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The subprime mortgage crisis was a sharp rise in home foreclosures which started in the United States in late 2006 and became a global financial crisis during 2007 and 2008.
The crisis began with the bursting of the housing bubble in the USBill Moyers Journal. 29 June 2007. "Egg Cracks Differ In Housing, Finance Shells", Wall Street Journal, 24 December 2007. "It\'s now conventional wisdom that a housing bubble has burst. In fact, there were two bubbles, a housing bubble and a financing bubble. Each fueled the other, but they didn\'t follow the same course." and high default rates on "subprime" and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favorable terms later. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% versus 2006. U.S. FORECLOSURE ACTIVITY INCREASES 75 PERCENT IN 2007 (2008). Retrieved on 2008-02-24. As of December 22, 2007, a leading business periodical estimated subprime defaults would reach a level between U.S. $200-300 billion. The credit crunch (2008). Retrieved on 2008-02-24.
The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately U.S. $170 billion as of February 2008, as cited below. Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.
The widespread dispersion of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to make loans at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was impacted. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.
The subprime crisis also places downward pressure on economic growth, because fewer or more expensive loans decrease investment by businesses and consumer spending, which drive the economy. A separate but related dynamic is the downturn in the housing market, where a surplus inventory of homes has resulted in a significant decline in new home construction and housing prices in many areas. This also places downward pressure on growth. FRB: Testimony--Bernanke, Economic outlook--January 17, 2008 (2008). Retrieved on 2008-02-24. With interest rates on a large number of subprime and other ARM due to adjust upward during the 2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or defer interest rate adjustments was implemented to reduce the impact. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in the January 22, 2008 decision by the U.S. Federal reserve to cut interest rates and the economic stimulus package signed by President Bush on February 13, 2008. FRB: Press Release--FOMC statement--January 22, 2008 (2008). Retrieved on 2008-02-24. The stimulus package (2008). Retrieved on 2008-02-24. [http://biz.yahoo.com/ap/080213/economy_stimulus.html Rebate Checks in the Mail by Spring: Financial News - Yahoo! Finance] (2008). Retrieved on 2008-02-24.Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
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Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. The word Subprime refers to the credit-worthiness of the borrower (being less than ideal) and does not refer to the interest rate of the loan. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody\'s or other rating firms, albeit for an "alternative" means.
The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, How severe is subprime mess? - Real estate - MSNBC.com (2008). Retrieved on 2008-02-24. with over 7.5 million first-lien subprime mortgages outstanding. FRB: Speech, Bernanke--The Subprime Mortgage Market--May 17, 2007 (2008). Retrieved on 2008-02-24.Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. FRB: Speech--Bernanke, The Recent Financial Turmoil and its Economic and Policy Consequences--October 15, 2007 (2008). Retrieved on 2008-02-24. By January of 2008, the delinquency rate had risen to 21%. FRB: Speech--Bernanke, Financial Markets, the Economic Outlook, and Monetary Policy --January 10, 2008 (2008). Retrieved on 2008-02-24.
Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007. Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey (2008). Retrieved on 2008-02-24.A total of nearly 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007, including those with prime, alt-A and subprime loans. This is double the 223,000 properties in the year-ago period and 34% higher than the 333,627 in the prior quarter."FORECLOSURE ACTIVITY UP 30 PERCENT IN THIRD QUARTER", RealtyTrac, Nov. 1, 2007. This increased to 527,740 during the fourth quarter of 2007, an 18% increase versus the prior quarter. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings including default notices, auction sale notices and bank repossessions can include multiple notices on the same property."U.S. FORECLOSURE ACTIVITY INCREASES 75 PERCENT IN 2007", RealtyTrac, Jan. 29, 2008.
The estimated value of subprime adjustable-rate mortages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining. "ARM resets peaking: Borrowers unprepared - Oct. 17, 2007". Retrieved on 2008-02-24. An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008. FRB: Testimony--Chairman Bernanke on the economic situation and outlook--November 8, 2007 (2008). Retrieved on 2008-02-24.
The reasons for this crisis are varied and complex. FT.com / Video & Audio / Interactive graphics - Credit squeeze explained (2008). Retrieved on 2008-02-24. Understanding and managing the ripple effect through the world-wide economy poses a critical challenge for governments, businesses, and investors. Due to innovations in securitization, the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by either the borrower or the lender; inappropriate mortgage incentives, and rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. There are three primary risk categories involved:
Worldwide] (2008). Retrieved on 2008-02-24.
Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:
Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent."CENSUS BUREAU REPORTS ON RESIDENTIAL VACANCIES AND HOMEOWNERSHIP", U.S. Census Bureau, October 26, 2007.
This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%. CSI: credit crunch (2008). Retrieved on 2008-02-24. Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade. America\'s economy (2008). Retrieved on 2008-02-24. A culture of consumerism is a factor. In the early 2000s recession that began in early 2001 and which was exacerbated by the September 11, 2001 terrorist attacks, Americans were asked to spend their way out of economic decline with "consumerism... cast as the new patriotism". This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop" TIMEeurope.com: How the world has changed (2008). Retrieved on 2008-02-24., and corporations like General Motors produced commercials with the same theme.
Overbuilding during the boom period, increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices have significantly increased the supply of housing inventory available. Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981. New home sales fell by record amount in 2007 - Real estate - MSNBC.com (2008). Retrieved on 2008-02-24. Further, a record of nearly four million unsold existing homes were available. Housing Meltdown (2008). Retrieved on 2008-02-24.
This excess supply of home inventory places significant downward pressure on prices. As prices decline, more homeowners are at risk of default and foreclosure. According to the S&P/Case-Shiller housing price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their 2006 peak. America\'s economy (2008). Retrieved on 2008-02-24.However, there was significant variation in price changes across U.S. markets, with many appreciating and others depreciating.http://www.ofheo.gov/media/pdf/3q07hpi.pdf The price decline in December 2007 versus the year-ago period was 10.4%. As of February 2008, housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.
A variety of factors have contributed to an increase in the payment delinquency rate for subprime ARM borrowers, which recently reached 21%, roughly four times its historical level. FRB: Speech--Bernanke, Financial Markets, the Economic Outlook, and Monetary Policy --January 10, 2008 (2008). Retrieved on 2008-02-24.
Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S. (see United States housing market correction and United States housing bubble), refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts. Other homeowners, facing declines in home market value or with limited accumulated equity, are choosing to stop paying their mortgage. They are essentially "walking away" from the property and allowing foreclosure, despite the impact to their credit rating. "Troubled borrowers are walking away from their homes - Feb. 6, 2008". Retrieved on 2008-02-24.
Mortgage fraud by borrowers from US Department of the Treasury http://www.fincen.gov/MortgageLoanFraud.pdf
Misrepresentation of loan application data is another contributing factor. In a January 13, 2008 column in the New York Times, George Mason University economics professor Tyler Cowen wrote, "There has been plenty of talk about \'predatory lending,\' but \'predatory borrowing\' may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study. The research was done by BasePoint Analytics, which helps banks and lenders identify fraudulent transactions; the study looked at more than three million loans from 1997 to 2006, with a majority from 2005 to 2006. Applications with misrepresentations were also five times as likely to go into default. Many of the frauds were simple rather than ingenious. In some cases, borrowers who were asked to state their incomes just lied, sometimes reporting five times actual income; other borrowers falsified income documents by using computers." [1]
US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005. http://www.fincen.gov/MortgageLoanFraud.pdf
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 Warning signs of a bad home loan (Page 2 of 2) (2008). Retrieved on 2008-02-24. , 9% in 1996 NPR: Economists Brace for Worsening Subprime Crisis (2008). Retrieved on 2008-02-24., 13% ($160 billion) in 1999 Warning signs of a bad home loan (Page 2 of 2) (2008). Retrieved on 2008-02-24. , and 20% in 2006. NPR: Economists Brace for Worsening Subprime Crisis (2008). Retrieved on 2008-02-24. A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "subprime markup" or "risk premium") declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower and loan characteristics declined overall during the 2001-2006 period, which should have had the opposite effect. The combination is common to classic boom and bust credit cycles. Paper not found (2008). Retrieved on 2008-02-24.
In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. One example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Another example is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004-2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. NPR Article NPR: Economists Brace for Worsening Subprime Crisis (2008). Retrieved on 2008-02-24.
Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.Lewis, Holden. "\'Moral hazard\' helps shape mortgage mess", Bankrate.com, April 18, 2007.
Borrowing Under a Securitization Structure
Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment.Black\'s Law Dictionary (7th ed) There are many parties involved. Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Asset securitization began with the structured financing of mortgage pools in the 1970s. Asset Securitization Comptroller’s Handbook. US Comptroller of the CurrencyAdministrator of National Banks (November 1997).
The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Paper not found (2008). Retrieved on 2008-02-24. Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — were to blame for the current global credit crisis. Greenspan sees signs of credit crisis easing - Stocks & economy - MSNBC.com (2008). Retrieved on 2008-02-24.Mortgage brokers don\'t lend their own money. There is not a direct correlation between loan performance and compensation. They have big financial incentives for selling complex, adjustable rate mortgages (ARM\'s), since they earn higher commissions. Mortgage brokers get fatter payoff for selling riskier loans North County Times - North San Diego and Southwest Riverside County News (2008). Retrieved on 2008-02-24.
According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the U.S., with subprime and Alt-A loans accounting for 42.7% of brokerages\' total production volume. New Research About Mortgage Brokers Published (2008). Retrieved on 2008-02-24.
The chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn\'t do enough to examine whether borrowers could repay. Brokers, bankers play subprime blame game - Real estate - MSNBC.com (2008). Retrieved on 2008-02-24.
Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting.
In 2007, 40 percent of all subprime loans were generated by automated underwriting. http://www.nytimes.com/2007/03/23/business/23speed.html?_r=1&partner=rssnyt&emc=rss&oref=slogin An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. "We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation."Bank Systems & Technology (2008). Retrieved on 2008-02-24. Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown. REALTOR® Magazine-Daily News-Are Computers to Blame for Bad Lending? (2008). Retrieved on 2008-02-24.
Some economists claim that government policy actually encouraged the development of the subprime debacle through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise uncreditworthy consumers.DiLorenzo, Thomas J. (2007-09-06). The Government-Created Subprime Mortgage Meltdown. LewRockwell.com. Retrieved on 2007-12-07. Liebowitz, Stan. The Real Scandal - How feds invited the mortgage mess. New York Post. Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. The Bubble Economy (2008). Retrieved on 2008-02-24. A taxpayer-funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. Weiner, Eric. "Subprime Bailout: Good Idea or \'Moral Hazard", NPR.org, November 29, 2007.
Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Department\'s Office of the Comptroller of the Currency, at the insistence of national banks, struck down such attempts as violations of Federal banking laws.Bagley, Nicholas (2008-01-24). Crashing the Subprime Party: How the feds stopped the states from averting the lending mess.. Slate.
In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices. Free Preview - WSJ.com (2008). Retrieved on 2008-02-24.
Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings are theoretically due to the multiple, independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play.
Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dotcom bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. The Wall Street Journal Online - Featured Article (2008). Retrieved on 2008-02-24. There is significant debate among economists regarding whether this is the optimal strategy. Assets and their liabilities (2008). Retrieved on 2008-02-24.
Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf. http://www.gao.gov/cgi-bin/getrpt?GAO/GGD-00-67R
A potential contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation. The Wall Street Journal Online - Featured Article (2008). Retrieved on 2008-02-24.
