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 wererates were low, the economy was healthy, and people were making their payments. Who could have foretold what actually happened?
Despite being a key player in the subprime crisis, banks tried to ease the high demand for mortgages as housing prices rose because of falling interest rates.
Two Myths About What Caused The Crisis
Fannie Mae and Freddie Mac were government-sponsored enterprises that participated in the mortgage crisis. They may have even made it worse. But they didn’t cause it. Like many other banks, they got caught up in the practices that created it.
Another myth is that the Community Reinvestment Act created the crisis. That’s because it pushed banks to lend more to poor neighborhoods. That was its mandate when it was created in 1977.
In 1989, Financial Institutions Reform, Recovery, and Enforcement Act strengthened the CRA by publicizing banks’ lending records. It prohibited them from expanding if they didn’t comply with CRA standards. In 1995, President Clinton called on regulators to strengthen the CRA even more.
But, the law did not require banks to make subprime loans. It didn’t ask them to lower their lending standards. They did that to create additional profitable derivatives.
Loose Lending Standards In The Housing Market
In the decade leading up to 2007, real estate and property values had been rising steadily, encouraging people to invest in property and buy homes.
By early to mid-2000s, the residential housing market was booming. To capitalize on the boom, mortgage lenders rushed to approve as many home loans as they could, including to borrowers with less-than-deal credit.
These risky loans, called subprime mortgages, would later become one of the main causes of the Great Recession.
A subprime mortgage is a type of loan issued to borrowers with low credit ratings. A prospective subprime borrower might have multiple dings on their credit history or dubious streams of income. In fact, the loan verification process was so lax at the time that it drew its own nickname: NINJA loans, which stands for “no income, no job, and no assets.”
Because subprime mortgages were granted to people who previously couldn’t qualify for conventional mortgages, it opened the market to a flood of new homebuyers. Easy housing credit resulted in the higher demand for homes. This contributed to the run-up in housing prices, which led to the rapid formation of the 2000s housing bubble.
In the rush to take advantage of a hot market and low interest rates, many homebuyers took on loans without knowing the risks involved. But the common wisdom held that subprime loans were safe since real estate prices were sure to keep rising.
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Federal Response To The Great Recession
Decisive action by the Federal Reserve, along with massive government spending, kept the US economy from total collapse.
Aiming to boost borrowing and capital investment, the Fed reduced interest rates to zero for the first time ever and launched a quantitative easing program, whereby it bought financial assets to add more money into the economy.
As for the federal government, it creating two key programs aimed to provide emergency assistance:
- Troubled Asset Relief Program : This initiative helped stabilize the economy by having the government purchase up to $700 billion in toxic assets, with most of the money used to bail out troubled banks.
- The American Recovery and Reinvestment Act : A stimulus package enacted in 2009, ARRA implemented a series of tax cuts, government spending mandates, loan guarantees, and unemployment benefits to help kickstart the economy.
These measures were effective, preventing the recession from developing into a decade-long affair, like the Great Depression. The stock market began to rebound in 2009. Still, other aspects of the economy took several years to recover what economists characterize as an L-shaped recovery.
Us House Prices Fell Borrowers Missed Repayments
The catalysts for the GFC were falling US house prices and a rising number ofborrowers unable to repay their loans. House prices in the United States peakedaround mid 2006, coinciding with a rapidly rising supply of newly built houses insome areas. As house prices began to fall, the share of borrowers that failed tomake their loan repayments began to rise. Loan repayments were particularlysensitive to house prices in the United States because the proportion of UShouseholds with large debts had risen a lotduring the boom and was higher than in other countries.
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What Was The Reason For 2008 Recession
The major causes of the initial subprime mortgage crisis and following recession include the Federal Reserve lowering the Federal funds rate and creating a flood of liquidity in the economy, international trade imbalances, and lax lending standards contributing to high levels of developed country household debt and
Subprime Mortgage: The Cause Of 2008 Financial Crisis Explained
Its been more than a decade since 2008 financial crisis originated in USA. Since then, there has been several publications pointing at the causes of the crisis. The most common cause is assigned to subprime mortgage.Subprime mortgage refers to Mortgage Backed Securities , but of a very special category. We will read more why Im referring it as very special.
It was Lew Ranieri who first coined the theory of securitisation of mortgages. This eventually let to the formation of our modern day mortgage backed securities. So first blame of the crisis must be on him.
In theory, Lew Ranieri can be blamed. But practically there were series of mistakes, ignorances, and malpractices which eventually led to the global crisis.
In this article we will try to discuss the chain of activities which gave birth to subprime mortgages, which in turn caused the 2008 financial crisis.
Allow me to explain the events in a sequential manner.
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How Much Did Home Values Drop In 2008
The real estate Web site Zillow.com calculated that home values have dropped 8.4% year-over-year during the first three quarters of 2008, compared with the same period of 2007. Some 11.7 million Americans are now underwater, owing more on their mortgage balances than their homes are worth.
Arguments Against Stimulus By Tax Cuts
There is significant debate among economists regarding which type of fiscal stimulus generates the largest “bang for the buck,” which is technically called a fiscal multiplier. For example, a stimulus of $100 billion that generates $150 billion of incremental economic growth would have a multiplier of 1.5. Since the U.S. Federal government has historically collected about 18% of GDP in tax revenue, a multiplier of approximately 5.56 would be required to prevent a deficit increase from any type of stimulus. Technically, the larger the multiplier, the less the impact on the deficit because the incremental economic activity is taxed.
Various economic studies place the fiscal multiplier from stimulus between zero and 2.5. In testimony before the Financial Crisis Inquiry Commission, economist reported that infrastructure investment provided a high multiplier as part of the American Recovery and Reinvestment Act, while spending provided a moderate to high multiplier and tax cuts had the lowest multiplier. His conclusions by category were:
- Tax cuts: 0.32-1.30
- Investment: 1.57
To summarize the above studies, infrastructure investment and spending are more effective stimulus measures than tax cuts, due to their higher multipliers. However, any type of stimulus spending increases the deficit.
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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.
How Investors Of Mbs Made Money
Suppose there is a MBS which was worth $1 billion. It was capable of earning $57.2 million p.a. for next 30 years.
From where this earning was coming? From the monthly payments made by the borrowers again their mortgages.
These monthly payments received by the investment bank , will be proportionately distributed among the investors in proportion to their shareholdings. If there are one billion number shares, then income per share of this MBS will be $0.0572.
- What will be the yield per share for the investors?
- Income: $0.0572.
- Yield: 4.77% .
It means, by buying a share of MBS, the investor will earn a return of 4.77% upon his/her investment.
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How Has Mortgage Finance Changedor Notsince The Crisis
Deregulation of the financial industry tends to be followed by a financial crisis of some kind, whether it be the crash of 1929,the savings and loan crisis of the late 1980s, or the housing bust 10 years ago. But though anger at Wall Street was at an all-time high following the events of 2008, the financial industry escaped relatively unscathed.
In fact, much of the mortgage securitization chain remains intact today. Lenders still sell their mortgages to Fannie Mae and Freddie Mac, which still bundle the mortgages into bonds and sell them to investors. And the bonds are still spread throughout the financial system, which would be vulnerable to another American housing collapse.
While this understandably elicits alarm in the news media, theres one key difference in housing finance today that makes a financial crisis of the type and scale of 2008 unlikely: the riskiest mortgagesthe ones with no down payment, unverified income, and teaser rates that reset after two yearsare simply not being written at anywhere close to the same volume. It is much harder to get a mortgage today.
The qualified mortgage provision of the 2010 Dodd-Frank reform bill, which went into effect in January 2014, gives lenders legal protection if their mortgages meet certain safety provisions. Qualified mortgages cant be the type of risky loans that were issued en masse prior to the crisis, and borrowers must meet a certain debt-to-income ratio.
What Caused The Global Financial Crisis 2007
The 2007 financial crisis is the breakdown of trust that occurred between banks the year before the 2008 financial crisis. It was caused by the subprime mortgage crisis, which itself was caused by the unregulated use of derivatives. Despite these efforts, the financial crisis still led to the Great Recession.
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Is It Good To Buy A House In A Recession
When the economy is in decline, it does mean that house prices can be lower. This is because recessions lead to a loss of jobs and income, making people less willing to make large investments. Its worth nothing that while purchase prices will be lower, you may need a larger deposit than you would in a healthy economy.
Financial And Economic Effects Of The Subprime Mortgage
According to Tsanis , there was declared bankruptcy by most of the banks and financial companies as borrowers defaulted in payments. Lending also became difficult on the bankers as the crisis tightened liquidity.
The large number of defaulters meant that the financial institution lost their money in the hands of the borrowers and this in a way tied their lending hands. Furthermore, possible implications could include a large number of bad debts from the mortgage defaulters who could not manage to repay their loans due to the financial crisis that resulted from the spill over of the subprime mortgage crisis.
The large number of defaulters could in addition be attributed to the fact that under normal circumstances, the borrowers could still be unable to repay since their credit worthiness was overlooked as they were being awarded the loans. The mortgage crisis also had its spill over into the general economy causing a larger financial crisis. This resulted into rise in unemployment as employers moved to cut costs for sustainability in the caused volatile economic environment .
As Jansen and co authors explained, the crisis had effects on stock markets. This was noticed not only in the United States, but globally. Major among the affected stock market were the Dow Jones and the German stock exchange market.
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Development Of The Crisis
The crisis is majorly attributed to the interest rates that that were greatly reduced. The subprime lending was another cartelist in the whole matter. The issue of subprime lending which was in a way an investment move by the financial institutions increased borrowing to even potential defaulters. Almost every willing individual could move in and acquire a mortgage. The house ownership then got to its rise and the increased demand pull saw the inflation in the real estate industry.
People even mortgaged for other purposes. The natural market forces stepping in, corrected the inflated prices and the result was a drastic fall in real estate values. The defaulting borrowers had effects on the financial institution and the Federal Reserve moved in to correct the situation by increasing the interest rates though many argued that it was a late move .
How Did The Subprime Mortgage Crisis Start
How did the U.S. economy get to a point where in 2007, a full-on housing crisis began?
It doesn’t happen overnight. In the early-to-mid 2000s, interest rates on house payments were actually quite low. In what looked to be a solid economy after a brief early 2000s recession, more and more people with struggling credit were able to qualify for subprime mortgages with manageable rates, and happily acted on that.
This sudden increase in subprime mortgages was due in part to the Federal Reserve’s decision to significantly lower the Federal funds rate to spur growth. People who couldn’t afford homes or get approved for loans were suddenly qualifying for subprime loans and choosing to buy, and American home ownership rose exponentially.
Real estate purchases rose not only for subprime borrowers, but for well-off Americans as well. As prices rose and people expected a continuation of that, investors who got burned by the dot com bubble of the early 2000s and needed a replacement in their portfolio started investing in real estate.
Housing prices were rising rapidly, and the number of subprime mortgages given out was rising even more. By 2005, some began to fear that this was a housing bubble. From 2004-2006, the Federal Reserve raised the interest rate over a dozen times in an attempt to slow this down and avoid serious inflation. By the end of 2004, the interest rate was 2.25% by mid-2006 it was 5.25%.
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Also A Large Policy Response
Despite the Australian financial system being in a much better position before theGFC, given the magnitude of the shock to the global economy and to confidence morebroadly, there was also a large policy response in Australia to ensure that theeconomy did not suffer a major downturn. In particular, the Reserve Bank lowered thecash rate significantly, and the Australian Government undertook expansionary fiscalpolicy and provided guarantees on deposits at and bonds issued by Australian banks.
Following the crisis, APRA implemented the stronger global banking regulations inAustralia. Together, APRA and the financial market and corporate regulator, theAustralian Securities and Investments Commission, have also strengthened lendingstandards to make the financial and private sectors more resilient.
Arguments For Systematic Refinancing
The Economist described the issue this way: “No part of the financial crisis has received so much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping over America. Government programmes have been ineffectual, and private efforts not much better.” Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one million in a typical year.
Critics have argued that the case-by-case loan modification method is ineffective, with too few homeowners assisted relative to the number of foreclosures and with nearly 40% of those assisted homeowners again becoming delinquent within 8 months.
On 18 February 2009, economists Nouriel Roubini and recommended an “across the board” reduction of mortgage principal balances by as much as 20-30%. Lowering the mortgage balance would help lower monthly payments and also address an estimated 20 million homeowners that may have a financial incentive to enter voluntary foreclosure because they are “underwater” .
Roubini has further argued that mortgage balances could be reduced in exchange for the lender receiving a warrant that entitles them to some of the future home appreciation, in effect swapping mortgage debt for equity. This is analogous to the bondholder haircut concept discussed above.
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Increased Borrowing By Banks And Investors
In the lead up to the GFC, banks and other investors in the United States and abroadborrowed increasing amounts to expand their lending and purchase MBS products.Borrowing money to purchase an asset magnifiespotential profits but also magnifies potential losses.As a result, when houseprices began to fall, banks and investors incurred large losses because they hadborrowed so much.
Additionally, banks and some investors increasingly borrowed money for very shortperiods, including overnight, to purchase assets that could not be sold quickly.Consequently, they became increasingly reliant on lenders which included otherbanks extending new loans as existing short-term loans were repaid.