IJER, Vol. 10, No. 1, January-June, 2013, pp. 73-95

THE ROOT CAUSES OF THE 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 , American International Group (AIG) , 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 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 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 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 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. The push for Americans to spend was emphasized and propagated throughout the population, and everyone was encouraged to buy to bolster the economy. It worked, and the economy began to steadily expand in 2002. About this time, a massive influx of mathematic Ph.D.s to Wall Street began creating esoteric financial models and carving up and reassembling existing financial Figure 4 Annual Growth of Subprime Lending 78 Luis Eduardo Rivera-Solis assets so they could be custom fit to investors’ needs. These structured new instruments had hidden time bombs that would explode at very inopportune times. The subprime mortgage market consists of loans to borrowers with high credit risk and the institutions used to originate service and finance these loans. (Lohr, 2009) Broadly speaking, the three major sectors of the private label mortgage market are subprime, Alt-A, and Jumbo. Several factors contributed to the fast growth of the subprime market but the main one was an increase in the rate of securitization. Securitization is the creation and issuance of debt securities whose payments of principal and interest derive from cash flows generated by separate pools of assets. Examples of these are mortgage-backed securities (MBS), of which the largest investors are mutual funds, hedge funds, insurance companies, and pension funds. Various credit innovations and a proliferating array of mortgage products also were available to the subprime borrower. Subprime and alternative-A mortgages accounted for about 15% of all mortgages during the period from 2001-2007. During this time, three of every four of mortgages issued in the United States were adjustable rate mortgages. In 2007 house prices in the United States began to decline. Refinancing and flipping houses, which had become an American pastime, became more difficult, and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. In addressing the economic crisis to the nation on September 24, 2008, former President George W. Bush stated, “The decline in the housing market has set off a domino effect across the U.S. economy. When home values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted on their mortgages. Investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses.” The Federal Deposit Insurance Corporation defined subprime lending as follows: “The term subprime refers to the credit characteristics of individual borrowers. Subprime borrowers typically have weakened credit histories that include payment delinquencies and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They also may display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. Subprime loans are loans to borrowers displaying one or more of these characteristics at the time of origination or purchase. Such loans have a higher risk of default than loans to prime borrowers.” Perhaps a better explanation comes from Associate Professor of Public Policy Studies and Economics from Duke University, Jacob Vigdor, who said, “They (subprime mortgages) open the housing market to those whose incomes and credit histories otherwise would preclude them from participat­ing.” No matter how one chooses to define them, one thing was certain; almost everyone qualified for a subprime mortgage based on a no-income-check policy, and the banks and mortgage companies were handing out these mortgages as fast as they could. The biggest names on Wall Street and Swiss investment banker Credit Suisse were all purchasing The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 79

Figure 5 Subprime Loan Delinquencies: September 1998-December 2006

Source: Faten, S. and Scholflocher, 2007. billions of dollars of subprime mortgages from nonbank lenders, securitizing them, and then resecuritizing them into CDOs, selling some of them overseas. A growing percentage of mortgages put into bonds were loans made to borrowers who either had bad credit or were considered income risks. Stated income mortgages generally worked like this: The borrowers stated their income and the lenders believed them. The borrowers got their mortgage at a slightly higher interest rate, and Wall Street enjoyed repackaging these high rate loans. These loans were more lucrative then the conventional high quality loans due to the higher fees charged to the borrower.

4. THE HOUSING BOOM AND MORTGAGE SECURITIZATION In the years leading up to the crisis, housing throughout the United States boomed, along with new ways to package and sell mortgages. Low interest rates and an overflow of capital in credit led to the housing market boom. Home ownership rate and national median home price reached all-time highs in years leading up to the crisis, topping out at 69.2 and 4.6 times the median household income respectively. Getting a home loan became easier, and more and more people received loans. Especially attracted were investors who bought properties, looking to flip them at a higher price in the future. This trend led to one of the bigger factors in the subprime mortgage crisis, the housing bubble. Housing Bubbles typically are characterized by rapid increases in the valuations of real property until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability. Decreases in home prices may follow that result in many owners finding themselves in a position of negative equity, a mortgage debt higher than the value of the property. Due to the increased demand for homes, the prices increased further, generating the need for more mortgages. However, if homeowners were struggling to make payments on their mortgages, due to the increased value of their 80 Luis Eduardo Rivera-Solis homes, they could refinance on the value of those homes, causing homeowners to go into more debt to pay off their existing debt. Many people ultimately ended up with mortgages worth more than the actual depressed value of their home. While homeowners were going into more debt and borrowing more (household debt reached $14.5 trillion in 2008), prices of homes kept rising. This escalation led to a high number of unsold homes and a high number of foreclosures. The increase in payments on adjustable rate mortgages and ultimately in foreclosures is at the heart of the crisis. When people could not make payments on their mortgages because of the adjusted payments, the housing bubble burst. People defaulting on their mortgage payments led to foreclosures, which led to more houses on the open market, which led to a surplus of houses with limited buyers, ultimately driving the prices of houses down. Mortgage companies stopped giving out high risk mortgages, leading to significant losses for many of the country’s top subprime mortgage lenders. Another problem with foreclosures is the difficulty in preventing them. Due to the mortgages being sold to investors in securitization, it is hard to keep track of exactly where the mortgages are and who the current owner of the mortgage is. In the past when a bank held a mortgage, it would work with the people who took out the mortgage to make sure that the loans were paid, but this was not the case with private investors holding the mortgages. Even though housing prices were going through the roof, people were not making any more money. From 2000 to 2007, the median household income stayed flat. The more housing prices rose, the more tenuous the whole situation became. No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they could not possibly afford, no matter what the mortgage machine tried, the borrowers just could not manage their debt, but they refused to accept the consequences. Meanwhile, the global economy and the housing market in particular were flourishing, due to excess capital around the world. People looked for low-risk investments, but because such investments are rare, money flowed into the U.S. mortgage market, partly due to securitization of mortgages. In an article titled the Subprime Mortgage Crisis Explained (2007), securitization is described as: An individual gets a mortgage loan from a broker. Then the broker sells the mortgage to a bank, which in its turn again sells the mortgage but this time to an investment firm on Wall Street. The securitization of mortgages, as well as the trading of mortgage- backed securities was a huge profit center for the likes of Bear Stearns, Lehman Brothers, and several other banks with bond trading desks. Such firms collect thousands of mortgages in one big pile and repackaged them. This in fact represents thousands of mortgage checks coming every month, a monthly income that was supposed to continue for the life of the mortgages. The firm in turn sells shares of that income to investors who are willing to buy them. Many investors calculated their risk using a method called the Gaussian Copula formula invented by Davis X. Li. This formula measured risk by examining the correlation or the relationship between disparate events. This piece of financial technology allowed hugely complex risks to The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 81 be modeled with more ease and accuracy than ever before making it possible for traders to sell vast quantities of new securities. Due to the financial crisis this technique eventually fell apart (Salmon, 2009).

Figure 6 The Securitization Process

Sourc: Faten, S. and Scholflocher, 2007.

Figure 6 above provides an excellent description of this securitization process. However, these flaws did not become apparent until after billions of dollars of subprime mortgages had been sold, which in turn did not allow the people who originally took out the mortgages to extend their loans. Complicating the matter, lenders also added more risky loan options to mortgages and loosened requirements to obtain a mortgage. Some of the options were such things as NINJA loans and payment loans. NINJA loans were loans given to people with, No Income, No Job, and No Asset. Payment option loans were loans that allowed just the interest to be paid during the initial period. All of this allowed for larger fees and profits. 82 Luis Eduardo Rivera-Solis

5. EFFECTS OF THE SUBPRIME MORTGAGE CRISIS The global economy has been in a deep recession since the demise of the subprime mortgage market. Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. Housing prices have dropped 20%, and total home equity in the United States has dropped from $13 trillion to $8.8 trillion. The largest financial firms’ market capitalization plummeted, and seven disappeared all together. Tables 1 through 3 above show the financial firms’ market capitalization at its peak, trough, and on September 11, 2009, respectively.

Table 1 At Stock Market’s Peak Financial firm Market Cap (Blns) Financial firm Market cap (Blns) Citigroup $236.7 Washington Mutual $31.1 Bank of America $236.5 Capital One Financial $29.9 AIG $179.8 State Street $27.5 JP Morgan Chase $161.0 SunTrust Banks $27.0 Wells Fargo $124.1 BB&T $23.2 Wachovia $98.3 Fifth Third Bancorp $16.8 Goldman Sachs $97.7 National City Corp $16.4 American Express $74.8 Northern Trust $15.8 Morgan Stanley $73.1 Bear Stearns $14.8 Fannie Mae $64.8 KeyCorp $13.2 Lynch $63.9 Marshall & Lisley $11.6 U.S. Bancorp $57.8 Legg Mason $11.4 Bank of New York Mellon $51.8 Country –wide Financial $11.1 Freddie Mac $41.5 Comerica $8.3 Lehman Brothers $34.4 Source: Russell NY Times 9/13/09.

Table 2 At Stock Market’s Trough Financial firm Market Cap (Blns) Financial firm Market cap (Blns) Citigroup $5.8 Washington Mutual gone Bank of America $24.0 Capital One Financial $3.4 JP Morgan Chase $59.8 State Street $7.6 Wells Fargo $42.3 SunTrust Banks $3.6 Wachovia gone BB&T $8.0 Goldman Sachs $37.3 Fifth Third Bancorp $0.8 American Express $12.5 National City Corp gone Morgan Stanley $17.7 Northern Trust $10.7 Fannie Mae $2.1 Bear Stearns gone Merrill Lynch gone KeyCorp $3.0 U.S. Bancorp $17.9 Marshall & Lisley $1.9 Bank of New York Mellon $20.7 Legg Mason $1.5 Freddie Mac/AIG $5.7 Country –wide Financial gone Lehman Brothers gone Comerica $2.0 Source: Russell NY Times 9/13/09 The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 83

Table 3 The Market Capitalization as of September 11, 2009 Financial firm Market Cap (Blns) Financial firm Market cap (Blns) Citigroup $105.5 Washington Mutual gone Bank of America $146.8 Capital One Financial $17.3 AIG $26.2 State Street $26.1 JP Morgan Chase $167.1 SunTrust Banks $10.9 Wells Fargo $128.1 BB&T $18.4 Wachovia gone Fifth Third Bancorp $7.8 Goldman Sachs $91.8 National City Corp gone American Express $40.6 Northern Trust $14.1 Morgan Stanley $39.2 Bear Stearns gone Fannie Mae $9.1 KeyCorp $5.2 Merrill Lynch gone Marshall &Lisley $1.9 U.S. Bancorp $41.8 Legg Mason $4.1 Bank of New York Mellon $34.5 Country –wide Financial gone Freddie Mac 6.1 Comerica $4.2 Lehman Brothers gone Source: Russell NY Times 9/13/09.

5.1 Bear Stearns Bear Stearns Companies Inc. was a publicly listed holding company mainly engaged in investment banking, sales and trading, and asset management. The firm was founded in 1923 with $500,000 in capital. Since then it saw enormous growth, at one point reaching the stature of the fifth largest investment bank. At that point, it possessed almost $400 billion in assets and worldwide had more than 14,000 employees. Bear Stearns had a reputation for taking risks in hopes of obtaining greater returns. In the 1990s, it branched into asset management for institutional clients and high net worth individuals. It also was involved with investment services for its own and third party hedge funds. Bear Stearns created a new hedge fund in 2003 called High Grade Structured Credit Strategies Master, which was led by Ralph Cioffi. The fund was involved in the purchase of structured finance products called Collateralized Debt Obligations (CDOs) that were backed by AAA rated subprime mortgage backed securities (MBSs). These instruments carried a very high rate of return and proved to be very profitable for Bear Stearns and allowed the actual leverage ratio to be much higher than the reported leverage ratio on funds under management. Where they reported leverage ratios of 2:1 and 3:1 on their funds, CDOs increased the ratios considerably. They also purchased Credit Default Swaps (CDSs) as insurance against movements in the credit market. They needed this insurance because of their highly leveraged position and the large overall risks they were taking. The swaps were being used to hedge the risk of falling collateral values. Securitization allowed risk to be shifted to those who could bear it. However, it also had the effect of disconnecting the borrowers from the lenders, and monitoring of loans became nonexistent. The high-grade hedge fund had proved very profitable for Bear Stearns in the past. It had a cumulative return of 50% through January 2007. 84 Luis Eduardo Rivera-Solis

Things began to come apart for Bear Stearns as the housing market began to cool in 2006. Concerns began to mount over the degree of leverage and the quality of the MBSs in which Bear had invested. At one point, Goldman Sachs announced that it would not take exposure to Bear Stearns. As this news spread, it turned into a virtual run on an investment bank, and Bear could not find adequate financing to fund its activities. The move to a mortgage model known as “originate and distribute,” in which banks repackaged mortgages and sold them, was about to take a devastating toll on Bear Stearns. Banks began to pool mortgages and transferred them to a special purpose vehicle (SPV). This was a trust that was independent of the parent. The rationale was that a bank could reduce strain on regulatory capital, and companies could lower apparent debt. They also tranched their financial products with ratings that suited certain types of investors. The senior tranche would obtain an AAA rating, and other subordinate tranches received lower ratings. The lower rating tranches also were rebundled with other tranches to receive a higher credit rating, despite being complex combinations of poor quality subprime mortgages. Bear Stearns used short-term Asset Backed Commercial Paper (ABCP) to fund their investments. They would roll them over on a regular schedule, but on March 14, 2008, Bear Stearns could not roll over the assets and was not able to meet payments due three days forward. To prevent a chain of bankruptcies from occurring, the Federal Reserve Bank of New York stepped in with a 28-day loan via JP Morgan Chase. It became obvious that a takeover was needed, and JP Morgan ultimately paid shareholders $10 per share, and took on the first billion dollars in losses. The Federal Reserve added a $29 billion loan and a near financial collapse was averted. Bear Stearns needed the bailout because of its role in global derivative trades and the risk of an international financial crisis spreading. This raised a larger question of inherent moral hazard. Would other banks take larger risks if they were assured of a bailout by the Federal Reserve? (Chaplinsky, 2009)

5.2 Lehman Brothers Lehman Brothers Holdings Inc. was a global financial-services firm founded in 1850 that participated in business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. It was also a primary dealer in the U.S. Treasury securities market. Lehman Brothers, a giant in the global financial-services world, served the needs of corporations, governments and municipalities, institutional clients, and high-net-worth individuals. Lehman Brothers was a major player in both the Commercial Paper and Credit Default (CDS) markets. Because of the firm’s position, its bankruptcy would have an arduous impact on these financial markets. As a funding intermediary, Lehman Brothers was one of the largest dealers in the Commercial Paper market. Furthermore, Lehman Brothers’ influence on the $55-trillion CDS market was threefold. First, Lehman Brothers was a top 10 counterparty in the CDS market, with contracts amounting to roughly $800 billion. Thus, it sold insurance to The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 85 investors against the chance of other firms defaulting, and these firms were unable to pay their debt, so Lehman Brothers had to pay the investors on the other side of the contract. Lehman Brothers’ second exposure to the CDS market in general dealt with contracts on the firm’s own debt and specifically with those who had sold insurance against the firm’s going into bankruptcy. Lehman Brothers third impact on the CDS market was derived through synthetic collateralized debt obligations (CDOs). Synthetic CDOs invested in CDSs, typically broken down into portions, or tranches, which then were sold to investors based on their level of risk appetite. The performance of a synthetic CDO was based, therefore, upon defaults insured by a CDS portfolio. In order to match each tranche with each investor’s desired risk level, each tranche took the CDS default losses in a specific order, with the riskier tranches taking the losses before the senior tranches. Each of these exposures to the CDS market resulted in significant counterparty risk or the risk that the party on the other side of the contract failed to pay its obligation to the opposite party. In August 2007, the firm closed its subprime lender, BNC Mortgage. Lehman began to take considerable losses from its investments in subprime mortgages. In 2008 Lehman’s loss was apparently a result of having held on to large positions in subprime and other lower rated mortgage tranches when securitizing the underlying mortgages. Like other financial institutions, Lehman was chasing large profits. Large losses accrued in lower rated mortgage-backed securities throughout 2008. In the second fiscal quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman stock lost 73% of its value as the credit market continued to tighten. On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank was considering buying the bank. It culminated on September 9, 2008, when Lehman’s shares plunged 45% to $7.79, after it was reported that the state-run South Korean firm had put talks on hold. Investor confidence continued to erode as Lehman’s stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors’ concerns about the security of the bank. The U.S. government failed to provide any assistance for any possible financial crisis that emerged at Lehman. As Lehman CEO Richard Fuld Jr. worked the phones trying to find a suitor to buy Lehman, his efforts came up short as a deal with Bank of America failed to materialize. On September 15, 2008, Lehman Brothers Holdings announced it would file for Chapter 11 bankruptcy protection, citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. It further announced that its subsidiaries would continue to operate as normal. A group of Wall Street firms agreed to provide capital and financial assistance for the bank’s orderly liquidation, and the Federal Reserve, in turn, agreed to a swap of lower quality assets in exchange for loans and other assistance from the government. The Fed’s decision to let Lehman Brothers fail after investors had assumed a false sense of security roiled the markets and had seismic consequences, resulting in what was potentially the largest meltdown in the history of the Commercial Paper market. 86 Luis Eduardo Rivera-Solis

The Reserve Primary Fund, a large money market fund that had invested largely in Commercial Paper issued by Lehman Brothers, “broke the buck” (i.e., its net asset value dropped below $1 per share, thereby resulting in an asset value lower than the dollar amount deposited). This event created a shockwave in the Commercial Paper market because investors who previously deemed the funds as safe investments pulled their money to place it in safer short-term investments, such as Treasuries, and in money market funds, which had stopped buying Commercial Paper in the hopes of regaining investor confidence. Because these funds were the largest buyers of Commercial Paper, their reluctance to buy effectively halted operation of the Commercial Paper market. (Story & Landon, 2009)

5.3 American International Group (AIG) AIG is an American insurance corporation with offices in New York City, London, Paris, and Hong Kong. AIG was once the 18th-largest public company in the world. AIG was managed originally by Hank Greenberg in 1968, under whose guidance the focus shifted from personal insurance to high- corporate coverage. The company went public in 1969. Greenberg focused on selling insurance through independent brokers, and AIG became heavily involved in the selling of credit insurance in the form of Credit Default Swaps on Collateralized Debt Obligations that had been steadily declining in value. AIG suffered from a liquidity crisis when its credit ratings were downgraded below “AA” levels in September 2008, forcing it to post $14.5 billion in collateral. Fearing a collapse of the company could jeopardize the global financial system and result in a domino effect of failed international financial companies, the U.S. government seized control of AIG by providing an $85 billion bailout and obtaining an 80% equity stake in the form of warrants, which followed a failed attempt by AIG to raise $75 billion from private sector banks. The two-year loan carried an interest rate of Libor plus 8.5 percentage points. The bridge loan provided by the Fed enabled AIG to sell off its assets in an orderly manner. The Fed was able to lend to a private insurer under legal authority granted in the Federal Reserve Act, which allows it to lend to nonbanks under “unusual and exigent” circumstances, a contingency which it also invoked with Bear Stearns. The Fed took this unusual step because banks and mutual funds are major holders of AIG’s debt and they could have been wiped out if the insurer were to default. By late September 2008, AIG’s share prices were down by 94% for the year. AIG’s problems stemmed largely from losses in its financial products unit, which was directly involved in selling the Credit Default Swaps. These were designed to protect investors against default in an array of assets that included subprime mortgages. Ben Bernanke, in testimony to the Senate Budget committee, stated that “it became obvious that AIG exploited a huge gap in the regulatory system and made irresponsible bets and took huge losses.” (Karnits-schnig, Solomon, Liam & Hilsenrath 2009). The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 87

5.4 Fannie Mae and Freddie Mac Fannie Mae and Freddie Mac are two government-sponsored enterprises (GSE) that buy mortgages from banks, a process known as buying on the secondary market. They then package these into mortgage-backed securities and resell them to investors on Wall Street. In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing mortgage-backed securities that included loans to low income borrowers. Thus began the involvement of the Fannie Mae and Freddie Mac with the subprime market. In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. From 2002 to 2006, as the U.S. subprime market grew 292% over previous years; they now own or guarantee about $1.4 trillion, or 40%, of all U.S. mortgages, with $168 billion in subprime mortgages. Government regulations preclude Fannie Mae and Freddie Mac from buying mortgages that do not meet down payment and credit requirements. However, as the mortgage market changed, so did their business. During the period 2005-2007, few of the mortgages acquired were conventional fixed-interest loans with 20% down. Fannie Mae’s loan acquisitions were (Amadeo 2009): • 62% negative amortization • 84% interest only • 58% subprime • 62% required less than 10% down payment. Freddie Mac’s loans were even more risky, consisting of: • 72% negative amortization • 97% interest only • 67% subprime • 68% required less than 10% down payment. Fannie and Freddie used derivatives to hedge the interest-rate risk of their portfolios. When the value of the derivatives fell, so did their ability to insure loans. However, this exposure proved their downfall, as it did for most banks. As housing prices fell, even qualified borrowers ended up owing more than the home was worth. If they needed to sell the house for any reason, they would lose less money by allowing the bank to foreclose. Borrowers in negative amortization and interest-only loans were in even worse shape. For Fannie and Freddie, the 17% of subprime and Alt-A loans made up over half of the losses in 2007. Congress approved a bailout plan for Fannie and Freddie. The plan allowed the U.S. Treasury Department to guarantee as much as $25 billion in loans held by the two corporations, which hold or guarantee more than $5 trillion, or half, of the nation’s mortgages (Mizen). Table 4 compares the 2007 financial characteristics of Fannie Mae and Freddie Mac. 88 Luis Eduardo Rivera-Solis

Table 4 Comparison of 2007 Financial Characteristics Financial Characteristics of Fannie Mae and Freddie Mac as of 2007 Characteristic Fannie Mae Freddie Mac Revenue $44.8 billion $43.1 billion Operating Income – 5.1 billion – 6.0 billion Net Income – 2.0 billion – 3.1 billion Total Assets $882.5 billion $794.4 billion Equity $44.0 billion $26.7 billion Source: Watkins. San Jose State.

5.5 Private Mortgage Companies Three private mortgage companies dominated the subprime mortgage business in the last decade. They were American Home Mortgage, New Century, and Countrywide Financial Corporation. These companies had a policy of lending to families with extremely small amounts of disposable income, often compromising their ability to pay living expenses. This guideline was established by the investors to whom they sold their loans. However, these mortgage companies had no qualms in following through despite knowing those families would likely fail to make monthly payments because these loans were sold to investors shortly thereafter. Employees used scripts as a sales aid when talking to customers about taking out subprime loans. Subprime mortgage lenders also used software packages that allowed for instant underwriting with automatic screening techniques. The software enabled brokers to increase their rate of origination in dramatic fashion. In the early 1970s subprime was still a foreign word in the mortgage industry. Any mortgage being funded by a second lien lender was called a nonconforming mortgage, meaning it did not conform to standards set by Fannie Mae and Freddie Mac. The mortgage companies that originated the loans usually created a trust and sell to the trust all of its legal rights to receive payment on the mortgages. The trust thus becomes the owner of the loans. The trust is a special purpose vehicle that underwrites the securities and is exempt from taxes. It also allows the originator to treat the transaction as a loan sale, and insulates investors from the liabilities of the originator. The trust passes the interest and principal on to the investors. Countrywide Financial Corporation, once led by Angelo Mozilo, did not start out as a subprime mortgage banker but, lured by high fees from these mortgages, eventually became number one in that business. Countrywide wrote more subprime loans than any other company. These mortgages were the highest yielding loans backed by something tangible: a house. A higher yielding mortgage meant that Wall Street firms such as Bear Stearns and Lehman Brothers could create a higher yielding bond to sell to an investor. These bonds based on subprime mortgages paid huge commissions to the bond seller. Everything seemed rosy in the mortgage securitization business until doubts began to The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 89 mount about the ability of subprime borrowers to keep paying on mortgages backed by homes that were now worth less. Countrywide announced second quarter earnings results that were down by one third to $400 million. As the housing market worsened, so did Countrywide’s bottom line. Their stock dropped 11% after a conference call in which Mozilo irresponsibly mentioned the Great Depression in his statements. The Dow Jones Average also plunged 226 points when Mozilo’s remarks were made public. Within a month the Dow dropped by 1,000 points more, and the great subprime mortgage-led unraveling of the U.S. economy was officially underway. On January 11, 2008, Bank of America announced that it planned to purchase Countrywide Financial for $4.1 billion in stock. On June 5, 2008, Bank of America Corporation received approval from the Board of Governors of the Federal Reserve System to purchase Countrywide Financial Corporation. On June 25, 2008, Countrywide received the approval of 69% of its shareholders to the planned merger with Bank of America. On July 1, 2008, Bank of America Corporation completed its purchase of Countrywide Financial Corporation.

Figure 7 Countrywide Financial Stock Price vs. the DJIA

Source: Yahoo.com

New Century Financial Corporation, based in Irvine, California, was one of the largest publicly traded subprime lenders in the United States. In 2007, New Century was the second-biggest subprime mortgage lender in the United States. At one point, it did business with up to 47,000 mortgage brokers spread around the country. New Century began in 1996 with a loan from Salomon Brothers for $175 million and, in return, Salomon received first preference on 70% of the lenders’ first $500 million in loans. During that first year, the company originated or brought from other lenders $357 million in subprime loans. In 1997 New Century’s subprime loan volume increased to nearly $2 billion. New Century was famous for holding signing parties where they would review problematic loans and come up with creative ways to approve the loan. Poor quality loans eventually were funded despite misgivings among the more conservative executives. In April 2004, against the advice of Bear Stearns, New Century converted to a Real Estate Investment Trust (REIT). The latter 90 Luis Eduardo Rivera-Solis is a firm that owns and operates income-producing properties. New Century was now a mortgage lending REIT, raising close to $800 million in an initial public offering. This amount was more than 25 times the size of its first IPO in 1997 when it raised $31 million. In 2005, at the peak of the housing boom, New Century was the largest publicly traded subprime lender in the nation with loan originations totaling $56 billion. Its profits were over $400 million for the year, but market forces began to turn against them. Home prices had peaked and borrowers were not as eager to take equity out of their homes as they previously had been. Another sign that things were not going to be good for all subprime mortgage lenders was the raising of short-term interest rates by the Federal Reserve to control inflation. Lenders now were forced to borrow at high interest rates and lend long term at low interest rates, which proved to be a detrimental mix. In April 2007 New Century Financial Corporation and its related entities filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court, District of Delaware, located in Wilmington, Delaware. New Century Financial Corporation listed liabilities of more than $100 million. New Century Financial Corporation also announced that the employment of about 3,200 people, 54% of its workforce, would be terminated. New Century also had to restate earnings for the first nine months of 2006 and record a loss for the final quarter since it had understated the damage caused by an increasing number of bad loans. American Home Mortgage Investment Corporation a Melville, New York,-based lender specializing in mortgages for people who fell just short of top credit scores, filed for bankruptcy, becoming the second-biggest residential lender in the U.S. to do so. Its filing signaled that mortgage delinquencies had spread outside of the subprime market. American Home sought federal court protection, with assets of more than $20.6 billion and debt of more than $19.3 billion. By the end of 2006, more than 6,000 of its employees had been laid off, leaving only 1,000 employees. Before trading of American Home shares on the New York Stock Exchange was suspended, the share price fell to 44 cents at one point American Home had some of the biggest investment banks as its top creditors. The top five unsecured creditors include Deutsche Bank AG, Wilmington Trust Corp., JPMorgan Chase & Co., Countrywide Financial Corp, and Bank of America Corp. American Home did not provide estimates for how much each of its top 40 unsecured creditors was owed. The company filed for bankruptcy in part because of margin calls from banks that provided it with the cash necessary to write mortgages. Regulators in New York, California, and four other states suspended the company’s lending licenses or barred it from accepting additional mortgage applications. American Home eventually was delisted from the New York Stock Exchange. Investment bankers halted credit to American Home as concerns about subprime mortgages spread, leaving the lender unable to fund at least $750 million in loans and stranding thousands of borrowers. American Home originated almost $60 billion in mortgages in 2006 and issued $16.7 billion in the first quarter of 2007. Lower bids by investment banks that buy mortgages and securities backed by The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 91

home loans forced American Home to write down the value of its holdings. The drop in value prompted banks that provide credit lines to demand more collateral as a cushion against default. American Home specialized in Alt-A mortgages, an alternative for A-rated borrowers who cannot meet all the terms for a prime mortgage. The company was the 20th largest Alt-A lender in 2006. (Morris) (Muolo)

Figure 8 American Home Mortgage (AHM) Stock Price

Source: Yahoo.com

There were many other subprime lenders besides the previously three mentioned above. They filed for bankruptcy, were sold or closed their doors. A partial list of lenders follows in Table 5.

Table 5 Other Subprime Lenders Company Headquarter Status Date Southstar Funding Atlanta, GA Bankrupt 4/11/2007 Mortgage Lenders Network USA Middletown, CT Bankrupt 2/5/2007 People’s Choice Irvine, CA Bankrupt 3/20/2007 Equifirst Corp. Charlotte, NC Sold to Barclays 4/2/2007 Fieldstone Mortgage Columbia, MD Acquired by C-BASS 4/2007 Champion Mortgage Parsippany, NJ Sold to Nationstar Mortgage 1/2007 Harbourton Mortgage Santa Rosa, CA Closed 4/20/2006

5.6 Government Involvement in the Crisis and Its Response Some believe that the government was partly or fully to blame for the subprime mortgage crisis. The government deregulation and failed regulation have been pointed at as a cause of the crisis. The Security and Exchange Commission admitted publicly that the self-regulation of banks was a precipitating cause in the crisis. In 2004, the SEC scaled back some of its policies in allowing banks to take on debt, which 92 Luis Eduardo Rivera-Solis increased the number of subprime mortgages. This action caused the top five investment banks to increase their leverage, which in turn led to their becoming more susceptible to losses through the subprime mortgage crisis. The chart below from the Security and Exchange Commission shows the level of risk increase that these banks had during this time.

Figure 9 Leverage Ratios for Major Investment Banks

Another policy that has been widely criticized for contributing to the crisis was the Community Reinvestment Act from 1977, which had been enacted to prevent discrimination in loans made to individuals and businesses from low- and moderate- income neighborhoods. The Act mandates federal banking agencies evaluate all banking institutions that receive FDIC insurance to determine if the bank offers credit in all communities in which it takes deposits. The law does not list specific criteria for evaluating the performance of financial institutions. Some economists and politicians have charged that the CRA contributed in part to the 2008 financial crisis by encouraging banks to make unsafe loans. Others, however, including the economists from the Federal Reserve and the FDIC, disputed this contention. The Federal Reserve and the FDIC stated that empirical research has not validated any relationship between the CRA and the 2008 financial crisis. Financial experts have noted that CRA-regulated loans tend to be safe and profitable, and that subprime excesses came mainly from institutions not regulated by the CRA. The federal government has taken steps to resurrect the sagging U.S. economy and escalating unemployment rate. The Federal Reserve Bank lowered the Federal Funds rate from 5.25 % to 2 %. On February 13, 2008, President Bush signed a $168 billion economic stimulus package and in July 2008 signed into law the Housing and Economic Recovery Act, which authorizes the Federal Housing Administration to guarantee up to $300 billion in new 30-year fixed-rate mortgages for subprime The Root Causes of the Subprime Mortgage Crisis and the Impact on Financial Markets 93 borrowers. In October 2008 Bush signed the Emergency Economic Stabilization Act, creating a $700 billion Troubled Asset Relief Program (TARP) to purchase toxic bank assets. The Securities and Exchange Commission also eased mark-to-market accounting rules that required financial institutions to show the deflated value of assets on their balance sheets. On February 17, 2009, after taking office, President Obama also signed a stimulus package, the American Recovery and Reinvestment Act of 2009, worth $787 billion. The act has tax cuts, unemployment benefits, and welfare provisions that are intended to help bolster the struggling economy. The Obama Administration also introduced the Homeowners Affordability and Stability Plan with the intention of helping homeowners avoid foreclosure. Given the number of people who are “under water” and struggling with negative equity, some have argued that steps needed to be taken to address this problem. The intent of President Obama’s plan was to help nine million struggling subprime mortgage holders to stay in their homes by allowing them to refinance. A total of $75 billion was provided as an incentive for lenders to reduce interest rates for those homeowners most likely to face foreclosure. A further $200 billion was provided to Fannie Mae and Freddie Mac to offer more affordable mortgages to struggling borrowers. Jacob Vigdor (2009) discussed several factors that could be implemented by the government to end the subprime mortgage crisis. His suggestions require that borrowers receive complete, accurate, and intelligible information about mortgage products; holding lenders and brokers to higher, more uniform standards during loan origination, increasing the likelihood that borrowers will be able to repay their debts; and supporting community-based groups that provide counseling to homeowners, helping them understand how to live within a budget, how to manage debt, how to deal with unanticipated financial setbacks, and how to negotiate with lenders.

6. REGULATION AS A SOLUTION The issue of regulation of mortgage originators and the producers of structured finance products has been in the forefront since the beginning of the subprime mortgage crisis. Originating mortgages without attention to the credit quality of the borrowers must be examined. The predatory lending practices of the mortgage originators need to be examined closely, along with the issue of whether they acted in the best interest of borrowers. The Community Reinvestment Act has come under close scrutiny since it required lenders to offer mortgages to borrowers of less than stellar credit. Regulation of mortgages with prepayment penalties is being examined, and the Federal Reserve is contemplating establishing rules to prevent mortgages being sold without verification of income and financial assets. A further item being reviewed is allowing banks to avoid regulation by using off balance sheet vehicles to conduct business in structured finance products. The Financial Accounting Standards Board (FASB) is looking closer at Statement 140, which allows banks to transfer assets and liabilities to Special Purpose Vehicles. The current arrangement provides for an incentive to minimize the capital requirements by creating such off balance sheet 94 Luis Eduardo Rivera-Solis entities to hold assets and liabilities. The regulation of rating agencies is also under scrutiny because it has a poor track record in rating structured finance products. Another issue is the adequacy of the rating agencies models for structured finance products. No testing was performed under turbulent economic shocks to see if the models would perform correctly. The nature of the models and the stress testing should be performed under worst-case conditions. The current economic climate has shed new emphasis on the topic of financial regulation across many disciplines because many parties were responsible for the mispricing of risk and the ensuing subprime mortgage debacle that followed. (Vignor, 2009)

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