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The subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system.
Many USA mortgages issued in recent years were made to subprime borrowers, defined as those with lesser ability to repay the loan based on various criteria.[1] When USA house prices began to decline in 2006-07, mortgage delinquencies soared, and securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and USA government sponsored enterprises, tightening credit around the world.
The crisis began with the bursting of the United States housing bubble[2][3] and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices.[4][5] Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and 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 as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.[6]
Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of 17 July 2008.[7][8] The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.
The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.[9] Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.[10] Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.[11]
Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate. These criteria pertain to the borrower's credit score, credit history and other factors.[12] If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender can take possession of the residence acquired using the proceeds from the mortgage, in a process called foreclosure.
The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, [13] with over 7.5 million first-lien subprime mortgages outstanding.[14] Between 2004-2006 the share of subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in 2001-2003 and during 2007.[15][16] In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures begun during that quarter.[17] By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.[18] By January 2008, the delinquency rate had risen to 21%.[19] and by May 2008 it was 25%.[20]
The value of all outstanding residential mortgages, owed by USA households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008.[21] During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[22] As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.[23] 936,439 USA residences completed foreclosure between August 2007 and October 2008.[24]
Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions. [25]
This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk:[26][27]
The aggregate effect of these and other risks has recently been called systemic risk, which refers to when formerly uncorrelated risks shift and become highly correlated, damaging the entire financial system.[28]
When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets.
Investors in MBS and CDOs can insure against credit risk by buying credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments.
The reasons proposed for this crisis are varied[29][30] and complex.[31] The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments, poor judgment by borrowers and/or lenders, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary policy, and government regulation (or the lack thereof).[32] Utimately, though, moral hazard lay at the core of many of the causes.[33]
In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes:
A culture of consumerism is a factor "in an economy based on immediate gratification."[35] Starting in 2005, American households have spent more than 99.5% of their disposable personal income on consumption or interest payments.[36] If imputations mostly pertaining to owner-occupied housing are removed from these calculations, American households have spent more than their disposable personal income in every year starting in 1999.[37]
Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis.[38] The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.[39] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing.
This rise in demand fueled rising house prices and consumer spending.[40] Between 1997 and 2006, the price of the typical American house increased by 124%.[41] During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[42] This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[43]
Household debt grew from $705 billion at year-end 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income.[44] During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.[45]
This credit and house price explosion led to a building boom and a surplus of unsold homes. Easy credit, and a belief that house prices would continue to appreciate, encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.
By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.[46][47] This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages. As of March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners — had negative equity in their homes, a number that is believed to have risen to 12 million by November 2008. Borrowers in this situation have an incentive to "walk away" from their mortgages and abandon their homes, even though doing so will damage their credit rating for a number of years.[48] The reason is that unlike what is the case in most other countries, American residential mortgages are non-recourse loans; once the creditor has regained the property purchased with a mortgage in default, he has no further claim against the defaulting borrower's income or assets. As more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale increase. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.[49]
Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981.[50] Furthermore, nearly four million existing homes were for sale,[51] of which almost 2.9 million were vacant.[52] This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.
Economist Nouriel Roubini wrote in January 2009 that subprime mortgage defaults triggered the broader global credit crisis, but were just one symptom of multiple debt bubble collapses: "This crisis is not merely the result of the U.S. housing bubble’s bursting or the collapse of the United States’ subprime mortgage sector. The credit excesses that created this disaster were global. There were many bubbles, and they extended beyond housing in many countries to commercial real estate mortgages and loans, to credit cards, auto loans, and student loans. There were bubbles for the securitized products that converted these loans and mortgages into complex, toxic, and destructive financial instruments. And there were still more bubbles for local government borrowing, leveraged buyouts, hedge funds, commercial and industrial loans, corporate bonds, commodities, and credit-default swaps." It is the bursting of the many bubbles that he believes are causing this crisis to spread globally and magnify its impact.[53]
Speculation in residential real estate has been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."[54]
While homes had not traditionally been treated as investments, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.[55] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.[56]
Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."[57] Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values:[58][59]
Speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.[60]
Lenders began to offer more and more loans to higher-risk borrowers,[61] including illegal immigrants.[62] Subprime mortgages amounted to $35 billion (5% of total originations) in 1994,[63] 9% in 1996,[64] $160 billion (13%) in 1999,[63] and $600 billion (20%) in 2006.[64][65][66] A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined from 280 basis points in 2001, to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though the credit ratings of subprime borrowers, and the characteristics of subprime loans, both declined during the 2001–2006 period, which should have had the opposite effect. The combination of declining risk premia and credit standards is common to classic boom and bust credit cycles.[67]
In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.[68] By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.[69]
One high-risk option was the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[70]
Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation.[71] In 2007, 40% of all subprime loans resulted from automated underwriting.[72][73] The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.[74] Mortgage fraud by borrowers increased. [75]
Securitization, a form of structured finance, involves the pooling of financial assets, especially those for which there is no ready secondary market, such as mortgages, credit card receivables, student loans. The pooled assets serve as collateral for new financial assets issued by the entity (mostly GSEs and investment banks) owning the underlying assets.[76] The diagram at right shows how there are many parties involved.
Securitization, combined with investor appetite for mortgage-backed securities (MBS), and the high ratings formerly granted to MBSs by rating agencies, meant that mortgages with a high risk of default could be originated almost at will, with the risk shifted from the mortgage issuer to investors at large. Securitization meant that issuers could repeatedly relend a given sum, greatly increasing their fee income. Since issuers no longer carried any default risk, they had every incentive to lower their underwriting standards to increase their loan volume and total profit.
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors through MBS and CDOs. Securitization created a secondary market for mortgages, and meant that those issuing mortgages were no longer required to hold them to maturity.
Asset securitization began with the creation of private mortgage pools in the 1970s.[77] Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.[67] Alan Greenspan has stated that the current global credit crisis cannot be blamed on mortgages being issued to households with poor credit, but rather on the securitization of such mortgages.[78]
Investment banks sometimes placed the MBS they originated or purchased into off-balance sheet entities called structured investment vehicles or special purpose entities. Moving the debt "off the books" enabled large financial institutions to circumvent capital requirements, thereby increasing profits but augmenting risk.[79] Investment banks and off-balance sheet financing vehicles are sometimes referred to as the shadow banking system and are not subject to the same capital requirements and central bank support as depository banks.[80]
Some believe that mortgage standards became lax because securitization gave rise to a form of moral hazard, whereby each link in the mortgage chain made a profit while passing any associated credit risk to the next link in the chain.[81][82] At the same time, some financial firms retained significant amounts of the MBS they originated, thereby retaining significant amounts of credit risk and so were less guilty of moral hazard. Some argue this was not a flaw in the securitization concept per se, but in its implementation.[26]
According to Nobel laureate Dr. A. Michael Spence, "systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability." [83]
In 1995, the Community Reinvestment Act (CRA) was revised to allow CRA mortgages to be securitized. In 1997, Bear Sterns was the first to take advantage of this law.[84] Under the CRA guidelines, a mortgage issuer receives credit for originating subprime mortgages, or buying mortgages on a whole loan basis, but not holding subprime mortgages. This rewarded issuers for originating subprime mortgages, then selling them to others who would securitize them. Thus any credit risk in subprime mortgages was passed from the issuer to others, including financial firms and investors around the globe.
Credit rating agencies are now under scrutiny for having given investment-grade ratings to CDOs and MBSs based on subprime mortgage loans. These high ratings were believed justified because of risk reducing practices, including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Emails exchanged between employees of rating agencies, dated before credit markets deteriorated and put in the public domain by USA Congressional investigators, suggest that some rating agency employees suspected that lax standards for rating structured credit products would result in major problems.[85] For example, one 2006 internal Email from Standard & Poor's stated that "Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[86]
High ratings encouraged investors to buy securities backed by subprime mortgages, helping finance the housing boom. The reliance on agency ratings and the way ratings were used to justify investments led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities. This was exacerbated by the SEC's removal of regulatory barriers and its reduction of disclosure requirements, all in the wake of the Enron scandal.[87]
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.[88] On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities.[89] On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.[90]
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.[91]
In December 2008 economist Arnold Kling testified at congressional hearings on the collapse of Freddie Mac and Fannie Mae. Kling said that a high-risk loan could be “laundered” by Wall Street and return to the banking system as a highly rated security for sale to investors, obscuring its true risks and avoiding capital reserve requirements.[92]
Both government action and inaction have contributed to the crisis. Some are of the opinion that the current American regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws."[93] The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.[94][95]
Increasing home ownership was a goal of the Clinton and Bush administrations.[96][97][98] There is evidence that the Federal government leaned on the mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower lending standards.[99][100][101] Also, the U.S. Department of Housing and Urban Development's (HUD) mortgage policies fueled the trend towards issuing risky loans.[102][103]
In 1995, the GSE began receiving government incentive payments for purchasing mortgage backed securities which included loans to low income borrowers. Thus began the involvement of the GSE with the subprime market.[102] Subprime mortgage originations rose by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of subprime mortgages in just nine years.[104] The relatively high yields on these securities, in a time of low interest rates, were very attractive to Wall Street, and while Fannie and Freddie generally bought only the least risky subprime mortgages, these purchases encouraged the entire subprime market.[105] In 1996, HUD directed the GSE that at least 42% of the mortgages they purchased should have been issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.[106] From 2002 to 2006 Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion, thus fulfilling their government mandate to help make home buying more affordable. During this time, the total market for subprime securities rose from $172 billion to nearly $500 billion only to fall back down to $450 billion. [107]
By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the amount outstanding.[108] The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion.[109] When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers' expense.[110][111]
Liberal economist Robert Kuttner has suggested that the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 may have contributed to the subprime meltdown, but this is controversial.[112][113] The Federal government bailout of thrifts during the savings and loan crisis of the late 1980s may have encouraged other lenders to make risky loans, and thus given rise to moral hazard.[114] [115]
Economists have also debated the possible effects of the Community Reinvestment Act (CRA), with detractors claiming that the Act encouraged lending to uncreditworthy borrowers.[116][117][118][119] and defenders claiming a thirty year history of lending without increased risk.[120][121][122][123] Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of mortgages issued to otherwise unqualified low-income borrowers, and also allowed for the first time the securitization of CRA-regulated mortgages even though some of these were subprime.[124][125]
Central banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.[126][127]
Some market observers have been concerned that Federal Reserve actions could give rise to moral hazard.[128] A Government Accountability Office critic said that the Federal Reserve Bank of New York's rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to believe that the Federal Reserve would intervene on their behalf if risky loans went sour because they were “too big to fail.”[129]
A contributing factor to the rise in house prices was the Federal Reserve's lowering of interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[130] This was done to soften the effects of the collapse of the dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of deflation.[126] The Fed believed that interest rates could be lowered safely primarily because the rate of inflation was low; it disregarded other important factors. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, said that the Fed's interest rate policy during the early 2000s was misguided, because measured inflation in those years was below true inflation, which led to a monetary policy that contributed to the housing bubble.[131]
Many financial institutions, investment banks in particular, issued large amounts of debt during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default. Beginning in 2007, financial institutions and individual investors holding MBS also suffered significant losses from mortgage payment defaults and the resulting decline in the value of MBS.[27]
A 2004 SEC ruling allowed USA investment banks to issue substantially more debt, which was then used to purchase MBS. Over 2004-07, the top five US investment banks each significantly increased their financial leverage (see diagram), which increased their vulnerability to the declining value of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about 30% of USA nominal GDP for 2007. Further, the percentage of subprime mortgages originated to total originations increased from below 10% in 2001-2003 to between 18-20% from 2004-2006.[132][133]
Three investment banks either went bankrupt (Lehman Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch) during September 2008. The failure of 3 of the 5 large USA investment banks augmented the instability in the global financial system. The remaining two investment banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting themselves to more stringent regulation.[134]
The New York State Comptroller's Office has said that in 2006, Wall Street executives took home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."[42]
Investment banker incentive compensation was focused on fees generated from assembling financial products, rather than the performance of those products and profits generated over time. Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO created did not perform. In addition, the increased risk (in the form of financial leverage) taken by the major investment banks was not adequately factored into the compensation of senior executives.[135]
Credit defaults swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.
Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008, there was no central clearinghouse to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[136]
Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[137][138] Merrill Lynch's large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill's CDOs. The loss of confidence of trading partners in Merrill Lynch's solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.[139][140]
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."[141]
As of August 2008, financial firms around the globe have written down their holdings of subprime related securities by US$501 billion.[142] Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 billion to $646 million in the same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance since 1990. In all of 2007, insured depository institutions earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.[143][144]
The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported.[145] During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.[146] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other.[147] As the crisis deepened, more and more financial firms either merged, or announced that they were negotiating seeking merger partners.[148]
On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.[149]
On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Through 2008, large daily drops became common, with, for example, the KOSPI dropping about 7% in one day,[150][dead link] 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[151][dead link][152] and home builders[153][154][dead link] 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.[155]
Stock indices worldwide trended downward for several months since the first panic in July–August 2007.
The crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value".[156] Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle."[157][158] Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.[159]
Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. Poor economic data on manufacturing contributed to the day's panic, but were eclipsed by the severe developments of the financial crisis. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.
The much anticipated passage of the $700 billion bailout plan was struck down by the House of Representatives in a 228–205 vote on September 29. In the context of recent history, the result was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss (7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P 500 fell 8.8%, both of which were the worst losses those indices experienced since the 1987 stock market crash.
Despite congressional passage of historic bailout legislation, which was signed by President Bush on Saturday, Oct. 4, Dow Jones Index tumbled further when markets resumed trading on Oct. 6. The Dow fell below 10,000 points for the first time in almost four years, losing 800 points before recovering to settle at -369.88 for the day.[160] Stocks also continued to tumble to record lows ending one of the worst weeks in the Stock Market since September 11, 2001."[161]
The subprime crisis has had a number of actual and likely economic effects. Declining house prices have reduced household wealth and the collateral for home equity loans, which is placing downward pressure on consumption.[162] Members of USA minority groups received a disproportionate number of subprime mortgages, and so have experienced a disproportionate level of the resulting foreclosures. Minorities have also born the brunt of the dramatic reduction in subprime lending.[163][164] House-related crimes such as arson have increased.[165] There have been significant job losses in the financial sector, with over 65,400 jobs lost in the USA as of September 2008.[166] The unemployment rate rose to its highest level since 1994 in October 2008, reaching 6.5%.[167]
Many renters became innocent victims, by being evicted from their residences without notice, because their landlords' property has been foreclosed.[168] In October 2008, Tom Dart, the elected Sheriff of Cook County, Illinois, criticized mortgage lenders for their actions vis-a-vis tenants, and announced that he was suspending all foreclosure evictions.[169]
The tightening of credit has caused a major decline in the sale of motor vehicles. Between October 2007 and October 2008, Ford sales were down 33.8%, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%.[170]This contributed to a global automobile industry crisis and possible government intervention.
Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.
The central bank of the USA, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy."[19] The Fed has:
Regulators and legislators have contemplated taking action with respect to lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.[180] Regulations or guidelines can influence the transparency and reporting required of lenders and the types of loans they choose to issue. Congressional committees are also conducting hearings to help identify solutions and apply pressure to the various parties involved.[181]
On 13 February 2008, President Bush signed into law an economic stimulus package costing $168 billion, mainly taking the form of income tax rebate checks mailed directly to taxpayers.[192] Checks were mailed starting the week of 28 April 2008. However, this rebate coincided with an unexpected jump in gasoline and food prices. This coincidence led some to wonder whether the stimulus package would have the intended effect, or whether consumers would simply spend their rebates to cover higher food and fuel prices. Some Congressmen even contemplated a second round of tax rebates to ensure that the American economy would indeed be stimulated. Secretary of the Treasury Henry Paulson strongly opposed such initiative.
The Housing and Economic Recovery Act of 2008 included six separate major acts intended to restore confidence in the American mortgage industry.[193] The Act:
As of June 30, 2008, residential mortgages owed by USA households totaled US$10.6 trillion.[212] As of August 2008, 9.2% of these mortgages were either seriously delinquent or in foreclosure.[23]
On 19 September 2008, the U.S. Federal government announced a plan, requiring Congressional approval, to purchase from financial institutions large amounts of mortgage backed securities (MBSs) and collateralized debt obligation (CDOs) backed by subprime mortgages.[213] The estimated cost of this plan was at least $700 billion.[214] The plan also banned short-selling the stocks of financial firms.[215] On 29 September 2008, the House of Representatives rejected a revised version of the plan.[216] On 1 October 2008, the U.S. Senate approved an amended version of the plan,[217] which was ratified by the House on October 3 and immediately signed into law by President Bush.
A Congressional Oversight Panel (COP) chaired by Harvard Professor Elizabeth Warren was created to monitor the implementation of the law. COP issued its first report on 10 December 2008, which was primarily a series of questions and answers.[218][219] In an interview, Warren stated that banks cannot be stabilized unless foreclosures are addressed.[220]
Both lenders and borrowers may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have offered troubled borrowers more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Borrowers have also been encouraged to contact their lenders to discuss alternatives.[221]
Corporations, trade groups, and consumer advocates have begun to cite data on the numbers and types of borrowers assisted by loan modification programs. There is some disagreement regarding the data, and the adequacy of measures taken to date. A report January 2008 report stated that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 foreclosures were initiated. Consumer groups claimed these modifications affected less than 1% of the 3 million ARM subprime mortgages outstanding as of the third quarter.[222]
The State Foreclosure Prevention Working Group, a coalition of state attorney generals and bank regulators from 11 states, reported in April 2008 that loan servicers could not keep up with the rising number of foreclosures. 70% of subprime mortgage holders are not getting the help they need. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. In order to slow the growth of foreclosures, the Group has recommended a more automated method of loan modification that can be applied to large blocks of struggling borrowers.[223]
In December 2008, the U.S. FDIC reported that more than half of mortgages modified during the first half of 2008 were delinquent again, in many cases because payments were not reduced or mortgage debt was not forgiven. This is further evidence that case-by-case loan modification is not effective as a policy tool.[224]
On October 5, 2008, the Bank of America, following on a legal settlement with several states, announced a more aggressive and systematic program intended to help an estimated 400,000 borrowers keep their homes. The program will limit payments as a fraction of household income, and reduce mortgage balances.[225]
In November 2008, Fannie Mae, Freddie Mac and their network of mortgage service providers announced a streamlined loan modification program and foreclosure suspension, designed to help keep borrowers in their homes.[226][227]
Several Australian lenders have amended their policies for higher risk mortgage types. These changes have been relatively minor, with the exception of those nonconforming lenders that lend to credit impaired and subprime borrowers. It remains to be seen if this trend will continue, or if Australian lenders will eventually stop offering riskier loan products.[228]
President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs.[229][230] A refinancing facility called FHA-Secure was also created.[231] These actions are part of the Hope Now Alliance, an ongoing collaborative effort between the US Government and private industry to help certain subprime borrowers.[232] In February 2008, the Alliance reported that during the second half of 2007, it had helped 545,000 subprime borrowers with shaky credit, or 7.7% of 7.1 million subprime loans outstanding as of September 2007. A spokesperson for the Alliance acknowledged that much more must be done.[233]
During February 2008, a program called "Project Lifeline" was announced. Six of the largest USA lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for borrowers 90 or more days delinquent on their mortgage payments. The intent of the program was to reduce foreclosures by encouraging loan adjustments.[234]
As of May 2008, major financial institutions had obtained over $260 billion in new capital, taking the form of bonds or preferred stock sold to private investors in exchange for cash.[235] This new capital has helped banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to losses on subprime loans or CDO investments. Raising additional capital has been advocated by the leadership of the U.S. Federal Reserve and the Treasury Department.[236] Well-capitalized banks are in a better position to lend at favorable interest rates, and to offset the falling liquidity and rising uncertainty in credit markets. Banks have obtained some of their new capital from the sovereign wealth funds of developing countries, which may have political implications.[237]
Certain major banks have also reduced their dividend payouts to stabilize their financial position.[238] Of the 3776 FDIC insured institutions that paid a dividend on their common stock in the first quarter of 2007, almost half (48%) paid a lower dividend in the first quarter of 2008, and 666 institutions reduced their dividend to zero. Insured institutions paid $14.0 billion in total dividends in the first quarter of 2008, down $12.2 billion (46.5%) from the first quarter of 2007.[239]
Litigation related to the subprime crisis is underway. A study released in February 2008 indicated that 278 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts was not quantified but is also believed to be significant. The study found that 43% of the cases were class actions brought by borrowers, such as those that contended they were victims of discriminatory lending practices. Other cases include securities lawsuits filed by investors, commercial contract disputes, employment class actions, and bankruptcy-related cases. Defendants included mortgage bankers, brokers, lenders, appraisers, title companies, home builders, servicers, issuers, underwriters, bond insurers, money managers, public accounting firms, and company boards and officers.[240] Former Bear Stearns managers were named in civil lawsuits brought in 2007 by investors, including Barclays Bank PLC, who claimed they had been misled.[241]
An important issue related to the restructuring of mortgage loans involves the contractual rights of investors who purchased related MBS. Investor permission is often required to modify the underlying mortgages, resulting in a "case-by-case" loan modification regime. This presents a challenge for banks and governments who are attempting to limit foreclosures by helping large groups of homeowners re-negotiate the terms of their mortgages efficiently. A class-action lawsuit was filed in December 2008 that may have significant implications.[242]
The number of Federal Bureau of Investigation (FBI) agents assigned to mortgage-related crimes increased by 50% between 2007 and 2008.[243] In June 2008, the FBI stated that its mortgage fraud caseload has doubled in the past three years to more than 1,400 pending cases.[244] Between 1 March and 18 June 2008, 406 people were arrested for mortgage fraud in an FBI sting across the country. People arrested include buyers, sellers and others across the wide-ranging mortgage industry.[243]
On 8 March 2008, the FBI began a probe of Countrywide for possible fraudulent lending practices, securities fraud.[245]
On 19 June 2008, two former Bear Stearns managers were arrested by the FBI, and were the first Wall Street executives arrested related to the subprime lending crisis. They were suspected of misleading investors about the risky subprime mortgage market.[241]
On July 16, 2008, an unnamed US Government official said that the FBI is investigating IndyMac for possible fraud. It is not clear if the investigation began before the bank was taken over by the FDIC upon its $32 billion collapse. [246][247]
On 23 September 2008, in response to concerns about the bailouts of so many firms, two government officials stated that the Federal Bureau of Investigation was looking into the possibility of fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group, bringing to 26 the number of corporate lenders under investigation.[248]
On 18 June 2008, a Congressional ethics panel started examining allegations that Democrat Senators Christopher Dodd of Connecticut (the sponsor of a major $300 billion housing rescue bill) and Kent Conrad of North Dakota received preferential loans by troubled mortgage lender Countrywide Financial Corp.[249]
Banks and executives are under pressure to reduce bonuses, as much of the profits recognized by major banks were wiped out by subsequent losses during the crisis. The extent of risk taken was not properly factored into bonus computations. Several executives have foregone bonuses in light of what turned out to be poor performance. However, few firms had "clawback" provisions to recapture the bonuses, which were based on short-term profits rather than long-term value creation.[250][251] Credit Suisse bank announced it will begin paying bonuses out of a fund containing troubled assets on its books, in place of cash. Gains or losses on the fund will affect employee bonuses. This approach was praised as "monstrously clever" by one analyst.[252]
The Federal government's efforts to support the global financial system have resulted in significant new financial commitments, totaling $7 trillion by November, 2008. These commitments can be characterized as investments, loans, and loan guarantees, rather than direct expenditures. In many cases, the government purchased financial assets such as commercial paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in frozen markets.[253] As the crisis has progressed, the Fed has expanded the collateral against which it is willing to lend to include higher-risk assets.[254]
The extent to which the Federal government is at risk because of these investments and guarantees remains to be seen.[255] The upshot has been a US$1 trillion increase in the national debt of the USA during FY 2008, compared to an average increase of US$550 billion during the previous five years. The total debt reached $10 trillion in September 2008.[256]
In addition, state and local government property tax collections are expected to decline because of an estimated $1.2 trillion reduction in housing prices, and a slowing of the overall American economy.[257] This expectation is affecting the ability of state governments to finance their operations through bond sales. Finding themselves unable to borrow, the states of California and Massachusetts have requested that the Fed lend them the amounts they would have borrowed elsewhere under normal conditions.
Several years before the crisis Fairfax Financial's Prem Watsa warned:
"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... 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?[258]
Stifel Nicolaus, writing in MarketWatch, has claimed that the problem mortgages are not confineed to the subprime niche: "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 lenders "continue to believe conditions will get worse".[259]
The crisis has led to a drastic decline in new housing starts in the USA. Historically, such declines precede a surge of unemployment in the following year.[260] This fact points to another possible consequence of the crisis.
As of 22 November 2007, analysts at a leading investment bank estimated losses on subprime CDO could eventually amount to US$148 billion.[261] As of 22 December 2007, a leading business periodical estimated subprime defaults between U.S. $200–300 billion.[262] As of 1 March 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350–600 billion.[263]
On 20 March 2008, the Organization for Economic Cooperation and Development downgraded its economic forecasts for the United States, the Eurozone and Japan for the first half of 2008.[264]
On 19 May, 2008, Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, was quoted as saying that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s".[265]
Because debt instruments backed by suprime mortgages were purchased worldwide, the International Monetary Fund (IMF) "says that worldwide losses stemming from the USA subprime mortgage crisis could run to $945 billion."[266]
Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector, which was characterized by lighter regulation, pared-back government, and lower taxes. Significant financial sector regulatory changes are expected as a result of the crisis.[267]
Fareed Zakaria believes that the crisis may force Americans and their government to live within their means. Further, some of the best minds may be redeployed from financial engineering to more valuable business activities, or to science and technology.[268]
The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman of the Federal Reserve System from 1986 to January 2006. Senator Chris Dodd claimed that Greenspan created the "perfect storm".[269] Greenspan has remarked that there is a one-in-three chance of recession from the fallout. When asked to comment on the crisis, Greenspan spoke as follows:[126]
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