U.S.

Subprime Mortgage Crisis

Introduction
 In the late 1990s, there was excessive speculation of internet-based companies due to the
increased internet usage, leading to an unprecedented rise in technology stock valuation in
the US known as the dot-com bubble or internet bubble. The small companies and start-ups
started getting funds from the venture capitalists, although these companies did not
generate any revenue. By early 2000 the dot-com bubble burst happened. Another critical
incident, the 9/11 terrorist attacks in 2001, created a market depression, leading to the
central banks' intervention to revive the economy. The banks tried to create capital liquidity
by reducing interest rates. This step led the investors to choose investments with risky but
higher returns. The lenders started approving loans to borrowers with low credit ratings.
These people sometimes had neither an income nor an asset; hence they did not qualify for
conventional mortgages. This easy availability of loans led to high consumer demand to an
all-time high. Lenders converted these subprime mortgages into securities known as
Mortgage-Backed Securities (MBS) and sold to investors who received regular income
payments. In the late 2000s, a series of economic conditions caused a significant blow to the
real estate market and the mortgage finance market. This real estate bubble burst led to
another collapse of the US economy and other developed and developing economies of the
world, known as the subprime mortgage crisis. The impacts of the subprime crisis deeply
affected the world economy. There was no single cause or a single person or entity on
whom the liability of the crisis could have been attributed. It was a collective failure of the
central banks, lenders, investors, subprime borrowers, the rating agencies, and the
underwriters.
The Great Recession
Between 2007 and 2009, there was a marked decline in the national economies around the
world caused by the series of events that started after the housing bubble burst in the
United States during 2005 - 2006. This recession was considered to be the worst economic
situation after the Great Depression of the 1930s. The subprime mortgage lending led to
these homeowners not being able to make payments for obvious reasons. The only way
forward was to default with the payments. The default led to the collapse of the mortgage-
backed securities market. These securities were sold to the investors who were desperate
for the high rate of returns. The investors lost the money, so did the banks, and many of
these banks were almost on the verge of bankruptcy. The homeowners, who had defaulted
with the payments, ended up in foreclosure, the legal process of recovering the loan
balance from the borrower who has stopped making payments by forcing the lender to sell
the asset used for the collateral for the loan. Here the guarantee was the home itself. The
employment rate had decreased, leading to a further decrease in economic growth and
reduction in consumer demand. The demand for real estate also reduced. The U.S.
government intervened during the subprime crisis by rolling out several bailout packages
intended to stabilize the market situation. The intervention was carried out in not only the
U.S. but also in other parts of the world economies. Banking sector reforms were suggested,
which would reduce speculation and lead to greater control by the governments.

The Role of Lenders

There was a misconception in the U.S. markets that the housing industry was a safe bet for
the lenders to invest their money. Before the subprime crisis, lenders were confidently
issuing mortgages. The confidence lay in the notion that if the borrowers were unable to pay
their mortgages, they would sell the collateral and pay the due with the proceeds. The
guarantee was the borrower's home, and eventually, the lenders would get back the
invested amount as well as earn profit due to the booming housing sector. It was a win-win
situation for the lenders, but hey failed to realize that the booming housing sector was a
temporary situation on the verge of collapse. Before the subprime crisis and market
collapse, the lenders employed several ways to woo the potential subprime borrowers by
offering them lower interest rates in the initial years. Then, in the long run, the rates were
converted from fixed to floating rates or the market-adjusted rates. In the early 2000s, an
estimated one-third of all adjustable-rate mortgage's initial rates were below four percent.
After the introductory grace period was over, the interest rates increased very steeply, and
the borrowers had no choice left but to default the loan payments as they could not afford.
Tricky underwriting techniques were also practiced. These risky loans were made possible
by lenient underwriting and lax credit verification standards. What once was a thorough
process of financial documents verification, such as verifying bank account statements,
previous tax returns, etc., the underwriters now required fewer documents to verify and
process the loan for approval. An underwriter only required to verify borrowers' assets
without verifying the income. Borrowers were simply asked to state their income and taken
at their word. Some lenders offered no income loans, which were products requiring proof
of ability to repay irrespective of zero earning from employment. Another common type of
stated income loan was the NINJA (no income, no job or asset) loan. These loans could be
approved without the need to furnish any kind of financial documents and the borrower's
application. Also, no independent verification was conducted for the borrowers' ability to
repay, which led to anticipated defaults. Low underwriting standards encouraged the
development of an environment where people that posed a real credit risk were ready to
receive home loans. Most of the time, subprime borrowers were targeted for predatory
loans with complex and harsh provisions. Special mortgage loans were created only for
borrowers who were unable to return up with the cash for a deposit. The lender would issue
one loan to hide the deposit and shutting costs under a so-called "piggyback" loan, then a
second loan to hide the home's price. These loans allowed borrowers to get homes with
zero deposit and avoid paying private mortgage insurance i.e., insurance designed to guard
the lender should the borrower default.

The Role of Real Estate and Financial Services

Improper mortgage lending practices played an exceptionally more significant role within
the financial collapse. Activities in the land and auxiliary financial services markets
contributed a more significant deal to the broader economic problems the country
experienced during the recession. The land prices in the country inflated across the nation
due to excessively high-value appreciation of homes. The appraisers usually overvalued
homes or used evaluation methods, which were incomplete. This led to increased housing
values to circulate in the land markets. Successively, borrowers took out loans for amounts
that were quite the homes were worth within the open market. Appraisers' overvaluation of
homes was the important root of the financial crisis.
Securitization may be a necessary and customary practice within the financiers.
Securitization is the practice of converting assets into securities. The mortgages are
converted into stocks and bonds. Hence, by pooling assets together, there is a collection of
regular income streams from the newly formed securities. The financial sector began
securitizing mortgages within the late 1980s. Doing so allowed lenders to mitigate a number
of the risks by giving out subprime loans as the debt was pooled and re-issued to securities
investors. If there was a default of a couple of subprime mortgages, it might have been
compensated for by the profits generated by the securities. This process seemed to be very
profitable, and lenders believed they might profit no matter whether any borrower went
into default or not. Even if they didn't make money off of the loan, they might still make
money by issuing securities or by selling the house through foreclosure if the borrower
defaulted. Thus, lenders were incentivized to form as many home loans as possible. As a
result, banks began increasing the volume of the lucrative practice of securitizing mortgage
loans and selling collateralized debt obligations. Of course, the concept of spreading the
danger works only when most of the loan amounts are paid back by the borrowers. If the
percentage of the loans defaulted is too high, the securities' values fall sharply. At that time,
the investment banks that held these enormous securities were forced to register huge
portfolio losses. These losses caused the failure of huge investment banks like Bear Sterns
and Lehman Brothers and, therefore, the failure of Indymac, one among the most important
mortgage originators within the U.S.

The Role of Homebuyers

The homebuyers were also responsible for the crisis as they were ready to buy houses that
they could barely afford. They were hoping for the prices to appreciate. That price
appreciation would allow them to refinance at lower rates and take the equity out of the
home for use in another spending. However, this did not happen, and the housing prices
went down. The homebuyers to refinance at higher rates they could not afford. Finally,
many of them defaulted on their loan.
Response of the Congress to Economic Crisis
In response to the financial crisis of 2008, the Obama administration rolled out a massive
piece of economic reform legislation known as the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The intent of the Act was to prevent similar catastrophe in the
future. The Act contained several provisions spelled out over roughly 2,300 pages, which
were to be implemented over several years. It targeted the financial system sectors, which
were thought of as the main culprits for the cause of the 2008 financial crisis, including
banks, mortgage lenders, and credit rating agencies. It was said that the regulatory burdens
it imposed could lead to the firms in the United States less competitive than their foreign
counterparts. In 2018, Congress passed a new law that rolled back some of the restrictions
in the Dodd-Frank Act.

The key provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act
include the monitoring of financial stability of major financial firms whose failure can lead to
a negative impact on U.S. market. This monitoring is done by the Financial Stability
Oversight Council and Orderly Liquidation Authority. This law also has provisions for
liquidations or restructurings through the Orderly Liquidation Fund.

The Financial Stability Oversight Council can break up banks that might pose systemic risk
considering their size. The council can also force the banks to increase their reserve
requirements. The new Federal Insurance Office identified and monitored insurance
companies whose failure would be disastrous to the greater economic system. The CFPB,
has been given the job to prevent predatory mortgage lending and make the consumers
aware of the terms and conditions of the mortgage before agreeing to them. Thus, deterring
the brokers to earn higher commissions for closing loans can lead to higher fees and/or
higher interest rates and steer potential borrowers to the loan that results in the highest
payment for the banker.

Another important rule, known as the Volcker Rule, controls the bank's investment in
speculative trading and eliminate proprietary trading. Also, banks are not allowed to be
involved in risky hedge funds or private equity firms. Financial firms are also not allowed to
trade proprietarily which do not have the ability to incur risk.
 By giving out misleadingly favourable investment ratings, the credit rating agencies which
were also responsible for the financial crisis. The SEC Office of Credit Ratings ensures that
agencies provide meaningful and reliable credit ratings of the businesses, municipalities,
and other entities they evaluate.

Subprime Mortgage Crisis Impact in India

The Indian national economy was not directly exposed to the developed nations' toxic or
distressed assets because Indian banks had few branches abroad. However, there was an
indirect impact on the economy due to the recession elsewhere. The decoupling theory did
not hold good. The indirect effect was felt each through trade and capital flows. The fall in
foreign goods costs and crude oil reduced the import bill from previous estimates. The
import growth rate had also reduced. The recession abroad harmed India's exports of goods
and services. This decline in the growth rate in exports strongly affected the sectors where
export business was a significant proportion of the total production. The portfolio capital
has turned negative, with a substantial impact on the stock market. Firms based in India
experienced difficulties in raising money abroad. All of these had impacted the exchange
rate.

Conclusion

A single cause cannot be attributed to the financial crisis of late 2000s. It was rather due to
the various activities across lending, banking, and the real estate markets. The main culprit
on both prime and subprime loans was mortgage-backed securities, collateralized debt
obligations, and rising adjustable mortgage interest rates. There was pressure from
government and community organizations to provide mortgages so that more people could
become homeowners. The rapid expansion of the housing market was making the real
estate seem like excellent security for mortgages.

All these combined factors created an atmosphere where the banks had an incentive to
make the qualifications and requirements for mortgages lenient. This atmosphere led to
banks issuing more and more mortgages to people who were less and less qualified. Thus,
loans were issued to risky borrowers. Also, approximately seventy percent of these loan
applications may have contained false information. It was common for applicants to make
false income statements or create fake income verification documents. The lax investigation
procedures and the general loose credit atmosphere made these misrepresentations often
undetected. After Dodd-Frank legislation, which included the Mortgage Act and the
Consumer Financial Protection Act, mortgage lending practices have now evolved to comply
with the new practices required by the law.

The role of human behaviour and greed cannot be ignored, which drove the demand,
supply, and investor appetite for these types of loans. 

References:

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