The genesis of the sub prime crisis

The sub prime crisis assumed monstrous proportions thanks to a combination of factors. These included:
v low interest rates,
v political intervention,
v a laissez-faire attitude on the part of government officials and regulators,
v lax and predatory lending practices,
v a false belief that the housing boom would go on forever,
v a originate-to-distribute securitization process that separated origination from ultimate credit risk,
v imbalances in the global financial system,
v new derivatives like credit default swaps that fuelled speculation in segments of the mortgage market.

Let us explore these themes in a little more detail in the following paragraphs.
Many economists and market analysts believe the roots of the current financial melt down go back at least eight years in time. The US economy had been facing the risk of a deep recession after the dotcom bubble burst in early 2000. This situation was worsened by the 9/11 terrorist attacks, which created a great deal of panic and uncertainty among Americans. In response, the US Central bank, the Federal Reserve (Fed) under the leadership of Alan Greenspan tried to stimulate the economy by reducing interest rates aggressively. In particular, Greenspan hoped housing would get the momentum back into the US economy. Between New Year’s Day 2001 and mid-2003, the Fed cut the Federal Funds rate from 6.5% to 1%. The rate remained at 1% for 12 months from July 2003 to July 2004. Naturally people got an opportunity to borrow much more money than they otherwise would have been able to afford.
owning a house is part of the American dream. And the housing market, which is huge as mentioned earlier, has a big impact on the business cycle in the US. Not surprisingly, American politicians have strongly supported the cause of home ownership. Over the years, various pieces of legislation have been introduced in the US to make mortgages affordable to more people.

· The Federal Housing Administration (FHA) was set up in 1934 to insure mortgage loans provided given by private firms. Initially, a borrower had to make a 20% down payment to qualify for the loan. Later, this requirement was reduced. By 2004, the required down payment for FHA’s most popular program was 3%.
· The Home Mortgage Disclosure Act, 1975 asked lending institutions to report their loan data so that the underserved segments could be targeted for special attention.
· The Community Reinvestment Act (CRA), 1977 required institutions to provide loans to people in low and moderate income neighbourhoods. Congress amended CRA in 1989 to make banks’ CRA ratings public information. In 1995, the regulators got the power to deny approval for a merger to a bank with low CRA rating.
· The Depository Institutions Deregulatory and Monetary Control Act (DIDMCA), 1980 eliminated restrictions on home loan interest rates. Financial institutions could charge borrowers a premium interest rate.
· The Alternative Mortgage Transaction Parity Act (AMTPA) allowed lenders to charge variable interest rates and use balloon payments.

In 1992, Congress directed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. In 1996, Fannie and Freddie were told to allocate 42% of this financing to such borrowers. The target increased to 50% in 2000 and 52% in 2005. Fannie and Freddie were also directed to support “special affordable” loans to borrowers with low income. Fannie and Freddie could sustain this aggressive lending as the markets believed there was an implicit guarantee from the government. So the cost of funds was only slightly more than that of Treasury securities. In September 2003, during House Financial Services Committee proceedings, suggestions were made to rein in Fannie and Freddie. But people like Barney Frank who is leading the efforts to restore the health of the American banking system today, fought hard to maintain the status quo.
President Bush personally championed the cause of housing when he articulated his vision of an “ownership society.” In 2003, he signed the American Dream Down payment Act, a program offering money to lower income households to help with down payments. The Bush administration also put pressure on Fannie Mae and Freddie Mac to provide more mortgage loans to low income groups. By the time of the sub prime crisis, these two pillars of the American housing system had become heavy investors in the triple A rated, senior tranches of CDOs, which lay at the heart of the crisis.
At some points of time, Congress did raise some concerns about predatory lending, i.e., aggressive lending in which borrowers are not fully aware of the long term implications of the loan. In 1994, Congress passed the Home Ownership and Equity Protection Act (HOEPA) which authorised the Fed to prohibit predatory lending practices by any lender, irrespective of who regulated the lender. The Fed however used these powers only sparingly.

By mid-2004, fears about deflation had diminished while those about inflation had increased. When the Fed got into a tightening act, the benchmark interest rate went up to 5.25%. People who had borrowed when rates were 1% did not have time to adjust to the pressures of larger interest payments. With traditional profit making opportunities drying up, lenders became willing to take greater risks and entered the subprime segment in a big way. They did this by introducing adjustable rate mortgages, which came with several options:

v Low introductory interest rate that adjusted after a few years.
v Payment of only interest on the loan for a specified period of time.
v Payment of less interest than was due, the balance being added to the mortgage.
v Balloon payments in which the borrower could pay off the loan at the end of a specified period of time.

Adjustable Rate Mortgages (ARMs) had been around for the past 25 years. But in the past, they were offered to creditworthy borrowers with stable incomes and who could make bigger down payments. In 2006, 90% of the sub prime loans involved ARMs.

Traditionally, as a risk mitigation measure, lenders insisted that borrowers making small down payments must buy mortgage insurance. But insurance was costly. To allow home buyers to avoid buying mortgage insurance, generally required for large loans with low down payments, lenders counselled borrowers to take out two mortgages. This way, they circumvented the system and made it easier than ever for people to get a mortgage loan. In short, borrowers and lenders collaborated to beat the system!
As homes became more and more unaffordable, lenders became even more aggressive. Loans were offered without the need for borrowers to prove their income. “Stated income” loans went mainstream. They came to be known as liars’ loans. By 2006, well over half of the subprime loans were stated income loans. Some builders even set up their own mortgage lending affiliates to ensure that credit kept flowing even if traditional lenders refused to lend.
Home equity played a big role in fuelling the boom. As real estate prices continued to rise, sub prime borrowers were able to roll over their mortgages after a specified number of years. They paid the outstanding loan with funds from a new larger loan based on the higher valuation of the property. Thus, borrowers could immediately spend the gain they booked on the property. From 1997 through 2006, consumers drew more than $9 trillion in cash out of their home equity. In the 2000s, home equity withdrawals were financing 3% of all personal consumption in the US.

Even with soaring house prices, the market could not have expanded so much without securitization. Previously, mortgages appeared directly on a bank's balance sheet and had to be backed by equity capital. Securitization allowed banks to bundle many loans into tradable securities and thereby free up capital. Banks were also able to issue more mortgage loans for a given amount of underlying capital.

For securitisation to take off, clever marketing was required. Few investors would have looked seriously at sub prime mortgage securities considered alone. To make subprime mortgages more palatable to investors, they were mixed with higher rated instruments. In the products so created, different groups of investors were entitled to different streams of cash flows based on the risk return disposition of the investors. These products came to be known as Collateralised Debt Obligations (CDOs). We shall cover CDOs in more detail a little later in the chapter.

As mentioned in Chapter 2, the imbalances in the global financial system also played a crucial role in helping securitisation take off. Many countries in the Asia Pacific and the Middle East had registered huge trade surpluses with the US and accumulated huge amounts of foreign exchange reserves. Traditionally, these countries had invested their excess dollars in US treasury bills and bonds. To generate more returns, they began to look at other US instruments including those related to mortgage, more seriously.

Complex, opaque instruments and heavy speculation transformed the market conditions dramatically. The basic principles of risk pricing were conveniently ignored. Indeed, the risk pricing mechanism broke down. A study by the Fed indicated that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. This happened even as subprime borrower and loan characteristics deteriorated overall during the 2001–2006 period. The more investors started to buy mortgage backed securities, the more the yields fell. Eventually a high rated security fetched barely more than a sub prime mortgage loan. But investors, having succumbed to the temptation, failed to back off. Rather than trying to reduce their positions, they tried to generate greater returns, using leverage.

As mentioned earlier, the payment burden for subprime mortgage borrowers increased sharply after an initial period. Borrowers were betting on rising home prices to refinance their mortgages at lower rates of interest and use the capital gains for other spending. Unfortunately, this bet did not pay off. Real estate prices started to drop in 2006 while interest rates rose. So the easy gains from refinancing mortgages evaporated. Many of the sub prime mortgages had an adjustable interest rate. The interest rate was low for an initial period of two to five years. Then it was reset. These reset rates were significantly higher than the initial fixed "teaser rate" and proved to be beyond what most subprime borrowers could pay. This double whammy, fall in home value and higher reset rates, proved to be too much for many borrowers.

To get an idea of the magnitude of the problem, the value of U.S. subprime mortgages had risen to about $1.3 trillion as of March 2007. Of this amount, the estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates was $400 billion for 2007 and $500 billion for 2008. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, about three times the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. Subprime ARMs only represented 6.8% of the home loans outstanding in the US. But they accounted for 43.0% of the foreclosures started during the third quarter of 2007.

The number of home loan of defaults arose from an annualised 775,000 at the end of 2005 to nearly 1 million by the end of 2006. A second wave of defaults and foreclosures began in the spring of 2007. A third wave of loan defaults and disclosures happened when home equity turned negative for many borrowers. As many as 446,726 U.S. household properties were subject to some sort of foreclosure action from July to September 2007. The number increased to 527,740 during the fourth quarter of 2007. For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively compared to 2006. These developments forced a crash in the housing market. At the start of 2007, new and existing home sales were running close to 7.5 million units per year. By the end of the year, the number had fallen below 5.5 million.

Total home equity was valued (in the US) at its peak at $13 trillion in 2006. This dropped to $8.8 trillion by mid-2008. Total retirement assets fell from $10.3 trillion to $8 trillion during the same period. At the same time, savings and investment assets lost $1.2 trillion and pension assets $1.3 trillion during the same period.