The Subprime Crisis of 2007-2008, Research Paper Example

Introduction

The Subprime Crisis of 2007-2008 is believed to have been triggered by the mortgage crisis in the real estates sector of the United States of America. The crisis led to the foreclosures and mortgage delinquencies leading to a massive fall of the financial markets and banks all over the world. This financial meltdown is believed to have started way back in the late 1990s revealing considerable weaknesses and laxity in the regulation of the financial industry. During this period, over 80 percent of the mortgages issued in the form of adjustable- rate mortgages- where the interest rate is periodically amended on the basis of a variety of standard indices (Krugman 15).

Sub-Prime Lending

This term is mostly used to refer to the credit quality of particular borrowers, who by one way or another have led to the weakened and more risky loan defaulting than the prime borrowers. By the year 2007, the subprime value of the U.S mortgage was US$1.3trillion with a 7 million outstanding subprime mortgage holdings. There is substantial evidence that the state administration together with other competitive forces accelerated the magnitude of this subprime lending prior to the onset of this financial crisis. Government organized enterprises such as Fannie Mae and major investment banks in the U.S. are known to have played a leading role I the growth of the increased- risk lending (Ben 11).

Until 2004, subprime mortgages were always less than 10 percent of the entire mortgage originations. However in the year 2005- 06, they averaged at 20 percent thus marking the epitome of the housing bubble in the U.S. in the year 2004, the U.S. Securities and Exchange Commission had eased the “net capital rule” which persuaded the biggest investment banks to rapidly raise their fiscal leverage and passionately boost their issuance of mortgage supported securities. Although this delinquency rate of payment of the subprime mortgage was ranging between 10 – 15 percent from 1998 to 2006, a 25 percent mark was recorded in both 2007 and 2008 (Krugman 25).

On average, the cost of an American residential house rose by 124 percent by the year 2007. This reduced the number of homeowners refinancing their loans at the reduced interest rates. In some situations, some homeowners were forced to seek second mortgages with a possible price appreciation as the security. By the close of 2007, the US housing debt to rose to 127 percent of the Disposable Personal Income as compared to 77 percent in 1999.

The house price rapid increase caused the “building bloom” thus creating excess of unsold housing units. This made the entire housing prices in the U.S to gradually decline from mid 2005. The perception of possible continued housing price reduction and the access to easy credit had attracted the subprime borrowers to seek the Adjustable- rate Mortgages. This lured the borrowers who operated on a lower market interest rate. As housing prices began to reduce in various regions in the US, these borrowers were unable to repay their mortgage and most of them defaulted as the monthly payments were too high. This exerted pressure on the housing prices thus decreasing the house owners’ equity. This is attributed to the consequent eroding of the financial health and effective value of the banks and other financial institutions. This meant that borrowers owned negative or at best zero equity in their housing units (Ben 23).

Factors Believed to Have Caused the Subprime Mortgage Crisis

Speculative Borrowing

This has been cited as a paramount contributor to this crisis. For example in the year 2006, on average 1.65 million housing units representing 22 percent of homes were purchased for investment purposes. During the same period about 1.07 million unit vacation homes representing 14 percent were also sold out. The respective figures for year 2005 were 28 and 12 percent. This reveals that speculative borrowers had left the market in 2006 making the investment sales to drastically reduce as compared to the primary market (Krugman 56).

The situation was further aggravated by the negative effects of lack of mortgage policies and tax adjustments as the housing complex treatment took a more speculative rather than the convectional conservative investment hedge thus leading to a near total asset value collapse.

Inaccurate Credit Ratings

Currently, these agencies are being scrutinized to determine their role in selling out the mortgage- backed securities to investors thus making them potential contributor to the housing bloom crises. These ratings were resorted to due to potential risky practices such as credit default insurance with the equity investors prepared enough to absorb the initial losses. It is believed also that there are some organizations which practiced these credit ratings even with prior knowledge of their ineffectiveness. As the investment banks and other financial institutions were being paid out, there arose conflict of interest between the lenders of the structured securities and rating agencies (Bloomberg 2).

U.S. Securities and Exchange Commission thought out on some rules and measures aimed at overseeing the credit agencies. The commission concluded that there were “significant weakness in the earlier adopted rating practice” and not necessarily just the conflict of interest.

Government Policies

During this period it is became apparent that the government had failed to offer the required regulation and/or deregulation prior to the meltdown.

Financial Crisis: The Setting

Over the years and across the economies, economic financial crisis of all the cases resemble each other in similar design. At first an innovation emerges, this mostly takes the form of technological advancement or generally financial ingenuity such as junk bonds, joint stock ventures or collateralizing of debt responsibilities. Initially this may likely create fear to the investors however they immediately rush in to reap the accompanying extraordinary benefits.  Banks and other financial institutions also join din thus broadening their balance sheets. The increasing asset prices is however likely to pester out due to economic shock or likelihood of exhaustion. This reveals the flaw in the accounts of the organization which defended the increased leverage of the potential huge capital gains. They are compelled now to tighten their credit availability thus contracting their economic activity.

The Responsibility of Real Estate Market

The immediate cause of the financial crisis is thus attributed to the fall in the housing industry: US housing bubble. The subprime lending (non- prime, near prime or alternative chance lending) in the fiscal market meant that loans in the risky class are usually sold from prime loans in the market. The criteria for determining the potential risk of a loan depends on the structure, credit rating of the borrower, magnitude of the loan and the  ratio of the loan with respect to the collateral value.

In the late 2006, the mortgage subprime of the United States entered to what was later referred to as the financial crisis “meltdown”. This was evident with the rise in subprime mortgage defaults incidences and the consequent foreclosures which led to the collapse of more than 100 mortgage lenders, with the most notable being the New Century financial Corporation initially ranked as the second largest subprime lender. The collapse of these organizations is believed to have led the collapse of over $6.5 trillion mortgage security prices. This threatened not only the housing market but also the US economy as a whole. By the close of the year 2008, the meltdown was still going on despite the great attention from the political administration, lawmakers and the media than earlier in 2007 (Krugman 58).

The resulting financial crisis had far more reaching consequences across the globe. Sub prime debts were repackages by financial institutions such as banks and other trading houses into enticing investment packages and securities that were shattered by banks, hedge funds and investors in the US, Asia and Europe. Those who had earlier invested in this venture realized that their investment was near worthless. There were cases where the apparent value was difficult to estimate thus causing uncertainty.

Refinancing was not possible due to the rise in housing prices as the interest rates declined. In some cases, the mortgage loan value increased considerably compared to the constant reducing house prices. This eroded the economy’s financial strength as well as draining the wealth of the ordinary consumers. This is greatly attributed to the foreclosure epidemic which came into being towards the end of 2006. During this period, considerable foreign money moved into the U.S mostly from the rapid developing economies of Asia and the oil producing nations of the Middle East. The influx of these finances together with the reduced interest rates in the U.S aggravated the poor credit condi.0tions thus the credit and housing blooms. This in turn increased the mortgage Backed Securities (MBS). This MBS obtain their value from the housing prices and the mortgage payments. This form of financial ingenuity assisted investors and institutions globally to invest in the housing sector. As the crisis extended, losses and defaults of loans from other parts of the economy were experienced. It is believed that the subprime meltdown led to the losses of trillions dollars globally.

As this meltdown continued, a number of factors made the financial and economic system highly fragile. Policymakers could not comprehend the increased responsibility of the hedge funds and investment funds commonly referred to as “shadow banking system”. Although not subjected to equal regulations, these institutions behaved like depository (commercial) banks offering credit to the economic sectors of the U.S.  Together with some designated regulated banks, they took substantial debt obligations through provision of loans meant to cushion MBS losses as well as high loan defaults. This period also was characterized by decline in the national and global economic activity as the losses influenced the capability of these financial institutions to offer credit to the struggling firms.

On the general economy, housing market turmoil and the resulting financial crisis led to the considerations of a number of decisions throughout the globe by the reserve banks to reduce the interest rates and also come up with packages aimed at stimulating and resuscitate back the falling economies. The stock market losses as well as the decline in the housing prices had a negative impact on consumer spending which is the key economic driving force. This necessitated collective global responsibility with the key global leaders meeting in November 2008 and later in March the following year to chart the way forward as well as strategizing on actions to betaken to fully address the crisis. Although a conglomerate of ideas had been put forward by economists, government leaders, bankers and business executives, by April 2009, no clear action had been yet taken to combat the meltdown.

The International Consequences of the US Crisis

According to Carmen, this crisis spilt over into other markets and economies throughout the globe with Japan and Germany hardest hit. Due to limited and at times dismal domestic real estate market in both countries, the financial institutions in Germany and Japan looked for more enticing returns in the subprime market in the US. This has revealed that these financial institutions had no slight exposure to the subprime market of the United States thus giving a classic route of transmission and contagion on which the meltdown spilled out from one country to another.

There were other countries which were experiencing equal economic difficulties as the US in this period probably due to identical features that were attributed to the creation of the subprime crisis. In particular, several; European countries and other regions for instance New Zealand were recorded as having their own version of the domestically grown real estate bubble, thus placing them clear from the US generated crisis.

In Germany for instance, the country was not directly hit by the mortgage price bubble or the resulting market crisis, however the investors especially in the banking sectors and other financial institution suffered huge write- offs and related losses equivalent to 38 billion Euros.

Aftermath of the Subprime Crisis

Homeowner Assistance

Although fore closure is a lengthy and costly approach, both borrowers and lenders are often likely to benefit. This has made some lenders to assist hard pressed borrowers with a more pocket friendly packages such as loan modification, refinancing and loss mitigation. It is believed that over 9 million homes may enter into a fore closure in the period between 2009 and 2011 as compared to just one million cases on a typical equivalent period.  With an averages $50 000 per foreclosure, this period cost may be way over $450 billion as losses (Carmen).

Between 2007 and 2009, a number of government sponsored and private supported programs have been implemented to assist these homeowners to alleviate the effects of the foreclosure crisis throughout the US. For example, the US administration partnered with private industry through the Hope Now Alliance as a perpetual; effort to of offering a case-by case mortgage recovery support. In the second half of the year 2007, the Alliance is believed to have assisted over 500,000 borrowers with insecure credit.

Conclusion

Policy Lessons: The Banking Supervision

During the period of the crisis, the lessons learnt were that proper supervisory array is critical for advanced economies and the emerging markets. In the US for example, a section of supervisory obligation is usually delegated to the individual states administrations. It is believed that during this period, the state supervisors were quite relaxed in warning the depositories when they were issuing unsuitable mortgages to the potential borrowers. In the private sector realm, mortgage brokers required nothing more than a signature as security for repayment. This sense of trusty and faith is believed to have emanated from the compensation of originating loans rather than the loans given out. Encouraged by their own charge structure, the Credit Rating Agencies paid attention to the underwriters’ reassurances of ability to predict in the face of poor track record (Carmen).

Change is therefore necessary in both public and private financial sectors as the current reaction is rather inefficient and overdone. Banks and other financial institutions need to stiffen and tighten their standards and terms for new lending. Using their pro- cyclical predisposition, rating agencies need to overreact in order to absorb of the investing public through narrow interpretation of regulations as well as strengthening the ordinary tendencies of the depository’s capability of tightening the credit availability.

Of late politicians have turned their attention to the financial industry. Much of the recommended approaches are rather more of legislative than mere policy formulation. This includes regulations aimed at restructuring the insurance companies and depository institutions as well as supervision of the credit rating agencies. This calls for more political intervention to craft the necessary legal framework for these recommendations (Carmen).

Work Cited

Bloomberg, J. “Subprime Losses Reach $506 Billion on Brokers’ Writedowns” 28 Aug. 2008. 2   Dec. 2009. <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aDmQ66OoJbfw

Ben S. Bernanke. “The Recent Financial Turmoil and its Economic and Policy Consequences” New York Times [New York] 9 Nov. 2002.

Krugman, Paul. The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited. New York , 2008.

Carmen M. Reinhart.  Reflections on the International Dimensions and Policy Lessons of the US Subprime Crisis.16 Sept. 2008. 2 Dec. 2009. < http://www.nakedcapitalism.com/2007/08/jim-   grant-on-subprime-crisis.html>.