US Subprime Lending Crisis (2007)

 Conveived & compiled by - Ashish Masurekar

Preface

Everyone has been constantly reading in almost all newspapers about the US subprime mortgage crisis which has been said to have the potential to bring the US economy to a brink of a recession. It has led to the ouster of top executives of Merrill Lynch, Citibank etc to name a few because of exposure to the subprime mortgage turmoil. Ironically, the same crisis has led to an Indian born banker- Vikram S Pandit being put at the helm of the world’s largest bank – Citigroup. So what is exactly the subprime crisis all about?

The following extract seeks to explain what we mean by the term “subprime lending”. Then we decipher what is the subprime mortgage lending crisis all about and what led to its happening. Lastly, we seek to find its potential impact on the US and Indian economy.

“Subprime” means what

It refers to the category of borrowers with weak credit history. These borrowers usually find it tough to land mortgage-backed loans. Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for loans at market interest rates because of problems with their credit history or the lacking of their ability to prove that they have enough income to support the monthly payment on the loan for which they are applying. Thus, a subprime loan is one that is offered at an interest rate higher than A-paper (Prime) loans due to the increased risk. 

Background to the crisis

The easy liquidity policy in the US led to the U S Fed rates touching about 40-plus year lows about four years ago. The low-interest rate policy led to a boom in mortgage financing. As lenders exhausted high quality clients, they gradually started moving down the credit curve of borrowers towards the subprime category.

This gave rise to sizeable loans to borrowers who figured low on credit quality. The boom in these loans has been on an unprecedented scale (as shown in the adjacent diagram). This home buying spurred by low interest led to realty prices going way of out of line with realistic levels. It made homeowners believed that the realty prices will continue to grow and make future refinance and second mortgages quite profitable. At the same time eased lending standards allowed them to buy more expensive homes than they could afford.

Lenders were prompt to offer riskier loans Adjustable Rate Mortgages (ARMs) (which have a floating interest clause) to subprime borrowers as loan products with such adjustable rates, transferred great part of a risk from the lender to the borrower. This risk transfer was also main reason why they often offered greater commission to Mortgage Brokers if they sold adjustable rate loan. Probably some of the brokers were overtaken by greed and were offering and suggesting adjustable mortgages even to borrowers who would qualify for prime loans.

On the advantages of Subprime lending

The obvious advantage of the expansion of subprime mortgage credit is the rise in credit opportunities and homeownership. Because of innovations in the prime and subprime mortgage market, nearly 9 million new homeowners in US are now able to live in their own homes, improve their neighbourhoods, and use their homes to build wealth.

On the challenges of Subprime lending

While the basic developments in the subprime mortgage market may seem to be positive, the relatively high default rates in the subprime market do raise issues on the viability of such lending. So there are two sides to the issue of subprime lending:

·        Yes, they extend home ownership to many Americans who might not otherwise afford it.

·        But they are also a contributing factor in the number of home foreclosures in the United States.

The Actual crisis

Continuing from the background to the crisis, as mentioned earlier the home buying spurred by low interest led to real estate prices going way of out of line with realistic levels. The sharp price rise had an in-built trigger to snowball into a problem at some stage unless the period of extraordinarily low interest rates sustained. This was never going to be the case.

As the U.S Federal Reserve moved to raise rates (there were 17 successive hikes of 25 basis points each spread from June 2004 to June 2006) leading to the Fed Rate moving from a low of 1 % to 5.25 % - the impending crisis in U.S property markets got fast tracked in terms of time.

The Housing Price Crash

The wave of repossessions is having a dramatic effect on house prices in USA. It is reversing the housing boom seen in the last few years and is causing the first ever decline in US house prices since the 1930s.

Causes of the crisis

Observers of the meltdown suggest that blame needs to be shared between the Mortgage banker and the consumer i.e. the house owner/borrower. Others have charged mortgage brokers with steering borrowers to unaffordable loans, and their house appraisers with inflating housing values. The causes may be explained with the help of five points namely: Role of lenders, Role of homeowners, Role of government and regulators, Role of Credit Rating agencies & Role of Central banks.

·         Role of lenders: A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. Not only did lenders lend to higher-risk borrowers (subprime borrowers), they have also offered increasingly high risk loan options and incentives to them.
Example1:  is the interest-only adjustable-rate mortgage (ARM), which allowed the homeowner to pay just the interest (not principal) during an initial period.
Example2:  is a "payment option" loan, in which the homeowner could pay a variable amount, but any interest not paid would be added to the principal. Further, an estimated one-third of ARM which originated between 2004 to 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.
Example3: Lenders practised the unscrupulous method of Predatory lending.

Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race because it has been found that African Americans and other minorities had been disproportionately led to sub-prime mortgages with higher interest rates than their white counterparts.

·         Role of homeowners: Consumer-borrowers have been criticised for overstating their incomes on loan applications, which did not require verification and entering into loan agreements they could not meet or did not understand, or were motivated by greed.

The home prices growth in US in early 2000s was completely unrealistic (that's obvious now). It made homeowners believe that the prices will continue to grow and make future refinance and second mortgages quite profitable and eased lending standards allowed them to buy more expensive homes than they could afford. Besides, they entered into riskier loan agreements like the ARMs without understanding them, and they even lied on their stated income in the loan applications.

·         Role of government and regulators: Some observers claim that government policy actually encouraged the development of the subprime disaster through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise non-creditworthy consumers. In response to a concern that lending was not properly regulated, the House and Senate are now considering bills to regulate lending practices.

·         Role of Credit Rating agencies: Regulators have turned their attention to Rating agencies, who they think had incorrectly given investment-grade ratings to securitisation transactions holding subprime mortgages.

·         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 the central banks should play an important role in avoiding such asset bubbles and whether the current strategy adopted by them of cure rather than prevention is the correct one or not.

The Subprime lending Impact

The sharp rise in foreclosures after the fall in housing values caused several major subprime mortgage lenders to shut down or file for bankruptcy. This activity has lead to the collapse of stock price of some of the largest lenders in US such as Countrywide Financial, Washington Mutual, the government sponsored Fannie Mae, and Citigroup (a component of the Dow Jones Industrial Average).

Subprime loan packages became investment vehicles available for purchase by banks and other investment entities throughout the world, and the U.S.- created crisis is thought by many to have had its effect on stock markets globally. Several Hedge funds became worthless, and coordinated Central bank interventions became necessary.

·        Impact on the US stock markets: Lenders who provided sub-prime loans packaged them together and sold it to investors as securitised assets (referred to as the process of Securitisation). As such loans and risk appetite to buy securitised assets based on such loan pools increased, more exotic versions were added. All this led to the Dow Jones Industrial Average (DJIA) hitting a record high on July 19, 2007 by closing above 14,000 for the first time. But 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. Year 2007's largest daily drop by the S&P 500 in the U.S. was in February, all as a result of the subprime crisis.

Mortgage lenders and home builders 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.

There has been a significant decline in liquidity in the US markets. Trading levels for some asset-backed bonds have declined dramatically and these include bonds with AA or AAA ratings (high investment grade). There are few buyers even for such high quality assets. It is even harder to trade risky high-yield bonds, junk bonds and loans for borrowers with high debt. As December being the vacation season, liquidity has been further affected in these markets.

·        Impact on the US Bond Market: Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds. These have fallen sharply in value in the last few months, and are now worth between 20% and 40% of their original value for most asset classes, even those considered safe by the ratings agencies. If the banks are forced to reveal their losses based on current prices, they will be even bigger. It is estimated that ultimately losses suffered by financial institutions could be between $220bn and $450bn, as the $1 trillion in sub-prime mortgage bonds is re-valued.

 ·         Impact on US Housing industry: The wave of repossessions is having a dramatic effect on house prices in USA. It is reversing the housing boom seen in the last few years and is causing the first ever decline in US house prices since the 1930s. Today there is an excess supply of four million unsold homes that is depressing prices, as builders have also been forced to lower prices to get rid of these unsold properties.

The property crash is also affecting the broader US economy, with the building industry expected to cut its output by half, with the loss of between one to two million jobs. Many smaller builders will go out of business, and the larger firms are all suffering huge losses. The building industry makes up 15% of the US economy, but a slowdown in the property market also hits many other industries. Example: makers of durable goods, such as washing machines, and DIY stores, such as Home Depot.

·         Impact on corporations: Many banks, mortgage lenders and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of 21^st November, 2007 banks had recognized subprime-related losses exceeding US $30 billion, with an additional US$8-$11 billion expected from Citibank.

The losses could be much greater, as many banks have concealed their holdings of sub-prime mortgages in exotic, off-balance sheet instruments such as "Structured Investment Vehicles" or SIVs. Although the banks say they do not own these SIVs, and therefore are not liable for their losses, they may be forced to cover any bad debts that they accrue.

Other companies around the world have also suffered significant losses, from Europe to China. A number of mortgage lenders have filed for bankruptcy or are expected to do so during 2007.

Losses of major banks due to subprime lending

    Source: Wikipedia

Certain businesses filing for bankruptcy

·         Impact on India: The sub-prime and credit market crisis is not likely to have an impact on the fundamental story in India. However, it may have an impact on sentiment and liquidity flows in the short term. This could lead to high volatility in the short term and some corrective phases. However, it does not change the long-term outlook and positive view on our Indian markets. (Source: BNP Paribas)

How Sub-prime lending affected one city – Cleveland (The sub-prime capital of America.)

Actions to manage the crisis (Source: Wikipedia)

The following parties have taken or begin taking the following 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 collateralised 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.

Central banks around the world have begun coordinated efforts of their own to increase liquidity in their own currencies to stabilize foreign exchange rates (thus reducing a further fall in the American dollar and diminishing any incentive to sell them off) and prevent the probable significant global consequences a run on the American dollar would cause. It marks the first time the American, European, and Japanese central banks have taken such actions together since the aftermath of the September 11, 2001 terrorist attacks.

As of August 10, 2007, the United States Federal Reserve (Fed) has injected a combined 43 billion USD, the European Central Bank (ECB) 156 billion euros (214.6 billion USD), and the Bank of Japan 1 trillion Yen (8.4 billion USD). Smaller amounts have come from the central banks of Australia, and Canada.

• 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 favourable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives.

• 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.

• Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counselling, education, and the licensing and qualifications of lenders. On December 6 , 2007, 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". (Source: TOI dated 7^th Dec, 2007)
  

• Media can help educate the public and parties involved. 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.

Conclusion

The most important question to be resolved now is: What will be done to minimize effects of crisis on the overall US economy and what will be done to enable defaulted homeowners keep their homes? We all expect major players in this game to show now their skills and efforts so that American dream about owning a home could turn again into pleasant dream, achievable to those US citizens who are facing the worst homeowner's nightmare ever - eviction from home.