Subprime Crisis

Subprime crisis Introduction The subprime crisis is one of the biggest disasters of the financial system. It originated in the US subprime mortgage market in 2006 and within a year it engulfed the financial sector of USA along with numerous mature economies. The weaker income groups comprising the Afro-Americans and the Hispanics suffered home losses. It is projected that the number of subprime foreclosures will reach 2 million, if measures are not taken to resolve the crisis.

This accompanied by the shortage of funds in the mortgage market will result in a significant slowdown in the growth of housings. Business operations and investment activities have been hampered by the lack of flow of funds. The central banks throughout the world resorted to numerous rescue operations to curb the growing threat. The bank rates were cut to increase investor confidence, personal tax rebates were given and liquidity was injected in the market. But, these measures have failed to uplift the market sentiments. Subprime issues

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There are a number of issues and puzzles in the subprime crisis which are enlisted as follows: 1)The magnitude of the meltdown and the output and employment loss is disproportionately large compared to the default in the subprime market. The losses of $ 34 billion is insignificant when compared to the $57 trillion US financial system. 2)The failure of the sophisticated risk management techniques comprising the securitization of loans and collateralized debt obligations. 3)The subprime problem took place when the US was enjoying a robust GDP growth and a declining rate of unemployment.

For this reason, the slide in the economy is a bit puzzling. 4)Unlike in 2001-02, when the Fed’s policy arrested the recessionary trend following the dotcom bubble burst, in this occasion the Fed’s policy have failed to arrest the economic slide. . Growth of the subprime market Subprime lending consists of loans extended to borrowers with weak credit characteristics. The factors that led rise to the growth of subprime lending can be grouped under: 1)Enabling legislations : The most important legal initiatives were- -Depository Institutions Deregulatory and monetory control Act (1980) -Alternative Mortage Transactions parity Act( 1982)

These acts removed the important constraints that tended to limit the commercial viability of subprime mortgages. Thus the acts created conditions under which the subprime mortgages would be driven by market forces. The deposit and the lending rates would be governed by the extent of risk aversion of the savers and the borrower’s risk of default. -The Tax Reforms Act of 1986 also made subprime loans attractive to lenders and borrowers. Interest deductions were allowed on mortgages for a primary house and an additional residence.

These twin factors of the rise in demand and the reduction of risk resulted in the flow of funds in the subprime market. 2)Financial and institutional innovations: The government sponsored enterprises (GSEs) played a significant role in the development of the US mortgage market. They started securitizing conventional mortgages and issuing mortgage backed securities. ( MBSs). This led to the creation of a secondary market where banks and other financial institutions could flow funds into the mortgage market. Between 1980 and 2007, the GSE MBSs recorded a phenomenal rise from $200 billion to $4 trillion. s much as 90% of the mortgages were awarded high ratings and found a pool of investors. 3)Macroeconomic environment, policy regime and housing price inflation: The annual GDP rate at 3. 2% was well above the rate attained in the previous decades and it was also accompanied by low interest rates. Such a macroeconomic environment provided a boost to housing. The rising house prices, the large gap between the house price and inflation rates, low interest- all these contributed to the demand for mortgage financed houses. Origins and manifestations of the crisis

The most popular explanation of the crisis refers to the deterioration of lending standards, incomplete documentation, low interest rates. The securities were awarded high ratings and the banks had a high exposure to their clients. The roots of the crisis can be traced back to the loose monetary policy of the Federal Reserve (between 2001 and 2004). The third explanation focuses on the housing price bubble in terms of the belief that the US had entered a growth trajectory in which the housing prices were expected to only rise. House price bubble and bust

The housing prices between (1996 and 2006) were highly inconsistent with the market prices according to economic fundamentals. The current price of a house should Be governed by the real rent during the lifetime of the residence and the interest rates that were expected to prevail. The prices increases in the 1990s were consistent to the above theory. But beyond 2001, there was a divergence between the parameters which suggests the prevalence of a housing bubble over 2001-2006. The citizens expected the prices to increase further without any significant macroeconomic factor for the same.

In 2001, the US Fed fund rates were as low as 1%. Housing loans were available at very cheap prices, which resulted in more people taking loans and buying houses. There were two prevalent schemes in the market: 1) Borrowers were required to pay 2% interest rate for 2 years and thereafter a rate of ( Fed’s rate + 5%) till maturity; or 2) Borrowers to pay a fixed rate of 4% till maturity. The former option was more lucrative to the citizens and people bought more loans on mortgage. The values to assets increased and they took more loans by re-mortgaging. The bursting of the housing bubble

The inflation increased in the US markets, so to decrease the liquidity in the market the Fed increased the rate from 1% to 5. 25%. The payment obligations on the loans kept increasing and subprime borrowers started to default, and some of the prime borrowers became subprime. The banks started to call back the loans and there were numerous foreclosures. With high interest rates, people became very cautious and the demand for houses decreased. An alternative explanation The delinquency of many mortgages during the period of 2005-2006 triggered of the crisis.

A number of low income borrowers were eligible for the mortgage loans following the housing bubble due to which their valuation of the property increased. Although there is a close correspondence between the boom and decline of housing and the cutbacks and hikes in the federal funds rate, there are reasons according to which the Fed wasn’t primary responsible for the formation and the bursting of the bubble. 1)The link of the mortgage market with the international capital markets had reduced the impact of federal funds rate on home finance. )People were expected to focus on long term fundamentals rather than monetary policies. 3)The buyers and the lenders ignored the divergence between the real home prices and the rent. A change in the bank’s assessment of the risks involved with housing finance would explain better the crisis. The banks bundle all mortgages they hold and sell them to other financial institutions (Securitization). The institutions divide the mortgages into securities that are supported by collateral. These are called residential mortgage backed securities (RBMS).

These were sold as collateralized debt obligations (CDO) to investors. During the Sub-prime the investors are not able to sell their CDOs because their sale was driving the prices down. The current scenario The rating agencies have begun to downgrade these securities. The banks are trying to sell these securities at the earliest opportunity which results in a further drop in property prices. New regulations are being implemented to deal with the crisis by the legislators. The subprime crisis has affected the economy badly and it will take a few years for the real estate industry in the US to recover.

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