Mortgage company executives in August 2007 had to share the sentiment of" The Poseidon Adventure" of 1972 . The struggles of the survivors of the luxury ocean liner is compared here with the mortgage lenders who went deep underwater as the tidal waves of the subprime meltdown swept them overboard and human agony knew no bounds.
What is subprime mortgage?
Subprime lending is a new feature of the mortgage market that offers legitimate credit to people with poor credit scores, low income level and cannot meet the minimum down payment requirements. So a subprime mortgage expands credit to that section of the population who were turned down from mortgage in the past.
What are the features?
The interest charged for subprime lending is higher than that charged for prime lending because of the risk of lending to someone with a poor credit record.
History of Home Prices
http://www.fdic.gov/bank/analytical/fyi/2005/021005fyi_table1.pdf
Why buy a house?
Homeownership is the most important source of household equity and a great deal of attention has been paid to the mortgage market and residential property is worth more than commercial property .
Was housing bubble anticipated?
Karl Case and Robert Shiller define a bubble as "a situation in which excessive public expectations for future price increases cause prices to be temporarily elevated."
Where was the subprime mortgage crisis highest?
When did it begin?
Parts of Texas, Oklahoma and Louisiana experienced large decline in house prices in the 1980's, New England and California experienced smaller price declines between 1989 and 1995. These regions faced the after effects of recession.For couple of years the rise in house prices toppled the growth in disposable income. By the year 2003 the total mortgage debt was $1.4 trillion. Low interest rates for mortgage repayment increased home prices far more than the increase in disposable income.Around 2005-2006 there was a high default rate on subprime and adjustable rate mortgages (ARM) and the long trend of rising housing prices could not be maintained. People lost their main source of equity for refinancing. This led to default and foreclosures.
Most mortgages in defaults were issued in 2006 and 2007 when the house prices were at its peak. Many people made either very little or no down payment so they had little equity in their houses from the beginning. In 2007 nearly 1.3 million U.S. houses were subject to foreclosure leading to a rise of 79% from 2006 and in March 2008 about 8.8 million homeowners had zero or negative equity for their homes. The relentless slide of housing prices caused the default on mortgage payments as one in every six of U.S. homeowners mortgage debt rose far above their home value. According to Mortgage Bankers Association the delinquency rate for subprime borrowers was 14% and the data from Equifax shows a more severe figure of 26% in the second quarter of 2007. By the end of May 2008 131,000 foreclosures were completed on subprime loans. The inventory of new homes reached a peak in January 2008 which was the highest since 1981.This excess supply of houses lowered down their prices. This decline followed the speculative borrowing concept of the Keynesian economist Hyman Minsk who pointed out speculative borrowing lead to accumulation of debt and decline in asset values. This decline will continue until the house price reaches an equilibrium level. If this process is not fast it will push more home-owners to the risks of defaults and foreclosures. This high foreclosure rates are trickling down the housing market, mortgage market and financial markets.
What caused a subprime meltdown?
Markets which showed a considerable rise in home prices over a couple of decades had two common features:-
Large change in population and employment growth through economic changes;
Limited space for new development which restricted the supply of new housing.
Supply side and demand side factors a couple of reasons can also be responsible for a subprime meltdown.
High Risk Loans— The Ninja loans or the "No Income, No Job and No Assets "loans fall in this category. In 2005, 43% of buyers acquiring Ninja loans made no down payment. Besides this, mortgage underwriting issues including providing loans without any credentials.The hybrid ARM's can have a sharp jump in interest in a short time which will render the borrowers unable to pay them back.
Government Action— " America 's Home Ownership Challenge" made the Fannie Mae and Freddie Mac to make to make more than 5.5 million new minorities and low income mortgage loans.The ACORN (Association for Community Organizations for Reform Now) empowered some people to demand more loans.
Securitization— According to Alan Greenspan, the securitization of home loans for people with poor credit record and not the loan itself is responsible for the current crisis. As the house prices started to stabilize in 2006, the investors demand for collateralized mortgage securities waned and mortgages were issued continuously.
The situation can be compared to the Napoleonic complex— Napoleonic indomitable cant was solely responsible for his decline.
Speculation— Financial leverage means borrowing at a lower interest rate and investing at a higher interest rate. A Diamond Dybvig model is followed in making mortgage loans —current expenditures will fructify into higher returns in the future. Too much speculation and extrapolation of the rising trend of home prices into the future is a culprit for this crisis.
Comparison with 1929--
There was also a steep fall in house prices during 1929. The structure of mortgage credit was the form of short term, callable, non-amortizing loans. With the decline in home prices, the home-owners were unable to pay back their dues. To prevent this situation in the future, the federal mortgage programmed the long-term,, non callable, amortizing loans.
Effects
Trouble in the Financial Sector—
"Analyst reported the world losing $5.2 trillions as a result of global slowdown triggered by the US housing market"---------------------- BBC News
The subprime crisis spread to other credit markets. Major banks and financial institutions reported losses of US $ 435 billion as of July 2008. Most notable is the downfall of Bear Stearns, the bank which survived the Great Depression. On June 2007 the firm found its collateralized debt obligations (CDO 's) to be worth less than their market value prompting investors to liquidate the CDO 's followed by liquidation of similar assets in other portfolios.
Following Lehman Brothers downfall investors found out the sub-prime mortgage backed securities of AIG were priced higher than Lehman Brothers. This caused a 60% drop in AIG 's stock prices in September followed by a downgrade of its credit rating by Moody.
The international financial scene also shared the woes.— German bank IKB Deutsche Industriebank AG was bailed out by state-owned KfW Group.
The Market In Trouble— Dow Jones index declined by 22% in its 118 year history. S&P 500 Index got its negative point in 2007.
Not only U.S. the subprime mortgage crisis contaminated the world stock markets— In London, the main FTSE 100 index lost more than 150 points, the first time since the 9/11 terrorist attacks.
In Paris, the stock market fell 12.3% in January and was down 15.3% in the three months from November.
India's BSE Index fell 16% , China's stock market fell by 21.4% and Turkey suffered a loss of 22.7%.
Source:- Bloomberg
Government Actions
"If we know the price of cream and the price of skim milk, we can figure out the price of milk with 1 per cent cream, 2 per cent cream, or 4 per cent cream. There might be some money in repackaging, but not the billions that banks made by slicing and dicing sub-prime mortgages into packages whose value was much greater than their contents."
--Joseph Stiglitz
Noble Laureate '2001 for Economics of Information
Refinancing Options— The Federal Housing Authority's FHASecure program is offering refinancing options to move delinquent hybrid ARM borrowers into fixed-rate loans. It should help about 250,000 home owners through 2008, according to Department of Housing and Urban Development.
Freezing Lower Interest Rates – The U.S. Treasury Secretary Henry Paulson has organized a voluntary organization " HOPE NOW" which will allow borrowers of subprime mortgages to pay a lower interest rate for a fixed period, say 5 to 7 years till they find other sources of re-financing.
A $700 billion proposal was presented to the Congress in September'2008. On 3rd October, President George W. Bush signed the bill to help financial markets.
The ECB injected a €95bn (£63bn) emergency funding to prevent the US subprime mortgage slump to proliferate in the European banking systems.
Prevention is Better than Cure On Feb'27, 2007 Freddie Mac announced tougher subprime mortgage lending standards to prevent the risk of default. Freddie Mac is developing fixed rate, hybrid ARM's that will have reduced adjustable margins with longer fixed rate terms to prevent credit default. The company will also minimize the use of low documentation underwriting to ensure that borrowers will have necessary funds to afford their homes.
In 2007 The State Foreclosure Prevention Working Group met with the 20 largest servicers of subprime mortgage loans to discuss opportunities to prevent unnecessary foreclosures.
The Foreclosure Prevention Act is passed in 2008 – It provides a $100million additional funding is provided for housing counseling . To help veterans and returning soldiers to avoid foreclosures this bill has increased the time –span a lender must wait before starting foreclosures.
References:-
http://www.speculativebubble.com/videos/real-estate-roller-coaster.php http://www.fdic.gov/bank/analytical/regional/ro20041q/na/infocus.html; http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf http://www.freddiemac.com/news/archives/corporate/2007/20070227_subprimelending.html http://www.fdic.gov/bank/analytical/regional/ro20041q/na/infocus.html http://en.wikipedia.org/wiki/American_International_Grouphttp://news.bbc.co.uk/1/hi/business/7239506.stm http://www.financialsense.com/editorials/lee/2008/0208.html http://money.cnn.com/2007/12/05/real_estate/FHASecure_status/index.htm?postversion=2007120512 http://www.heritage.org/research/regulation/wm1742.cfm http://banking.senate.gov/_files/040208_ForeclosurePreventionActSummary.pdf
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