4 The Global Financial Crisis of
4.4 SUBPRIME MODEL OF MORTGAGE LENDING
Figure 4.1 describes the primary parties in the subprime housing market in the situation where mortgage-backed securities are created by investment banks and sold to investors.
4.4.1 Contributing Events to the Credit Crisis
To gain a clear understanding of the interrelationship of the events embroiled in the crisis it is important to find a “window” through which to gain a clear perspective. The perspective selected is based on a number of interlinked “vicious circles” some of which have been
5In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1–270 days. It is a money-market security issued (sold) by large banks and corporations to get money to meet short-term debt obligations and is only backed by an issuing bank or corporation’s promise to pay the face amount on the maturity date specified on the note. The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one-year or shorter timeframes. Trading in the money markets involves Treasury bills, commercial paper, bankers’ acceptances, certificates of deposit, federal funds and short-lived mortgage-and asset-backed securities (Fabozziet al. 2002). It provides liquidity funding for the global financial system.
6In the United States the federal government created several programmes or government sponsored entities to foster mortgage lending, construction and encourage home ownership. These included the Government National Mortgage Association (known as Ginnie May), the Federal National Mortgage Association (known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (known as Freddie Mac). These programmes worked by buying a large number of mortgages from banks and issuing mortgage-backed bonds to investors which are known as mortgage-backed securities.
Homebuyer
Lenders
Investors
Monthly Payments
Monthly Payments
Government Sponsored Enterprises or Investment Banks
Mortgage Loan
Sale of Securities
1 2
4 5
Cash Payment
Monthly Payments Cash and
Fee
3
6 8
7
Figure 4.1 Relationship between the parties engaged in the subprime housing market Legend
1. Ahomebuyerobtains a mortgage from alender(typically a bank). The lender transfers the money into the homebuyer’s account. The mortgage may be obtained through an intermediary – a broker.
2. Thehomebuyerrepays the loan amount in accordance with an agreed schedule.
3. Thelenderconsiders holding the mortgage in its portfolio (i.e. simply collect the interest and principal payments over the next several years) or selling it. The lender elects to sell the mortgage (to raise finance to make other loans) to a government-sponsored enterprise such as Fannie Mae or Freddie Mac, or a private entity such as financial institutions or Wall Street investment firms (investment banks).
4. Theinvestment bankgroups the mortgage with similar mortgages it has already purchased (referred to aspooling the mortgages). The mortgages in the pool have common characteristics (similar interest rates, maturities, etc.). Theinvestment bankthen prepares for sale securities that represent an interest in the pool of mortgages, of which the homebuyer’s mortgage is a small part (calledsecuritisingthe pool). The products for sale are called mortgage-backed securities (MBSs).
5. Prior to the sale of the MBSs, credit rating agencies (such as Standard & Poor’s, Moody and Fitch) gave ratings to every type of bond according to its risk. Letter grades mark the safety of the investments.
AAA (the best rating) is given to the safest ones, for example government bonds. Of note is that the credit rating agencies awarded most MBSs an AAA rating.
6. Theinvestment bankthen sells the MBSs to investors in the open market. With the funds from the sale of the MBS, theinvestment bankcan purchase more mortgages and create more MBSs for a fee.
7. Investors demanded MBSs as they were considered safe investments that paid a higher rate of return than Treasury bills (during the boom period) when defaults were minimal.
8. When thehomebuyermakes monthly mortgage payments to thelender, thelenderkeeps a fee and sends the rest of the payment to the investment bank. Theinvestment bankin turn takes a fee and passes what is left of the principal and interest payment along to the investors who hold the MBS.
The Global Financial Crisis of 2007–2009: A US Perspective 63
Housing Surplus
Homeowners’
Inability to Refinance
Inability to Meet Higher
Payments
Mortgage Defaults &
Foreclosures Reduced
Lending Capability of
Banks
Steep Decline in House
Prices
Mortgages Reset Lenders
Lenders Incur Losses
ARM Mortgages
Lender Behaviour
Figure 4.2 Increased foreclosures from mortgages resetting
described by writers such as Nouriel Roubini.7 Here three integrated vicious circles are proposed, labelled “foreclosures”, “negative equity” and “housing surplus”. These vicious circles or self-reinforcing downward spirals were created by the behaviour and practices of participant groups, including government departments, investment banks, rating agencies, lenders, brokers, borrowers and house builders. The circles are presented as diagrams and provide a very simplistic representation of reality. Their content is not intended to be exhaustive and they do not illustrate the strength of influence of one event on another.
4.4.2 Foreclosures
The first vicious circle relates to the event of adjustable rate mortgages resetting and the inability of predominantly subprime homeowners to refinance their properties with a new mortgage with more favourable terms. As a consequence homeowners were trapped in a mortgage that they could longer afford. They defaulted and the lenders foreclosed. Figure 4.2
7Nouriel Roubini is the cofounder and Chairman of Roubini Global Economics, an independent, global macroeconomic and market strategy research firm. He is also a professor of economics at New York University’s Stern School of Business. From 1998 to 2000, he served as the senior economist for international affairs on the White House Council of Economic Advisors and then the senior advisor to the undersecretary for international affairs at the US Treasury Department.
and the descriptions that follow illustrate the cause-and-effect relationship between the events which resulted in a self-reinforcing downward spiral of increasing foreclosures.
Lenders
There was a perceptible change in lender behaviour prior to the credit crisis. Against a backdrop of a buoyant US economy, very low interest rates, rising house prices, low federal regulation, excess global capital, heavy global demand for mortgage-backed securities and ease of risk transfer, lenders (typically banks) sought to satisfy demand by increasing the pool of borrowers and in turn increase their profits. However, in the main, those borrowers that had sought and had qualified for a mortgage had already been provided with one. Hence the qualification guidelines had to change and they were progressively relaxed. Mortgages were provided to customers whose poor credit histories had prevented them from buying homes in the past.
Lenders considered that while house values were rising – they had risen over 100% between 1997 and 2006 – borrowers were less likely to default on their mortgages as they could release money from their homes if they ran into debt. This group of borrowers was known collectively as the subprime market. Subprime borrowers typically had poor credit histories, insufficient money for a down payment and reduced repayment capacity. As a consequence of the credit worthiness of the borrowers, subprime loans had a higher risk of default than loans to prime borrowers. As the lending qualifications became increasingly relaxed borrowers no longer had to prove their annual income, they just had to state it. Subsequently borrowers did not even have to notify who their employer was, just provide a positive bank balance. Why were lenders so relaxed about the risk of default? Well, lenders did not keep the mortgages. They sold the mortgages to Wall Street investment banks. They simply transferred the risk.
As a consequence of the foreclosure process, lenders suffered losses which led to reduced financial assets and hence lending capabilities. At the same time interest rates were rising, making mortgages even more expensive. This exacerbated the situation for existing mortgage owners seeking a new mortgage whose low interest introductory period was about to finish.
As the rate of foreclosures increased, the ability and willingness of lenders to offer mortgages in this market decreased, creating a downward spiral of foreclosures.
Adjustable-Rate Mortgages
Approximately 80% of US mortgages issued to subprime borrowers were adjustable-rate mortgages8 (ARMs). ARMs typically had a fixed interest rate for a period of two or three years, after which time they reset to a much higher rate. An estimated one-third of ARMs which originated between 2004 and 2006 had attractive or “teaser” interest rates of below 4%
which then increased significantly after two or three years, frequently to double the initial rate.
This meant that while the loan was affordable to the borrower at the initial rate, it may have become unaffordable when the rate was reset. The benefit of ARMs for homeowners was that the starter rates were lower than those of traditional, fixed-rate mortgages. That meant lower (initial) monthly payments, making home ownership more affordable and allowing borrowers
8Some of the creative ARM products that flourished included interest-only and payment option loans. With the former, during the introductory period a borrower only paid the interest on the loan and nothing towards the principal balance. With payment option ARMs borrowers get to choose how much they pay each month – including just the interest or less than the interest. In the case of the last scenario, the unpaid interest was added onto the principal, leaving borrowers owing more than the amount of the original loan.
The Global Financial Crisis of 2007–2009: A US Perspective 65 to qualify for a larger loan. These products were sold to borrowers who thought their homes would appreciate (based on rising house prices over a number of years), enabling them to sell their home for a profit after a few years or refinance. As a home appreciates, even borrowers who are not paying the principal loan amount build up more equity. This would have made it easier for subprime borrowers to refinance into another loan with a low interest rate. ARMs put more homebuyers in the market, helping to raise home ownership rates to record levels in 2004, pushing up demand and house prices.
Mortgages Reset
At the time borrowers came to refinance, interest rates were rising, house prices were falling and lenders were becoming more cautious. In many cases homeowners were unable to refinance and either had to struggle with their existing mortgage or default.
Mortgage Defaults and Foreclosures
If a borrower was delinquent in making timely mortgage payments, the lender would in most cases take possession of the property in a process called foreclosure. Mortgage delinquencies can be traced back to 2004 when interest rates started to rise. In 2004 the US Federal Reserve started a cycle of interest rate rises that would lift borrowing costs from 1%, their lowest since the 1950s. In fact it went on to increase interest rates 17 times in a row as it tried to slow inflation. It paused in June 2006, setting the cost of borrowing costs at 5.25%. These increases pushed many ARMs beyond the means of borrowers. It tipped borrowers over the edge, making repayments unaffordable and contributed to the mortgage crisis. By the fourth quarter of 2007, the rate of serious delinquency as measured by credit records stood at 2% of all mortgage borrowers, up nearly 50% from the end of 2004.9To understand the financial scale of the problem, by November 2007 the value of US subprime mortgage payments outstanding was estimated at$1.4 trillion.10 By October 2007, approximately 16% of subprime ARMs were delinquent (Bernanke 2007). By January 2008, the delinquency rate had risen to 21%
and by May 2008 it was 25% (Bernanke 2008a, 2008b).
4.4.3 Negative Equity
The second vicious circle refers to the rising tide of homeowners with negative equity (Fig- ure 4.3) which came about after the collapse of the US housing bubble. This bubble, as other bubbles before it, was characterised by a rapid increase in the valuations of domestic property until unsustainable levels were reached in relation to incomes and other measures of affordability. A massive rise in household mortgage debt had arisen. A housing surplus was generated by a combination of an oversupply of new homes and mortgage foreclosures. This oversupply placed downward pressure on housing prices which lowered current homeowners’
equity. Homeowners with negative equity owed more on their mortgages than their properties were worth. They were incentivised to default on their mortgage.
9These figures are reported by Ben Bernanke (2008a) and are based on information from TrenData drawn from the credit records of a geographically stratified random sample of more than 20 million individuals for each calendar quarter beginning in 1992. “Serious delinquency” includes accounts that are 90 days or more past due or are in foreclosure.
10Remarks by Martin Gruenberg of the US Federal Deposit Insurance Corporation, 27 November 2007.
Mortgage Defaults &
Foreclosures
Steep Decline in House Prices
Homeowners with Negative
Equity
Mortgage Default Incentive Housing
Surplus
Job Losses House Building
Increase in Interest
Rates
Oversupply of New Homes House Builder Behaviour
Figure 4.3 Negative equity triggers mortgage defaults
As of March 2008 an estimated 8.8 million borrowers, 10.8% of all homeowners, had negative equity in their homes, a number which was believed to have risen to 12 million by November 2008. By June 2009 the US Government Accountability Office had discovered through research conducted in 16 metropolitan areas that the percentage of nonprime borrowers with negative equity ranged from about 9% (Denver, Colorado) to more than 90% (Las Vegas, Nevada).11As of the third quarter of 2010, it was estimated that almost 11 million mortgages or 22.5% of all mortgage holders owed more on their mortgage than the properties were worth, with another 2.4 million mortgages approaching negative equity.12
Borrowers in this situation had an incentive to “walk away” from their mortgages and abandon their homes, even though doing so would damage their credit rating for a number of years. As the number of foreclosures grew, the supply of homes increased creating even greater downward pressure on house prices and the number of homeowners with negativity equity grew, creating a negative or downward spiral.
Job Losses
Job losses exacerbated mortgage defaults and foreclosures. The news media recorded the trend in unemployment as it evolved month by month. According to the US Department of Labor, the US jobless rate rose to 7.3% in December 2008, the highest monthly figure for 16 years, as a result of employers laying off 524 000 staff. This figure was surpassed many times in 2009,
11US Government Accountability Office. “State-Level Information on Negative Home Equity and Loan Performance in the Nonprime Mortgage Market”, 14 May 2010.
12New York State economic report, February 2011.
The Global Financial Crisis of 2007–2009: A US Perspective 67 with the unemployment rate reaching 10.1%. The US Department of Labor’s Bureau of Labor Statistics unemployment figures record the increase in unemployment between December 2006 and December 2009 as 7.2 million. The US national press described the drop in employment as the biggest decline since the Great Depression. The total US unemployment figure for 2006 was 7 million and by 2009 it had reached 14.27 million (9.3%). Job losses had not only occurred in the housing and service industries (banks and insurance companies) which were directly affected by the subprime turmoil but had spread to retail, manufacturing, leisure and professional services. Falling house prices, combined with news of rising unemployment in other parts of the country, made homeowners both less wealthy and more cautious, contributing to a gradual decline in spending. Less consumer spending eventually weakened the economy, prompting companies to start laying off workers in a vicious cycle that caused households to become even more frugal.
4.4.4 Housing Surplus
Another vicious circle was created by the housing stock surplus (Figure 4.4) generated by a combination of an excessive production of new homes which outstripped demand, a fore- closure tsunami arising from adjustable-rate mortgages resetting, overvaluation of properties, speculators withdrawing from the market and borrowers overstretching themselves. During October 2007 the US Department of Housing recorded that the number of new building per- mits granted in the US (a signal of future construction activity) fell 6.6%, the biggest monthly
Job Losses Mortgage
Defaults &
Foreclosures
Building Company
Failures
Company Downsizing Housing
Surplus
Reduced Building Output
Figure 4.4 Housing surplus leads to fall in construction and job losses
decline in 14 years. This surplus created a huge and sustained downward pressure on house prices. It was exacerbated by mortgage delinquencies and foreclosures. As the volume of foreclosures rose, more houses were released onto the market, suppressing house prices fur- ther. When the property was placed back on the market by the lender it was common for the value of the property to have fallen. By early 2005 house prices had peaked and by 2006 they had started to decline. However, they continued to fall on a year-on-year basis, the first time this had occurred since the Great Depression. Average home sale prices nationwide fell 4.2%
in the 12 months to September 2007.13 In October 2007, the US Secretary of the Treasury, Henry Paulson, called the bursting of the bubble “the most significant risk to our economy”.
In response to this surplus building output was reduced and house builders were forced to reduce the sale price of their new properties. The reduced demand for new homes placed pressure on companies initially in the house building sector and subsequently those allied to it.
A significant number of house builders either downsized or went into liquidation, contributing to the pool of unemployed. As this pool grew it expanded the number of mortgage defaults, driving up the number of vacant properties.
The housing problems continued into 2010. When the tax credits designed to boost sales ended in May 2010 house sales began to slump. The National Association of Realtors sub- sequently recorded a plunge in house sales in July 2010 of 27% compared with the previous month. July had been the third month in a row that sales of previously built single homes had fallen. More significantly, the monthly sales figure was the worst in ten years. On the an- nouncement the Dow Jones Index closed down 134 points at 10 040.45, close to the perceived critical 10 000 threshold.
4.4.5 Vicious Circles
The three vicious circles described are interlinked as they directly influence each other and all contain the event “mortgage defaults and foreclosures” (Figure 4.5).