subprime mortgage crisis in 2007 group report

But there are many cases where even though subprime mortgages are securitized, they still have a high rating AAA...7Subprime mortgage crisis phases:...10Impact in the United States:...12

ECO121 - Subprime Mortgage Crisis in 2007

Group Report August 7, 2022

Table of Contents

Introduction: 3

Causes: 4

2.1 Securitization 5

2.2 Credit rating agency 7

Standard & Poor's, Moody's and Fitch are credit rating agencies in the United States The agency will assess the risks of companies and investments Although these rating agencies are private, they are subject to government oversight Rating boards analyze companies and financial instruments to give them a rating from AAA (high quality) to D (lowest) But there are many cases where even though subprime mortgages are securitized, they still have a high rating (AAA) 7

2.3 Government policies 7

2.4 Predatory lending 8

(1) Structure of loans 9

(2) Rent-seeking 9

(3) Illegal deceit 9

(4) Non-transparency, discrimination 9

Subprime mortgage crisis phases: 10

Impact in the United States: 12

Impact in Europe: 15

Conclusion: 17

References: 17

The American subprime mortgage crisis was a national financial crisis that lasted from 2007 to

2010 and contributed to the recession that lasted from December 2007 to June 2009 After a housing bubble burst, there was a sharp decrease in home values that set off the crisis, which resulted in mortgage defaults, foreclosures, and a decline in the value of instruments tied to the housing market Reductions in household spending, business investment, and home investment all occurred prior to the recession Spending reductions were more pronounced in places where substantial family debt and more pronounced home price drops were present

Mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which initially promised greater interest rates (i.e., better returns) than government securities together with alluring risk ratings from rating agencies, were used to finance the housing bubble that preceded the crisis Although the crisis's origins first became apparent in 2007, several important financial institutions collapsed in September 2008, severely disrupting the flow of credit to individuals and companies, and heralding the start of a severe global recession

The reasons for the crisis were numerous, with differing degrees of responsibility being placed

on, among others, financial institutions, regulators, credit agencies, government housing policy, and consumers by observers The growth in subprime lending and the rise in home speculation were two immediate reasons From 2004 to 2006, the proportion of poorer-quality subprime mortgages generated each year increased from the previous range of 8 percent or below to over 20 percent, with higher ratios in some regions of the U.S More than 90% of these subprime mortgages in 2006, for instance, were adjustable-rate mortgages The share of mortgage originations to investors (i.e., individuals who own properties other than their primary residences) climbed dramatically from approximately 20% in 2000 to around 35% in 2006-2007, indicating a surge in housing speculation as well When prices dropped, investors—even those with excellent credit ratings—were far more likely to default than non-investors These modifications were a part of a larger pattern of looser lending rules and riskier mortgage products, which let U.S homeowners accumulate more debt By the end of 2007, the proportion

of household debt to disposable personal income had increased from 77% to 127%

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It became increasingly challenging for borrowers to refinance their loans as U.S home prices fell sharply after peaking in mid-2006 Mortgage delinquencies shot through the roof as adjustable-rate mortgages started to reset at higher interest rates (resulting in higher monthly payments) Financial institutions around the world that held a lot of securities backed by mortgages, notably subprime mortgages, saw a significant decline in value As the capacity and willingness of the private banking sector to support lending declined, so did purchases of mortgage-backed debt and other assets by international investors Credit was tightened globally and economic development in the US and Europe was slowed as a result of worries about the stability of US credit and financial systems

The U.S and European economies suffered significant, long-lasting effects as a result of the crisis With over 9 million jobs lost between 2008 and 2009, or around 6% of the total, the United States experienced a severe recession It took until May 2014 for the number of jobs to reach the pre-crisis peak of December 2007 From its pre-crisis peak in Q2 2007, the U.S household net worth decreased by over $13 trillion (about $40,000 per person in the US) (20%) until recovering in Q4 2012 By early 2009, U.S house values had dropped by an average of over 30 percent, and the stock market had dropped by around 50 percent By September 2012, equities had recovered to their December 2007 levels According to one estimate, the crisis has resulted in "at least 40% of 2007's gross domestic product" in lost output and income

In addition, Europe's own economic crisis persisted, with high unemployment and significant bank losses totaling €940 billion between 2008 and 2012 When interest on loans is considered,

as of January 2018, U.S bailout monies have been entirely recovered by the government Due

to various rescue measures, $626 billion was invested, borrowed, or given, whereas $390 billion was returned to the Treasury With additional interest payments on rescue loans totaling $323 billion, the Treasury made a $87 billion profit

Causes:

The subprime crisis is the outcome of two sets of forces: one set acting on the economy as a whole and the other set acting on the specific workings of the mortgage market In the middle of the 1990s, rising securitization encouraged and made it possible for lenders to provide subprime loans with excessively lax credit requirements Low interest rates and rising property values

simultaneously concealed the credit risks associated with subprime loans, allowing homeowners

to refinance rather than go into default Refinancing could no longer hide the borrowers' credit risk when property values started to fall, which is when delinquencies and foreclosures started

to rise

In the middle of the 1990s, subprime lending initially began to grow Governments promoted loans to low-income borrowers during this period, and technological advancements made it easier for lenders to evaluate and price credit risk Additionally, the expansion of secondary mortgage markets enabled lenders to shift the risk associated with subprime loans to investors This increase in subprime loans was made possible by macroeconomic conditions that existed before and throughout the 2001 crisis Subprime loan default rates rose shortly before and during the recession of 2001 This tendency, however, started to reverse due to historically low mortgage rates and rising property prices Because of the low interest rates and rising property values, many homeowners were able to refinance rather than face foreclosure, which decreased the effect of mortgage rate resets 8 million homeowners refinance in 2002 15 million house mortgages, or one in three, were refinanced in 2003

Although some predicted tragedy early on and gained billions from the subprime crisis, the main trend of more subprime loans persisted despite falling property values and an increase in foreclosures that began in 2005 Lenders did not tighten loan conditions until 2007 when they became aware of the rising default rate in the subprime sector Residential mortgage foreclosures reached a record high in the first quarter of 2007, and as a response, lenders tightened their rules for subprime loans Problems with the subprime sector eventually caused industry- and economy-wide catastrophe in August 2007 As investors were aware that significant sources of liquidity may become victims of the subprime fallout, the credit markets froze up Investors are unsure as to when the subprime crisis's repercussions will end due to the economic ramifications' recent escalation Investor demand for subprime mortgages was previously high, but they are now deadly to balance sheets and may lead to company collapse These above-macro economic factors paired with the following factors:

2.1 Securitization

Large pools of assets are packaged via securitization, and the bundled assets are then sold as securities to investors on a secondary market Credit card receivables, vehicle leasing receivables, and mortgages are a few examples of underlying assets that are often included in securitization The underlying asset is packaged in enormous quantities and marketed to 5

investors who are interested in the asset's revenue stream The total risk and cost of the bundled assets are estimated using historical default rates and other complex statistical evaluations of the underlying assets

Subprime mortgage securitization is prevalent, with up to 80% of subprime mortgages and 50%

of all mortgages being securitized The mortgages are pooled together and transferred from the mortgage originator (a lender or broker) to a legally separate organization known as a special purpose vehicle in a typical subprime securitization transaction (SPV) Investors get debt securities from the SPV in return Homeowners pay monthly interest and principal to investors in accordance with the securitization's unique structure Many homeowners are unaware of this transaction since the original loan servicer still collects payments and handles loan servicing Subprime lending is made possible and encouraged through securitization Because securitization enables lenders to transfer risk, they are ready to issue subprime loans, which are riskier than prime loans The risk of loan default shifts from the lender to the investors after securitized subprime loans are moved from the lender to an SPV and investors buy an interest

in the securitized loans When the debt security is bought, the investor makes upfront payments

to the lender However, there are structural and contractual provisions intended to guarantee that lenders retain some credit risk and, as a result, have an incentive to keep the credit quality

of subprime loans at an acceptable level For instance, some securitization contracts mandate that lenders replace defaulted loans with performing loans Although many of these measures were overlooked by investors because of the enormous demand for subprime-backed securities, many other protections did not work as planned

Investors are rewarded for and shielded from this risk even if the lender can transfer it The securitization's design shielded investors from legal and credit risk Higher (senior) tranches in securitized assets are paid off before lower (subordinated) tranches, allowing the lower tranches

to absorb any losses from borrower defaults Additionally, since prepaid loans generate less cash flow than regularly paid mortgages, investors desire security against borrower prepayments These concessions made to investors may influence debtors Because these clauses attract a greater price when securitized, lenders are motivated to impose higher interest rates and prepayment penalties There is proof that higher mortgage rates were the outcome of rating agencies' requests for stronger investor protections

Securitization is a complex financial transaction that was developed and carried out outside of low-income areas, yet it is essential to understanding the causes of the subprime crisis This

risk transfer made it more difficult for lenders to conduct thorough credit checks on loan applicants and encouraged them to incorporate "predatory" clauses like prepayment penalties in loan agreements High profitability and built-in investor safeguards made securitized subprime loans immensely popular While securitization made it possible for lenders to offer loans to borrowers who would not have otherwise been eligible, it also encouraged unfavorable terms to seep into mortgage contracts and an excessive supply of loans with lax credit requirements, which prepared the ground for a sharp rise in foreclosures

2.2 Credit rating agency

Standard & Poor's, Moody's and Fitch are credit rating agencies in the United States The agency will assess the risks of companies and investments Although these rating agencies are private, they are subject to government oversight Rating boards analyze companies and financial instruments to give them a rating from AAA (high quality) to D (lowest) But there are many cases where even though subprime mortgages are securitized, they still have a high rating (AAA)

The rating agencies have taken actions in the interest that contributed to the economic crisis Rating agencies have generated large sums of money from securitization transactions, both traditional rating services and consulting fees on how to structure securitized products to rank highly The rating agency is paid directly by the company whose product is being queued for review Given the complexity of the securitization transaction, the corporate queuing organizers charged twice as much as the traditional corporate bond rating fee The governing body has charged a fee to advise leaders on how to structure securitized subprime mortgages in such a way that they can be appreciated Leadership agencies were slow to downgrade as mortgage defaults increased Delays cause harm as more under-mortgage loans are created Affect the economy heavily

2.3 Government policies.

The government encourages homeownership because it helps people, families, and communities

The Community Reinvestment Act (CRA) encourages lending in impoverished regions by requiring banks to meet local credit requirements CRA mandates banks to reinvest deposit monies in their communities Federal authorities rate each institution annually depending on

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whether it meets community needs Federal authorities evaluate ratings and data to authorize mergers, branch openings, and relocations

There is no obligatory quantitative transfer of capital to low-income neighborhoods, although banks make quantitative pledges to increase merger approval prospects The CRA favors capital allocations to low-income and minority communities regardless of loan quality CRA incentives pushed banks to lend leniently in disadvantaged neighborhoods, which is now questioned

Micro causes exist Bernakee argued that many loan originators are independent brokers, not banks Small brokers are harder to supervise and control, therefore they securitized loans to reduce risk These independent brokers promoted lax, abusive lending

2.4 Predatory lending

Predatory lending is a loaded term with an amorphous definition Hunting for lending behaviors often includes fraud and unfair tricks to deceive the borrower about the true nature of lending obligations Ethical lenders may charge too much and do not consider whether the borrower can repay the loan or not These lenders often target vulnerable consumers with products that may cause them to be stuck in their debt, causing damage to their financial well-being Pre-prime lending includes practices prohibited by state and federal law or a set of terms and practices that are considered unfair or fraudulent, even if not expressly prohibited by law In a report put out by the Departments of Housing and Urban Development and the Treasury, early lending was defined as "deception or fraud, manipulating borrowers through aggressive sales tactics, or taking advantage of a borrower's ignorance of loan terms."

People are often misled by scam operators and unfairly pre-hunted lenders into believing that they have no interest in doing this Often, these loans are insolvent, have confusing or misleading terms, and come with high fees Pre-hunt lenders often target consumers who they believe have few lending alternatives But keep in mind that the products offered by pre-approved lenders are designed to help the lenders, not borrowers

Usually, predatory lending targets the minority, the poor, the elderly, or the uneducated in society, as many of these people need immediate cash in different situations, like payment, medical expenses, etc Also, these kinds of things have become more common in-home

mortgage loans since the main home of a real estate lender can benefit from the terms of the loan and the sale of the home if the homeowner does not pay

Predatory lending includes practices such as the following:

(1) Structure of loans This includes loans that hurt borrowers while benefiting lenders and brokers 2/28 (or 3/27) loans are predatory The first two years of a 2/28 loan have a low teaser rate The interest rate changes every six months after two years Interest rates often rise Borrowers who can't afford the higher interest rate remortgage to get another two-year teaser rate Many lenders approved customers based on the first teaser rate 85 percent of customers were late on 2/28 loans following interest rate changes, therefore lenders collected hefty refinancing costs

(2) Rent-seeking This involves high fees or interest rates given the borrower's credit risk Prepayment penalties are more frequent in subprime mortgages than prime mortgages 57 Prepayment penalties are charged for paying off a loan early, generally as a percentage of the outstanding loan amount or a predetermined number of months of interest Refinancing costs more with prepayment penalties 58 Some say lenders issued loans they knew would need refinancing or promoted repeated refinancing to earn fees

Others say prepayment penalties are a sensible, risk-based reaction When a borrower prepays

a mortgage, the lender reinvests the cash at an unpredictable (and perhaps lower) interest rate Subprime borrowers have a higher prepayment risk since they are more likely to refinance 59 Prepayment penalty loans attract a greater price in the secondary market, giving lenders an incentive to include them

(3) Illegal deceit This includes breaches of TILA, HOEPA, and RESPA (RESPA) This includes anti-predatory lending breaches 60

(4) Non-transparency, discrimination Non-disclosure of mortgage costs and conditions, mandatory arbitration provisions, and racial/ethnic discrimination in lending are other predatory lending practices

Predatory lenders have been accused for years In a moment of increasing housing values, lenders are more inclined to engage in predatory lending since they may reclaim the value of their loans if they fail Securitization reduces predatory lending incentives since investors seek quality assets Securitization insulates investors from subprime default credit risk and promotes less stringent lending policies

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Predatory lending's imprecise definition makes it hard to examine as a subprime crisis cause Some activities are predatory to different actors but not to others, and the same technique may not be in some situations The subprime crisis was caused by the pervasiveness and effect of predatory behavior For this article, it's enough to say that 2/28 loans and prepayment penalties are linked to the subprime crisis, whether they're predatory or not

Subprime mortgage crisis phases:

With new house sales declining month after month in the early months of 2008 and more than 800,000 unsold properties dragging on the market, home prices in the United States continued

to decline The lack of credit available for commercial endeavors has demonstrated a declining market Due to their inability to secure bank financing, many businesses had to scale back their investment plans, while others were forced to scrap their successful business strategies In comparison to a 4% increase in 2006, the US GDP increased by only 0.6 percent in the fourth and first quarters of 2007 Even if the Bureau of National Economic Research (NBER) disagreed, many analysts have said that the US economy is in a recession as a result of the monthly unemployment rate steadily rising since April 2008

The subprime crisis gained global proportions following the bankruptcy of the investment bank Lehman Brothers in the second half of 2008 Stock markets plummeted, commodity prices fell, and risk aversion measures reached record levels Quickly, the wave of pessimism turned into a systemic crisis with repercussions for world production, employment, and the flow of trade The liquidity pooling and the freezing of credit operations affected advanced and emerging economies, and global economic authorities made joint decisions to try to mitigate the adverse effects of the crisis The International Monetary Fund estimated that large U.S and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009 These losses were expected to top $2.8 trillion from 2007 to 2010 U.S bank losses were forecast to hit $1 trillion and European bank losses would reach $1.6 trillion The IMF estimated that U.S banks were about 60 percent through their losses, but British and eurozone banks were only 40 percent The crisis had severe, long-lasting consequences for the U.S and European economies The U.S entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly 6% of the workforce The number of jobs did not return to the December 2007 pre-crisis peak until May 2014

International investment banks compete to provide financing to financial institutions that focus

on lending subprime mortgages or to launch their own lending businesses Huge profits have