2007 subprime mortgage financial crisis

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The subprime mortgage financial crisis of 2007 was a sharp rise in home foreclosures which started in the United States during the fall of 2006 and became a global financial crisis within a year, the Subprime mortgage crisis.

The root of the crisis started with "subprime" mortgage loans, which were made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. The share of subprime mortgages to total originations increased from 9% in 1996, to 20% in 2006.[1] Further, loan incentives including "interest only" repayment terms and low initial teaser rates (which later reset to higher, floating rates) encouraged borrowers to assume mortgages believing they would be able to refinance at more favorable terms later. While U.S. housing prices continued to increase during the 1996-2006 period, refinancing was available. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically. By October 2007, 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days into default or in foreclosure proceedings, roughly triple the rate of 2005.[2] Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007.[3]

The mortgage lenders that retained credit risk (the risk of payment default) were the first impacted, as borrowers became unable or unwilling to make payments. Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS). Individual and institutional investors holding MBS faced significant losses, as the value of the underlying mortgage assets and payment streams declined and became difficult to predict. In addition, certain legal entities designed to isolate this risk from the originating lenders, called collateralized debt obligations (CDO) and structured investment vehicles (SIV), held substantial amounts of MBS. As the value of payments into these entities declined, their value also declined, forcing the sale of MBS at fire sale prices in some instances.

The widespread dispersion of credit risk and the unclear impact on large banks, MBS, CDO, and SIV caused banks to reduce their loans to each other or make them at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was impacted. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets.

The combination of impacts due to credit risk and liquidity risk caused several major corporations and hedge funds to shut down or file for bankruptcy. Stock market declines among both depository and non-depository financial corporations were dramatic. Many hedge funds and other institutional investors holding MBS also incurred significant losses.

With interest rates on a large number of subprime mortgages due to adjust upward during the 2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or defer interest rate adjustments was implemented to limit the impact. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Restrictions on lending practices are under consideration. Many lenders have stopped subprime lending or dramatically curtailed it.

Contents

Background information

Main article: Subprime lending

Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody's or other rating firms, albeit for an "alternative" means.

The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007,[4] with over 7.5 million first-lien subprime mortgages outstanding.[5]Approximately 16% of subprime loans with adjustable rate mortgages (ARM) are 90-days into default or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005.[6] A total of nearly 447,000 U.S. housing units were subject to some sort of foreclosure action from July to September 2007, including those with prime, alt-A and subprime loans. This is nearly double the 223,000 properties in the year-ago period and 34% higher than the 333,000 in the prior quarter.[7] The estimated value of subprime adjustable-rate mortages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining.[8] An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.[9]

Understanding the causes and risks of the subprime crisis

The reasons for this crisis are varied and complex.[10] Understanding and managing the ripple effect through the world-wide economy pose a critical challenge for governments, businesses, and investors. Due to innovations in securitization, the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by either the borrower or the lender; inappropriate mortgage incentives, and rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. There are three primary risk categories involved:

  • Credit risk: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is now shared more broadly with investors, because the rights to these mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. Further, the MBS investor has the right to cash flows related to the mortgage payments. To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create separate legal entities, called special-purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively sell the mortgage assets (i.e., banking accounts receivable, which are the rights to receive the mortgage payments) to these SPE. In turn, the SPE then sells the MBS to the investors. The mortgage assets in the SPE become the collateral.
  • Asset price risk: Most CDOs require that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows, collateral ratings, or market values. Because the ability of sub-prime and lower-quality (e.g., Alt-A) mortgage homeowners to pay is now in question, the value of the mortgage asset may be reduced suddenly. For deals with market value tests, if the valuation falls below certain levels, the CDO may be required by its terms to sell collateral in a short period of time, often at a steep loss, much like a stock brokerage account margin call. If the risk is not legally contained within an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types of assets, as well, to satisfy the terms of the deal.
  • Liquidity risk: A related risk involves the commercial paper market, a key source of funds (i.e., liquidity) for many companies. Companies and SPE called structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected.[11] The amount of commercial paper issued as of October 18, 2007 dropped by 25%, to $888 billion, from the August 8 level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels.[12]

Understanding the impact on corporations and investors

Average investors and corporations face a variety of risks due to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:

  • Bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Companies value their mortgage assets (receivables) based on estimates of collections from homeowners. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables.[13]
  • Mortgage lenders and Real Estate Investment Trusts: These entities face similar risks to banks. In addition, they have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance secured by mortgages. Investors have become reluctant to fund such investments and are demanding higher interest rates. Such lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy.[14]
  • Special purpose entities (SPE): Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called structured investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks.[15]
  • Investors: The stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection.

Causes of the crisis

Role of borrowers

Some homeowners had been using the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. Between 1997 and 2006, American home prices increased by 124%.[16] Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period. With housing prices now depreciating moderately in many parts of the U.S., refinancing has become difficult, leaving homeowners with higher payments than anticipated.

In the early 2000s recession that began in early 2001 and which was exacerbated by the September 11, 2001 terrorist attacks, Americans were asked to spend their way out of economic decline with "consumerism... cast as the new patriotism". This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop"[17], and corporations like General Motors produced commercials with the same theme.

The housing bubble was largely fed by the lowering of interest rates to record low levels to diminish the blow of the massive collapse of the dot-com bubble. The collapse of the housing bubble, and resultant decline in property values, and increase in defaults has left lenders unable to recover losses.[18]

Additional problems are anticipated in the future from the impending retirement of the baby boomer generation. It is believed that a significant proportion of baby boomers are not saving adequately for retirement and were planning on using their increased property value as a "piggy bank" or replacement for a retirement-savings account. This is a departure from the traditional American approach to homes where "people worked toward paying off the family house so they could hand it down to their children"[19].

Role of financial institutions

A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 [20] , 9% in 1996[21], 13% ($160 billion) in 1999 [22] , and 20% in 2006.[23] Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others.

In addition to considering higher-risk borrowers, lenders have offered increasingly high risk loan options and incentives to them. One example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Another example is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004-2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[24]

Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.[25]

Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race.[26] African Americans and other non-whites are being disproportionately led to sub-prime mortgages with higher interest rates than their white counterparts. .[27] Even when median income levels were comparable, home buyers in minority neighborhoods were more likely to get a loan from a subprime lender. This may in some cases be due to other objective metrics such as credit ratings or past bankruptcies.[26] However, in July 2007, a report published by the Federal Home Loan Mortgage Corporation showed that minority borrowers pay higher annual percentage rates on mortgage loans than non-minorities with equal income and equal credit risk. In 2005, African American borrowers paid an average of 128 basis points more for loans than their white counterparts.[28] In the subprime market, the difference was greater: 275 basis points more. This has lead the NAACP to file a class action suit against a large group of lenders charging racism in lending practices.[28] However, home ownership among black Americans has increased from 42% to 48% since the mid 1990's, with the overall rate of U.S. home ownership increasing from 64% to 69%. Subprime loans were a significant contributor to this increase.[29]

Role of mortgage brokers

Mortgage brokers don't lend their own money. There isn't a direct correlation between loan performance and compensation. They have big financial incentives for selling riskier loans, since they earn higher commissions. [30]

According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the U.S., with subprime and Alt-A loans accounting for 42.7% of brokerages' total production volume. [31]

Role of mortgage underwriters

Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting.

In 2007, 40 percent of all subprime loans generated by automated underwriting. [32] An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. "We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation." [33] Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown. [34]

Role of government and regulators

Some observers claim that government policy actually encouraged the development of the subprime debacle through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise uncreditworthy consumers.[35] Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. [36] A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. [37]

In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.[38]

Role of credit rating agencies

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings are theoretically due to the multiple, independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play.

Role of central banks

Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dotcom bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy.[39]

Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf. [40]

Impacts

Impact on stock markets

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.[41] By August 15, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Large daily drops became common, with, for example, the KOSPI dropping about 7% in one day,[42] although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis.

Mortgage lenders[43][44] and home builders [45][46] fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.[47]

Impact on financial institutions

See also: Subprime crisis impact timeline

Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of December 11, 2007 banks had recognized subprime-related losses or writedowns exceeding U.S. $60 billion, with an additional $8-$11 billion expected from Citibank.[48][49] Other companies from around the world, such as IKB Deutsche Industriebank[50], have also suffered significant losses [51] and scores of mortgage lenders have filed for bankruptcy.[52] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.[53]

Businesses filing for bankruptcy
Business Type Date
Flag of the United States New Century Financial subprime lender April 2 2007
Flag of the United States American Home Mortgage mortgage lender August 6 2007
Flag of the United States Sentinel Management Group investment fund August 17 2007[54]
Flag of the United States Ameriquest subprime lender August 31 2007
Flag of the United States NetBank on-line bank September 30 2007[55]
Flag of Norway Terra Securities securities November 28 2007[56]
Losses or writedowns on loans and MBS
Business Type Loss
Flag of the United States Citigroup investment bank $14,5 - $17,500,000,000 [57][58][59]
Flag of the United States Merrill Lynch investment bank $8,400,000,000[60]
Flag of the United Kingdom Barclays Capital investment bank $2,700,000,000 [61][62]
Flag of the United Kingdom HSBC bank $3,400,000,000 [63]
Flag of Switzerland Swiss Re re-insurance $1,070,000,000 [64]
Flag of Switzerland UBS AG investment bank $13,400,000,000 [65]
Flag of Germany Deutsche Bank bank $3,100,000,000 [66][67]
Flag of the United States Bear Stearns investment bank $1,200,000,000 [68]
Flag of the United States Morgan Stanley investment bank $13,100,000,000 [69]
Flag of the United States Lehman Brothers investment bank $700,000,000[70]
Flag of the United States Freddie Mac mortgage GSE $3,600,000,000 [71]
Flag of Switzerland Credit Suisse bank $1,900,000,000 [72][73]
Flag of the United States Wells Fargo bank $1,400,000,000 [74]
Flag of the United States Wachovia bank $1,100,000,000 [75]
Flag of Canada RBC bank $360,000,000 [76][77]
Flag of the United States Bank of America bank $3,000,000,000 [78]
Flag of the United States Fannie Mae mortgage GSE $896,000,000 [79]
Flag of the United Kingdom RBS bank $2,600,000,000 [80]
Flag of the United States Washington Mutual savings and loan $1,600,000,000 [81]

Impact on subprime borrowers

Impact on other home owners

Actions to manage the crisis

  • Central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans. [82] Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed assets. This helps lenders, SPE, and SIV avoid selling mortgage-backed assets at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline.
  • Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives.[83]
  • Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.[84]
  • Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. [85] Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings help identify solutions and apply pressure to the various parties involved.[86]
  • The media can help educate the public and parties involved.[87] It can also ensure the top subject material experts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions.[88]

President Bush's plan

President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs, declaring "I have a message for every homeowner worried about rising mortgage payments: The best you can do for your family is to call 1-800-995-HOPE (sic)" [89]. The correct number is 1-888-995-HOPE).[90]. A refinancing facility called FHA-Secure was also created. [91] This is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance. [92]

The U.S. Treasury Department is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing ARM increases, rather than working through loans on a case-by-case basis.[93]

Expectations and forecasts

As early as the 2003 Annual Report issued by Fairfax Financial Holdings Limited, Prem Watsa was raising concerns about securitized products:

"We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds) eliminates the incentive for the originator of the loan to be credit sensitive. Take the case of an automobile dealer. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard)... This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S.... Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Unlike..." [94]:

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm"[95]. Alan Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s"[96].

On September 7, 2007, the Wall Street Journal reported that Alan Greenspan has said that the current turmoil in the financial markets is in many ways "identical" to the problems in 1987 and 1998.[97]

The Associated Press described the current climate of the market on August 13, 2007, as one where investors were waiting for "the next shoe to drop" as problems from "an overheated housing market and an overextended consumer" are "just beginning to emerge.[98]" MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse"[99].

As described in the background section above, 16% of the estimated U.S. $1.3 trillion in subprime mortgages were in default as of October 2007, or approximately $200 billion. Considering that $500 billion in subprime mortgages will reset to higher rates over the next 12 months (placing additional pressure on homeowners) and recent increases in the payment default rate cited by the Federal Reserve, direct loss exposure would likely exceed the $200 billion figure. This figure may be increased significantly by "Alt-A" defaults. The impact will continue to fall most directly on homeowners and those retaining mortgage origination risk, primarily banks, mortgage lenders, or those funds and investors holding mortgage-backed securities. As cited above, many such entities have reported significant losses from both revising the valuation of mortage assets and the sale of MBS at steep losses. Regulators are carefully monitoring this exposure. In addition, a consortium of banks are establishing a fund to prepare for this impact and have committed nearly $100 billion as of October 24th.[100]

See also

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