the immediate cause or trigger of the crisis was the bursting of the united states housing bubble...

8/9/2019 The Immediate Cause or Trigger of the Crisis Was the Bursting of the United States Housing Bubble Which Peaked i

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CHAPTER S Page No

I INTRODUCTION 5

Background of the Study 7

Statement of the Problem 12

Objectives of the Study 13

Hypotheses of the Study 14

Significance of the Study 15

Scope and Limitations of the Study 19

Definition of Terms 20

II REVIEW OF RELATED LITERATURE 51

III THEORETICAL FRAMEWORK 52

IV METHODOLOGY 106

Research Design Sources ofData

Method ofData Collection/Data Collection Procedure

Analytical Procedures/Methods ofAnalysis

V RESULTS AND DISCUSSION 108

VI SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS 115

Summary 115

Conclusions & Recommendations 117

BIBLIOGRAPHY 118

APPENDIXES


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Declaration

I Matthew Bhasker Singh Roll no M.Phil/1456/MBA/008D, student of M.Phil of

The Global Open University Nagaland, hereby declare that the Research report

on Subprime crises a five factor Model, is an original and authenticated work

done by me. I further declare that it has not been submitted elsewhere by any other

person in any of the University for the Award of any degree or diploma.

Date (Matthew B Singh)


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The purpose of the research is to unearth the contributing factor of the subprime crises. The

result has shown significant reasons which have contributed to set the ball of subprime crises

rolling. It has been found that five main factors have synergized the crises. These factors are:

y Decrease in prime lending rate

y

S

ecuritization

y Adjustable rate Mortgage

y Increase in interest rate of prime borrowers

y Mortgage backed securities

In the first stage when the housing loan was magnified due to low prime rate and easy loan

at a subprime rate to the people with default credit history. These loans were advanced the loan

created in the assets side of the balance sheet were converted into marketable securities known as

Mortgage backed securities through the mechanism ofsecuritization. The fund acquired by

selling Mortgage backed securities was again extended as loan and again these loans were

securitized and, hence a single loan was multiplied several times along with the exposure of risk.

These loans were extended with an Adjustable rate mortgage condition which means that

the loan rates were subjected to changes as per market conditions. As some defaults started

pouring in the biggest mistake that the American bank did was that they increased the interest


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rate of prime rate borrowers. As the interest rate of prime rate borrowers increased, they being

from service class with a calculated income could not maintain pace with increased interest rate

and, they too started to default. This default due to increase interest rate took the face of

uncontrollable reaction and the entire housing loan market crashed.

Because the loan was magnified many times through the means of securitization due to rise

in the market of housing loans the bankers faced heavy liquidity crises to repay the deposit and

thus many banks went bankrupt. In order to provide with liquidity the banks started selling their

securities which increased the supply of shares in the market. When the supply went so high and

was not justified by the demand the stock exchange also crashed.


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Subprime crises consist of two words Sub and Prime. Prime here means standard and

subprime means below standard. Prime rate is the rate on which the banks give loan to its

permanent customers at a lower interest rate as compared with the other borrowers. Subprime

loan is loan which is subprime or below standard. Therefore subprime loan is situation where the

banks have extended loans to people with default credit history at a higher rate.

Subprime started in US where the private banks were in kingdom and enjoying their reign.

These banks started extending loans to people with bad credit history at a higher interest rate.

They thought that the loan will be secured with the mortgage of the property purchased by the

borrower. This was the point where the banks did a mistake, Because of rise in demand of the

real estate the price of real estate were already inflated therefore the collateral security of the

property was not enough to cover the loan 100%. When these subprime loans stated mounting up

some defaults form few borrowers started pouring in the bank in order to recover these losses

raised the interest rate of prime borrowers, The prime borrowers who were service class people

could not maintain pace with rising interest rate and they too started defaulting. Bankers when

saw that the rate of default started increasing they started seizing the house of the borrowers and

selling them in the real estate market this shifted the entire paradigm of the market. The prices of

the real estate which were too high due to increase in demand crashed down due to excess supply


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of real estate property, the banks could not realized the amount of loan due to fall in property

prices and the loan could not be recovered. The bank suffered with serious credit crunch to repay

the money to the borrowers; Due to inability of the banks to repay the money to the borrowers

they went bankrupt.


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The problems we are witnessing today developed over a long period of time. For more than a

decade, a massive amount of money flowed into the United States from investors abroad. This

large influx of money to U.S. banks and financial institutions along with low interest rates

made it easier for Americans to get credit. Easy credit combined with the faulty assumption

that home values would continue to rise led to excesses and bad decisions. Many mortgage

lenders approved loans for borrowers without carefully examining their ability to pay. Many

borrowers took out loans larger than they could afford, assuming that they could sell or refinance

their homes at a higher price later on. Both individuals and financial institutions increased their

debt levels relative to historical norms during the past decade significantly.

Optimism about housing values also led to a boom in home construction. Eventually the number

of new houses exceeded the number of people willing to buy them. And with supply exceeding

demand, housing prices fell. And this created a problem: Borrowers with adjustable rate

mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or

refinance their homes before the adjustments occurred were unable to refinance. As a result,

many mortgage holders began to default as the adjustments began.

These widespread defaults (and related foreclosures) had effects far beyond the housing market.

Home loans are often packaged together, and converted into financial products called "mortgage-


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backed securities". These securities were sold to investors around the world. Many investors

assumed these securities were trustworthy, and asked few questions about their actual value.

Credit rating agencies gave them high-grade, safe ratings. Two of the leading sellers of

mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were

chartered by Congress, many believed they were guaranteed by the federal government. This

allowed them to borrow enormous sums of money, fuel the market for questionable investments,

and put the financial system at risk.

The decline in the housing market set off a domino effect across the U.S. economy. When home

values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted

on their mortgages. Investors globally holding mortgage-backed securities (including many of

the banks that originated them and traded them among themselves) began to incur serious losses.

Before long, these securities became so unreliable that they were not being bought or sold.

Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with

large amounts of assets they could not sell. They ran out of the money needed to meet their

immediate obligations. And they faced imminent collapse. Other banks found themselves in

severe financial trouble. These banks began holding on to their money, and lending dried up, and

the gears of the American financial system began grinding to a halt.


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Stages of the crisis

The crisis has gone through stages. First, during late 2007, over 100 mortgage lending

companies went bankrupt as subprime mortgage-backed securities could no longer be sold to

investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial

institutions have recognized massive losses as they adjust the value of their mortgage backed

securities to a fraction of their purchased prices. These losses as the housing market continued to

deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1

2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in

government guarantees, after it was unable to continue borrowing to finance its operations.

Fourth, during September 2008, the system approached meltdown. In early September Fannie

Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the

U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for

bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became

insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80%

nationalized by the U.S. government, due to concerns regarding its ability to honor its

obligations via a form of financial insurance called credit default swaps. These sequential and

significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of

credit markets and more serious global impact. The interconnected nature of Lehman was such

that its failure triggered system-wide (systemic) concerns regarding the ability of major

institutions to honor their obligations to counterparties. The interest rates banks charged to each


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other (see the TED spread) increased to record levels and various methods of obtaining short-

term funding became less available to non-financial corporations. It was this "credit freeze" that

some described as a near-complete seizing of the credit markets in September that drove the

massive bailout procedures implemented by worldwide governments in Q4 2008. Prior to that

point, each major U.S. institutional intervention had been ad-hoc; critics argued this damaged

investor and consumer confidence in the U.S. government's ability to deal effectively and

proactively with the crisis. Further, the judgment and credibility of senior U.S. financial

leadership was called into question.[4]

Since the near-meltdown, the crisis has shifted into what some consider to be a deep

recession and others consider to be a "reset" of economic activity at a lower level, now that

enormous lending capacity has been removed from the system. Unsustainable U.S. borrowing

and consumption were significant drivers of global economic growth in the years leading up to

the crisis. Record rates of housing foreclosures are expected to continue in the U.S. during the

2009-2011, continuing to inflict losses on financial institutions. Dramatically reduced wealth due

to both housing prices and stock market declines are unlikely to enable U.S. consumption to

return to pre-crisis levels.

Thomas Friedman summarized how the crisis has moved through stages:

When these reckless mortgages eventually blew up, it led to a credit crisis. Banks stopped lending.

That soon morphed into an equity crisis, as worried investors liquidated stock portfolios. The equity crisis

made people feel poor and metastasized into a consumption crisis, which is why purchases of cars,

appliances, electronics, homes and clothing have just fallen off a cliff. This, in turn, has sparked more


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company defaults, exacerbated the credit crisis and metastasized into an unemployment crisis, as

companies rush to shed workers.

Alan Greenspan has stated that until the record level of housing inventory currently on the

market declines to more typical historical levels, there will be downward pressure on home

prices. As long as the uncertainty remains regarding housing prices, mortgage-backed securities

will continue to decline in value, placing the health of banks at risk


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Research Gaps:-

The research conducted till date has explained the conceptual frame work of subprime crises and

the factors which contributed to it. This research is different because it doesnt blame subprime

loans for the crises but other important factors in lieu of which the crises would have not come

into picture.

The questions, which the study hopes to answer.

1: Is the subprime loan the only cause for the crises,

2: How did if effect the global economy,

3: What could have been done to stop the crises?

4: What can be done to reverse the crises?

Objective:

The Importance of study is to find other related factors that have caused the recession in the

global market. The main factor that has been known for the crises is the subprime loan (Below

standard loan) which was advanced by the US Banks. However the study shows that the


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subprime cause was not the only factor that caused this entire phenomenon. The study has

focused upon the other contributing factors which have magnified this entire process.

The Importance of study is to find other related factors that have caused the recession in the

global market. The main factor that has been known for the crises is the subprime loan (Below

standard loan) which was advanced by the US Banks. However the study shows that the

subprime cause was not the only factor that caused this entire phenomenon. The study has

focused upon the other contributing factors which have magnified this entire process.

History is the knowledge that teaches us. The present crises will become history tomorrow.

But the real history must be known. If we miss out, or the entire reasons are not taken into

consideration may be we may miss out with the root cause of the recession.

The objective of the study is to go deep down and to highlight the entire process which has

caused the crises.

The importance of study is for the following outfits:-

1: Banks and Financial Institutions,

2: Stock Exchanges, Brokers

3: Companies,

5: Government.


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H0=If the securization has magnified the crises to the maximum level which was beyond

control then subprime rate mortgage is not the primary cause of the crises.

H1= If the securization has not magnified the crises to the maximum level which was

beyond control then subprime rate mortgage is the primary cause of the crises.


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A key factor in evaluating the report is understanding which problem it seeks to correct. The

subprime mortgage crisis requires responses to three problems: the thousands of individuals who

may lose their homes due to unaffordable mortgage payments; the stresses in the overall

financial system caused by huge losses on investments backed by these mortgages; and the credit

practices surrounding the granting of mortgages, their packaging into structured investments, and

the evaluation of those financial instruments. The report focuses exclusively upon the third area.

Improved Credit Ratings

The report calls for credit rating agencies to improve the way in which they "grade"

securities. Currently, both traditional securities and structured credit products are graded the

same way. Structured credit products are sophisticated and often highly complex packages that

include such ingredients as tranches (pieces) of mortgages representing a specific level of

repayment risk. They are designed to meet specific investor needs.

When credit rating agencies gave structured credit products ratings that appeared to be the

same as those given to traditional securities, investors assumed that they had received the same

level of scrutiny and carried an equivalent risk level. In fact, the analysis was often based on

models with faulty assumptions (such as continuously rising housing prices) and greatly


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underestimated the actual risk. Since the model and assumptions used to evaluate structured

credit products were not disclosed, investors were unable to evaluate properly either the

securities or the ratings given to them.

In response, the working group recommends that credit rating agencies make their processes

more transparent. This includes publishing sufficient information about the assumptions

underlying their credit rating models and methodologies and clearly differentiating the ratings

given to complex products from those given to traditional instruments. In addition, the report

encourages formal and periodic reviews of those assumptions. Investors would be told to what

extent the agencies had examined the actual assets that were securitized to create the structured

credit products. In the case of mortgage-related securities, this would indicate whether the actual

mortgages were credit-worthy and properly originated.

Many of these improvements are already being implemented by the credit rating agencies

themselves. However, to ensure that these reforms continue, the agencies would set up a private-

sector group with representatives from issuers, investors, and underwriters to monitor the

situation and develop recommendations for additional actions to improve transparency, the actual

ratings, and the way that ratings are used.

Improving Mortgage Origination

One factor in the current upheaval is that mortgages were made to homebuyers who normally

would not qualify for them and were presented as being of much higher quality than they

actually were. While much attention has focused on underwriting problems in the subprime

market, the fact is that credit standards were relaxed for most classes of loans with the result that


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exposed to risk and potential liquidity problems than expected, especially as credit conditions

have deteriorated.

Improved firm risk management will be supplemented by regulatory improvements designed

to encourage firms to improve both capital and liquidity cushions and enhanced guidance for the

risk associated with firms that distribute sophisticated financial products to investors or other

sellers. Equally important are recommendations for improved disclosure of off-balance sheet

obligations, including the actual value of complex or illiquid investments.

Significant number should also result in an international effort to improve capital standards

and regulation. Such improvements would enable investors to do a better job of evaluating the

financial institution's true condition and give regulators a better understanding of the risk that a

particular institution could pose to the financial system.


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If properly implemented, the recommendations is for the Working Group of Financial

Markets should go a long way toward preventing financial crises like the current subprime

mortgage problems. However, since the report is nothing more than a series of general guidelines

and statements, how its recommendations are implemented will be extremely important.

Implementation needs to be both consistent among the various state and federal regulators and

balanced. While most of the report's recommendations can be put into effect under existing laws,

it will be important to watch carefully for congressional attempts to use them to justify harsh new

laws that could end up crippling credit markets. The key is to learn from recent events and to use

those lessons to ensure that the current crisis is not repeated.


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Mortgage Backed Securities

Mortgage Backed Securities can be referred to as asset backed securities, where the flow of

funds is supported by the regular payments towards the principal amount and payments of

interests for a number of mortgage loans.

Advantages of Mortgage Backed Securities:

The need of mortgage backed securities has been felt in the past few years by the mortgage

originators to refill their investments. The mortgage backed securities aid in the development

of new instruments to collect funds from the market, as the mortgage backed securities are

usually very economic and more effective than the other financing instruments offered by the

banks and the other forms of financing issued by the central government. The mortgage

backed securities mainly aid the companies dealing in these securities, to posses a better

alternative than the assets owned by them. The financing companies will now be relieved of

the costs of maintenance of the assets and other costs related to assets, which will reduce their

overheads immensely and increase the profit ratio.


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Special Feature of Mortgage Backed Securities:

The commercial mortgage-backed securities are bought in exchange of offices, manufacturing

units, land, multi-story buildings, and hotels, which means that they are gained against the

personal or commercial holdings. The loans provided in lieu of the above mentioned

collaterals can be extended beyond 5 years at fixed interest rates and may not provide the

facility of paying off the loans before the specified tenure. These loans are also stretched over

shorter periods like a maximum of 3 years with the facility of payment before time and are

mostly accompanied by adjustable interest rates.

Exceptions to Mortgage Backed Securities:

The mortgage-backed securities can, however, prove problematic in case of the home

mortgage lenders of the United States of America, as home loan applicants there are provided

with the facility to make the loan payment before time to cover up a part of the next month's

interest amount. Such activities have a deep impact on the loan amount and the

inconsistencies in payment make it difficult to have an idea about the exact amount of funds

to be obtained at every month from the mortgage-backed securities.


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Kinds of Mortgage Backed Securities:

The mortgage backed securities can be divided into various kinds, but the most prominent

mortgage backed securities are:

y Commercial mortgage backed securities

y Collateralized mortgage obligation

y Stripped mortgage backed securities

y Residential mortgage backed securities

The residential mortgage backed securities (RMBS) are special bonds found in the security

market in the US and are the kind of securities which are supported by private property

especially the house of the mortgagor, this private property here serves as the collateral. The

stripped mortgage backed securities (SBMS) can be further classified into two kinds- the

interest only stripped mortgage backed securities and the principal only stripped mortgage

backed securities. The interest only stripped mortgage backed securities are supported by the

interest payments towards the collateral of the mortgagor, whereas the amount that is paid

towards the principal amount of the collateral of the mortgagor supports the principal only

stripped mortgage backed securities. The commercial mortgage backed securities are

supported by the properties used for business purposes.


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Asset-backed security

An asset-backed security is a security whose value and income payments are derived from

and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is

typically a group of small and illiquid assets that are unable to be sold individually. Pooling

the assets into financial instruments allows them to be sold to general investors, a process

called securitization, and allows the risk of investing in the underlying assets to be diversified

because each security will represent a fraction of the total value of the diverse pool of

underlying assets. The pools of underlying assets can include common payments from credit

cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty

payments and movie revenues.

Often a separate institution, called a special purpose vehicle, is created to handle the

securitization of asset backed securities. The special purpose vehicle, which creates and sells

the securities, uses the proceeds of the sale to pay back the bank that created, or originated,

the underlying assets. The special purpose vehicle is responsible for "bundling" the

underlying assets into a specified pool that will fit the risk preferences and other needs of

investors who might want to buy the securities, for managing credit riskoften by

transferring it to an insurance company after paying a premiumand for distributing

payments from the securities. As long as the credit risk of the underlying assets is transferred

to another institution, the originating bank removes the value of the underlying assets from its

balance sheet and receives cash in return as the asset backed securities are sold, a transaction

which can improve its credit rating and reduce the amount of capital that it needs. In this case,


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a credit rating of the asset backed securities would be based only on the assets and liabilities

of the special purpose vehicle, and this rating could be higher than if the originating bank

issued the securities because the risk of the asset backed securities would no longer be

associated with other risks that the originating bank might bear. A higher credit rating could

allow the special purpose vehicle and, by extension, the originating institution to pay a lower

interest rate (that is, charge a higher price) on the asset-backed securities than if the

originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from their

balance sheet by having another institution assume the credit risk, so that they (the banks)

receive cash in return. This allows banks to invest more of their capital in new loans or other

assets and possibly have a lower capital requirement.


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Types

Home equity loans

Securities collateralized by home equity loans (HELs) are currently the largest asset class

within the ABS market. Investors typically refer to HELs as any nonagency loans that do not

fit into either the jumbo or alt-A loan categories. While early HELs were mostly second lien

subprime mortgages, first-lien loans now make up the majority of issuance. Subprime

mortgage borrowers have a less than perfect credit history and are required to pay interest

rates higher than what would be available to a typical agency borrower. In addition to first

and second-lien loans, other HE loans can consist of high loan to value (LTV) loans, re-

performing loans, scratch and dent loans, or open-ended home equity lines of credit

(HELOC),which homeowners use as a method to consolidate debt.

Auto loans

The second largest subsector in the ABS market is auto loans. Auto finance companies issue

securities backed by underlying pools of auto-related loans. Auto ABS are classified into

three categories: prime, nonprime, and subprime:

y Prime auto ABS are collaterized by loans made to borrowers with strong credit

histories.

y Nonprime auto ABS consist of loans made to lesser credit quality consumers, which

may have higher cumulative losses.

y Subprime borrowers will typically have lower incomes, tainted credited histories, or


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both.

Owner trusts are the most common structure used when issuing auto loans and allow investors

to receive interest and principal on sequential basis. Deals can also be structured to pay on a

pro-rata or combination of the two.

Credit card receivables

Securities backed by credit card receivables have been benchmark for the ABS market since

they were first introduced in 1987. Credit card holders may borrow funds on a revolving basis

up to an assigned credit limit. The borrowers then pay principal and interest as desired, along

with the required minimum monthly payments. Because principal repayment is not scheduled,

credit card debt does not have an actual maturity date and is considered a non amortizing

loan.

ABS backed by credit card receivables are issued out of trusts that have evolved over time

from discrete trusts to various types of master trusts of which the most common is the de-

linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are

trenched into senior/subordinated bonds. A master trust has the advantage of offering multiple

deals out of the same trust as the number of receivables grows, each of which is entitled to a

pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the

senior and subordinate series within a trust and issue them at different points in time. The

latter two structures allow investors to benefit from a larger pool of loans made over time

rather than one static pool.


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Student loans

ABS collateralized by student loans (SLABS) comprise one of the four (along with home

equity loans, auto loans and credit card receivables) core asset classes financed through asset-

backed securitizations and are a benchmark subsector for most floating rate indices. Federal

Family Education Loan Program (FFELP) loans are the most common form of student loans

and are guaranteed by the U.S. Department of Education ("DOE") at rates ranging from 95%-

98% (if the student loan is serviced by a servicer designated as an "exceptional performer" by

the DOE the reimbursement rate was up to 100%). As a result, performance (other than high

cohort default rates in the late 1980's) has historically been very good and investors rate of

return has been excellent. The College Cost Reduction and Access Act became effective on

October 1, 2007 and significantly changed the economics for FFELP loans; lender special

allowance payments were reduced, the exceptional performer designation was revoked, lender

insurance rates were reduced, and the lender paid origination fees were doubled.

A second, and faster growing, portion of the student loan market consists of non-FFELP or

private student loans. Though borrowing limits on certain types of FFELP loans were slightly

increased by the student loan bill referenced above, essentially static borrowing limits for

FFELP loans and increasing tuition are driving students to search for alternative lenders.

Students utlilize private loans to bridge the gap between amounts that can be borrowed

through federal programs and the remaining costs of education.

The United States Congress created the Student Loan Marketing Association (Sallie Mae) as a

government sponsored enterprise to purchase student loans in the secondary market and to


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securitize pools of student loans. Since its first issuance in 1995, Sallie Mae is now the major

issuer of SLABS and its issues are viewed as the benchmark issues.

Stranded cost utilities

Rate reduction bonds (RRBs) came about as the result of the Energy Policy Act of 1992,

which was designed to increase competition in the US electricity market. To avoid any

disruptions while moving from a non-competitive to a competitive market, regulators have

allowed utilities to recover certain "transition costs" over a period of time. These costs are

considered nonbypassable and are added to all customer bills. Since consumers usually pay

utility bills before any other, chargeoffs have historically been low. RRBs offerings are

typically large enough to create reasonable liquidity in the aftermarket, and average life

extension is limited by a "true up" mechanism.

Others

There are many other cash-flow-producing assets, including manufactured housing loans,

equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, and

royalties. Intangibles are another emerging asset class.


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Trading asset-backed securities

"In the United States, the process for issuing asset-backed securities in the primary market is

similar to that of issuing other securities, such as corporate bonds, and is governed by the

Securities Act of 1933, and the Securities Exchange Act of 1934, as amended. Publicly issued

asset-backed securities have to satisfy standard SEC registration and disclosure requirements,

and have to file periodic financial statements."

"The Process of trading asset-backed securities in the secondary market is similar to that of

trading corporate bonds, and also to some extent, mortgage-backed securities. Most of the

trading is done in over-the-counter markets, with telephone quotes on a security basis. There

appear to be no publicly available measures of trading volume, or of number of dealers

trading in these securities."

"A survey by the Bond Market Association shows that at the end of 2004, in the United States

and Europe there were 74 electronic trading platforms for trading fixed-income securities and

derivatives, with 5 platforms for asset-backed securities in the United States, and 8 in

Europe."

"Discussions with market participants show that compared to Treasury securities and

mortgage-backed securities, many asset-backed securities are not liquid, and their prices are

not transparent. This is partly because asset-backed securities are not as standardized as

Treasury securities, or even mortgage-backed securities, and investors have to evaluate the

different structures, maturity profiles, credit enhancements, and other features of an asset-

backed security before trading it."


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The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap

rate. For example, the price of a credit card-backed, AAA rated security with a two-year

maturity by a benchmark issuer might be quoted at 5 basis points (or less) to the two-year

swap rate."

"Indeed, market participants sometimes view the highest-rated credit card and automobile

securities as having default risk close to that of the highest-rated mortgage-backed securities,

which are reportedly viewed as substitute for the default risk-free Treasury securities."


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Adjustable Rate Mortgage

ARM. A mortgage with an interest rate that may change, usually in response to changes in the

Treasury Bill rate or the prime rate. The purpose of the interest rate adjustment is primarily to

bring the interest rate on the mortgage in line with market rates. The mortgage holder is protected

by a maximum interest rate (called a ceiling), which might be reset annually. ARMs usually start

with better rates than fixed rate mortgages, in order to compensate the borrower for the additional

risk that future interest rate fluctuations will create.

Characteristics

Index

Rates for some common indexes used for Adjustable Rate Mortgages (1996-2006)

All adjustable rate mortgages have an adjusting interest rate tied to an index.[1]

In Western Europe, the index may be the ECB Refi rate (where the mortgage is called a

tracker mortgage), TIBOR or Euro Interbank Offered Rate (EURIBOR).

Six common indices in the United States are:

y 11th District Cost of Funds Index (COFI)

y London Interbank Offered Rate (LIBOR)


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y 12-month Treasury Average Index (MTA)

y Constant Maturity Treasury (CMT)

y National Average Contract Mortgage Rate

y Bank Bill Swap Rate (BBSW)

In some countries, banks may publish a prime lending rate which is used as the index. The

index may be applied in one of three ways: directly, on a rate plus margin basis, or based on

index movement.

A directly applied index means that the interest rate changes exactly with the index. In other

words, the interest rate on the note exactly equals the index. Of the above indices, only the

contract rate index is applied directly.

To apply an index on a rate plus margin basis means that the interest rate will equal the

underlying index plus a margin. The margin is specified in the note and remains fixed over

the life of the loan. For example, a mortgage interest rate may be specified in the note as

being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

The final way to apply an index is on a movement basis. In this scheme, the mortgage is

originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike

direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments

are tied to an index.


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Basic features ofARMs

The most important basic features of ARMs are:

1. Initial interest rate. This is the beginning interest rate on an ARM.

2. The adjustment period. This is the length of time that the interest rate or loan period on an

ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the

monthly loan payment is recalculated.

3. The index rate. Most lenders tie ARM interest rates changes to changes in an index rate.

Lenders base ARM rates on a variety of indices, the most common being rates on one-,

three-, or five-year Treasury securities. Another common index is the national or regional

average cost of funds to savings and loan associations.

4. The margin. This is the percentage points that lenders add to the index rate to determine the

ARM's interest rate.

5. Interest rate caps. These are the limits on how much the interest rate or the monthly

payment can be changed at the end of each adjustment period or over the life of the loan.

6. Initial discounts. These are interest rate concessions, often used as promotional aids, offered

the first year or more of a loan. They reduce the interest rate below the prevailing rate (the

index plus the margin).

7. Negative amortization. This means the mortgage balance is increasing. This occurs whenever

the monthly mortgage payments are not large enough to pay all the interest due on the

mortgage. This may be caused by the payment cap contained in the ARM when are high

enough that the principal plus interest payment is greater than the payment cap.

8. Conversion. The agreement with the lender may have a clause that allows the buyer to

convert the ARM to a fixed-rate mortgage at designated times.


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9. Prepayment. Some agreements may require the buyer to pay special fees or penalties if the

ARM is paid off early. Prepayment terms are sometimes negotiable.

It should be obvious that the choice of a home mortgage loan is complicated and time

consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan

Bank Board have prepared a mortgage checklist.

Limitations on charges (caps)

Any mortgage where payments made by the borrower may increase over time brings with it

the risk of financial hardship to the borrower. To limit this risk, limitations on charges

known as caps in the industryare a common feature of adjustable rate mortgages. Caps

typically apply to three characteristics of the mortgage:

y frequency of the interest rate change

y periodic change in interest rate

y total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of caps:

Interest rate adjustment caps:

y interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year

y interest adjustments made only once a year, typically 2% maximum

y interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:


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y maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative

amortization loans

Life of loan interest rate adjustment caps:

y total interest rate adjustment limited to 5% or 6% for the life of the loan.

Caps on the periodic change in interest rate may be broken up into one limit on the first

periodic change and a separate limit on subsequent periodic change, for example 5% on the

initial adjustment and 2% on subsequent adjustments.

Although uncommon, a cap may limit the maximum monthly payment in absolute terms

(for example, $1000 a month), rather than in relative terms.

ARMs that allow negative amortization will typically have payment adjustments that

occur less frequently than the interest rate adjustment. For example, the interest rate may be

adjusted every month, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment

cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap

on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two

values are given, this indicates that the initial change cap and periodic cap are the same. For

example, a 2/2/5 cap structure may sometimes be written simply 2/5.


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Securitization of Debt

Securitization Defined

Securitization of debt, or asset securitization as is more often referred to, is a process by

which identified pools of receivables, which are usually illiquid on their own, are transformed

into marketable securities through suitable repackaging of cashflows that they generate.

Securitization, in effect, is a credit arbitrage transaction that permits for more efficient

management of risks by isolating a specific pool of assets from the originator's balance sheet.

Further, unlike the case of conventional debt financing, where the interest and principal

obligations of a borrowing entity are serviced out of its own general cash flows, debt servicing

with assetbacked securities (ABS) is from the cash flows originating from its underlying assets.

What can be Securitized?

In concept, all assets generating stable and predictable cash flows can be taken up for

securitization. In practice however, much of the securitised paper issued have underlying

periodic cashflows secured through contracts defining cash flow volumes, yield and timing. In

this respect, securitization of auto loans, credit card receivables, computer leases, unsecured

consumer loans, residential and commercial mortgages, franchise/royalty payments, and other

receivables relating to telecom, trade, toll road and future export have gained prominence.

Typically, asset portfolios that are relatively homogeneous with regard to credit, maturity and


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interest rate risk could be pooled together to create a securitization structure. However, to make

reasonable estimates of the credit quality and payment speed of the securitised paper, it would be

essential to analyse the historical data on portfolio performance over some reasonable length of

time.

Why Securitize?

Securitization effort will call for considerable investments in time and resources. Hence, on a

comparative cost scale it can even be somewhat more expensive than other types of debt

financing that may be available to a borrower, at least in the initial stages. However, it has been

demonstrated that a continuing securitization program rather than a single deal often goes to

reduce the costs, as economies of scale and expertise pick up over a period of time. Bearing this

in mind, many securitization programs are run with a long-term strategic perspective. Growing

importance of securitization is perhaps best illustrated by the volume through-put in the non-

OECD world over the past few years. Criteria that constitute the general motivation behind most

securitization efforts are examined. From the viewpoint of an originator of such paper, the

following are typically the main persuasions to securitize.

Funding alternative

Being distinct and different from the originator's own obligations, a well structured ABS

stands on its own credit rating and thus generates genuine incremental funding. This is so as the

originator's existing creditors may invest in the ABS in addition to providing lines of credit to the

originator. Further, there may also be other investors in the ABS who do not have a lending

relationship with the originator. It is also possible to achieve a superior credit rating for the ABS


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than the originator's own through appropriate structuring and credit enhancement.This could

mean accessing an investor base focusing on high grades, which otherwise may not be possible

for an originator. Also, where the originator is not permitted to issue capital market instruments

on his own ABS could help overcome such constraints.

Balance sheet management

Fundamental benefit of a true sale, i.e., freeing up the capital of the originator would apply in

the case of all securitization transactions. In response, the balance sheet gets compressed and

becomes more robust. Its

ratios improve. Alternately, reduction in leverage post-securitised sale can be restored by

adding on new assets to the balance sheet. Thus the asset through-put of the originator's balance

sheet increases. Securitization can also generate matched funding for balance sheet assets.

Further, it may also enable the disposal of non-core assets through suitable structuring.

Re-allocation of risks

Securitization transfers much of the credit risk in the portfolio to the ABS investors and helps

to quantify the residual credit risk that the originator is exposed to. This is very useful, as the

originator can then take larger

exposure to individual obligors as well as provide a higher degree of comfort to his creditors.

Securitization also transfers the originator's market risks, i.e., liquidity, interest rate and

prepayment risks, to ABS investors and reduces risk capital requirement. This can lead to more

competitive pricing of the underlying asset products.


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Operating process efficiency

The extent of portfolio analysis and information demanded by securitization programs often

lead to serious re-examination and consequent reengineering of operating processes within the

originator organisation. Further, specialist handling of various functional components, such as

origination, funding, risk management and administration, often achieved through outsourcing,

promotes efficiency across operating processes.

Securitization improves operating leverage

The originator usually assumes the function of the servicer, the issuing and paying agent, and

sometimes that of the credit enhancer. Fees accrue on account of all of these. Excess servicing,

i.e., the difference between the asset yield and the cost of funds, is also normally extracted by the

originator. These income streams can push up the operating leverage of the originator generating

income from a larger asset base than what may be otherwise possible for a given capital

structure. Apart from the incentives that it offers to originators, ABS confer several benefits to its

investors as well. These include:

Low event risk

The pool of assets representing the obligations of a number of entities is usually more

resilient to event risks than the obligations of a single borrower i.e. the risk that the credit

rating of the security will deteriorate due to circumstances usually beyond the obligor's control is

much higher in the latter case. The diversity that the securitization pool represents makes the

ABS largely immune to event risks.


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Higher yields for lower/similar risk

ABS usually offer higher yields over securities of comparable credit and maturities. The

yield spread typically represents the premium paid to compensate for prepayment risk,

amortizing cashflows and the uniqueness of the instrument. In some cases, ABS also provide an

opportunity to invest into a pool of otherwise illiquid and inaccessible assets.

Structured issuances

Through appropriate structuring, an ABS can be tailored to meet investor standards on credit

quality, yield and maturity. Working with a pool of receivables gives the originator the needed

flexibility to be able to offer investors a menu of options around which issuances could be made.

Secondary MarketLiquidity

Investment decisions of institutional investors accord a sizeable weightage to instrument

liquidity. ABS does fit the requirement in this regard. While the ideal scenario would be to have

an active secondary market trading in ABS, institutional investors are often willing to settle for

credible liquidity backstops provided by well-rated institutions.


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Parties in a Securitization Transaction

Securitization programs usually involve several participants, each carrying out a specialist

function, such as, creating and analyzing the asset pool, administration, credit rating, accounting,

legal negotiation, etc. These include:

The Originator also interchangeably referred to as the Seller is the entity whose

receivable portfolio forms the basis for ABS issuance,

Special Purpose Vehicle (SPV), which as the issuer of the ABS ensures adequate

distancing of the instrument from the originator,

The Servicer, who bears all administrative responsibilities relating to the securitization

transaction,

The Trustee or the Investor Representative, who act in a fiduciary capacity safeguarding

the interests of investors in the ABS, The Credit Rating Agency, which provides an objective

estimate of the credit risk in the securitization transaction by assigning a well-defined

creditrating,

The Regulators, whose principal concerns relate to capital adequacy, liquidity, and credit

quality of the ABS, and balance sheet treatment of thetransaction,

Service providers such as Credit Enhancers and Liquidity Providers, and,

Specialist functionaries such as legal and tax counsels, accounting firms,

pool auditors, et al. However, more important than all the aforementioned are the investors in

the securitised paper. Investors are the ultimate judges of any securitization effort.

Originators should therefore interact actively with the investor community to get to know

investor preferences and concerns for effective structuring and distribution of ABS. Such


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knowledge would also make the origination process more efficient. Further, it shall always

be remembered that investors have their constraints in the form of legal restrictions,

complexity of credit analysis, house name limits, long response time for in-house approvals,

etc., all of which can block a deal, and more so in the case of ABS, which, on account

of their uniqueness and complexity, present a host of issues which are not normally

encountered, say in a straightforward bond investment.


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SecuritizationProcess

Essential features of a securitization transaction comprise the following:

1. Creation of asset pool and its sale

The originator/seller (of assets) creates a pool of assets and executes a legal true sale of the

same to a special purpose vehicle (SPV). An SPV in such cases is either a trust or a company, as

may be appropriate under applicable law, setup to carry out a restricted set of activities,

management of which would usually rest with an independent board of directors.

2. Issuance of the securitised paper

This activity is usually performed by the SPV. Design of the instrument however would be

based on the nature of interest that investors would have on the asset pool. In the case of pass-

through issuances, the investors will

have a direct ownership interest in the underlying assets, while pay-throughs are debt issued

by the SPV secured by the assets and their cash flows.

3. Credit Risk

It must be made abundantly clear at the very outset that the accretions on the asset-backed

security, i.e., interest, amortisation and redemption payments, are entirely dependent on the

performance of the pooled assets, and will have nothing to do with the credit of the originator.

By the same argument, such cash flows would also be not influenced by events affecting the

condition of the originator, including insolvency.


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4. Pool Selection

The process of selecting assets to build a securitization pool would take into careful

consideration, loan characteristics that are important from a cash flow, legal, and credit points of

view, such as type of asset, minimum and maximum loan size, vintage, rate, maturity and

concentration limits (geographic, single-borrower, etc.). 'Cherry-picking' to include only the

highest quality assets in the pool should be consciously avoided. Ideal selection would be a

random choice among assets conforming only to cash flow or legal criteria. Often, substitution of

eligible assets in the place of original assets that mature/prepay in order to maintain the level of

asset cover would also be required.

5. Administration

Formal delineation of duties and responsibilities relating to administration of securitised assets,

including payment servicing and managing relationship with the final obligors must be spelt out

clearly through a contractual agreement with the entity who would perform those functions. In

addition, the following features are often included as part of a securitization transaction:

Credit enhancement to support timely payments of interest and principal and to handle

delinquencies,

Independent credit rating of the securitised paper from a well known credit rating agency, and,

Providing liquidity support to investors, such as appointment of market makers.


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Documentation

In documentation lies the heart of all securitization. An appropriate set of documentation,

perfected against the applicable legal framework, is fundamental to structuring transactions.

While the specifics may vary from one jurisdiction to another, there is a generic body of

documentation that is normally applicable in most cases. Legal opinions constitute the very

foundations. These must provide clear affirmation on all things fundamental, such as the legality

of the transaction, the bankruptcy remoteness of the issuer from the originator, the issuer's

authority to enter into such transactions, the legal true sale of receivables to the issuer, the

creation of security over the receivable pool, etc.

Other documentation relate to receivables, security, administration and operational aspects.

Receivable documentation should first establish the existence and nature of underlying

obligations, such as payment schedules, the conditions under which the obligors may either

renege or repudiate payments, and terms of sale of such receivables. It must also confirm that the

receivables have been originated in compliance with the applicable statutes. When receivables

are sold, documentation specifying the items sold, the mechanics of sale and the representations

and warranties made by the seller on their characteristics would be drawn up. Further, the claims

of investors in ABS over such flows need to be established clearly through the security

documentation. Service documentation specifying the duties and responsibilities of the servicer

or servicing agent would also be a key one. In practice, originators often double up as servicers.

Related documentation in addition to the above would typically comprise those relating to credit

enhancement, liquidity and market-making, listing agreements with stock exchanges, as well as

transaction prospectus or information memoranda, as may be appropriate.


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Structuring Considerations

These are fundamental to every securitization deal, as they determine the specifics relating to

the ABS instrument, the issuer, the relevant tax and accounting treatment, and other key factors.

Every ABS issuance may have to be structured differently in order to take the best advantage of

the various environmental factors. First of the structuring decisions would concern the manner in

which the pool of assets will be sold/transferred. This would be followed by the design of the

ABS instrument, as either a pass through or a pay through security. Pass-throughs represent

direct ownership interests in theunderlying assets, which are typically held in trust for the

investors, so that payments on the assets are passed through to the investors directly from the

assets (after payment of all fees and expenses, including excess servicing). Pay throughs, on the

other hand, are general obligations or preferred stock of the issuer (SPV), substantially all the

assets of which consist of a pool of receivables and the related credit enhancement or other

structural support.

As the assets are owned by this entity rather than the investors, who as a matter of law receive

payments on a separate security backed by the general credit of the entity rather than an interest

in the assets, payments on these assets are said to be paid rather than passed through to the

investors. Tax and accounting treatments constitute other important dimensions of structuring.

Typical tax issues that need to be addressed relate to transfer charges (stamp duty), capital gains

taxation as applicable to the originator on sale of assets, taxation of the issuer, and withholding

tax or taxes deducted at source as applicable to the issuer and the investors. Accounting

treatment of securitization could fall into one of the following three categories, viz., full


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derecognition, partial derecognition where only transferred assets receive derecognition, and full

on-balance sheet recognition. Specialist opinion must be obtained on both tax and accounting

aspects. These would be environment specific. Credit enhancement of the ABS would also be an

important structuring consideration, as it strives to strike a balance between the investor and the

issuer needs on the credit quality of the instrument. Typical forms of credit enhancement include:

Spread Account or Reserve Account, Over collateralization, Letters of credit, Insurance company

guarantees, Senior/ Subordinated structure, etc. Other structuring issues that need to be addressed

relate to extraction of excess servicing, identification of payment and loss priorities, etc.


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Capital adequacy ratio

Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio

(CRAR) is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure

that it can absorb a reasonable amount of loss and are complying with their statutory Capital

requirements.

Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as

a percentage of its risk weighted credit exposures.

Capital adequacy ratio is defined as

where Risk can either be weighted assets ( ) or the respective national regulator's minimum

total capital requirement. If using risk weighted assets,

10%.

The percent threshold (10% in this case, a common requirement for regulators conforming to

the Basel Accords) is set by the national banking regulator.

Two types of capital are measured: tier one capital (T1 above), which can absorb losses

without a bank being required to cease trading, and tier two capital (T2 above), which can absorb

losses in the event of a winding-up and so provides a lesser degree of protection to depositors.


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Use

Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of

meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most

simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's

depositors or other lenders. Banking regulators in most countries define and monitor CAR to

protect depositors, thereby maintaining confidence in the banking system.

CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of

debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-

equity; since assets are by definition equal to debt plus equity, a transformation is required).

Unlike traditional leverage, however, CAR recognizes that assets can have different levels of

risk. Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of

meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most

simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's

depositors or other lenders. Banking regulators in most countries define and monitor CAR to

protect depositors, thereby maintaining confidence in the banking system.

Risk weighting

Since different types of assets have different risk profiles, CAR primarily adjusts for assets

that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR

calculation vary from country to country, but general approaches tend to be similar for countries

that apply the Basel Accords. In the most basic application, government debt is allowed a 0%


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"risk weighting" - that is, they are subtracted from total assets for purposes of calculating the

CAR.


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BACKGROUND

This article has been written in form of literature review from various sources including, wall

street journal, financial management Taxman, Wikipedia free encyclopedia, ICFAI journal on

finance, Guest lectures, personal interrogation and internet search.

This article exists in modified from the original templates. In the past research the main area

covered are phenomena and the explanation of the entire crises. This research focus on the micro

elements of the crises and what aggravated it rather than the only conceptual frame work.

LITERATURE

1 Greg Ip, Mark Whitehouse, and Aaron Lucchetti, U.S. Mortgage Crisis Rivals S&LMeltdown, Wall StreetJournal, December 10, 2007, p. A1.

2 ABC News, Who Qualifies for Bush's Mortgage Bailout Plan? December 7, 2007,http://abcnews.go.com/GMA/Consumer/story?id=3968737&page=1.3 Jane Sasseen, Does the housing plan go far enough,Business Week, Dec 11, 2007,http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db2007126_445035.htm.4 Errol Louis, The Guilty Parties,New York Daily News, December 11, 2007,http://www.nydailynews.com/opinions/2007/12/09/2007-12-09_the_guilty_parties.html.5 Organization for Economic Cooperation and Development, Standardized Unemployment Rate(SUR): October2007,

FINDINGS

The finding shows that the factors responsible for the crises were

y Decrease in prime lending rate

y Securitization

y Adjustable rate Mortgage

y Increase in interest rate of prime borrowers

y Mortgage backed securities


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The immediate cause or trigger of the crisis was the bursting of the United States housing

bubble which peaked in approximately 20052006. High default rates on "subprime" and

adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan

incentives such as easy initial terms and a long-term trend of rising housing prices had

encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly

refinance at more favorable terms. However, once interest rates began to rise and housing prices

started to drop moderately in 20062007 in many parts of the U.S., refinancing became more

difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired,

home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices

also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter

foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to be

a key factor in the global economic crisis, because it drains wealth from consumers and erodes

the financial strength of banking institutions.

In the years leading up to the crisis, significant amounts of foreign money flowed into the

U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds

combined with low U.S. interest rates from 2002-2004 contributed to easy credit conditions,

which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit

card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part

of the housing and credit booms, the amount of financial agreements called mortgage-backed

securities (MBS), which derive their value from mortgage payments and housing prices, greatly


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increased. Such financial innovation enabled institutions and investors around the world to invest

in the U.S. housing market. As housing prices declined, major global financial institutions that

had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and

losses on other loan types also increased significantly as the crisis expanded from the housing

market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars

globally.

While the housing and credit bubbles built, a series of factors caused the financial system to

become increasingly fragile. Policymakers did not recognize the increasingly important role

played by financial institutions such as investment banks and hedge funds, also known as the

shadow banking system. Some experts believe these institutions had become as important as

commercial (depository) banks in providing credit to the U.S. economy, but they were not

subject to the same regulations. These institutions as well as certain regulated banks had also

assumed significant debt burdens while providing the loans described above and did not have a

financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted

the ability of financial institutions to lend, slowing economic activity. Concerns regarding the

stability of key financial institutions drove central banks to take action to provide funds to

encourage lending and to restore faith in the commercial paper markets, which are integral to

funding business operations. Governments also bailed out key financial institutions, assuming

significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent

financial market crisis were primary factors in several decisions by central banks around the

world to cut interest rates and governments to implement economic stimulus packages. Effects


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on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October

2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their

holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have

averaged about 40%. Losses in the stock markets and housing value declines place further

downward pressure on consumer spending, a key economic engine. Leaders of the larger

developed and emerging nations met in November 2008 and March 2009 to formulate strategies

for addressing the crisis. As of April 2009, many of the root causes of the crisis had yet to be

addressed. A variety of solutions have been proposed by government officials, central bankers,

economists, and business executives.


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Mortgage market

Number of U.S. residential properties subject to foreclosure actions by quarter (2007-2009).

Subprime borrowers typically have weakened credit histories and reduced repayment capacity.

Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is

delinquent in making timely mortgage payments to the loan servicer (a bank or other financial

firm), the lender may take possession of the property, in a process called foreclosure.

The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with

over 7.5 million first-lien subprime mortgages outstanding. Between 2004-2006 the share of

subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in

2001-2003 and during 2007. In the third quarter of 2007, subprime ARMs making up only 6.8%

of USA mortgages outstanding also accounted for 43% of the foreclosures which began during

that quarter. By October 2007, approximately 16% of subprime adjustable rate mortgages

(ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly

triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008

it was 25%.

The value of all outstanding residential mortgages, owed by USA households to purchase

residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6

trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly

1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81%

increase vs. 2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either


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delinquent or in foreclosure. By September 2009, this had risen to 14.4%. Between August 2007

and October 2008, 936,439 USA residences completed foreclosure. Foreclosures are

concentrated in particular states both in terms of the number and rate of foreclosure filings. Ten

states accounted for 74% of the foreclosure filings during 2008; the top two (California and

Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84%

of households.


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Causes

The crisis can be attributed to a number of factors pervasive in both housing and credit

markets, factors which emerged over a number of years. Causes proposed include the inability of

homeowners to make their mortgage payments, due primarily to adjustable rate mortgages

resetting, borrowers overextending, predatory lending, speculation and overbuilding during the

boom period, risky mortgage products, high personal and corporate debt levels, financial

products that distributed and perhaps concealed the risk of mortgage default, monetary policy,

international trade imbalances, and government regulation (or the lack thereof) Three important

catalysts of the subprime crisis were the influx of moneys from the private sector, the banks

entering into the mortgage bond market and the predatory lending practices of mortgage brokers,

specifically the adjustable rate mortgage, 2-28 loan. On Wall Street and in the financial industry,

moral hazard lay at the core of many of the causes.

In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15

November 2008, leaders of the Group of 20 cited the following causes:

During a period of strong global growth, growing capital flows, and prolonged stability

earlier this decade, market participants sought higher yields without an adequate appreciation of

the risks and failed to exercise proper due diligence. At the same time, weak underwriting

standards, unsound risk management practices, increasingly complex and opaque financial

products, and consequent excessive leverage combined to create vulnerabilities in the system.

Policy-makers, regulators and supervisors, in some advanced countries, did not adequately

appreciate and address the risks building up in financial markets, keep pace with financial

innovation, or take into account the systemic ramifications of domestic regulatory actions.


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Between 1997 and 2006, the price of the typical American house increased by 124%. During

the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times

median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble

resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing

consumer spending by taking out second mortgages secured by the price appreciation. USA

household debt as a percentage of annual disposable personal income was 127% at the end of

2007, versus 77% in 1990.

While housing prices were increasing, consumers were saving less and both borrowing and

spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable

personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008,

134% of disposable personal income. During 2008, the typical USA household owned 13 credit

cards, with 40% of households carrying a balance, up from 6% in 1970. Free cash used by

consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in

2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. U.S. home

mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73%

during 2008, reaching $10.5 trillion.

This credit and house price explosion led to a building boom and eventually to a surplus of

unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. Easy

credit, and a belief that house prices would continue to appreciate, had encouraged many

subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers

with a below market interest rate for some predetermined period, followed by market interest

rates for the remainder of the mortgage's term. Borrowers who could not make the higher


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payments once the initial grace period ended would try to refinance their mortgages. Refinancing

became more difficult, once house prices began to decline in many parts of the USA. Borrowers

who found themselves unable to escape higher monthly payments by refinancing began to

default.

As more borrowers stop paying their mortgage payments (this is an on-going crisis),

foreclosures and the supply of homes for sale increases. This places downward pressure on

housing prices, which further lowers homeowners' equity. The decline in mortgage payments

also reduces the value of mortgage-backed securities, which erodes the net worth and financial

health of banks. This vicious cycle is at the heart of the crisis.

By September 2008, average U.S. housing prices had declined by over 20% from their mid-

2006 peak. This major and unexpected decline in house prices means that many borrowers have

zero or negative equity in their homes, meaning their homes were worth less than their

mortgages. As of March 2008, an estimated 8.8 million borrowers 10.8% of all homeowners

had negative equity in their homes, a number that is believed to have risen to 12 million by

November 2008. Borrowers in this situation have an incentive to default on their mortgages as a

mortgage is typically nonrecourse debt secured against the property. Economist Stan Leibowitz

argued in the Wall Street Journal that although only 12% of homes had negative equity, they

comprised 47% of foreclosures during the second half of 2008. He concluded that the extent of

equity in the home was the key factor in foreclosure, rather than the type of loan, credit

worthiness of the borrower, or ability to pay.


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Increasing foreclosure rates increases the inventory of houses offered for sale. The number of

new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the

inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest

value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of

which almost 2.9 million were vacant. This overhang of unsold homes lowered house prices. As

prices declined, more homeowners were at risk of default or foreclosure. House prices are

expected to continue declining until this inventory of unsold homes (an instance of excess

supply) declines to normal levels.

the immediate cause or trigger of the crisis was the bursting of the united states housing bubble...

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