The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets
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IJER, Vol. 10, No. 1, January-June, 2013, pp. 73-95 THE ROOT CAUSES OF THE SUBPRIME MORTGAGE CRISIS AND THE IMPACT ON FINANCIAL MARKETS LUIS EDUARDO RIVERA-SOLIS* Dowling College, Thomas Tallerico, Dowling College ABSTRACT The subprime financial crisis of 2007 and its subsequent impact has shaken the financial system of the US and the world. It is the purpose of this paper to examine the roots of this crisis and its direct impact on financial institutions such as Lehman Brothers, American International Group (AIG) , Fannie Mae and Freddie Mac, private mortgage companies, and the US government’s response to the crisis. It concludes with recommended solutions to this problem. JEL CLASSIFICATION: G21. 1. BACKGROUND The subprime mortgage financial crisis of 2007 that nearly laid waste to the nation’s economy brought a sharp rise in home foreclosures, which started in the United States in 2006 and ultimately became a global financial crisis within a year. The root of the crisis was calamitous lending of “subprime” mortgage loans, issued to higher risk borrowers with low income, low FICO scores (less than 620), high loan to value ratios, and questionable credit history. Schloemer et al., (2006) provide an excellent analysis of how homeowners have fared during the period 1998 to 2006. However, the real story dates back five years to the loosening of credit after the September 11th attacks on America. In response to the attacks, during 2001 the Federal Reserve cut interest rates dramatically, with the Fed Funds rate hitting 1% in 2003. The Federal Reserve’s goal was to use low interest rates to encourage borrowing, which ultimately should drive spending and investing. (Barnes, 2009) The government became the cheerleader as the American public went on a buying spree fueled by cheap credit. The real estate market began to explode as the number of homes sold and the prices they sold for increased dramatically, beginning in 2002. Wall Street responded to the frenzy by creating exotic derivative instruments called Collateralized Debt Obligations (CDOs) and Credit Default Swaps (CDS). The subprime mortgages were used as underlying assets for these derivatives. The growth of the CDO is illustrated in Fig. 1 below: * Corresponding author: Townsend School of Business, Dowling College, 150 Idle Hour Boulevard, Oakdale, New York 11769, E-mail: [email protected]. 74 Luis Eduardo Rivera-Solis Figure 1 Collateralized Debt Obligations Subprime mortgage lenders partnered with Wall Street investment banks to sell their risky debt. Subprime loans were packaged with other loans (of varying quality), given high credit ratings by rating agencies, and sold to investors. However, financial disaster Figure 2 Growth of Loan Origination Volume2001-2006 Source: Inside Mortgage Finance as presented in Sandra Thompson Testimony, March 22, 2007. The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 75 eventually engulfed the economy as the ratio of subprime mortgages to total mortgages increased from 9% in 1996 to 20% in 2006. Figure 2 reveals the dramatic rise in loan origination volume during the period 2001-2006. (Faten, and Scholpflocher, 2007) Customized loans, including interest-only repayment terms and low initial rates that later readjusted to higher rates (and thus higher payments), enticed borrowers to take mortgages that they wrongly assumed they could afford. With U.S. housing prices dramatically increasing during the last decade, refinancing was easily available. As housing prices began their downward plunge in 2006–2007, credit began to tighten and refinancing became ever more difficult. Foreclosure activity increased dramatically in 2007. By October 2007, 16% of subprime loans with adjustable rate mortgages (ARMs) were 90 days into default or in foreclosure, three times the foreclosure rate during 2005. Subprime ARMs roughly represented only 7% of the loans outstanding in the U.S., yet they accounted for 43% of the foreclosures started during the third quarter of 2007. Wall Street banks and mortgage lenders began to fail in response to the alarming rate of foreclosures as their fantastic new derivative products (of packaged mortgages called Asset Backed Securities) prove to be worthless. As bank failures rippled across America and ultimately the globe, financial distress gripped world economies. (Barnes, 2009) This chapter examines the havoc that the subprime mortgage crisis and the esoteric financial instruments created during this credit bubble had on world financial markets. In addition, the chapter explores whether financial regulatory reform can prevent a repeat of this economic crisis in the future. 2. SUBPRIME MORTGAGE CRISIS The current global economic recession has, as its roots, a vast array of causes. One of the main factors for the current deep recession has been the selling and securitization of subprime mortgages. As subprime mortgage lenders such as Countrywide Financial, American Home Mortgage, and New Century rapidly declared bankruptcy, the U.S. financial markets were gripped with the fear of a major global credit crunch, which ultimately could affect borrowers at every strata of the economy. New Century Financial, the nation’s largest lending company, saw its stock drop 84% and eventually filed for Chapter 11 bankruptcy. The U.S. government seized control of insurance giant American International Group Inc. in an $85 billion deal that signaled the intensity of its concerns about the danger a collapse could pose to the financial system. This reflects a dramatic turnabout for the government, which initially resisted overtures from AIG for some form of intervention to prevent the insurer from falling into bankruptcy. The Federal Deposit Insurance Corporation seized Washington Mutual and sold its banking assets to JP Morgan Chase for $1.9 billion. By the first week of October 2008, the Dow Jones Industrial Average responded to the crisis with its worst week in the past 75 years, losing 22.1% and 40% from its record high. The CBOE Volatility Index (VIX), (which shows the market’s expectation of 30-day volatility) is calculated from the implied volatilities of several different S&P 76 Luis Eduardo Rivera-Solis Figure 3 VIX index During the Subprime Mortgage Crisis Source: Chicago Mercantile Exchange. 500 index options. The index is meant to be a predictor and is calculated from call and put options. This index measures market risk and is referred to as the “investor fear gauge”. It rose above 80 in September 2008 as it reacted to the economic crisis as global markets continue to sink. As the crisis spread globally, Central banks were compelled to inject liquidity into rattled financial markets. Central Banks in the USA, England, China, Canada, Sweden, Switzerland, and the European Central Bank cut interest rates in a coordinated effort to bolster the sinking world economy. The real estate markets plummeted after unprecedented annual growth rates. As the first seismic quivers started showing on Wall Street, Lehman Brothers and other banks either declared bankruptcy or were bailed out and sold at fire sale prices. Ultimately, JP Morgan purchased Bear Stearns in 2008 at $10/share. The subsequent financial crisis centered on the U.S. housing market and Wall Street’s creativity in packaging mortgages into a new type of bond called a Collateralized Mortgage Obligation (CMO) or a Collateralized Debt Obligation (CDO), which were simply securities created from other securities. A CMO was structured as follows: Bonds of different levels of credit risk were created in order to generate cash- flow streams from borrowers to investors. By employing credit tranching, the securitized loans were divided into different classes depending on their risk level. The triple-A and double-A rated bonds were the top tranches. More subordinate bonds were below these top tranches. The lowest level bonds were the first loss tranche, which carries no rating and have the highest chance of default. Through credit tranching the senior bonds obtained investment grade status even though the debt was subprime. Not backing the triple-A tranche by specific loans but only by a set of rules governing cash flows from the loans protects the senior tranches from losses up to a predetermined level. The set of rules is defined as a CMO. Through their hedge funds, The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 77 banks were making side bets on other subprime bonds by purchasing hundreds of insurance policies called credit default swaps. These exotic securities, backed with subprime mortgages widely held by financial firms, lost most of their value. Fallout from the failing subprime mortgage market affected the credit markets, as well as domestic and global stock markets, and much of the world economy lay mired in a deep recession. (Barnes, 2009) Many began to wonder if this crisis was the result of a lack of government regulation of the over-the-counter derivative market, simple greed, or a combination of the two. (Craig, McCracken et al., 2008) 3. THE ROOTS OF SUBPRIME LENDING The subprime mortgage crisis only became headline news recently but dates back to the late 1990s and early 2000s. The threat of global terrorism after September 11, 2001, battered an already wounded economy, one that was just beginning to come out of the recession induced by the high tech bubble of the late 1990s. Although exciting new technologies fueled the high tech bubble, the bubble itself was a standard case of stock market hype and overshoot stemming from excitement over the growth of the Internet. In response to these economic woes, during 2001 the Federal Reserve cut rates drastically, and the fed funds’ rate sat at 1% in 2003, which in central banking parlance is essentially zero. The goal of a low federal funds rate is to expand the money supply and encourage borrowing, which should spur spending and investing.