The U.S. subprime mortgage crisis was a set of events that led to the 2008 financial crisis, characterized by a rise in subprime mortgage defaults and foreclosures. This paper seeks to explain the causes of the U.S. subprime mortgage crisis and how this has led to a generalized credit crisis in other financial sectors that ultimately affects the real economy. In recent decades, financial industry has developed quickly and various financial innovation techniques have been abused widely, which is the main cause of this international financial crisis. In addition, deregulation, loose monetary policies of the Federal Reserve, shadow banking system also play dominant roles in this crisis. From the bankruptcy of Lehman Brothers, AIG, Washington Mutual Bank, government takeover a series of financial institutions, the world’s major economies continued to fall. The direct consequence of this financial crisis will inevitably lead to the global economic downturn and even recession. Introduction
This paper has two sections. Section I gives an overview and background of the subprime mortgage crisis, the recent financial instruments and innovations, and how the crisis led to a generalized credit crisis in the financial industry. Section II discusses the causes of the crisis, including deregulations, loose monetary policies and so on. 1. Background and Financial Derivatives
1.1 Housing industry and subprime mortgages
Some years before, the U.S. housing mortgage party was prosperous, investors and mortgage bankers made millions, even billions from this party, which may due to the low interest rates. In the wake of the dot.com bust and 9.11 disaster, the U.S. Federal Reserve Chairman Alan Greenspan lowered interest rates to only 1% to keep the economy strong, which is a low return on investment that led investors to seek for better investment opportunities. So the investors turned into the housing industry. Wall Street earned $27 billion in revenue from selling and trading asset-backed securities (Farzad, 2007a). Many middle class families saw their home equity rise and felt rich. Even those from lower classes were able to own houses with minimal or even zero down payment. As house prices rose, every people had a good time. The house prices in the U.S. shot up 40% between 2000 and 2006 to a high of $234,000. However, the housing bubbles burst and house prices started to decline by early 2006 and are expected to fall sharply in 2007 and 2008. Accordingly, defaults and foreclosure rates began to increase. In 2006, 1.2 million household loans were foreclosed, up 42% from the previous year.
It is expected that two million homes will be foreclosed on in 2007 and even more in 2008 when 2.5 million adjustable rate mortgages will reset higher (Schwartz, 2007.). Subprime mortgages simply mean lending money to house borrowers who with irresponsible credit. Lenders did so by providing homebuyers minimal or zero down payment, do not need home owners provide proof of, no documents, and weak credit checks. Between 2004 and 2006, $1.5 trillion of subprime mortgages were booked. Total subprime loans from 25% of the housing mortgage market (Capell, 2007.). These subprime loans were fine as long as the housing market continued to boom and interest rates did not rise. If these conditions vanished, the subprime borrowers may default. These defaults had negative influence of the mortgage backed securities (MBS), the collateralized debt obligations (CDOs) and credit default swap (CDS) market, which soon had detrimental impacts on everyone. 1.2 Mortgage Back Securities (MBS)
Building on the definition of a bond, a mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization (Wikipedia). Securitization enabled banks and mortgage companies who are the originators of loans, to take on more loans as they moved the securitized loans off their books. Many large housing developers asked house brokers to aggressively pushed mortgages to borrowers in order to improve house sales and earn more revenue. These brokers have neither the credit skills nor the interest to conduct proper payment due of potential homebuyers. Their interest is only in selling the houses as fast as they can. The MBS instruments allowed all financial institutions to transfer the risks to other investors. The dissociation of ownership of assets from risks encouraged poor credit assessment and was fundamental increasing the risks. 1.3 Collateralized Debt Obligations (CDOs)
Collateralized debt obligations (CDOs) refers to a kind of innovative derivative securities product which simply bundling mortgage debt, bonds, loans and other assets together and then rearranging these assets into different tranches with different credit ratings, interest rate payments, risks, and priority of repayment to meet the needs of different investors. As borrowers began to default, investors in the inferior tranche of the CDOs took the first hit, so the owner of this tranche of CDOs may be riskier. In order to compensate for the higher risk, the subordinate tranche receives higher rate of return while the superior tranche receives lower rate but still nice return. To make the top even safer, the banks ensured it small fee called the credit default swap (CDS). The banks do all of the works so that creating rating agencies will stamp the top tranche since as a safe, triple A rated investment which is the highest rating. However, the more subprime borrowers bought house and began to default, the less safe of the CDOs will be. In fact, the risks of the housing loans are shared by the bond holders through the issuance and sale of CDOs. 2. Main Factors Leading the Financial Crisis
The crisis can be attributed to a number of factors in both housing and credit markets. Causes include the inability of homeowners to make their mortgage payments and speculation, inaccurate credit rating, risky financial derivatives products that distributed and perhaps concealed the risk of mortgage default, loose monetary and housing policies, moral hazard which people’s greedy, international trade imbalances, and deregulation of government. 2.1 The Changes of Interest Rates
The loose monetary policy of the Federal Reserve Bank began in late 2001 when it is under the watch of Greenspan, which was aimed to stimulate the U.S. economy and help the U.S. economy out of recession contributed to the continuous boom in the housing market at that time. The interest rates were low to only 1%, so banks can easily borrow money from Federal Reserves and made them go crazy use with leverage which means borrowing money to amplify the outcome of a deal. There were an abundant of cheap credits at that time and in the meanwhile, the risks were existed in them.
However, Fed increases the level of interest rates for 17 consecutive times from June 2004 to June 2006, which made the benchmark interest rate from 1% to 5.25%, in order to alleviate economy overheating. So, this led to a floating interest rate which subprime mortgage rates based on continue to increase. A substantial increase in interest rates not only making house prices continue to decline, but also made a large number of low-income level subprime borrowers unable to pay the principal and interest of loans. The burden on the borrower’s repayment gradually increased and repayment pressure increases rapidly. Then, the subprime mortgage delinquencies were rising dramatically. 2.2 Boom and bust in the housing market
Because of the loose monetary policies and low interest rates, the housing market boom in the decades before the financial crisis. While housing prices were increasing, consumers were saving less and both borrowing and spending more. Then house price increased led to a housing boom and eventually to a surplus of unsold houses, which caused U.S. housing prices to peak and began to decrease in mid-2006. More and more subprime borrowers who were inability to pay for the monthly payment initially before buying the house and with low down payment began to default. As more borrowers stop paying their mortgage payments, defaults and the supply of homes for sale increase. This led to the downward pressure on housing prices, which further lowers homeowners’ equity. The decline also eroded the worth and financial health of banks. This vicious cycle is the core of the financial crisis. 2.3 Inaccurate Credit Ratings
Credit rating agencies are now under scrutiny for giving investment-grade ratings to MBSs based on risky subprime mortgage loans. These ratings were believed justified because of risk reducing practices. But the facts show that the credit ratings given by the rating agencies had some faults at that time and did not reflect the real risks that exist in these securities. Critics assert that the rating agencies suffered from conflicts of interest, since they were paid by investment banks and other institutions which organize and sell financial products to investors. Arnold Kling, an economist who once worked at Freddie Mac, testified that a high-risk loan could be “laundered,” as he put it, by Wall Street and return to the banking system as a triple-A-rated security for sale to investors, obscuring its true risks (The New York Times, Dec 9, 2008). In July 2007, these rating agencies lowered the credit rating to almost all of the sub-prime mortgage bonds. Such behavior directly caused extreme panic in the market, which led to the lack of global liquidity. 2.4 Globalization and Trade Deficit
In 2005, Ben Bernanke addressed the implications of the United States’s high and rising current account deficit, resulting from U.S. investment exceeding its savings, or imports exceeding exports (Federalreserve.gov, 2009-02-27). So, in order to balance the trade deficit, the U.S. attracted a great deal of foreign investment during 1996 to 2004. Then, American homeowners used funds borrowed from foreigners to finance consumption or to raise the prices of housing and financial assets, while the financial institution invested foreign funds in mortgage-backed securities. American housing and financial assets dramatically declined in value after the housing bubble burst. 2.5 Deregulation of Government
Despite the Federal Reserve and other financial regulatory authorities began to notice that the relaxation of lending standards, but the Fed does not regulate and take certain acts on financial institutions immediately, missing a good time of crisis prevention. The Fed still continued to raise interest rates and at the same time has continued to encourage lending institutions to develop and sell more varieties subprime securities. The Federal Reserve made necessarily market intervention until the New Century Financial Corporation in the United States bankruptcy in March 2007 and after the outbreak of the subprime mortgage crisis. So the deregulation of the government exacerbated the formation of this financial crisis 2.6 Abuse of Financial Innovation Products
Mortgage market bubble formed mainly because of high-risk mortgage innovation products. The subprime mortgage loan was considered a great financial innovation when it launched in 2003. Because it made the homebuyers who are poor and unable to afford houses dreams come true. As buying the original lender’s mortgage loan and then packaging loans securitized investment products resold to investors, it seems that there are high investment returns in the subprime mortgage derivative products objectively. In a low interest rates environment, these financial innovation products enable investors to obtain a higher return, which has attracted more and more investors. Loose credit environment or housing prices, if homebuyers default, the lending institutions can also refinance or mortgage the house to recover, and then can be sold. However, if there are changes in the credit environment, particularly falling house prices, refinancing or mortgage the house to recover and resell is not easy or impossible to achieve. When concentration of such events in a larger scale arises, the crisis may occur. This also reflects the fact is human’s greedy. Conclusion
The financial crisis impact on the U.S. economic entity and prompted the United States to adjust macroeconomic policies, and also the world economy have suffered a profound impact. The causes of this crisis are diversify mainly including the changes of interest rates, boom and bust in housing market, inaccurate credit ratings, globalization and trade deficit, deregulation of government and abuse of financial innovation products. It is telling that the U.S. Treasury Secretary, Paulson, a former Wall Street banker, warned as early as September of last year that the problem is not short term but will be with us for a while (cited in Callan, Grant and Barber, 2007).
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