Sub-prime Crisis Palak Bansal

The subprime mortgage crisis has shaken the financial system in US and number of countries around
the world. By the year 2007; consumer spending went down, number of property foreclosures
increased, the housing market has been collapsed, the stock market has suffered, and many financial
markets and banks around the globe incurred huge losses as a result of the subprime mortgage
crisis.

After the US property sales prices peaked in 2006 and began their sudden fall thereafter, refinancing
and repayment of mortgage loans became very difficult. Because Adjustable Rate Mortgages [ARM]
started to change at higher interest rates causing monthly mortgage payments at amount higher
than the borrowers’ ability to pay and afford, thus, delinquencies in mortgage loans raised.
Mortgage Backed Securities [MBS], which were widely held by financial institutions, lost their values
significantly. As a result of soared mortgage delinquencies, global investors greatly reduced to invest
in MBSs, thus, it caused slowing down the economic growth in the USA and number of countries
around the globe. According to Lahart the immediate cause of the crisis was the bursting of the
property bubble which has peaked in 2006 and fall down thereafter as a result of higher interest rate
imposition, which then caused a dramatic increase in foreclosure activities. This gave rise to a vicious
cycle of foreclosure and bank instability as shown in the fig.1.

Fig.1.Viscious Cycles of Foreclosure and Bank Instability

Deregulation by the US government has hugely contributed to the subprime mortgage crisis. Several
US presidents including G.W.Bush, Clinton, Reagan, and Roosevelt had the goals of increasing home
ownership in US. Congress introduced the AMTPA- “Alternative Mortgage Transaction Parity Act” in
1982, which enabled non-federally housing creditors to issue ARMs. New types of mortgage loans
have created opportunities for many people in US to afford a house, on the other hand, it has also
cultivated a new layer of borrowers- the subprime borrowers, where the chance of their default was
assessed so high. Hence, the problem in the US housing market rose when the subprime borrowers
have been introduced. Typically; subprime borrowers have very poor credit history including
delinquent payment record, low paying occupations, bankruptcies and other characteristics that had
failed them to take a mortgage loan in the past.

Lending institutions got to know that the price of residential houses had been increasing and
borrowers could refinance their loans very easily, this, these creditors were happily making loans to
subprime borrowers in return for a great incentive. On the other side, assuming continuous increase
in property prices were the only way to lending institutions in taking care of default risk of the
subprime borrowers. Residential housing market has been rolling until late 2006, mortgage rates
were reasonable and house prices kept increasing before the year 2007.

Before the crisis, lending institutions were attracting more customers by introducing attractive
mortgage loan packages such as little initial deposit or low interest rates for the first two or three
years of issued loan. Such easy initial terms and conditions of the loan and long-term rise trend in
property has strongly influenced the borrowers to enter into mortgage loan contracts since they felt
refinancing would be much easy at favourable terms of loan.

These attractive mortgage loan packages allowed many people to afford buying a property so easily.
Loans were easily made to several people even to those who were not qualified for a loan in the
past. Subprime lending increased dramatically from approximately $200bn in 2001 to $700bn in
2006. Such growth was not possible under traditional subprime lending system, where the banks
were the sole provider of mortgage loans to the homebuyers. Therefore, by adoption of new
subprime model, as shown in fig 2, several intermediaries were introduced to finance the SMC.

Fig.2.Traditional and New Subprime Model

Under the new subprime

model, lending institutions
were aware of the
subprime borrowers’ default
risk and progressive raise in
house prices encouraged
borrowers to get mortgage
loans. Nevertheless, a
increase in mortgage rates by
lending institution results
in having higher chances of
default borrowers,
therefore, lender decided to
spread out the associated
subprime mortgage risk among thousands of institutional investors. Thus, the subprime mortgages
were financed by using investment banks and securitisation process i.e., a process whereby assets
are pooled together, underwritten, re-packaged, and issued in the shape of debt securities. These
securities are then sold to institutional investors for trade.

MBSs are those wherein the subprime mortgages are the underlying assets. The number of MBS
agreements had greatly increased before the subprime mortgage crisis, such financial innovation
encouraged investors and institutions around the globe to invest in the housing market of USA. By
the time housing prices declined, major global investors and institutions that had invested
enormously in MBS reported huge losses. Losses and defaults on the other loan types also increased
dramatically. According to IMF reports (2010) the total losses are estimated in trillions of USD
internationally.

Credit Rating Agencies [CRA] were held responsible for having given high and inaccurate ratings to
MBSs. These high rated MBSs became the reason for housing boo which has peaked in 2006 and the
housing bubble was the immediate cause of the SMC. Moreover, CRAs were charged of having a
strong responsibility in the mortgage mess since they had been too careless in the ratings of
mortgage products. The continued upward trend in property prices led to lower probability of
subprime borrowers’ default risk that allowed investment banks to issue “Collateralized Debt
Obligations” [CDO] with up to AAA ratings and these ranked by CRAs. If those securities were
accurately rated by the credit rating firms then probably the investors would have been aware of the
high risks which were associated with the mortgage products and the crisis might have been less
severe.

Overall, subprime mortgage crisis caused millions of homeowners to lose their property, millions of
people lost their job, hedge funds and pension funds that bought subprime mortgage securities
suffered losses when the number of defaulters increased. The crisis not only caused people to lose
their homes and jobs bus also it caused many retired people to lose their savings for retirement.
Thus, every individual in the USA was affected by the crisis, the US economy suffered a lot, and it
caused a dramatic decline in US GDP and National Income.

Since, the start of crisis in 2007, several actions were taken by the US government to take control of
the crisis and provide necessary assistance. First of all, to stimulate economic activates, the Fed
lowered down the base rate from above 5% in 2007 to around 0.25% in 2009.

To restore liquidity in the financial market, stabilize the economy, and help people with their
mortgages and home affordability, the US government announced the “Troubled Asset Relief
Program” in October 2008 with total fund of $700 billion. However, to stop recession and create job
opportunities for people, several economic stimuluses were introduced during 2009, including
$787.2bn fund approved by President Barak Obama for “American Recovery and Reinvestment Act
2009” that was designed as a “tax relief stimulus”. Also, $8bn fund was committed for
“unemployment benefit extension program”.

These different economic stabilization acts helped restore and recover the US economy. But the real
problems are the root causes of crisis as discussed above; if similar mistakes are not avoided then
most probably such crisis will happen again.