2013

2008 Financial Crisis

Hafsa Memon
This document aims to inform the reader the root cause of the 2008 financial crisis.

Financial Institutions and Markets IBA 4/8/2013

The bursting of the U.S. housing bubble, which peaked in 2006, caused the values of securities tied to U.S. real estate pricing to plummet, damaging financial institutions globally. The financial crisis was triggered by a complex interplay of policies that encouraged home ownership, providing easier access to loans for subprime borrowers, overvaluation of bundled sub-prime mortgages based on the theory that housing prices would continue to escalate, questionable trading practices on behalf of both buyers and sellers, compensation structures that prioritize short-term deal flow over long-term value creation, and a lack of adequate capital holdings from banks and insurance companies to back the financial commitments they were making. Economies worldwide slowed during this period, as credit tightened and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion and institutional bailouts. In the U.S., Congress passed the American Recovery and Reinvestment Act of 2009. The blame for the subprime mortgage crisis is shared among several factors. Many mortgage brokers steered their clients toward loans they couldn't afford. Previously, when someone wanted a loan, he or she would go directly to the bank. More and more, people were going to mortgage brokers to act as the go-between. The result was an industry that wasn't directly accountable when a loan goes bad. Mortgage brokers didn't suffer any penalty when a loan they drafted defaulted, so there wasn't much incentive to turn down applicants in this commission-based industry. The U.S. Senate's LevinCoburn Report asserted that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." The 1999 repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depository banks in the United States. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets. A huge portion of the increased mortgage loan defaults are what are referred to as sub-prime loans. Most of the sub-prime loans have been made to borrowers with poor credit ratings, no down payment on the home financed, and/or no verification of income or assets (Alt-As). Close to 25% of sub-prime and Alt-As loans are in default. Why would banks make such risky loans? The answer is that the Clinton administration pressured the banks to help poor people become homeowners, a noble liberal idea. Owning a home is part of the 'American Dream'. The conditions were right for people to achieve that dream. In the early 2000s, mortgage interest rates were low, which allow you to borrow more money with a lower monthly payment. In addition, home prices increased dramatically, so buying a home seemed like a sure bet. Lenders understood that homes make good collateral, so they were willing to participate. Homeowners refinanced and took second mortgages to get

cash out of their homes' equity. Some of this money was spent wisely, and some simply maintained a standard of living while wages stayed stagnant. Also the Clinton Justice Department threatened banks with lawsuits and fines ($10,000 per application) for redlining if they did not make these loans. Also ACORN (Obamas community service organization) was instrumental in providing borrowers and pressuring the banks to make these loans. To allow Fannie Mae to make more loans, President Clinton also reduced Fannie Maes reserve requirement to 2.5%. That means it could purchase and/or guaran tee $97.50 in mortgages for every $2.50 it had in equity to cover possible bad debts. Principally Senate Democrats demanded that Fannie Mae & Freddie Mae buy more of these risky loans to help the poor. Since the mortgages purchased and guaranteed by FM&FM are backed by the U.S. government, the loans were re-sold primarily to investment banks which in turn bundled most of them, taking a hefty fee, and sold the mortgages to investors all over the world as virtually risk free. As long as the Federal Reserve (another government created agency) kept interest rates artificially low, monthly mortgage payments were low and housing prices went up. Many home owners got home equity loans to pay their first mortgages and credit card debt. Unfortunately home prices peaked in the winter of 2005-06 and the house of cards started to crumble. People could no longer increase their mortgage debt to pay previous debts. Fraud on the part of homebuyers and mortgage brokers also helped make the mortgage crisis more serious. Mortgage applications were not checked for accuracy as well as they should have been. As long as the party never ended, everything was fine. The borrowers also must bear some responsibility. In a time when credit was easily attainable, many didn't read the fine print of their loan terms or simply took too big of a risk on a loan that they couldn't afford to pay back. It's also common for someone looking to get into the housing market to overstate his or her income to secure a loan. Where did all that lending money come from? There was a glut of liquidity sloshing around the world - which quickly dried up at the height of the mortgage crisis. People, businesses, and governments had money to invest, and they developed an appetite for mortgage linked investments as a way to earn more in a low interest rate environment. Banks used to keep mortgages on their books. However, banks now sell your loan, and it may be further divided and sold to numerous investors. These investments are extremely complex; so many investors just rely on rating agencies to tell them how safe the investments are, without really understanding them. Another way subprime lending rears its ugly head is in the credit card industry. Subprime credit cardholders can expect to pay a variety of additional fees not typically found with prime cards.

Yearly fees, up-front fees, and higher late and over-the-limit fees are common. The late payment grace period is also usually not available to a subprime cardholder. One fee typically leads to another, resulting in a late fee that's figured into the balance, leading to over-the-limit fees. The system itself seems geared toward making money off the people that had financial difficulties to begin with. Subprime mortgages come in all shapes and sizes. The one factor that's generally consistent across the board is that the interest rate will be higher than the prime rate established by the Federal Reserve. The prime rate is what lenders charge people with good credit ratings. One of the more common subprime loans has an adjustable-rate mortgage (ARM) attached. ARMs became increasingly popular during the housing boom because of their initial low monthly payments and low interest rates. Introductory rates for ARMS typically last two or three years. The rate is then adjusted every six to 12 months and payments can increase by as much as 50 percent or more. Interest-only options are also often attached to subprime ARMs. These refer to when the first period of payments go only toward the interest rather than the principal of the loan. Subprime loans often have a prepayment penalty included in the terms. They may also have a balloon payment attached. This is when the remainder of the loan is due after the introductory period in one lump sum. Borrowers generally plan on refinancing at this point, but this isn't always possible. The presumption was that although there would be a higher default rate at the higher interest rates there would be some lenders large enough to pool these mortgages and even with their higher default rates make a higher rate of return. This was the logic behind junk bonds market created by Michael Milken at Drexel Burnham Lambert. In the case of the junk bonds the higher interest rates were not enough higher to compensate for their higher risk and the junk bond market collapsed. A similar sort of thing occurred with the subprime mortgages. Fannie Mae and Freddie Mac pooled the subprime mortgages and then created securities which were sold around the world. When the subprime borrowers defaulted on their mortgage payments that led to the real estate market being flooded with houses for sale. The subsequent decline in housing prices then led even prime borrowers to walk away from mortgages where the mortgage debt exceeded the market value of the property. Fannie Mae and Freddie Mac were inundated by default claims from the mortgage default insurance they had provided. When Fannie Mae and Freddie Mac were declared bankrupt by their managers there was an instantaneous loss in value for not only the subprime mortgages but also the prime mortgages. Fannie Mae and Freddie Mac had provided default insurance on approximately one half of all American home mortgages. Thus the bankruptcy of Fannie Mae and Freddie Mac could have led to the bankruptcy of any major holder of mortgages or securities based upon mortgages.

Fannie Mae and Freddie Mac both not only purchased mortgages they also provided payment insurance, for a fee, for other mortgages. They also created pools of mortgages and issued securities based upon the revenue received. This procedure was called securitization and the securities created were called collateralized debt obligations, CDO's. Such securities allowed investors to invest in the mortgage market by diversifying the risk. If such investors purchased a single mortgage there would have been too much risk concentrated in that single mortgage but if they, in effect, purchase one percent of a hundred such mortgage their risk would be diversified. Not only did Fannie Mae, Freddie Mac and other institutions create diversification through securitization but they created securities that partitioned the risk. One security would have first claim to the mortgage payments, another second claim; i.e., that security would receive payments only after the first claim security's obligations had been met. And so on down the line. The security last in line was the most risky and came to be known as toxic waste. Thus this partitioned securitization created some securities that were riskier than the original mortgages. The unemployment rate was also a factor leading to the crisis. Midwestern states hit hard by auto industry layoffs ranked among the highest in foreclosures. Many people had been counting on being able to refinance to make their loan affordable, but slowing appreciation rates in the housing market made it difficult or impossible. Once the introductory period on the subprime loans ran out, the new payments were more than many could handle. Once people started defaulting on loans in record numbers (and once the word got around that things were bad), the mortgage crisis really heated up. Banks and investors began losing money. Financial institutions decided to reduce their exposure to risk very quickly, and banks hesitated to lend to each other because they didnt know if theyd ever get paid back. Of course, banks and businesses need money to flow in order to operate. With bank weakness came bank failures. The FDIC ramped up staff in preparation for hundreds of bank failures caused by the mortgage crisis, and some mainstays of the banking world went under. The general public saw these high-profile institutions failing and panic increased. In a historic event, we were reminded that money market funds can break the buck.

References http://banking.about.com/od/mortgages/a/mortgagecrisis.htm http://www.sjsu.edu/faculty/watkins/subprime.htm http://www.investopedia.com/features/subprime-mortgage-meltdown-crisis.aspx http://www.publicintegrity.org/2009/08/26/2790/you-broke-it-you-fix-it http://www.wikinvest.com/concept/2008_Financial_Crisis http://www.forbes.com/fdc/welcome_mjx.shtml http://www.guardian.co.uk/business/2012/aug/07/credit-crunch-boom-bust-timeline http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=0