from 2003 to 2006, however, the discount rate was held well below the level suggested by that rule. The author of the rule, Professor John Taylor of Stanford University, has given an account of the consequences of that departure [6]. He argues that those low interest rates helped to foster the extraordinary surge which occurred in the demand for housing, and that the eventual fall in housing prices would have been less steep, and the following crisis less severe, had the Taylor rule been followed.

International capital flows

A connection has also been noted between the housing boom and increases in the availability of finance. However, the funds used to finance the surge in housing investment were obtained largely by borrowing from abroad, rather than from domestic savings [7]. In the early years of the 21st century there were large inflows of money from abroad, corresponding to the country's large current account deficit [8]. That development was attributed by some commentators to increases in the federal budget deficit, but Federal Reserve Board Chairman Ben Bernanke argued that it was caused mainly by a "savings glut" in China and other developing countries resulting in large purchases of American securities [9] (sometimes referred to as "the wall of money"). A correlation between the growing current account deficit and increases in housing investment had also been noted by the Board's previous Chairman [10].

Housing legislation

Another influence upon the housing market was the Community Reinvestment Act 1977 (CRA), which required the Federal Reserve and other government agencies to encourage banks to provide credit to low-income families ""in ways that are consistent with safe and sound banking operations".[11]. The Act does not provide for grants to individuals, but encourages regulatory authorities to make their authorisations, in response to applications by mortgage-lenders, conditional upon their performance in meeting the aims of the legislation. Since its inauguration, it has been strengthened by a succession of amending enactments, [12], and in 2008 there were reports that it was inducing mortgage-lenders to take greater risks than they had been accustomed to. For example, pressure to conform was reported to have influenced the government-sponsored enterprise known as "Fannie Mae" to undertake more risky investments [13]. A 2010 study suggests that there had been political pressure on the Government to expand mortgage credit, coming from both mortgage lenders and subprime borrowers [14].

Securitisation

A further contribution to the crisis arose from changes in the late 20th century in the way that mortgages are financed. Banks had previously financed their lending mainly by deposits from their customers. That practice was largely replaced by the practice of converting mortgages into graded securities and selling them on the bond markets [15] - a practice that made possible a massive increase in mortgage lending, [16]. Bank mortgages came to account for a substantial proportion of a market that had previously been dominated by the government-sponsored agencies (Fannie Mae and Freddie Mac) [17], and mortgage-related bonds came to occupy an important place in the bond market [18].

Lending policies

Other important factors were the easing of credit terms for loans to low-income borrowers by the government sponsored enterprises (Fannie Mae and Freddie Mac) [19] in pursuit of market share and despite repeated warnings of the risks involved [20], and the growing proportion of loans that went to subprime mortgage borrowers" [21] . Subprime borrowers were people who had been given low credit ratings [22] because they had a history of late payments or defaults. Subprime mortgages were much more profitable than normal mortgages because, compared with a typical 5 percent interest rate, subprime borrowers were usually charged about 7 percent. Often they were sold to existing home owners who needed money to pay off other debts [23]. Some were sold by mortgage brokers who adopted "predatory lending "[24] practices, or otherwise misled their clients, [25]. Most of them were "adjustable-rate mortgages" with initially low repayment rates that were due to be raised after the first two or three years.

The banking crisis

The surge in defaults in the subprime mortgages market led credit rating agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks [26]. Hedge funds guaranteed by the American Bear Stearns bank had run into difficulties. Mortgage defaults led subsequently to the collapse and a government rescue from bankruptcy of Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market ceased to operate. Banks that had relied upon that source of finance, such as the UK's Northern Rock also ran into difficulties leading to a further loss of confidence. The loss of investors' confidence in their assets, combined with the closure of what had been their major sources of short-term borrowing, put banks and other financial institutions throughout the world in severe financial difficulties, leading to their withdrawal from their normal contribution to economic activity of providing credit to industry and commerce.

Further developments are described in the article on the crash of 2008.

References

  1. "Gordon Does Good,", Paul Krugman, in The New York Times, 13/10/2008 [1]
  2. Paul A. Volcker: An Economy On Thin Ice, Washington Post, April 10, 2005
  3. Ben Bernanke: The Economic Outlook, Testimony before the Joint Economic Committee, October 20, 2005
  4. [Standard and Poor's House Price History
  5. [http://www.responsiblelending.org/mortgage-lending/research-analysis/foreclosure-paper-report-2-17.pdf Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest: Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners, Center for Responsible Lending December 2006]
  6. John Taylor Housing and Monetary Policy Stanford University September 2007
  7. The US saving rate had fallen from 6% in 1993 to about 1% in 2004
  8. The United States current account balance moved from a surplus of $46 billion in 1996 to a deficit of over $600 billion in 2004
  9. The Global Saving Glut and the U.S. Current Account Deficit, Remarks by Governor Ben S. Bernanke At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, Federal Reserve Board March 2005
  10. Current Account, Remarks by Chairman Alan Greenspan at the Advancing Enterprise 2005 Conference, London, England February 4, 2005, Federal Reserve Board 2005
  11. Text of the Community Reinvestment Act 1977
  12. Ben Bernanke The Community Reinvestment Act: Its Evolution and New Challenges Speech at the Community Affairs Research Conference, Washington, D.C. March 30, 2007
  13. Pressured to Take More Risk, Fannie Reached Tipping Point New York Times October 4 2008
  14. Atif Mian, Amir Sufi and Francesco Trebbi: The political economy of the subprime mortgage credit expansion, Vox 11 July 2010
  15. Adam Ashcroft and Til Schuermann: Understanding the Securitization of Subprime Mortgage Credit, Staff Report No 318, Federal Bank of New York, March 2008
  16. The total value of outstanding mortgages increased from $2,500 billion in 1995 to $6,000 billion in 2005
  17. The subprime lending crisis, Report of the Senate Joint Economic Committee October 2007
  18. By 2005 mortgage-related bonds accounted for $6 trillion out of a bond market total of $27 billion [2]
  19. Stephen Holmes: Fannie Mae Eases Credit To Aid Mortgage Lending, New York Times, September 1999
  20. The Role of Fannie Mae and Freddie Mac in the Financial Crisis, Henry Waxman: Opening Statement of the Chairman, Committee on Oversight and Government Reform December 9, 2008
  21. The proportion of mortgages held by subprime borrowers rose from less than 10% in 2000 to 20% in 2006
  22. Typically with a FICO credit rating (which range from 300 to 850) of less than 620.
  23. According to Mary Moore of the Center for Responsible Lending
  24. Predatory Mortgage Lending Center for Responsible Lending January 2005
  25. Keith Ernst, Debbie Bocian, and Wei Li: Steered Wrong: Brokers, Borrowers, and Subprime Loans, Center for Responsible Lending, April 8, 2008
  26. Financial Stability Report, pages 18 & 19, Bank of England October 28 2008
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