The Subprime Mortgage Crisis: Causes and Consequences

Introduction

Since 2006, however, a severe financial crisis has developed in the subprime credit market. It is especially rampant in the subprime mortgage market which has experienced an increasing rate of foreclosures. When interest rates rose, this led to adjustable-rate mortgages becoming more popular. But the housing bubble did not last and property values plummeted, borrowers could not fulfill their financial commitments and lenders could not recover their losses. The result is today’s harsh credit crunch which has led to big players in the subprime mortgage lending industry to shut down or file for bankruptcy.

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Others have been accused of encouraging deceptive income inflation on loan applications. Between December 2006 and March 2007, more than 30 subprime lenders closed operations. The rest have incurred serious losses and are in grave financial trouble. Lending standards have become more stringent and economists at Goldman Sachs have predicted this to cut annual demand for new homes to go down by one-fifth of last year’s sales (Roubini, 2007). In this paper, we attempt to discuss the causes and consequences of the U.S. subprime mortgage crisis, as well as shed light on how it has spread worldwide in more ways than one.

Analysis

The subprime mortgage crisis can be in large part attributed to the liquidity issues which surfaced in the global banking system due to the incidences of foreclosures which became rampant in the U.S. in the latter part of 2006. This, in turn, led to a financial crisis of global proportions during 2007 and 2008. As the U.S. housing bubble finally burst and subprime as well as adjustable rate mortgages saw high default rates, housing prices declined and refinancing became more of a problem. This caused there to be more defaults and foreclosures, and in 2007 alone, there was a 79% increase in foreclosure activity from the previous year, as according to RealtyTrac Inc. research, over 2 million foreclosure filings in that year as December 2007 was “the fifth straight month with more than 200,000 foreclosure filings reported” (RealyTrac staff, 2008).

The burst housing bubble was a major factor behind the subprime mortgage crisis that afflicts the U.S. economy today. The demand for housing and the upward trend in home ownership rates, which according to the U.S. Census Bureau (2006) were 64 percent in 1994 and reached their all-time peak of 69.2 percent in 2004, had a major contributing factor in subprime borrowing.

As demand increased, housing prices followed suit and so did consumer spending. In a span of a decade between 1997 and 2006, according to the S&P/Case-Shiller national home-price index, prices of American homes rose by 124% (CSI: Credit Crunch). As property values had significantly increased, homeowners took this as an opportunity to refinance their houses at lower interest rates and take out second mortgages against their property, using the added funds for consumer spending. As the Economist reported, whereas ten years earlier U.S. household debt as a percentage of income was 100%, in 2007, this figure had risen to 130% (Getting Worried Downtown).

The supply of houses on the other hand, also increased because during this period of boom, there was more than required building activity and increases in foreclosure incidents. Also, homeowners did not want to sell their property at lesser market prices. All these factors caused the sales volume of new homes to decline by 26.4% in 2007 as compared to 2006 (New Home Sales Fell by Record Amount in 2007). The inventory of unsold new homes hit its highest since 1981, as it was 9.8 months in January 2008 based on the sales volume of December 2007. Also, at this time there were a staggering number of unsold existing homes available for sale, four million to be precise (Coy, 2008). All this excess supply of housing property caused prices to start falling, and as prices declined in 2007 by 8% from their record high in 2006 (Getting Worried Downtown), the risk of defaults and foreclosures increased. There is a situation of excess supply of homes currently as well, and prices will continue to decline until a semblance of balance returns to the demand and supply of homes.

There were a number of reasons why a large number of subprime borrowers started to default on their payments: the payment delinquency rate was 21% in recent times, which is more almost four times the level it had been at historically (Bernanke, 2008). One of these reasons was the availability of credit, as well as the blind faith in the upward trend of housing prices. Both these combined led many subprime borrowers to attain Adjustable Rate Mortgages which they could not really afford to have once the initial incentive period was up. As housing prices started falling in various parts of America, homeowners were left with limited options. Some decided to refinance, some couldn’t afford this and started defaulting on their payments as their loan terms were reset to higher payments as well as higher interest rates. Yet others dealt with declines in property value and limited equity by opting to simply “walk away”: they chose to stop paying their mortgage and allow foreclosure to take place, ignoring the effect this will have on their credit rating, since they do not want to run the risk of bankruptcy by continuing to pay off a loan they can not afford (Christie, 2008).

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The mortgage crisis has also been caused in some part by fraudulent representation on loan applications. As Economics professor Tyler Cowen wrote, “There has been plenty of talk about ‘predatory lending,’ but ‘predatory borrowing’ may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications.” This was found by a company which helps banks as well as lenders unearth deceptive or fraudulent transactions: BasePoint Analytics conducted a study of more than three million loans between 1997 and 2006, with the major proportion being between 2005 and 2006 (Cowen, 2008).

Borrowers tricked lenders both simply and creatively, some used computers to generate false income documents while others just misstated their incomes. Applicants who had given false data were five times more probable to default on their payments than those who hadn’t. And default they did because when housing prices were rising, the emphasis was more on striking the deal, for both borrowers and lenders, rather than giving correct information or checking up on the accuracy of data. The fact that fraud played a role can also be judged by the fact that a lot of mortgages defaulted in their very first year (Cowen, 2008).

Lenders started offering a higher number of loans to subprime borrowers, as can be judged by the fact that share of subprime mortgages increased from 5% (1994), 9% (1996), 13% (1999) to 20% in 2006. Traditional boom and bust cycles caused the risk premium (which is the difference in mortgage interest rates between prime mortgage rates and subprime mortgage rates) to decline. Not only did loans to subprime lenders increase, the loan options and incentives also became risky than before. Examples of these are the Adjustable Rate Mortgage and the “payment option” loan (Bernanke, 2008). Mortgage brokers earn higher commissions from ARMs and hence have personal reasons to push this high-risk loan. Furthermore, according to Browning (2007) almost half of all subprime loans were generated by automated underwriting, leading one to conclude that a less-automated system might not have approved a large number of the borrowers who managed to attain loans.

Nevertheless the large number of subprime loans and the subsequent fall in housing prices led to defaults, foreclosures and a mortgage crisis of mammoth proportions. Banks, mortgage lenders, and real estate investment trusts all suffered huge losses and Onaran (2008) reported that by May 2008, banks and securities firms had suffered losses and write-downs from the subprime crisis worth more than U.S. $379 billion.

The 8,500 banks insured by the Federal Deposit Insurance Corporation witnessed their profits decline by a staggering 89 percent in the fourth quarter of 2007 as compared to the previous year, from $35.2 billion to $646 million. The defaults on loans as well as provisions for bad loans caused this to be the worst bank quarterly results since 1990. Their yearly profits for 2007 were approximately $100 billion, which was a 31% decline from $145 billion in 2006. Then in the first quarter of 2008, banks’ profits were down by 46% as compared to the same period in 2007, from $35.6 billion to $19.3 billion (FDIC Quarterly Profile). Banks suffered, top managements faced the music and many mortgage lenders filed for bankruptcy, got sold or closed down operations.

The job market also became tighter: Bloomberg reported that between July 2007 and March 2008, more than 34,000 employees were laid off by banks, securities companies and other financial institutions. Citigroup continued to suffer losses (recording losses of $5.1 billion loss and more than $15 billion in write downs) and laid off 4,200 people in January 2008 and another 9,000 layoffs were announced in April for the remaining part of 2008 (Onaran, 2008; Ellis, 2008).

When the subprime mortgage crisis first showed signs of occurring, it was thought of as nothing more than a domestic issue that would impact U.S. housing markets alone. But U.S. subprime mortgage crisis has surfaced in a variety of ways all over the world. One example of this would be the announcement made by the Bank of China in August 2007 that it held $9.7 billion dollars of American Subprime debt (Shaw, 2007). Another instance would be the crashing of Korean markets in January 2008 because investors went on selling spree, selling all the shares they held in US mortgages. The global economy has definitely been affected because investors all over the world had invested in US subprime mortgages and according to the International Monetary Fund (IMF), “the worldwide losses stemming from the US subprime mortgage crisis could run to $945 billion” (Finfacts team, 2008).

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Conclusion

The burst in the housing bubble and the consequent subprime delinquencies, foreclosures have led to profound implications for financial institutions and the world economy at large. Financial institutions continue to be troubled by their weakening balance sheets, financial markets suffer from the falling asset prices and the macroeconomic environment continues to be plagued by weakening global growth. This crisis has spread worldwide for the same reasons that can be gauged by the domestic situation described in the preceding discussion and as affirmed by the IMF, “the same overly benign global financial conditions, an inattention to appropriate risk management systems, and lapses in prudential supervision” (Finfacts team, 2008). However, Alan Greenspan (2007) predicts this crisis will pass without lasting ramifications: “after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.”

References

Bernanke, B. (2008). Financial Markets, the Economic Outlook, and Monetary Policy. Speech at the Women in Housing and Finance and Exchequer Club Joint Luncheon, Washington, D.C. Web.

Browning, L. (2007). The Subprime Loan Machine. The New York Times. Web.

Christie, L. (2008). Homeowners: Can’t pay? Just walk away. CNN Money. Web.

Cowen, T. (2008). So We Thought. But Then AgainThe New York Times. Web.

Coy, P. (2008). Housing Meltdown. Business Week. Web.

CSI: Credit Crunch. (2007). The Economist. Web.

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Ellis, D. (2008). Citi posts loss, cuts 9,000 more jobs. CNN Money. Web.

FDIC Quarterly Profile. Web.

Finfacts team. (2008). IMF says worldwide losses stemming from the US subprime mortgage crisis could run to $945 billion. Web.

Getting Worried Downtown. (2007). The Economist. Web.

Greenspan, A. (2007). The Roots of the Mortgage Crisis. The Wall Street Journal. Web.

New Home Sales Fell by Record Amount in 2007. (2008). MSNBC. Web.

Onaran, Y. (2008). Subprime Losses Top $379 Billion on Balance-Sheet Marks: Table. Bloomberg. Web.

RealyTrac staff. (2008). U.S. Foreclosure Activity Increases 75 Percent in 2007. Web.

Roubini, N. (2007). From the current subprime credit crunch to a generalized credit crunch: the incoming financial train wreck. Web.

Shaw, R. (2007). Subprime Effects Felt Worldwide. Straight Stocks. Web.

U.S. Census Bureau. (2006). Web.

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