Us Sub Prime

8/14/2019 Us Sub Prime

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Yusuf Onur Eker2004104444

EC 344

MONEY, BANKING AND FINANCIAL INSTITUTIONS

TERM PROJECT

Topic 17: U.S. MORTGAGE CRISIS BEFORE AND AFTER

US Sub prime Mortgage Crisis


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The mortgage crisis is the basis of current bank crisis, emerged in 2006 in U.S. In

this paper , the reasons of the crisis, how did it emerged and the regulations after the crisis

topics are covered:

The Beginning of Everything: Sub prime Mortgage Loans

In the past five years the private sector expanded its role in the mortgage bond

market, specializing new types of mortgages such as sub-prime lending to borrowers

who do not have good credit histories, level of income etc. The size of the sub prime

mortgage loans increased over years, the share of sub prime mortgages to total

originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and

20% ($600 billion) in 2006 :

1) The Rise of the Mortgage Bond Market

2) Sub prime Mortgage Market Growth


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3) The Share of Sub prime Mortgage in the total Mortgage Bond Market

What are the details of these Subprime Mortgage Loans exactly ? To sum up these

were the loans to borrowers with poor credit. As you can see above at chart 2, sub prime

mortgage loans existed after 1998 and then gained a great share closer to 2006 and 2007.

These loans have higher interest rates to compensate the risk posed by the borrowers,

most of these loans are ARMs (Adjustable rate mortgages ), wth interest only payment

options, penalties for paying off the loan early, and low documentation requirements

which borrowers need just a little paperwork to borrow the loans. According to First

American LoanPerformance in 2006 %56 of the loans were liar loans which borrowers

misrepresent information to obtain the mortgage loans. These borrowers are also called

mortgage frauds. The increase in the number of mortgage frauds can be viewed from this

chart:


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As the interest rates are low and house prices are increasing the sub prime market

prospered. Home price appreciation gave borrowers a confidence that even if they fail to

pay their debt they can cover this debt by selling their home in appreciated prices. During

that period (which home prices are increasing over time) delinquency rates were too low

which supports what I stated above. This law delinquency rate masked potential problems

in the sub prime market convincing lenders and investors that sub prime loans will face

defaults and foreclosures at a low rate.

The sub prime mortgage market splitted into parts by ABS (asset backed

securities) and CDOs (collateralized debt obligations). The relationship between the

borrower and the lender has been divided among various parties which have its own

benefits from its specialized role in the cycle. This cycle will play an important role in the

future of mortgage crisis which is now turning into a banking crisis that we are seeing

currently in 2008.

How the Sub prime Market Collapsed?

Everything was going fine, during the early 2000s, interest rates fell, borrowing

demand is increased, mortgage lenders were happy that they are expanding their business

and making more and more profits, new lenders were entering the market

And the story began, after the increase in US interest rates and decrease in the

prices of US housing market the risk of borrowers to default is increased sharply. Defaults

and foreclosure activity dramatically increased as ARM interest rates are reset higher.

Subprimes started to default and could not pay their debts back. But this crisis was not

only a two-sided transaction. As I stated above there are MBS (mortgage backed

securities) and CDO (collateralized debt obligations) which lenders passed the rights of

the mortgage payments to third parties. After sub primes could not pay back their debt ,


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banks has written losses to their accounts. Under you can find some sharts which explains

the situation :

1) US interest rates

2) US House Price Trends

3) Percentage of home mortgages foreclosure


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What are the effects ?

In 2007 the crisis affected the financial markets as Dow Jones dropped sharply

during August 2007, which the investors started to escape from the market by taking their

money out of risky mortgage bonds and putting their money into commodities.

A-Institutions: Banks, hedge funds , mortgage lending institutions suffered great

losses. As in 2008 the loss is estimated like 280 billion US Dollars. To give an example

UBS AG Bank has suffered $37.7 billion, Citibank $39.1 billion , Merrill Lynch

investment bank $29.1 billion etc. Expected losses in the next periods are even higher

B-Home prices: Another effect of this crisis is on home prices. At the end of 2007

home prices had fallen approximately %8 from their peak in 2006. Also the consruction

of houses dropped in the same period by the collapse of the industry.


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After the crisis: Steps and Regulations:

After the crisis the most important steps are taken by the Federal Reserve by

lowering the federal funds rate from %5.25 to %2 and the discount rate from %5.75 to

%2.25 through separate actions.

Fed interest rate cuts:


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In addition to that The Fed, the European Central Bank, and the Japanese Central

bank are all pumping liquidity into the economic global system. The injection of FED can

be clearly seen in the Bear Sterns case which is a large financial institution with

substantial mortgage-backed securities (MBS) investments and plunged in value. FED

helped JP Morgan with its purchase of Bear Stearns. These injections shows how liquidity

is an important problem during that period. After the crisis turned into a global banking

crisis liquidity become the main problem for the banks.

Top ten banking worries

Today

1. Liquidity2. Credit risk3. Credit spreads4. Derivatives5. Macroeconomic trends6. Risk management7. Equities8. Too much regulation9. Interest rates10. Hedge funds

20061. Too much regulation2. Credit risk3. Derivatives4. Commodities5. Interest rates6. High dependence on tech7. Hedge funds

8. Corporate governance9. Emerging markets10. Risk management

In addition to Fed there were other institutions who responded to this crisis. The Basel

Commitee on Banking Supervision come out with new regulations like proposing higher

capital charges for handling asset backed securities, closing loopholes that let banks

harbour risks out of regulatory sight and raising costs for holding volatile trading


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positions. The Committee thinks that these rules will increase the cost of banking but also

will develop much more stable banking system.

U.S. President George W. Bush annouced the Hope Now Alliance plan to help to

mortgage borrowers. This plan tried to adjust and refinance the mortgage debts of

homeowners. Hope Now Alliance Program helped more than %7 of Subprime loans

outstanding in 2007. Also the president signed a legislation a 168 billion rescue

package- to booster the economic activity in U.S. But this package lead an increase in oil

and food prices in 2008 that the package couldnt have a good effect.

Expectations:

According to the IMF Background Paper on the Update of the Global and Regional

Outlook , IMF forecasts the world economy to expand %3.7 in 2008. The IMF gave a

%25 chance that global growth will drop to %3 or less n 2008 and 2009 , which is close

to the global recession.

IMF forecasts the growth of US economy by % 0.5 in 2008 and %0.6 in 2009.

In May, 2008 FED have pulled back their expectations for growth. The most

pessimistic of the group expect the U.S. economy not to grow at all this year. But they

also expect higher inflation than they did in January, a reason for the reluctance to keep

cutting rates. On average most of the Fed members expect the GDP for this year will rane

between %0 and %1.5 . Unemployment rates are expected to be between %5.3 and % 6 at

the end of the year. After the latests news about the food and oil prices , FED also

changed its expectations about the inflation that prices would rise 2,8 to 3.8 percent in

2008 .

FED also thinks that cuts in federal funds rate is enough to fight with the current

economical situation. Currently there is no need to have a further cut in federal funds rate

according to FED.


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According to economist Paul Krugman , there will be $1 trillion of losses on

mortgage back securities . In addition to that Krugman expects the home prices will drop

%25 on average . Despite the announcement from FED, Krugman thinks that federal

funds rate will be cut more and more going down to zero.

Getting out of the recession:

It is not official but it is a strong belief that U.S. economy is currently in a recession.

Home prices are dropping sharply, inflation is rising, people are consuming less, banks

are announcing their negative balances and son on.

So what should FED do in order to stabilize the financial system again? According to

me pumping billions of dollars is not a good way to do it because it can end up with a

moral hazard. In addition to that billions of dollars is just a small portion of the securities

market so it will not have a good effect in the future. Currently new regulations is the best

way to deal with the system, preventing banks to have risky operations will decrease the

chance of having crisis in the future. FED should also extend its powers, from banking

system to all financial institutions, to intervene the possible crisis quickly.

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