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The Collapse of US Economy After Subprime Mortgages Crisis, Term Paper Example

Pages: 8

Words: 2215

Term Paper

1. Introduction

It was with the steep rise in home foreclosures in United States that subprime mortgage crisis came to the attention of public. During 2006 home foreclosures rose steeply and by 2007 it was out of control leading US to financial crisis and the whole global economy was affected by it by the end of that year. People no more dared to spend and it witnessed plummeting housing market. Stock market was also affected and this lead to dissension among lenders, customers and legislators. They furiously spawned debates on causes and methods to fix this issue. Subprime mortgage crisis was called as “mortgage meltdown” or mortgage “mess.” International Monetary Fund (IMF) reported that mortgage meltdown could lead to a loss of $565 billion Dollars. This was mentioned in semi annual Global Financial Stability Report of IMF in 2008, April 8th (DiMartino and John).

2. The roots

According to economists there are several factors that have led to mortgage crisis. Most of them are of the opinion that it was the result of a combination of factors where major role was played by subprime lending (DiMartino and John). Some of them are:

2.1 Housing Bubble

During a period of five years from 2001 – 2005, US housing sector began to experience housing bubble. Housing bubble is in reality an economic bubble effecting real estate market. During 2001 – 2005 value of property increased so high that it became unsustainable in comparison to income and other various other indicators (DiMartino and John). After this rapid and unsustainable price hike, house prices will go down while mortgage debt will be more than actual value of property. Housing bubble in US was the result of a market correction in 2006 (Angkinand).

2.2 Interest Rates

Some believe that interest rates in US became historically low and this resulted in housing bubble. Short term interest rates were cut by Federal Reserve Board from 6.5 to 1 percent on the basis of dot com bubble of 2000 and recession that began subsequently in 2001. These rates of federal fund will affect mortgage rates that are set with related to Treasury bond yields for 10 year. In US housing market acts as a key channel for transmission of monetary policy and was affected by interest rates (Rajdeep and Bryan).

2.3 Greenspan effect

Some are of the opinion that it was the decline in interest rates by Fed that inflated housing bubble in US. For this Fed’s than Chairman, Greenspan is held responsible for. Though Greenspan is denying this criticism President and CEO of the Federal Reserve Bank of Dallas,

Richard W. Fisher, states that it was the interest policy of Fed during 2000- 2003 were the result of misguided low inflation data and this led to housing bubble (James, Joe and James). As Fed was worried about economic issues faced by country during 2000 – 2002 and ability of US economy to withstand another crisis interest rates were reduced by Fed. They also aimed to keep growth stable even through environment was potentially deflationary. This was the easiest method FOMC could adopt. In a few years after some revisions only it came to notice that actual inflammation rates were higher than actually what every one thought. Interest rates were so lower than what would have been appropriate according to economic condition that was prevailing and this led to speculative market and housing activities (L. Randall and Éric).

2.4 The Burst of Bubble

Interest rates was raised 17 times by the Federal Reserve Board between 2004 – 2006 and the increase of rate was from 1% – 5.25%. Rate rise was stopped on fear of acceleration of housing market downturn that is likely to undermine whole economy. Economists like Nouriel Roubini of the New York University are of the opinion that rates were to be tightened up by Fed earlier to avoid housing bubble festering early. It was due to these slumping prices and sale during August 2006 that housing sector had a free fall and this led to recession next year (Jeffrey).

2.5 Correction of Housing Market

During housing bubble houses were over valued and crisis was also growing during 2006 – 07. Economists were also thinking that a correction will be there in housing market and this will range up to 50% or more from values that are considered peak values. Economists like Mark Zandi from Moody’s Economy.com believed that by 2007 – 2009 there will be depreciation by double digit (Angkinand).

3. Subprime Lending rise

During the years of bubble ownership rates of house increased with its demand and the reason was subprime borrowing. By 2004 ownership rates reached 69.2 which was an all time high as same rate during 1994 was only 64 percent. Home value increased by 124 percentages between 1997-06 and this was due to increased demand for houses which increased consumer spending and housing prices. Owners refinanced their homes on the basis of increased property value and this was at reduced interest rates. Second mortgages were also taken against added value and this amount was used for consumer spending. Thus household debt in US became 130 percent during 2007. Hike was 30 percent from average amount from whole decade (Angkinand). After housing bubble came various mortgage loans like Alt-A which provided loans to borrowers of high risk who were having a credit history that is lesser or who is having lower income than prime borrowers. In Alt- A risk profile falls between sub prime and prime. Though borrowers are those with clean credit history mortgage itself includes some issues that will increase risk profile. They are in adequate documentation of mortgage borrower, higher debt to income ratio and higher loan to value ratios (DiMartino and John). Sub prime mortgage share has increased from 9 percent in 1996 to 20 percent in 2006, reports Forbes and this amounted to $600 billion. Subprime mortgage accounts for one fifth of home loan market of US. There is an outstanding balance of $1.3 trillion from subprime loans in the country. Sub prime loans rose in number as lenders were taking more risk due to rise of value of real estate. Loans were being bundled to securities and these securities were sold to institutional investors and pension fund for higher returns. This act of Wall Street is believed to encourage increase of subprime mortgage (Rajdeep and Bryan).

3.1 Risk Premiums decline and emergence of new lenders

Difference between interest rates of prime and subprime mortgage reduced from 2.8 in 2001 to 1.3 percent in 2007 according to a Federal Reserve study conducted in 2007. This clearly indicates that lenders are no longer forced to provide a risk premium of great value for obtaining subprime mortgages. During 2001 – 2006 there was a decline of loan characteristics and borrower of subprime loans reduced during same period and this was supposed to create an opposite effect. But due to decline of risk premiums lenders began to consider those with higher risk as loan borrowers (Jeffrey).

Some economists are of the view that actual reason behind this is emergence during years of boom. Such lenders were not regulated by traditional banks. 60% of market of mortgage was carried by traditional lenders during 1970 and by 2012 this reduced to 10%. At the same period shares of commercial banks rose from almost zero to 40% of whole market share (James, Joe and James).

4. Lax Lending Standards and Risky Mortgage Products

With unregulated lenders subprime mortgages also rose in number and this raised an alarm. There was an increase of stated income mortgage loans, adjustable rate and interest only mortgage and this proves the statement (Angkinand). Stated income loans are otherwise called no doc loans and they can be said to be ‘liar loans” and are a kind of Alt-A loans. Income of the borrower is not be substantiated by providing documents to avail finance for purchasing home. Such loans will raise concern about loan quality when there is an increase in interest rate or when mortgage cannot be paid by borrower. Such loans though were not even known earlier became so common in areas of high appreciation and other during bubble period (DiMartino and John). It is to be noted that of the whole number of mortgages provided in 2004 at San Diego County, 80 percentages were adjustable rates and interest only loans counted to 47 percentages. Buyers were also offered incentives by lenders in addition to interest only loans and ARMs. During 2004 – 2006 out of total ARMs one third were with less than 4 percent teaser rates. \such reduced teaser rates are only for a temporary period and it will increase as time passes and at times will even double the monthly payment amount (Jeffrey).

During the period of boom down payment assistance (DPA) programs funded by sellers also initiated. In DPA programs money is given to some charitable organization by seller and this money is then given to buyer by charitable organization. Between the years of 2000 – 2006 of the total buyers more than 650,000 obtained down payment through non profits. These kinds of mortgages are of higher foreclosure and default rate as per Government Accountability Office (GAO). A study conducted by GAO revealed that in order to recoup non profit contributions DPA sellers inflated the prices of houses (Bhardwaj and Sengupta).

Non profit status of DPA was removed in May 2006 through a ruling of Internal Revenue Service and this was because of the cash flow nature that was circular where charity is paid by seller as a fee only after closing. Seller funded down payment programs were also banned by the Department of Housing and Urban Development through regulations on October 31st 2007 (Víctor).

5. Securitization

Securitization is defined by Black’s Law Dictionary as a structured finance process which acquires financial instruments, receivables or assets and is considered as pool for third party investment collateral is offered. With securitization it is likely that investors will begin to ask for mortgage backed securities (MBS) and along with that rating agencies are also likely to rate MBS with investment grade leading to an increase of high risk of default loans where risk is transferred to others readily (DiMartino and John).

According to Office of the Comptroller of the Currency’s Asset Securitization Comptroller’s Handbook securitization of asset began in 1970s with mortgage pools structured financing. In subprime mortgages some securitized share are passed to third party investors and this rate increased from 54 to 75 percent during 2001 – 2006. According to Alan Greenspan it is the securitization of loans (home loans) to those with poor credit to be blamed for mortgage meltdown and not alone the type of loans that are issued (L. Randall and Éric).

5.1 Fallout

It was in 2005 that federal interest rates climbed and housing bubble burst. Though there were foreclosures of houses that were purchased through subprime mortgage and it is likely to increase, the popularity of subprime mortgages continue to grow. Subprime lenders more frequently conducted foreclosure of property and during fist half of 2006 foreclosure filings increased by 31%. By 2007 subprime mortgage industry began to show collapsing signs due to higher home foreclosure rates than that was expected. Interest rates continued to grow to highest level and mortgage payments were not made by most home owners. Subprime lenders were not able to provide new loans and largest subprime lender, Ameriquest, lay off 3,800 employees and stopped providing new loans. They made a settlement for $325 million for deceptive lending and marketing practices to Attorney General of 30 states. By 2007 summer investors began to back away and thus the housing boom came to rest (Bhardwaj and Sengupta).

Conclusion

After so many years of chaos and discussion economists and financial analysts have now understood the cause of economic crisis of US. It was a combination of various mortgage forms like subprime mortgage, no docs and securitization that US economy plunged into history’s biggest crisis. Devastating effect of subprime mortgages in was witnessed by regulators, legislators and industry insiders and even common man. Several thousands became homeless and unemployed and even now country has not recovered from it completely. Even now after effects of subprime mortgage have not left US and new issues are found every day. Though every one is aware of the reason that led US to an economic crisis that had an impact on whole world, no one has been able to find a clear solution to get out of this issue completely.

References

Angkinand, Apanard P. “Banking regulation and the output cost of banking crises.” Journal of Financial Markets, Institutions & Money (2009): 240-257.

Bhardwaj, Geetesh and Rajdeep Sengupta. “Where’s the Smoking Gun? A Study of Underwriting Standards for U.S. Subprime Mortgages.” Working Paper No. 2008-036D. 2010.

DiMartino, Danielle and V. Duca. John. The Rise and Fall of Subprime Mortgages. Economic Letter-Insights . Dallas: Federal Reserve Bank of Dallas, 2007.

James, B. Bexley, F. James Joe and Haberman James. “The financial crisis and its issues.” Research in Business and Economics Journal (2011).

Jeffrey, A. Frankel. “The Global Financial Crisis: A Selective Review of Recent Research in the International Finance and Macroeconomics Program.” The National Bureaue of economic research (2009).

Randall, Wray and Tymoigne Éric. Macroeconomics Meets Hyman P. Minsky:The Financial Theory of Investment. Working Paper. Kansas City: The Levy Economics Institute and University of Missouri–Kansas City, 2008.

Rajdeep, Sengupta and J. Noeth Bryan. “Underwriting on Subprime Mortgages: What Really Happened?” Central Banke: Federal Reserve Bank of St. Louis November 2010.

Víctor, A, Beker. “Rethinking macroeconomics in light of the U.S. financial crisis.” Real-world economics review (2012): 102 – 116.

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