US Subprime Mortgage Crisis

Chapter 10

Learning Objectives

1. Explain causes of the US Subprime mortgage crisis of 2007 and response of major economies to this crisis.

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Subprime Mortgage Crisis• The subprime mortgage crisis is an ongoing

real estate crisis and financial crisis triggered by a dramatic rise in mortgage delinquencies (failure/default) and foreclosures (bankruptcy homes and properties) in the United States, with major adverse consequences for banks and financial markets around the globe.

• The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system.

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Subprime Mortgage Crisis• The crisis emerged from mortgage markets in U.S. • The US sub-prime mortgage crisis has led to plunging

property prices, a slowdown in the US economy, and billions in losses by banks. It stems from a fundamental change in the way mortgages are funded.

• Traditionally, banks have financed their mortgage lending through the deposits they receive from their customers. This has limited the amount of mortgage lending they could do.

• In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets. This has made it much easier to fund additional borrowing. 4

Subprime Mortgage Crisis• But it has also led to abuses as banks no longer have the

incentive to check carefully the mortgages they issue. • The U.S. housing was oversupplied and low interest rates

allowed many households to borrow money at cheap rates.

• In the past five years, the private sector has dramatically expanded its role in the mortgage bond market, which had previously been dominated by government-sponsored agencies like Freddie Mac.

• They specialised in new types of mortgages, such as sub-prime lending to borrowers with poor credit histories and weak documentation of income, who were shunned (rejected) by the "prime" lenders like Freddie Mac.

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Subprime Mortgage Crisis• However, when the housing market bubble busted, the prices

began to fall. • The borrowers did not have the funds to pay back the

mortgage instalments when the mortgage rates became higher on resetting.

• 80% of the mortgages were using adjustable rate mortgage, which was reset at higher rates (double) in the next two years and caused massive number of mortgage defaults in the U.S.

• This major and unexpected increase in the mortgage rate meant that many borrowers had zero or negative equity in their homes and their houses were worth less than their mortgages.

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THE RISE OF THE MORTGAGE BOND MARKET

• The wave of repossessions is having a dramatic effect on house prices, reversing the housing boom of the last few years and causing the first national decline in house prices since the 1930s.

• There is a glut (excess/surplus) of four million unsold homes that is depressing prices, as builders have also been forced to lower prices to get rid of unsold properties.

• The US sub-prime mortgage crisis has led to plunging property prices, a slowdown in the US economy, and billions in losses by banks.

• As a result, the major banks in the U.S. faced liquidity problems.

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Factors contributed to subprime crisis• The US Government policies ( Federal reserve) of low

interest rates to create easy credit condition to spur the property . It has been the goal of the several US president including Roosevelt, Reagan, Clinton and G.W Bush to increase American home ownership. Subprime lending was a major contributor to increasing home ownership rate.

• US housing bubble and housing market correction. Subprime lending contribute to the hike of housing price and consumer are encourage to take financing even though they may have low credit rating as the property is secured to the lending. The property industry is enjoying a market boom and eventually went bust in mid 2006.

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Factors contributed to subprime crisis• Homeowner speculation. The increase in housing prices lead

to speculative buying. House price nearly double between 2000 and 2006.

• High-risk mortgage loans and lending practices. Prior to crisis, many financial institutions in US have been very loose in offering loans. Loans are known to be offered even to the illegal immigrant. In 2006 the total loans totaled US $600 billion

• Inaccurate credit ratings. Credit rating agencies are known to give high ratings to Mortgage-based Securities in order for the subprime loans to be repackaged and sold to investors. Many of the repackage loan sold to equities investors and insurance companies. These are the agencies who suffer most.

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Factors contributed to subprime crisis• Policies of federal reserve. Less concern with the

asset price bubble. It is more concern with the monetary policies rather than trying to stop the price bubble.

• Lack of government regulation. Prior to the crisis, Mr Alan Greenspan ( Chairman of federal reserve) conceded/approved the Federal Reserve allowing the banking sector to self-regulate. However this is clearly a failure. The lack of regulation allows exploitation of loan mortgage to low creditworthy customers.

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AFTERMATH OF SUBPRIME MORTGAGE CRISIS

• The world capital markets lost nearly US$5.2 trillion in 2008 due to the subprime crisis.

• The capital markets suffered because some long-term securities such as asset-backed securities were backed mostly by these risky subprime mortgages, and now it was clear that these securities would also lose their values due to the loss in the values of the underlying assets.

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AFTERMATH OF SUBPRIME CRISIS - HOUSING AND THE ECONOMY

• The property crash is also affecting the broader economy, with the building industry expected to cut its output by half, with the loss of between one and two million jobs.

• Many smaller builders will go out of business, and the larger firms are all suffering huge losses.

• The building industry makes up 15% of the US economy, but a slowdown in the property market also hits many other industries.

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AFTERMATH OF SUBPRIME CRISIS• In London, the FTSE lost more than 15% and the Paris

market fell by 12.3%.• The emerging markets were hit hard. China lost 21%

in January 2008 and the Russian and Indian markets fell by 16% and 15% respectively.

• The entire U.S. auto industry was hard hit by the crisis. General Motors (GM), the giant American car market filed for Chapter 11 bankruptcy protection in June 2009.

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AFTERMATH OF SUBPRIME CRISIS• European markets and the U.K. also suffered due to

the slowdown in consumer spending. The European and the U.S. governments have injected more than US$1.5 trillion into the world financial system to bring it back from the gloom.

• The Japanese economy shrunk in the past few years and major Japanese companies, such as Toyota Corp., have reported massive losses due to the sharp fall for their exports in the U.S.

• Asian economis experienced a fall in the exports volume and unemployment.

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BOND MARKET COLLAPSE • Also suffering huge losses are the bondholders, such as

pension funds, who bought sub-prime mortgage bonds. • These have fallen sharply in value in the last few months,

and are now worth between 20% and 40% of their original value for most asset classes, even those considered safe by the ratings agencies.

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Lessons learnt from Crisis1. Improved and robust (healthy) financial

regulations

2. Checks and balances on new financial innovations and investors such as hedge funds

3. Coordination and cooperation between regional and local financial regulators

4. Transparent corporate governance practices

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1.Improved and robust financial regulations

• Establishment of regional/global think tanks to propose new global regulations.

• Government intervention in financial markets to avoid asset bubbles.

• Establishment or enhancement of current legal systems/courts to punish the brazen perpetrators of financial crimes against investing communities.

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2.Checks and balances on new financial innovations

• Multi-layered structure of complex financial products should be unbundled to reduce information asymmetries.

• Moral hazard among the parties involved in the structuring of innovative products should be checked.

• Poor due diligence and blind reliance on credit ratings must be stopped.

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3.Coordination and cooperation between regional and local financial regulators

• Ironing out differences in regional regulations through– dialogue, – negotiations– treaties and rules.

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4.Transparent corporate governance practices

• Identify weaknesses and failures in the corporate governance arrangements.

• Signposts and red flags to hint at excessive risk taking of managers.

• Boards’ vigilant (alert) oversight and access to critical information.

• Pay-for-performance ideology needs to be critically revised.

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