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 2007Group Report

Table of Contents

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

Subprime mortgage crisis phases: 10

Impact in the United States: 12

Impact in Europe: 15

References: 17

The American subprime mortgage crisis was a national financial crisis that lasted from 2007 to2010 and contributed to the recession that lasted from December 2007 to June 2009 After ahousing bubble burst, there was a sharp decrease in home values that set off the crisis, whichresulted in mortgage defaults, foreclosures, and a decline in the value of instruments tied to thehousing market Reductions in household spending, business investment, and home investmentall occurred prior to the recession Spending reductions were more pronounced in places wheresubstantial family debt and more pronounced home price drops were present.

Mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which initiallypromised greater interest rates (i.e., better returns) than government securities together withalluring risk ratings from rating agencies, were used to finance the housing bubble thatpreceded the crisis Although the crisis's origins first became apparent in 2007, severalimportant financial institutions collapsed in September 2008, severely disrupting the flow ofcredit 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 placedon, among others, financial institutions, regulators, credit agencies, government housing policy,and consumers by observers The growth in subprime lending and the rise in home speculationwere two immediate reasons From 2004 to 2006, the proportion of poorer-quality subprimemortgages generated each year increased from the previous range of 8 percent or below toover 20 percent, with higher ratios in some regions of the U.S More than 90% of thesesubprime mortgages in 2006, for instance, were adjustable-rate mortgages The share ofmortgage originations to investors (i.e., individuals who own properties other than their primaryresidences) 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 thosewith excellent credit ratings—were far more likely to default than non-investors Thesemodifications were a part of a larger pattern of looser lending rules and riskier mortgageproducts, which let U.S homeowners accumulate more debt By the end of 2007, the proportionof 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 pricesfell sharply after peaking in mid-2006 Mortgage delinquencies shot through the roof asadjustable-rate mortgages started to reset at higher interest rates (resulting in higher monthlypayments) Financial institutions around the world that held a lot of securities backed bymortgages, notably subprime mortgages, saw a significant decline in value As the capacity andwillingness of the private banking sector to support lending declined, so did purchases ofmortgage-backed debt and other assets by international investors Credit was tightened globallyand economic development in the US and Europe was slowed as a result of worries about thestability of US credit and financial systems.

The U.S and European economies suffered significant, long-lasting effects as a result of thecrisis With over 9 million jobs lost between 2008 and 2009, or around 6% of the total, theUnited States experienced a severe recession It took until May 2014 for the number of jobs toreach 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 ofover 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 hasresulted 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 significantbank 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 Dueto various rescue measures, $626 billion was invested, borrowed, or given, whereas $390 billionwas returned to the Treasury With additional interest payments on rescue loans totaling $323billion, the Treasury made a $87 billion profit.

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

simultaneously concealed the credit risks associated with subprime loans, allowing homeownersto refinance rather than go into default Refinancing could no longer hide the borrowers' creditrisk when property values started to fall, which is when delinquencies and foreclosures startedto rise

In the middle of the 1990s, subprime lending initially began to grow Governments promotedloans to low-income borrowers during this period, and technological advancements made iteasier for lenders to evaluate and price credit risk Additionally, the expansion of secondarymortgage 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 existedbefore and throughout the 2001 crisis Subprime loan default rates rose shortly before andduring the recession of 2001 This tendency, however, started to reverse due to historically lowmortgage rates and rising property prices Because of the low interest rates and rising propertyvalues, many homeowners were able to refinance rather than face foreclosure, whichdecreased the effect of mortgage rate resets 8 million homeowners refinance in 2002 15million house mortgages, or one in three, were refinanced in 2003

Although some predicted tragedy early on and gained billions from the subprime crisis, the maintrend of more subprime loans persisted despite falling property values and an increase inforeclosures that began in 2005 Lenders did not tighten loan conditions until 2007 when theybecame aware of the rising default rate in the subprime sector Residential mortgageforeclosures reached a record high in the first quarter of 2007, and as a response, lenderstightened their rules for subprime loans Problems with the subprime sector eventually causedindustry- and economy-wide catastrophe in August 2007 As investors were aware thatsignificant sources of liquidity may become victims of the subprime fallout, the credit marketsfroze up Investors are unsure as to when the subprime crisis's repercussions will end due tothe economic ramifications' recent escalation Investor demand for subprime mortgages waspreviously 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 assecurities to investors on a secondary market Credit card receivables, vehicle leasingreceivables, and mortgages are a few examples of underlying assets that are often included insecuritization The underlying asset is packaged in enormous quantities and marketed to5

investors who are interested in the asset's revenue stream The total risk and cost of thebundled assets are estimated using historical default rates and other complex statisticalevaluations 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 themortgage originator (a lender or broker) to a legally separate organization known as a specialpurpose vehicle in a typical subprime securitization transaction (SPV) Investors get debtsecurities from the SPV in return Homeowners pay monthly interest and principal to investors inaccordance with the securitization's unique structure Many homeowners are unaware of thistransaction since the original loan servicer still collects payments and handles loan servicing Subprime lending is made possible and encouraged through securitization Becausesecuritization enables lenders to transfer risk, they are ready to issue subprime loans, which areriskier than prime loans The risk of loan default shifts from the lender to the investors aftersecuritized subprime loans are moved from the lender to an SPV and investors buy an interestin the securitized loans When the debt security is bought, the investor makes upfront paymentsto the lender However, there are structural and contractual provisions intended to guaranteethat lenders retain some credit risk and, as a result, have an incentive to keep the credit qualityof subprime loans at an acceptable level For instance, some securitization contracts mandatethat lenders replace defaulted loans with performing loans Although many of these measureswere overlooked by investors because of the enormous demand for subprime-backedsecurities, many other protections did not work as planned

Investors are rewarded for and shielded from this risk even if the lender can transfer it Thesecuritization's design shielded investors from legal and credit risk Higher (senior) tranches insecuritized assets are paid off before lower (subordinated) tranches, allowing the lower tranchesto absorb any losses from borrower defaults Additionally, since prepaid loans generate lesscash flow than regularly paid mortgages, investors desire security against borrowerprepayments These concessions made to investors may influence debtors Because theseclauses attract a greater price when securitized, lenders are motivated to impose higher interestrates and prepayment penalties There is proof that higher mortgage rates were the outcome ofrating agencies' requests for stronger investor protections

Securitization is a complex financial transaction that was developed and carried out outside oflow-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 loanapplicants and encouraged them to incorporate "predatory" clauses like prepayment penalties inloan agreements High profitability and built-in investor safeguards made securitized subprimeloans immensely popular While securitization made it possible for lenders to offer loans toborrowers who would not have otherwise been eligible, it also encouraged unfavorable terms toseep 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 Theagency will assess the risks of companies and investments Although these rating agencies areprivate, they are subject to government oversight Rating boards analyze companies andfinancial instruments to give them a rating from AAA (high quality) to D (lowest) But there aremany cases where even though subprime mortgages are securitized, they still have a highrating (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, bothtraditional rating services and consulting fees on how to structure securitized products to rankhighly The rating agency is paid directly by the company whose product is being queued forreview Given the complexity of the securitization transaction, the corporate queuing organizerscharged twice as much as the traditional corporate bond rating fee The governing body hascharged a fee to advise leaders on how to structure securitized subprime mortgages in such away that they can be appreciated Leadership agencies were slow to downgrade as mortgagedefaults increased Delays cause harm as more under-mortgage loans are created Affect theeconomy heavily.

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

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

Micro causes exist Bernakee argued that many loan originators are independent brokers, notbanks Small brokers are harder to supervise and control, therefore they securitized loans toreduce 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 behaviorsoften includes fraud and unfair tricks to deceive the borrower about the true nature of lendingobligations Ethical lenders may charge too much and do not consider whether the borrower canrepay the loan or not These lenders often target vulnerable consumers with products that maycause them to be stuck in their debt, causing damage to their financial well-being Pre-primelending includes practices prohibited by state and federal law or a set of terms and practicesthat are considered unfair or fraudulent, even if not expressly prohibited by law In a report putout by the Departments of Housing and Urban Development and the Treasury, early lendingwas defined as "deception or fraud, manipulating borrowers through aggressive sales tactics, ortaking advantage of a borrower's ignorance of loan terms."

People are often misled by scam operators and unfairly pre-hunted lenders into believing thatthey have no interest in doing this Often, these loans are insolvent, have confusing ormisleading terms, and come with high fees Pre-hunt lenders often target consumers who theybelieve 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 insociety, 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 theloan 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 andbrokers 2/28 (or 3/27) loans are predatory The first two years of a 2/28 loan have a low teaserrate 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 teaserrate Many lenders approved customers based on the first teaser rate 85 percent of customerswere late on 2/28 loans following interest rate changes, therefore lenders collected heftyrefinancing 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 57Prepayment penalties are charged for paying off a loan early, generally as a percentage of theoutstanding loan amount or a predetermined number of months of interest Refinancing costsmore with prepayment penalties 58 Some say lenders issued loans they knew would needrefinancing or promoted repeated refinancing to earn fees

Others say prepayment penalties are a sensible, risk-based reaction When a borrower prepaysa 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 59Prepayment penalty loans attract a greater price in the secondary market, giving lenders anincentive to include them

(3) Illegal deceit This includes breaches of TILA, HOEPA, and RESPA (RESPA) This includesanti-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 predatorylending 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 oftheir loans if they fail Securitization reduces predatory lending incentives since investors seekquality assets Securitization insulates investors from subprime default credit risk and promotesless 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 maynot be in some situations The subprime crisis was caused by the pervasiveness and effect ofpredatory behavior For this article, it's enough to say that 2/28 loans and prepayment penaltiesare 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 than800,000 unsold properties dragging on the market, home prices in the United States continuedto decline The lack of credit available for commercial endeavors has demonstrated a decliningmarket Due to their inability to secure bank financing, many businesses had to scale back theirinvestment plans, while others were forced to scrap their successful business strategies Incomparison to a 4% increase in 2006, the US GDP increased by only 0.6 percent in the fourthand 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 themonthly unemployment rate steadily rising since April 2008.

The subprime crisis gained global proportions following the bankruptcy of the investment bankLehman 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 asystemic crisis with repercussions for world production, employment, and the flow of trade Theliquidity pooling and the freezing of credit operations affected advanced and emergingeconomies, and global economic authorities made joint decisions to try to mitigate the adverseeffects of the crisis The International Monetary Fund estimated that large U.S and Europeanbanks lost more than $1 trillion on toxic assets and from bad loans from January 2007 toSeptember 2009 These losses were expected to top $2.8 trillion from 2007 to 2010 U.S banklosses were forecast to hit $1 trillion and European bank losses would reach $1.6 trillion TheIMF estimated that U.S banks were about 60 percent through their losses, but British andeurozone banks were only 40 percent The crisis had severe, long-lasting consequences for theU.S and European economies The U.S entered a deep recession, with nearly 9 million jobslost during 2008 and 2009, roughly 6% of the workforce The number of jobs did not return tothe December 2007 pre-crisis peak until May 2014.

International investment banks compete to provide financing to financial institutions that focuson lending subprime mortgages or to launch their own lending businesses Huge profits have