Financial institutions and real estate sector are usually interrelated, and the decisions made by one sector affect the other sector. Moreover, the two sectors are so critical in the world economy such that adoption of inappropriate policies can trigger a recession of the whole economy (Shiller 45). Below is a report that investigates a sample case in the US which resulted into a second worst recession in the world economy.
The subprime crisis refers to a financial crisis that hit the US between 2006 and 2008.This financial crisis is attributed to the plummeted real estate market that characterized the US during that period. The crisis is traced back to a series of financial market operations that took place between towards the end of 2001 and 2005 (Madura, 221). The real estate market had been stable and until the beginning of 2002. During this time, the world liquidity was relatively very high and financial institutions, and other lenders were searching for investment that seemed less risky. Many of these institutions ended up channeling their loan facilities in the US housing and real estate market, to offer mortgage loans. Ready availability of capital combined with the good performance in the market increased demand for houses.
As a result of high capital demand, the terms and conditions of subprime mortgages were reviewed. In this review, restrictions that prevented many people from accessing the facilities were removed. For instance, a person was not needed to have any collateral security, or good credit history for him or her to qualify for a mortgage loan. Another feature that made the subprime mortgage loans more accessible was the lack of initial down payment (Zandi 241). They were structured in such a way that borrowers were given a grace period before they started repaying. In addition, the interest rate was initially at as low as 2%, and was later adjusted upwards as time went by. In some cases, the interest rate could rise to a rate of 28%. The low beginning interest rate enticed many borrowers. This is what latter came to be known as “predatory lending.” More mortgage brokers also came in during this time, and many people ended up taking the mortgage loans. The resulting high demand for subprime mortgages attracted more lenders from outside US. The capital inflow was therefore, very high, and very many houses were being constructed. In this case, the mortgages were used as securities, subject to foreclosures in case the borrowers became delinquent.
In 2006, many houses had been set up and therefore, demand for facilities begun to decline. The reduced demand implied that the prices for the houses also went down. This coupled with the ever increasing interest rates complicated the situation for borrowers when servicing their loans. The declining prices of the houses also made the investors who had already purchased the houses to sell them at loss prices. Other investors would go for a second mortgage in an attempt to improve the houses, but this did not restore the situation. In March 2007, the value of bad mortgage loans was approximately 1.3 US trillion dollars, distributed among 7.5 million defaulters. This negatively affected the lenders. By October, the same year, 43% of the subprime mortgages were at foreclosures and further 16% would be due in ninety days!
By the end of 2007, household debt ratio to disposable income stood at 124%, as compared to 77% in 1990. The housing and real estate market had totally plummeted and the loans, which had not, been paid by then could hardly be repaid. This financial meltdown also dominated the first months of 2008, and was passed on to the stock market through the hedge fund investment. The subprime mortgage crisis was the second worst world economy recession.
Roles Played by Different Parties in Subprime Crisis
In 2001, the Federal Reserve Board lowered the interest rates on mortgage facilities from 6.5% to as low as 1%, which increased demand for loans. During the same time, global liquidity surplus that had resulted from savings increased the liquidity in the financial institutions, and they rushed to give out mortgage loans. According to the CEO and president of Federal Reserve Bank of Dallas, the decreased interest rates in mortgage loans are to be blamed for the subprime mortgage. The Central bank also failed to notice that the low inflation rates that were going below 1% in late 2002 and early 2003 would be followed by a recession in the economy, and therefore, failed to give a warning that the prices of the mortgage houses would not rise as expected. From 2001 to 2005, the Federal Reserve Board raised the interests on mortgage loans seventeen times, from 1% to 5.25 % (Madura, 62). Most of these rises in interest rates were done towards 2005, which caused fear and tension to borrowers on how they would manage the loans. This made it difficult for borrowers to manage their mortgages and delinquencies began to take place.
Investment banks did not properly understand the statistics and implication of the low inflation rates that were present in the economy, and failed to foresee the economy recession that would follow was going to cause a decrease in the prices of the mortgage houses. Instead, they made more investments in the US real estate, which rewarded them huge losses as a result of the declining house prices in 2006. When the investors began to realize the resulting trend of the ever decreasing house and real estate properties, they all suddenly priced their properties at lower prices in an attempt to sale them. This resulted into price competition, and soon the whole market prices were all at losses.
The subprime banks revised and ended up loosening the terms and conditions that a borrower was supposed to meet in order to qualify for a mortgage loans. They also failed to exercise thorough evaluation on the subprime borrowers despite their bad, or absence of credit history. This coupled with the increased liquidity caused the subprime banks both from within and outside US to start giving out more unsecured mortgage loans, which became difficult to manage and recover when the housing and real estate market began melting down (Zandi 87). Due to the reviewed favourable mortgage requirements, subprime banks increased the amount of mortgage loans given to borrowers up to 600 billion US dollars. The mortgage loans contributed about 20% of the total loans given out by financial institutions globally. This overloaded the subprime borrowers, and hardly hit the financial institutions when the borrowers started defaulting.
Credit rating agencies
Credit rating agencies usually have very important information about borrowers. They assist the lenders by assessing the financial viability of a borrower and making informed decisions on whether a client is capable of repaying a loan or not. Credit rating agencies contributed greatly to the subprime mortgage crisis. They did not evaluate the borrowers accordingly and therefore, ended up giving false information about the borrowers. In a particular in the US, credit rating process was automated. This ineffective system qualified many borrowers who in actual sense were not eligible for loans. As a result, more mortgage loans were given out, and the borrowers ended up defaulting. In fact, the major credit rating agencies including Standards and Poor’s corp., Fitch ratings and Moody’s Investors Services Inc were had downgraded over 50 billion US dollars as of November 2007 (Shiller 224).
Investors (pension funds, hedge funds and global investors)
Investors also played some role in contributing towards the subprime crisis. For instance, Pension Funds accepted high risk bearing loans that had been bundled into securities in the Wall Street. They speculated that the loans would end up giving them higher returns, but failed to consider and evaluate the high risks that these securities had (Tsanis 266). They also failed to observe that the decreased interest rates on mortgage loans in 2001 would end up reducing the prices of the houses.
During the boom time, new mortgage lenders emerged to offer the facilities. Since these new lenders were not under control of the central bank, many lending requirements were overlooked, and mortgage loans became readily available to a larger number of borrowers. In particular, these unregulated lenders introduced the adjustable rate mortgages (ARMs), “stated-income loans” and interest-only mortgages (Muolo & Mathew 125). The flexible loan requirements also led to an overload of loans to borrowers resulting from easy accessibility. Lenders failed to carry out sufficient evaluation of the borrowers’ income and financial status. As a result, it became difficult for clients to manage their loans when the interest rates were reviewed upwards.
The high demand for and supply of mortgage loans increased the number of brokers between 2003 and 2004. According to a study conducted in 2004, brokers initiated 68% of all the mortgage loans awarded during that period (Kolb 114). Since the brokers did not own the money they were lending, they did not carry out adequate appraisal of the borrowers before giving them the loans. They would be paid upon successful identification of “potential” borrowers, and the burden of collecting the interest was left to the lender. Incorporation of automated underwriting also increased the number of mortgages awarded to borrowers that posed a greater risk of defaulting.
Mortgage credit insurers
According to Freddie Mac CEO, Richard Syron, mortgage credit insurers failed to note the existence of the housing bubble that was taking place in the US, until 2005 when there was a steady decline. They therefore, went ahead and provided insurance on these higher risk loans. The credit insurers contributed to the crisis when they failed to investigate the risks associated with these loans. Since the subprime borrowers did not have good credit histories, the insurance companies should have been careful when taking liability over such loans (Madura 89).
Between1994 and 2004, the demand for home ownership rose from 64% to 69.2% (Tsanis 96). This increased demand for residential houses increased home values up to 124%, and suddenly there was a scramble for mortgage loans, with people seeking to acquire or improve their homes. In the later case, borrowers approached financial institutions for mortgage funding, used part of the funds to improve their houses, and the rest of the funds were spent on other consumer needs. As a result, the ratio of household debt to disposable income rose to 130%. Some subprime borrowers took the mortgage loans after the interest rates had already gone up. Thus, they were unable to build up enough equity since the interest rates had already gone up, according to Fed chairman’s report, in a meeting held in March 2007. As a result, of the high household debt, the number of defaulters increased drastically in mid 2006 (Muolo & Mathew 46).
In other cases, the borrowers forged fraudulent income documents and presented them to financial institutions in order to be considered for mortgage loans. When most of them became unable to repay the loans due to the hiked interest rates, they flew away from their homes, leaving the lenders to conduct foreclosures.
Current and Potential Winners and Losers of the Crisis
Current and potential winners
Mortgage brokers and agencies are the only people who were not affected by the subprime mortgage crisis. This is because they were only used as intermediaries between lenders and borrowers. They served only to align potential borrowers and lenders. In most cases, the mortgage brokers were required to carry out credit evaluation on the borrowers. The banks would then make disbursements into the borrowers’ accounts (Tong & Shang 199). Mortgage brokers were not involved in subsequent activities such as the collection of loans, and therefore, they did not care on whether the borrower will eventually repay the loan or not, because the money they were lending did not belong to them. The lenders therefore, paid them their dues as soon as they identified potential customers (Shiller 251).
When the housing and real estate market in the US collapsed, the brokers had nothing to lose. They had already received their compensations from the lenders. The subprime crisis therefore, did not affect them.
Current losers and potential losers
Subprime Mortgage Lenders
As a result of the high default rates and poor performance of the foreclosures, the whole subprime industry was affected. The lenders were not able to recover the full loans that they had given out due to the declining prices in the housing and real estate market. Conducting foreclosures became difficult as there was very little demand for the houses. In addition, the companies had given out much of their funds, and were not able to continue giving loans. Several companies closed down including Ameriquets, which was formerly the largest subprime lender in the US (Kolb 99). The company was also fined 325 million US dollars for conducting deceptive lending and marketing practices.
Banks and Other Financial Institutions
Both the banks inside and outside US lost the funds which they had given as mortgages, in the earlier booming housing and real estate market. When this market fell, borrowers were not able to repay their loans. Furthermore, the poor market also affected the price of the houses and therefore, foreclosures could not return the funds that had been spent on them during construction. In addition, the mortgage-based securities (MBS) also affected other loans that dependent on them as securities. According to Standard and Poor’s, banking firms across the globe would write off approximately 285 billion US dollars on loans that were linked to securities related to the US subprime real estate. A report given by IMF in March 2007 stated that banks and other financial institutions incurred half of the total losses resulting from subprime mortgage crisis (Muolo & Mathew 118).
The Subprime Borrowers
Statistics show that individual borrowers lost about 142 US dollars per person. This was as a result of the foreclosures conducted by the lenders when the borrowers defaulted. The houses for which they had obtained loans to construct were repossessed by the lenders and sold at loss price.
The mortgage houses were to be sold to private and public companies and individuals upon completion, either for residential or commercial purposes (Tong & Shang 133). Those who had already bought the houses completed earlier with intentions of taking advantage of market speculations and later selling them at higher prices were affected. Contrary to their expectations, the prices of the properties they had bought dropped drastically and they ended up selling them at losses. Individuals who had purchased the houses for residential purposes also suffered some losses after the houses depreciated in value.
Magnitude of the Effects to the National and International Economy
The subprime mortgage crisis that reached its peak in mid 2007 is the second worst world economy recession experienced. This crisis affected not only the housing and real estate market, but the international economy as a whole. According to a report released by IMF on April 2008, losses of around 565 billion dollars related to the subprime crisis had occurred by then. The collapse in the housing and real estate market in the US affected all other sectors in the economy (Zandi 352). The crisis directly lamed operations of all the financial institutions that were involved. Statistics show that losses that resulted from these subprime mortgages on other loans and securities amounted to approximately 945 billion US dollars. According to a report released by Standard and Poor’s in March 2008, about 285 billion US dollars were written off as bad loans globally. In the US, American Home Mortgage ended up filing for bankruptcy in August 2007 (Kolb 145).
The subprime crisis also affected the stock exchange markets through the hedge funds. A good example is the Korea Composite Stock Price Index, which dropped by about 7 percent in a single day. According to a report given by RealtyTrac, the total number of foreclosures stood at 179,599 foreclosures as of July 2007. The housing market was adversely hit by this crisis due to bank repossessions. This report compares with the Mortgage Bankers Association’s report, which also indicates that the number of filed foreclosures in August 2007 was largest in a record of 55 years (Tsanis 152).
The subprime mortgage crisis is therefore, one of the worst crisis that hit the world economy between 2005 and 2007 (Tong & Shang 11). As pointed out in the report, the crisis arouse from a combination of failures from several sectors of the economy. The crisis also gives a clear reflection on the interplay between the different sectors of the economy, and how retrogressive policies made by one sector can adversely affect the whole world economy. This report therefore, can serve to give an insight and a precaution on what might happen when one sector in the economy makes uninformed decisions, and the other sectors just follow blindly.
Kolb, Robert W. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. Hoboken, N.J: Wiley, 2010.
Madura, Jeff. Financial Markets and Institutions. Australia: South-Western Cengage Learning, 2010. Print.
Muolo, Paul, and Mathew Padilla. Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. Hoboken, N.J: John Wiley & Sons, 2008.Print.
Shiller, Robert J. The Subprime Solution. Princeton [u.a.: Princeton Univ. Press, 2008. Print.
Tsanis, Konstantinos. The Impact of the 2007-2009 Subprime Mortgage Crisis in the Integrated Oil and Gas Industry. München: GRIN Verlag, 2010.Print
Tong, Hui, and Shang-Jin Wei. Real Effects of the Subprime Mortgage Crisis: Is It a Demand or a Finance Shock?Cambridge, Mass: National Bureau of Economic Research, 2008.Print.
Zandi, Mark M. Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis. Upper Saddle River, N.J: FT Press, 2009. Print.