US Sub-prime Mortgage Crisis

A Brief Background
“If you wait till you know everything, it will be too late.”
-Warren Buffett
The US subprime mortgage crisis is the outcome of excessive lending to borrowers who
couldn't pay it back and excessive money pushed into the mortgage market by investors
looking for quick profits. The crisis stands for the opposite of a period of low-interest rates,
increasing housing values, and financing Securitization resulted in enormous advantages.
Several elements, including laws like low loan interest rates, the Community Reinvestment
Act, mortgage lenders and brokers, and rating organisations played a part in creating the
catastrophe. The Sub Prime Saga has three key facets linked to lax investment bank
regulation and a lowering of lending standards driven by greed in a system of unrestrained
competition and asset market collapse
In an unprecedented action, the U.S. Federal Reserve Board (the "Fed") was instrumental
in coordinating JPMorgan Chase's acquisition of Bear Stearns, the fifth-largest U.S.
investment bank, in March 2008. There was nothing regular about this transaction between
two Wall Street investment banks. Bear Stearns' hazardous assets, which were connected to
the U.S. subprime mortgage crisis, might have resulted in losses of up to $29 billion, and the
Fed had agreed to cover those losses. The central bank authorised a direct credit line for
investment banks for the first time in history in a separate step to ease the credit crisis that is
affecting the economy. The approach deviated from the conventional practice of exclusively
lending directly to commercial banks. All these steps were taken to regain investors' trust
amid worries about the mortgage crisis' wider effects.
The Fed made multiple attempts to stop the problem from getting worse even before the
Bear Stearns agreement. As of March 2008, the Fed had lowered interest rates at the fastest
rate in decades, reaching 2.25%. The Bush administration approved a $150 billion fiscal
stimulus programme as a parallel attempt. However, these actions did not succeed in
restoring trust; as a result, the dollar fell to historic lows against a number of major
currencies, and many financial markets experienced falls not seen before the 9/11 terrorist
attacks. After the Great Depression of 1929, US economy faced a severe slowdown And the
markets plummeted hugely.
Housing Boom In the US in the Early 2000s
Over half of the U.S. states were impacted by the housing bubble in the country. The
problem with subprime mortgages was sparked by it. Early 2006 saw a peak in housing
prices, which then began to fall in 2006 and 2007. New lows were reached in 2011. The
Case-Shiller home price index showed its greatest price decline in its history on December
30, 2008. One of the major causes of the 2008 Recession in the United States was the credit
crisis due to the fall of the housing bubble.
A crisis in August 2008 for the subprime, Alt-A, collateralized debt obligation (CDO),
mortgage, credit, hedge fund, and foreign bank markets was brought on by rising foreclosure
rates among American homeowners in 2006–2007. A-paper, often known as "prime," and
"subprime," the riskiest category of mortgages, are both less dangerous than Alt-A
mortgages, also known as Alternative A-paper mortgages. These factors, together with their
magnitude in some situations, prevent Fannie Mae or Freddie Mac from buying Alt-A loans.
Although there isn't a single widely accepted definition of Alt-A, it usually has interest rates
that fall between prime and subprime mortgages because Alt-A interest rates are decided by
credit risk. The typical characteristics of Alt-A mortgages include borrowers with less than
complete documentation, average credit ratings, greater loan-to-value ratios, and more
secondary houses and investment properties.[1]
Financial Health in the Developed Economies
A sense of despair was developing in the developed world. Something was boiling in the
first-world countries which were yet to surface. This had taken root in the 1980s and became
significant during the 1990s but was invisible even up to 2004. This crisis revealed
everything in the open.
Widespread banking issues in Switzerland, Spain, the United Kingdom, Norway, Sweden,
Japan, and the U.S. were caused by credit risk, notably real estate loans. In the singular
failure of Herstatt, the market risk was the primary factor (Germany). The first phase of the
U.S. Savings and Loan failures was also a result of market risk. Major banking crises
frequently included financial liberalisation (deregulation) together with supervisory systems
that were unprepared for the transformation.
Nine out of the 13 episodes mentioned credit concentration risk, which is frequently
associated with real estate. The depth of the crises differed greatly. Only minor banks were
impacted in Switzerland, the UK, and the most recent occurrence in the United States.
The whole financial system was impacted in the 1980s in Spain, Norway, Sweden, Japan,
and the United States. Significant variations were also seen in the rates of resolution and
closures. The majority of the widely reported failures required some level of public backing,
often quite significant amounts. Credit risk issues were the root of all of the episodes that
received significant levels of popular support. With the exception of the United Kingdom,
most nations implemented regulatory adjustments as a result of the failures and small bank
crises.
Credit risk-related widespread banking crises were strikingly similar. Financial
deregulation during this time period led to a sharp increase in lending, especially for real
estate. More lending was encouraged by rapidly growing real estate values, which were often
helped by lax regulatory frameworks. Inflated real estate values fell during economic
downturns, thereby contributing to the failures.
The singular failures stood out from the pattern. Continental Illinois failed in the United
States as a result of losses on its portfolio of commercial loans, and a string of sub-prime
financial institutions also failed there as a result of fraud and losses on loans to clients with
poor credit histories. Financial fraud and commercial loan losses contributed to BCCI's
downfall. As opposed to the frequent failure incidents, the isolated failures were not as
strongly associated with the economic downturn. [2]
The Slow Built-up of The Bubble
In 2008, the housing bubble was broken by falling home prices brought on by subprime
mortgage defaults and hazardous investments in mortgage-backed securities.
In the United States, real estate values increased continuously for decades, with only
temporary slowdowns brought on by fluctuations in interest rates. Prices rose throughout time
in tandem with rising demand for homeownership through state-sponsored programmes and
the perception that owning real estate embodies the American dream. Real estate couldn't
continue to increase year over year at such a rate indefinitely, just like other assets, and the
bubble finally popped.

A Housing Bubble: What Is It?

Subprime mortgages—those given to borrowers with less-than-perfect credit—became
20% of the market in 2006, which set off loud rumblings that eventually led to the crash.
When late payments and defaults started to occur in large numbers in early 2008, several
banks that had made subprime mortgages their sole source of income collapsed. Insurance
companies like AIG that had insured these mortgages were swiftly taken down by heavy
subprime portfolios.
With the help of programmes provided by Fannie Mae, Freddie Mac, and others,
mortgages were made available to a wider variety of consumers, which would have given
money to some reckless homeowners who would subsequently fall behind on their payments.
Homeownership became even more accessible in the mid-1990s and early 2000s as interest
rates stayed at a manageable level.[3]
Mortgage pools that were utilised as investments were going bad, and companies like
Lehman Brothers and Bear Sterns which underwrote, held, and marketed a lot of these assets
witnessed value losses so big they had to close their doors and bring down others. From 2008
to 2010, a chain reaction expanded across the nation as a result of an increase in foreclosures
that started to depress the value of surrounding houses.
The likelihood of a national recession rises in the event that the U.S. housing bubble
bursts because any collapse would have a direct impact on mortgage markets, home builders,
real estate, home supply retail stores, Wall Street hedge funds controlled by major
institutional investors, and foreign institutions. President Bush and Federal Reserve Chairman
Ben Bernanke announced a limited rescue of the U.S. housing market for homeowners who
couldn't pay their mortgage bills because to worries about the effect of the collapsing credit
and housing markets on the greater U.S. economy.
The US government committed more than $900 billion in special loans and rescues for
the US housing bubble in 2008 alone. Both the public and commercial sectors participated in
this. Despite the fact that their mortgages were more conservatively underwritten and actually
outperformed those of the private sector, the Federal National Mortgage Association (Fannie
Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Housing
Administration received a significant portion of government support due to their sizeable
market shares.
What Caused The Bubble & How It Burst
According to Wharton experts, the housing bubble that developed in 2006 and 2007 and
led to the Great Recession that followed is not about to occur again in the United States.
Demand has been restrained by more cautious lending standards, rising interest rates, and
high housing prices. Wharton real estate professors Susan Wachter and Benjamin Keys
recently looked back at the crisis and how it has affected the current market on the
Knowledge at Wharton radio show on SiriusXM. They noted that while some misconceptions
about the major causes and effects of the housing crisis still exist, addressing them will help
to prevent policymakers and industry players from making the same mistakes. 
 The rush to lend money to homeowners without considering their ability to repay
was, in Wachter's opinion, one of the main errors that contributed to the housing bubble. As
the mortgage financing industry grew, it drew a large number of new companies with
resources to lend. In 2004, 2005, and 2006, Wachter stated, "We had a trillion dollars more
going into the mortgage market." That amounts to $3 trillion being invested in non-
traditional, or "NINJA," mortgages, which were not previously available (no income, no job,
no assets). These were [provided] by new players and financed by private-label mortgage-
backed securities, a relatively small, specialised segment of the market that reached its peak
in 2006 and comprised more than 50% of the market.
Keys pointed out that the money these new participants brought in from sources that often
weren't used for mortgages lowered borrowing costs. They also made it easier for middle-
class homeowners who wished to take out a second mortgage on their home or a home equity
line of credit as well as those with bad credit to get credit. "By doing this, they greatly
increased risk and greatly increased leverage in the system."
In the run-up to the previous crisis, credit increased everywhere — "any direction where
there was an appetite for anyone to borrow," according to Keys. The financial crisis has
taught us that just because someone is eager to lend you money doesn't mean you should take
it. [4]
Explaining the Crisis Under Macroeconomic Lens
Macroeconomics is defined as the branch of economics which studies economic
problems at the aggregate level of the economy, i.e., considering the whole economy. It deals
with subjects like national income, national output, employment etc. The term ‘macro’
means large. So, macroeconomics is that part of economic theory which studies the behaviour
of aggregates of the economy as a whole. It studies the performance of the economy as a
whole and not of any individual firm or business. It focuses on the study of problems like
inflation unemployment poverty etc.
The main tools of macroeconomics are:
1. Monetary Policy
2. Fiscal Policy
By December 2008, the federal funds rate had reached its effective lower bound, and the
FOMC had started using its policy statement to give the federal funds rate forward guidance.
It was stated that the rate will be maintained at extremely low levels "for some time" and
subsequently "for an extended period." By lowering the term structure of interest rates,
raising inflation expectations (or lowering the likelihood of deflation), and lowering real
interest rates, this guideline was meant to stimulate the economy's monetary system. The
forward guidance was enhanced by adding more explicit conditionality on specific economic
circumstances such as "low rates of resource utilisation, moderated inflation trends, and
stable inflation expectations" as a result of the Great Recession's long and shaky recovery.
This was followed by the explicit calendar guidance of "exceptionally low levels for the
federal funds rate at least through mid-2013" in August 2011, and finally by economic-
threshold-based guidance for raising the funds rate from its zero lower limits. This forward
guidance can be viewed as a continuation of the Federal Reserve's long-standing practice of
influencing the funds’ rate's present and potential future course.
 The Fed adopted two additional "non-traditional" policy steps during the Great
Recession in addition to its forward guidance. According to "Federal Reserve Credit
Initiatives during the Meltdown," one group of unconventional policies can be categorised as
credit easing programmes, which aimed to ease credit flows and lower credit costs.
The large-scale asset acquisition (LSAP) initiatives were another group of
unconventional strategies. The asset purchases were made in order to lower longer-term
public and private borrowing rates while the federal funds rate was close to zero. The Fed
said in November 2008 that it would buy US agency mortgage-backed securities (MBS) and
the debt of US government agencies involved in the housing market. The selection of assets
included a goal to lower the cost and expand the amount of credit available for home
purchases.[5]
These purchases helped to improve overall financial conditions while supporting the
property market, which served as the crisis and recession's focal point. The Fed was supposed
to purchase agency MBS for up to $500 billion and agency debt worth up to $100 billion
under the original plan, which was increased in March 2009 and ended in 2010. The FOMC
also announced in March 2009 a programme to buy $300 billion of longer-term Treasury
securities. This programme was finished in October 2009, just as the National Bureau of
Economic Research estimated the Great Recession to have ended. Together, through these
initiatives and their expansions, the Federal Reserve acquired around $1.75 trillion worth of
longer-term assets, expanding its balance sheet.

What Lessons Did The Sub-prime Crisis Teach Us

Many detractors emphasised the necessity for more regulation standards and oversight.
This was relevant to financial firms' inability to fully disclose the risks associated with their
loans and the potential for borrowers of subprime mortgages to later pay higher interest rates.
To put it another way, the riskiest products were offered to borrowers who lacked the
knowledge and resources necessary to evaluate the loans they were taking out. Additionally,
purchasers of the unique asset-backed securities had limited knowledge of the calibre of the
many underlying assets that made up the pool. Some suggested that the central bank should
supervise investment banks or perhaps concentrate more on the management of liquidity by
financial institutions in order to better identify the risks related to liquidity.
The three key takeaways from the Sub-prime crisis include:
1. A false feeling of comfort was created by high levels of debt, borrowers' sceptical
ability to repay loans, and the idea that house values would always rise, among other
issues.
2. Risk diversification was not achieved by spreading risk outside of the protected
banking system or by using "insurance" strategies like credit default swaps. All facets
of the financial system must comprehend risk.
3. Short-term decisions might have long-term effects that need to be carefully evaluated.
Citations:
1. https://en.wikipedia.org/wiki/Alt-A
2. https://www.bis.org/publ/bcbs_wp13.pdf
3. https://www.investopedia.com/ask/answers/100314/when-did-real-estate-bubble-
burst.asp
4. https://knowledge.wharton.upenn.edu/article/housing-bubble-real-causes/
5. https://www.federalreservehistory.org/essays/great-recession-of-200709