Question

In Chapter 27 you are introduced to the basic operation of saving and loan institutions - banks that take deposits and then loan a portion of those deposits out to borrowers.

In the 2000s these institutions significantly increase the number of subprime mortgages they offered. Note: subprime mortgages are loans to people who have not-so-good credit and/or ability to make loan payments for home purchases. After the 2008-09 recession, they became much less common.

Your assignment is to submit a paper, 1-2 pages, in which you argue that subprime mortgages are or are not good for the country and the individuals who take these mortgages. Whichever position you take (for or against), please consider how more (or less) of these loans could have positive and negative effects.

Answer 1

Question No 1

In my opinion, subprime mortgages are not good for a country. There were many causes of the crisis, we can blame the financial institutions, regulators, credit agencies, government housing policies, and consumers, who are the parties related in the crisis. Two proximate causes were the rise in subprime lending and the increase in housing speculation. The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market. When home prices fell in 2006, it triggered defaults.The risk spread into mutual funds, pension funds, and corporations who owned these derivatives. The ensuing 2007 banking crisis and the 2008 financial crisis produced the worst recession since the Great Depression.

The Causes or Impact of the Subprime Mortgage Crisis

Hedge funds, banks, and insurance companies caused the subprime mortgage crisis. Hedge funds and banks created mortgage-backed securities. The insurance companies covered them with credit default swaps. Demand for mortgages led to an asset bubble in housing. When the Federal Reserve raised the federal funds rate, it sent adjustable mortgage interest rates skyrocketing. As a result, home prices plummeted, and borrowers defaulted. Derivatives spread the risk into every corner of the globe. That caused the 2007 banking crisis, the 2008 financial crisis, and the Great Recession. It created the worst recession since the Great Depression.

Hedge Funds Played a Key Role in the Crisis

Hedge funds are always under tremendous pressure to outperform the market. They created demand for mortgage-backed securities by pairing them with guarantees called credit default swaps.What could go wrong? Nothing, until the Fed started raising interest rates. Those with adjustable-rate mortgages couldn't make these higher payments. Demand fell, and so did housing prices. When they couldn't sell their homes, either, they defaulted. No one could price, or sell, the now-worthless securities. And American International Group (AIG) almost went bankrupt trying to cover the insurance. The subprime mortgage crisis was also caused by deregulation. In 1999, the banks were allowed to act like hedge funds. They also invested depositors' funds in outside hedge funds. That's what caused the Savings and Loan Crisis in 1989. Many lenders spent millions of dollars to lobby state legislatures to relax laws. Those laws would have protected borrowers from taking on mortgages they really couldn't afford.

Derivatives Drove the Subprime Crisis

Banks and hedge funds made so much money selling mortgage-backed securities, they soon created a huge demand for the underlying mortgages. That's what caused mortgage lenders to continually lower rates and standards for new borrowers. Mortgage-backed securities allow lenders to bundle loans into a package and resell them. In the days of conventional loans, this allowed banks to have more funds to lend. With the advent of interest-only loans, this also transferred the risk of the lender defaulting when interest rates reset. As long as the housing market continued to rise, the risk was small. The advent of interest-only loans combined with mortgage-backed securities created another problem. They added so much liquidity in the market that it created a housing boom.

Subprime and Interest-Only Mortgages Don't Mix

Subprime borrowers are those who have poor credit histories and are therefore more likely to default. Lenders charge higher interest rates to provide more return for the greater risk. So, that makes it too expensive for many subprime borrowers to make monthly payments. The advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them. But, it increased the risk to lenders because the initial rates usually reset after one, three, or five years. But the rising housing market comforted lenders, who assumed the borrower could resell the house at the higher price rather than default.

Collateralized Debt Obligations

The risk was not just confined to mortgages. All kinds of debt were repackaged and resold as collateralized debt obligations. As housing prices declined, many homeowners who had been using their homes as ATMs found they could no longer support their lifestyle. Defaults on all kinds of debt started to creep up slowly. Holders of CDOs included not only lenders and hedge funds. They also included corporations, pension funds, and mutual funds. That extended the risk to individual investors. The real problem with CDOs was that buyers did not know how to price them. One reason was they were so complicated and so new. Another was that the stock market was booming. Everyone was under so much pressure to make money that they often bought these products based on nothing more than word of mouth.

Downturn in Real Estate Prices Triggered Disaster

Every boom has its bust. In 2006, housing prices started to decline. Subprime borrowers couldn't sell their houses at a higher price than they paid for them. Banks weren’t willing to refinance when the home's value was less than the mortgage. Instead, banks foreclosed.  

The Subprime Mess Spread to the Banking Industry

Many of the purchasers of CDOs were banks. As defaults started to mount, banks were unable to sell these CDOs, and so had less money to lend. Those who had funds did not want to lend to banks that might default. By the end of 2007, the Fed had to step in as a lender of last resort. The crisis had come full circle. Instead of lending too freely, banks lent too little, causing the housing market to decline further.

How a Little Accounting Rule Made Things Much Worse

Some experts also blame mark to market accounting for the banks' problems. The rule forces banks to value their assets at current market conditions.  First, banks raised the value of their mortgage-backed securities as housing costs skyrocketed. They then scrambled to increase the number of loans they made to maintain the balance between assets and liabilities.  In their desperation to sell more mortgages, they eased up on credit requirements. They loaded up on subprime mortgages. When asset prices fell, the banks had to write down the value of their subprime securities. Now banks needed to lend less to make sure their liabilities weren't greater than their assets. Mark to market inflated the housing bubble and deflated home values during the decline.

In 2009, the U.S. Financial Accounting Standards Board eased the mark to market accounting rule. This suspension allowed banks to keep the value of the MBS on their books. In reality, the values had plummeted. If the banks were forced to mark their value down, it would have triggered the default clauses of their derivatives contracts. The contracts required coverage from credit default swaps insurance when the MBS value reached a certain level. It would have wiped out all the largest banking institutions in the world.

The Bottom Line

The ultimate cause of the subprime mortgage crisis boils down to human greed and failed wisdom. The prime players were banks, hedge funds, investment houses, ratings agencies, homeowners, investors, and insurance companies.

Banks lent, even to those who couldn’t afford loans. People borrowed to buy houses even if they couldn’t really afford them. Investors created a demand for low premium MBS, which in turn increased demand for subprime mortgages. These were bundled in derivatives and sold as insured investments among financial traders and institutions.

So when the housing market became saturated and interest rates started to rise, people defaulted on their loans which were bundled in derivatives. This was how the housing market crisis brought down the financial sector and caused the 2008 Great Recession.  

Parties related to the subprime mortgage

• The subprime mortgage crisis was the collective creation of the world's central banks, homeowners, lenders, credit rating agencies, underwriters, and investors.
• Lenders were the biggest culprits, freely granting loans to people who couldn't afford them because of free-flowing capital following the dotcom bubble.
• Borrowers who never imagined they could own a home were taking on loans they knew they may never be able to afford.
• Investment banks, ratings agencies, and hedge funds also had a role to play in the subprime mess.
• Investors hungry for big returns bought mortgage-backed securities at ridiculously low premiums, fueling demand for more subprime mortgages.

The Biggest Culprit: The Lenders

Most of the blame is on the mortgage originators or the lenders. That's because they were responsible for creating these problems. After all, the lenders were the ones who advanced loans to people with poor credit and a high risk of default. Here's why that happened. When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors looked for riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their own investment returns. In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were—rates were low, the economy was healthy, and people were making their payments.

Partner In Crime: Homebuyers

We should also mention the homebuyers who were far from innocent in their role in the subprime mortgage crisis. Many of them played an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages such as 2/28 and interest-only mortgages. These products offered low introductory rates and minimal initial costs such as no down payment. Their hopes lay in price appreciation, which would have allowed them to refinance at lower rates and take the equity out of the home for use in another spending. However, instead of continuing to appreciate, the housing bubble burst, taking prices on a downward spiral with it. When their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created with the fall of housing prices. They were, therefore, forced to reset their mortgages at higher rates they couldn't afford, and many of them defaulted. Foreclosures continued to increase through 2006 and 2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression there was no risk to these mortgages and the costs weren't that high. But at the end of the day, many borrowers simply took on mortgages they couldn't afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. Exacerbating the situation, lenders and investors who put their money into securities backed by these defaulting mortgages ended up suffering. Lenders lost money on defaulted mortgages as they were increasingly left with property worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.

Investment Banks Worsen the Situation

The increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more, and the snowball began to build. A lot of the demand for these mortgages came from the creation of assets pooling mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize them into bonds, which were sold to investors through CDOs.

Rating Agencies: Possible Conflicts of Interest

A lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the AAA-rating given to the higher quality tranches. If the ratings were more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad. Moreover, some have pointed to the conflict of interest of rating agencies which receive fees from a security's creator and their ability to give an unbiased assessment of risk. The argument is rating agencies were enticed to give better ratings to continue receiving service fees, or they ran the risk of the underwriter going to a different agency. Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is they were simply bringing bonds to market based on market demand.

Fuel to the Fire: Investor Behavior

Just as the homeowners are to blame for their purchases gone wrong, much of the blame must also be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums instead of Treasury bonds. These enticingly low rates are what ultimately led to such a huge demand for subprime loans. In the end, it is up to the individual investors to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the AAA CDO ratings at face value.

Don't Forget the Hedge Funds

Another party added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. To illustrate, there is a hedge fund strategy best described as credit arbitrage. It involves purchasing subprime bonds on credit and hedging the positions with credit default swaps. This amplified demand for CDOs. By using leverage, a fund could purchase many more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs. Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls.

Here's the timeline from the early warning signs in 2003 to the collapse of the housing market in late 2006.

February 21, 2003: Buffett Warns of Financial Weapons of Mass Destruction

June 2004-June 2006: Fed Raised Interest Rates

August 25-27, 2005: IMF Economist Dr. Raghuram Rajan Warns the World's Central Bankers

December 22, 2005: Yield Curve Inverts

September 25, 2006: Home Prices Fall for the First Time in 11 Years

November 2006: New Home Permits Fall 28 Percent

How the Subprime Crisis Created the 2007 Banking Crisis

As home prices fell, bankers lost trust in each other. They were afraid to lend to each other because if they could receive mortgage-backed securities as collateral. Once home prices started falling, they couldn't price the value of these assets. But if banks don't lend to each other, the whole financial system starts to collapse.