Sub prime financial crisis 2008Sub prime financial crisis 2008

Before we delve further into discussion on subprime crisis, it is necessary to explain several little understood terms, namely subprime, subprime lending and subprime borrowers. In the United States, subprime lending refers to banks practice of extending loan facilities for purchase of home to subprime borrowers (Dorsey and Rockwell,2005,p.59).

According to Ashcraft and Schuermann (2008,p.14), the term subprime borrower generally refers to a 'risk-laden' borrower i.e. borrower who is likely to default in loan payment and generally display a range of credit risk characteristics, including one or more of the following:1) Two or more 30-day delinquencies in then last 12 months, or one or more 60-day delinquencies in the last 24 months;

2) Judgment,foreclosure,repossession, or charge-off in the prior 24 months;

3) Bankruptcy in the last 5 years;

4) Debt service-to-income ratio of 50 percent or greater or otherwise limited ability to cover family living expenses after deducting total debt repayment from monthly income.

If it weren't for the subprime loan market, these potential buyers might not be able to purchase home but extending loan facilities to buyers in each of these categories entails greater risk for the lending banks.Banks are willing to extend loan facilities to these riskier borrowers in exchange for a much higher interest rates and fees than the one they charge to their prime lenders(Dorsey and Rockwell,2005,p.59).

Subprime loan are secured by mortgage of the home purchased using the loan facility i.e. the borrowers mortgage their homes to the banks that provide them the loan facility to purchase that home. The subprime crisis has its origin in the boom in the secondary market for subprime loans i.e. the practice of some Wall Street firms and large mortgage banking companies buying subprime loans and use them as the basis for issuing private label mortgage-backed securities (Dorsey and Rockwell,2005,p.61). These are called trading in derivative, a more technical explanation of this practice is provided by Conrad (2010,p.13) as follow :

Derivative products such as CDOs (Collateralized Debt Obligations) .... are structured financial products comprised of a variety of loans, bonds, mortgages and credit derivatives....For the most parts, CDOs were put together using home mortgages and then resold as investment products by the major Wall Street investment banks. These CDOs were structured to meet the requirements of the major US rating agencies which based their risk calculations on complicated economic models and statistical analysis.

The subprime lending model works on the expectation that borrowers will rely on refinancing for loan repayment i.e. loan to risky borrowers were often made with the expectation that, because of home appreciation, the borrower will later be able to refinance at a lower rate mortgage (after the home is refinanced, the monthly repayment will be significantly lower). However due to historically unanticipated depth of the fall in housing prices, these borrowers could not refinance and in many cases they defaulted (Schwarcz,2010,p.70).

These defaults in turn affected Wall Street in that it caused substantial amounts of investment grade-rated subprime mortgage-backed securities to default and the highest rated securities (AAA) to be downgraded.These in turn, scared investors who had always believed that 'investmen grade' meant relative freedom from default and that AAA meant ironclad investment safety. The nett result was Wall Street investors started losing confidence in ratings and avoiding debt securities i.e. securities backed by mortgage (Schwarcz,2010,p.70).

The downhill cascade of what is now known as the subprime crisis started from thereon. Fewer investors meant that the price of debt securities started falling and the market prices of mortgage backed securities collapsed substantially below the intrinsic value of the mortgage assets underlying those securities. This collapse in market prices meant that banks and other financial institutions holding mortgage-backed securities had to write down their value. That caused these institutions to be more financially risky which in turn added another trickle in the cascade : many parties stopped dealing with them for fears that these institutions might themselves default on their contractual obligation. This is exacerbated by the refusal of the US government to bail out investment bank Lehmann Brothers in mid-September 2008 (Schwarcz,2010,p.70).

In early October 2008, the US government stepped in to rescue with the Emergency Economic Stabilization Act of 2008 which tasked the Federal Reserve Bank to protect US banks and financial institutions against collapse. This narrow focus of the Federal Reserve Bank reflected its historical and legal mission i.e. to act as lender of the last resort to banks and financial institutions (Schwarcz,2010,p.70).

Literature on subprime financial crisis blames insatiable appetite of bankers for huge profits and the unethical accounting practice to enable banks to register profitability as the cause of the subprime crisis. According to Conrad (2010,p.13), the obsession with shareholder value lead to banks unethical practice to increase their shareholder value. The simplest way to increase shareholder value and therefore stock value was to boost the firm's returns on investment (ROI). In order to obtain favourable ratings from the rating agencies, the banks were required to show a 25% ROI of capital.These Wall Streets banks utilise CDOs to boost ROI since CDOs were not required to be rated as loans but could be rated as security products. This classification allowed investment banks to realize additional profits by selling them on to other investors and not hold bank funds in reserve as collateral and therefore positively influence the banks balance sheets.

It is beyond comprehension how bankers (who invested in CDOs) could have such unlimited trust in the rating agencies and their recommendations. According to Conrad further, it should be expected that senior management planning an investment of billions of dollars would at least perform some degree of due diligence to gain an understanding of the rating agency's procedures. To rely so completely on the judgment of a third party (the rating agencies) is completely irresponsible (Conrad,2010,p.24).

This paper submits that in order for the subprime crisis not to repeat itself, tight government regulations must be in place. In this regard, the US government has taken several regulatory measures. For example, the US Securities and Exchange Commission (SEC) has strengthened its examination and oversight of broker-dealers, investment advisors and mutual funds and has stepped up investigations of abusive short selling (Shiller,2011,p.2).