Subprime mortgage crisis

A diagram of the elements of the subprime crisis

The subprime mortgage crisis is an ongoing financial crisis characterized by contracted liquidity in global credit markets and banking systems. A downturn in the housing market of the United States, risky practices in lending and borrowing, and excessive individual and corporate debt levels have caused multiple adverse effects on the world economy. The crisis, which has roots in the closing years of the 20th century but has become more apparent throughout 2007 and 2008, has passed through various stages exposing pervasive weaknesses in the global financial system and regulatory framework.

The crisis began with the bursting of the United States housing bubble and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. For a number of years prior to that, declining lending standards, an increase in loan incentives such as easy initial terms, and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets. The U.S. government also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in several decisions by the U.S. Federal Reserve to cut interest rates and the economic stimulus package passed by Congress and signed by President George W. Bush on February 13, 2008. During the week of September 14, 2008 the crisis accelerated, developing into a global financial crisis. Following a series of ad-hoc market interventions to bail out particular firms, a $700 billion proposal was presented to the U.S. Congress in September, 2008. These actions are designed to stimulate economic growth and inspire confidence in the financial markets. On 3 October 2008, President George W. Bush signed the amended version of the bill into law. The following week the U.S. stock market declined 22%, the worst week in its 118-year history. Since Jan. 1, 2008, owners of stocks in U.S. corporations have suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.

Economic background

Number of U.S. household properties subject to foreclosure actions by quarter.

Further information: [[:Subprime crisis background information]]

Subprime lending is the practice of making loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status. The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. Approximately 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days delinquent or in foreclosure proceedings as of October 2007, roughly triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%.

The U.S. mortgage market is estimated at $12 trillion with approximately 9.2% of loans either delinquent or in foreclosure through August 2008. Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007. During 2007, nearly 1.3 million properties were subject to foreclosure filings, up 79% versus 2006.

Understanding the risks of default

Understanding financial leverage.

Traditionally, banks lent money to homeowners for their mortgage and retained the risk of default, called credit risk. However, due to financial innovations, banks can now sell rights to the mortgage payments and related credit risk to investors, through a process called securitization. The securities the investors purchase are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). This new "originate to distribute" banking model means credit risk has been distributed broadly to investors, with a series of consequential impacts. There are four primary categories of risk involved: credit risk, asset price risk, liquidity risk, and counterparty risk. Each of these risk types is described separately in the background information.

Understanding the market mechanisms affecting corporations and investors

There is a greater interdependence now than in the past between the U.S. housing market and global financial markets due to MBS. When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain. Investors and businesses holding MBS have been significantly affected. The effect is magnified by the high debt levels maintained by individuals and corporations, sometimes called financial leverage. The mechanisms through which a decline in housing prices affects market participants is described separately in the background information.

Causes of the crisis

The reasons for this crisis are varied and complex. The crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period of time. There are many different views on the causes, including the inability of homeowners to make their mortgage payments, poor judgment by the borrower and/or the lender, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, financial innovation that distributed and perhaps concealed default risks, central bank policies, and government regulation (or alternatively lack thereof).

Boom and bust in the housing market

Further information: [[:United States housing bubble, United States housing market correction]]

Existing homes sales, inventory, and months supply, by quarter.

Common indexes used for adjustable rate mortgages (1996–2006).

A combination of low interest rates and large inflows of foreign funds helped to create easy credit conditions for many years leading up to the crisis. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The overall U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%.

This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%. For the two decades until 2001, the national median home price went up and down, but it remained between 2.9 and 3.1 times the median household income. By 2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6. Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade. A culture of consumerism is a factor "in an economy based on immediate gratification".Americans spent $800 billion per year more than they earned. Household debt grew from $680 billion in 1974 to $14 trillion in 2008, with the total doubling since 2001. During 2008, the average U.S. household owned 13 credit cards, and 40 percent of them carried a balance, up from 6 percent in 1970.

Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline, beginning in the summer of 2006. Easy credit, combined with the assumption that housing prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages (ARMs) they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S., refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.

An estimated 8.8 million homeowners — nearly 10.8% of total homeowners — had zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provided an incentive to "walk away" from the home, despite the credit rating impact.

Increasing foreclosure rates and unwillingness of many homeowners to sell their homes at reduced market prices had significantly increased the supply of housing inventory available. Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981. Further, a record of nearly four million unsold existing homes were for sale, including nearly 2.9 million that were vacant.

This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure. According to the S&P/Case-Shiller price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2 2006 peak and by May 2008 they had fallen 18.4%. The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%. Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.

Speculation

Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences. NAR's chief economist at the time, David Lereah, stated that the fall in investment buying was expected in 2006. "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."

While homes had not traditionally been treated as investments like stocks, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported the behavior of purchasing condominiums prior to completion, then "flipping" (selling) them for a profit without ever living in the home. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.

Keynesian economist Hyman Minsky described three types of speculative borrowing that can contribute to the accumulation of debt that eventually leads to a collapse of asset values: the "hedge borrower" who borrows with the intent of making debt payments from cash flows from other investments; the "speculative borrower" who borrows based on the belief that they can service interest on the loan but who must continually roll over the principal into new investments; and the "Ponzi borrower" (named for Charles Ponzi), who relies on the appreciation of the value of their assets (e.g. real estate) to refinance or pay-off their debt but cannot repay the original loan.

The role of speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.

High-risk mortgage loans and lending practices

A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "subprime markup" or "risk premium") declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower credit ratings and loan characteristics declined overall during the 2001–2006 period, which should have had the opposite effect. The combination is common to classic boom and bust credit cycles.

In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.

Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation. In 2007, 40% of all subprime loans were generated by automated underwriting. The chairman of the Mortgage Bankers Association claimed mortgage brokers profited from a home loan boom but did not do enough to examine whether borrowers could repay. Mortgage fraud has also increased.

Securitization practices

Borrowing under a securitization structure.

Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools, and offered as collateral for third-party investment. There are many parties involved. Due to the securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Asset securitization began with the structured financing of mortgage pools in the 1970s.

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — was to blame for the current global credit crisis.

Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.

Inaccurate credit ratings

Further information: [[:Role of credit rating agencies in the subprime crisis]]

MBS credit rating downgrades, by quarter.

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. These high ratings encouraged the flow of investor funds into these securities, helping finance the housing boom. The reliance on ratings by these agencies and the intertwined nature of how ratings justified investment led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities and furthered by SEC removal of regulatory barriers and reduced disclosure requirements in the wake of the Enron scandal. Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks. On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressured MBS and stock prices lower.

Government policies

Main article: Government policies and the subprime mortgage crisis

Several critics have commented that the current regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws. Recently, we've seen how one company can grow so large that its failure jeopardizes the entire financial system." The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.

Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree. A taxpayer-funded government bailout related to mortgages during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans. Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages. A study by a legal firm which counsels financial services entities on Community Reinvestment Act compliance found that CRA-covered institutions were less likely to make subprime loans(only 20-25% of all subprime loans), and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.

Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Department's Office of the Comptroller of the Currency, at the insistence of national banks, struck down such attempts as violations of Federal banking laws.

The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans. In 1995, Fannie Mae and Freddie Mac began receiving affordable housing credit for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. Subprime mortgage loan originations surged by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years. As of November 2007 Fannie Mae held a total of $55.9 billion of subprime securities and $324.7 billion of Alt-A securities in their portfolios. As of the 2008Q2 Freddie Mac had $190 billion in Alt-A mortgages. Together they have more than half of the $1 trillion of Alt-A mortgages. The growth in the subprime mortgage market, which included B, C and D paper bought by private investors such as hedge funds, fed a housing bubble that later burst.

A September 30, 1999 New York Times article stated, "... the Fannie Mae Corporation is easing the credit requirements on loans... The action... will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough... Fannie Mae... has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people... borrowers whose incomes, credit ratings and savings are not good enough... Fannie Mae is taking on significantly more risk... the government-subsidized corporation may run into trouble... prompting a government rescue... the move is intended in part to increase the number of... home owners who tend to have worse credit ratings..."

On September 10, 2003, U.S. Congressman Ron Paul gave a speech to Congress where he said that the then current government policies encouraged lending to people who couldn't afford to pay the money back, and he predicted that this would lead to a bailout, and he introduced a bill to abolish these policies.

Conflict of interest

Gerald P. O'Driscoll, former vice president at the Federal Reserve Bank of Dallas, stated that Fannie Mae and Freddie Mac had become classic examples of crony capitalism. Government backing let Fannie and Freddie dominate the mortgage-underwriting. "The politicians created the mortgage giants, which then returned some of the profits to the pols - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."

On April 18, 2006, home loan giant Freddie Mac was fined $3.8 million, by far the largest amount ever assessed by the Federal Election Commission, as a result of illegal campaign contributions. Much of the illegal fund raising benefited members of the United States House Committee on Financial Services, a panel whose decisions can affect Freddie Mac, and congressional representatives in general.

Some lawmakers received favorable treatment from financial institutions involved in the subprime industry. (See Countrywide financial political loan scandal). In June 2008 Conde Nast Portfolio reported that numerous Washington, DC politicians over recent years had received mortgage financing at noncompetitive rates at Countrywide Financial because the corporation considered the officeholders under a program called "FOA's"--"Friends of Angelo". Angelo being Countrywide's Chief Executive Angelo Mozilo. On 18 June 2008, a Congressional ethics panel started examining allegations that chairman of the Senate Banking Committee, Christopher Dodd (D-CT), and the chairman of the Senate Budget Committee, Kent Conrad (D-ND) received preferential loans by troubled mortgage lender Countrywide Financial Corp. Two former CEOs of Fannie Mae Franklin Raines and James A. Johnson also received preferential loans from the troubled mortgage lender. Fannie Mae was the biggest buyer of Countrywide's mortgages.

Policies of central banks

Central banks are primarily concerned with managing monetary policy, they are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are a matter of debate among economists.

Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf.

A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%. The central bank believed that interest rates could be lowered safely primarily because the rate of inflation was low and disregarded other important factors. The Federal Reserve's inflation figures, however, were flawed. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, stated that the Federal Reserve's interest rate policy during this time period was misguided by this erroneously low inflation data, thus contributing to the housing bubble.

Impacts and downturns in financial markets, 2007–2008

Main articles: Financial crisis of 2007–2008 and Global financial crisis of September–October 2008

Financial sector downturn

See also: Subprime crisis background information, Subprime crisis impact timeline, List of writedowns due to subprime crisis, and List of bankrupt or acquired banks during the subprime mortgage crisis

Leverage Ratios of Investment Banks Increased Significantly 2003-2007

FDIC Graph - U.S. Bank & Thrift Profitability By Quarter

Many financial institutions had made enormous investments based on the expected continuation of housing price appreciation. As housing prices declined, the value of the mortgage-backed securities (MBS) representing these investments declined and became uncertain. Due to financial leverage, what had magnified profits during the housing boom period now drove large losses after the bust. Financial institutions and investors holding MBS suffered significant losses as a result of widespread and increasing mortgage payment defaults or mortgage asset devaluation beginning in 2007 onward. Financial institutions from around the world have recognized subprime-related losses and write-downs exceeding U.S. $501 billion as of August 2008.

A SEC regulatory ruling in 2004 greatly contributed to US investment banks' ability to leverage their balance sheets. The top five investment banks each significantly increased their financial leverage during the 2004-2007 time period, which increased their vulnerability to the MBS losses. Three of the five largest U.S. investment banks either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch), costing shareholders billions. The remaining two converted to commercial bank models, subjecting themselves to much tighter regulation.

Profits at the 8,533 U.S. banks insured by the FDIC declined from $35.2 billion to $646 million (89%) during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007, these banks earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year, a decline of 46%.

The financial sector began to feel the consequences of this crisis in February 2007 with the $10.5 billion writedown of HSBC, which was the first major CDO or MBO related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other. Various institutions followed up with merger deals.

Market weaknesses, 2007

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.

On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Through 2008, large daily drops became common, with, for example, the KOSPI dropping about 7% in one day, although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis.

Mortgage lenders and home builders fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.

Stock indices worldwide trended downward for several months since the first panic in July–August 2007.

Market downturns and impacts, 2008

The TED spread – an indicator of credit risk – increased dramatically during September 2008.

The crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value". Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle." Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.

Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. Poor economic data on manufacturing contributed to the day's panic, but were eclipsed by the severe developments of the financial crisis. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.

The much anticipated passage of the $700 billion bailout plan was struck down by the House of Representatives in a 228–205 vote on September 29. In the context of recent history, the result was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss (7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P 500 fell 8.8%, both of which were the worst losses those indices experienced since the 1987 stock market crash.

Despite congressional passage of historic bailout legislation, which was signed by President Bush on Saturday, Oct. 4, Dow Jones Index tumbled further when markets resumed trading on Oct. 6. The Dow fell below 10,000 points for the first time in almost four years, losing 800 points before recovering to settle at -369.88 for the day. Stocks also continued to tumble to record lows ending one of the worst weeks in the Stock Market since September 11, 2001."

It is also estimated that even with the passing of the so-called bailout package, many banks within the United States will tumble and therefore cease operating. It is estimated that over 100 banks in the United States will close their doors because of the financial crisis. This will have a severe impact on the economy and consumers. As a result of the crisis it is expected that it will take years for the United States to recover from such a mess.

Other economic effects

See also: Subprime mortgage crisis - Other economic effects

The subprime crisis had a series of other economic effects. Housing price declines left consumers with less wealth, which placed downward pressure on consumption. Certain minority groups received a higher proportion of subprime loans and experienced a disproportional level of foreclosures. Home related crimes including arson increased. Job losses in the financial sector were significant, with over 65,400 jobs lost in the United States as of September 2008.

Many renters became innocent victims, often evicted from their homes without notice due to foreclosure of their landlord's property. In October 2008, Tom Dart, the elected Sheriff of Cook County, Illinois, criticized mortgage companies for their actions, and announced that he was suspending all foreclosure evictions.

The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. One in five car dealerships are expected to close in Fall of 2008.

Responses to crisis

Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.

Legislative and regulatory responses

The Federal Reserve

Further information: [[:Federal Reserve responses to the subprime crisis]]

The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy."

• Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions.
• The Fed and other central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans.
• The Fed is using the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months.
• In July 2008, the Fed finalized new rules that apply to mortgage lenders.
• In October 2008, the Fed expanded the collateral it will loan against to include commercial paper, to help address continued liquidity concerns.

Regulation

Further information: [[:Regulatory responses to the subprime crisis]]

Regulators and legislators are considering action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings to help identify solutions and apply pressure to the various parties involved.

• A sweeping proposal was presented 31 March 2008 regarding the regulatory powers of the U.S. Federal Reserve, expanding its jurisdiction over other types of financial institutions and authority to intervene in market crises.
• In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.
• In the wake of a subprime mortgage crisis and questions about Countrywide’s VIP program, ethics experts and key senators recommend that members of Congress should be required to disclose information about their mortgages.
• Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital reserve requirements as depository banks. Many of the investment banks had limited capital reserves to address declines in mortgage backed securities or support their side of credit default derivative insurance contracts. Nobel prize winner Joseph Stiglitz recommends that regulations be established to limit the extent of leverage permitted and not allow companies to become "too big to fail."
• UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008.
• The Australian federal government has announced an investment of AU$4 billion in non-bank lender mortgage backed securities in an attempt to maintain competition in the mortgage market.

Economic Stimulus Act of 2008

President Bush also signed into law on 13 February 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth. The economic stimulus package included the mailing of rebate checks to taxpayers. Such mailings started the week of 28 April 2008. These mailings, however, coincided with unexpected all-time jumps in food and gasoline prices. This coincidence prompted some to question whether the stimulus package would have the desired effect or whether consumers would just use it to make up for the gap generated by the higher food and fuel prices. Some Congressmen even contemplated legislation for a second round of stimulus rebate checks to ensure the initial intention of the stimulus package had the expected effect. The Treasury Secretary strongly opposed such initiative.

Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 included six separate major acts designed to restore confidence in the domestic mortgage industry. The Act included:

• Providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners.
• Establishing a new regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan banks.
• Raises the dollar limit of the mortgages the government sponsored enterprises (GSEs) can purchase.
• Provides loans for the refinancing of mortgages to owner-occupants at risk of foreclosure. The original lender or investor reduces the amount of the original mortgage (typically taking a significant loss) and the homeowner shares any future appreciation with the Federal Housing Administration. The new loans must be 30-year fixed loans.
• Enhancements to mortgage disclosures.
• Community assistance to help local governments buy and renovate foreclosed properties.

Government bailouts

Main article: Government Bailouts Due to Subprime Crisis

See also: List of bankrupt or acquired banks during the subprime mortgage crisis and Federal takeover of Fannie Mae and Freddie Mac

People queuing outside a Northern Rock bank branch in Birmingham, United Kingdom on September 15, 2007, to withdraw their savings due to fallout from the subprime crisis.

• Northern Rock had difficulty finding finance to keep the business going and was nationalized on 17 February 2008. As of October 8th, 2008, UK taxpayer liability for the bank had climbed to £87Bn ($150Bn) according to Robert Chote, director of the Institute for Fiscal Studies.
• Bear Stearns was acquired in March 2008 by J.P. Morgan Chase for $1.2 billion. In order for the deal to go through, the Fed issued a nonrecourse loan of $29 billion to Bear Stearns.
• Fannie Mae and Freddie Mac . In September 2008, the Treasury Department confirmed that both Fannie Mae and Freddie Mac would be placed into conservatorship with the government taking over management of the pair. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt.
• Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.
• Scottish banking group HBOS agreed on 17 September 2008 to be acquired by UK rival Lloyds TSB in an emergency takeover after its share price experienced significant falls amid fears over its exposure to toxic debt. The deal was encouraged by the UK government, who agreed to waive competition rules to allow the takeover to go ahead.
• Lehman Brothers declared bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out. Treasury Secretary Hank Paulson cited moral hazard as a reason for not bailing out Lehman Brothers.
• AIG: In September 2008, The Federal Reserve provided an emergency loan of $85 billion to AIG, which will be repaid by selling off assets of the company. This intervention gave the US government a 79.9% equity stake at AIG. Just over three weeks later the Fed reported that AIG had drawn down $70.3 billion of that $85 billion facility and AIG announced that it may tap an additional $37.8 billion in secured funding from the Federal Reserve.
• Washington Mutual: In September 2008, Washington Mutual declared bankruptcy. The United States Office of Thrift Supervision (OTS) announced that it was seizing WaMu and would sell most of its functional assets to JPMorgan Chase.
• On 29 September 2008, British bank Bradford & Bingley was nationalised by the UK government. The government will take control of the bank's £50bn mortgages and loans, while its savings operations and branches are to be sold to Spain's Santander.

Emerging plan to bail out financial institutions

See also: Emergency Economic Stabilization Act of 2008

On 19 September 2008, the U.S. government announced a plan to purchase large amounts of illiquid, risky mortgage backed securities from financial institutions, which is estimated to involve at minimum, $700 billion of additional commitments. This plan also included a ban on short-selling of financial stocks. The mortgage market is estimated at $12 trillion with approximately 9.2% of loans either seriously delinquent or in foreclosure through August 2008. On 29 September 2008 the House of Representatives rejected a revised version of the plan. On 1 October 2008 the U.S. Senate approved an amended version of the plan, which was approved by the House on October 3 and immediately signed into law by President Bush.

Lending industry action; Loan modification and loss mitigation

Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Homeowners have also been encouraged to contact their lenders to discuss alternatives.

Corporations, trade groups, and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs. There is some dispute regarding the appropriate measures, sources of data, and adequacy of progress. A report issued in January 2008 showed that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 new foreclosures. Consumer groups claimed the modifications affected less than 1% of the 3 million subprime loans with adjustable rates that were outstanding in the third quarter.

The State Foreclosure Prevention Working Group, a coalition formed by 11 state attorney generals and bank regulators, reported in April 2008 that the increasing pace of foreclosures exceeds the ability of loan servicers to keep up. Seventy percent of subprime mortgage holders are not getting the help required. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. The group has recommended applying a more systematic method of loan modification that can automatically be applied to a large number of struggling homeowners and slowing down the pace of foreclosures.

In response to a legal settlement with several states announced 5 October 2008, Bank of America has announced a more aggressive program to systematically help an estimated 400,000 homeowners stay in their homes. This includes limiting payments to a specific level of income and writing down the values of mortgages.

In Australia several lenders have amended their policy for low doc, no doc and no deposit loans that are considered to be riskier than standard home loans. Overall these changes have been relatively minor with the exception of the non conforming lenders that lend to credit impaired and subprime borrowers. It is unknown if this trend will continue or if Australian lenders will be forced to withdraw from riskier loan products.

Hope Now Alliance

President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs. A refinancing facility called FHA-Secure was also created. This action is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.

The Hope Now Alliance released a report in February 2008 indicating it helped 545,000 subprime borrowers with shaky credit in the second half of 2007, or 7.7% of 7.1 million subprime loans outstanding in September 2007. A spokesperson acknowledged that much more must be done. During February 2008, a program called "Project Lifeline" was announced. Six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for homeowners 90 or more days delinquent on payments. The intent of the program was to encourage more loan adjustments, to avoid foreclosures.

Bank capital replenishment

Major financial institutions obtained over $260 billion in new capital (i.e., cash investments) as of May 2008. Such capital is used to help banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to subprime loan or CDO losses. This capital was raised by issuing such instruments as bonds or preferred stock to investors in exchange for cash. Such capital raising has been advocated by the leaders of the U.S. Federal Reserve and the Treasury Department. Well-funded banks are in a better position to loan at favorable interest rates, which offsets the liquidity and uncertainty aspects of the crisis.

The ability of some banks and securities firms to place such large volumes of debt with investors is an indication to some analysts that these firms will survive the credit crisis. In response to the crisis, the last independent investment banks, Goldman Sachs and Morgan Stanley, elected to become bank holding companies in order to gain access to additional liquidity.

Banks have obtained some of this capital from sovereign wealth funds, which are entities that control the surplus savings of developing countries. An estimated U.S. $69 billion has been invested by these entities in large financial institutions over the past year. On 15 January 2008, sovereign wealth funds provided a total of $21 billion to two major U.S. financial institutions. Sovereign wealth funds are estimated to control nearly $2.9 trillion. Much of this wealth is oil and gas related. As they represent the surplus funds of governments, these entities carry at least the perception that their investments have underlying political motives.

Certain major banks have also reduced their dividend payouts to increase liquidity and further dividend reductions are expected by some analysts in 2008. Of the 3,776 U.S. FDIC insured institutions that paid common stock dividends in the first quarter of 2007, almost half (48%) paid lower dividends in the first quarter of 2008, including 666 institutions that paid no dividends. Insured institutions paid $14.0 billion in total dividends in the first quarter, down $12.2 billion (46.5%) from a year earlier.

Litigation

Litigation related to the subprime crisis is underway. A study released in February 2008 indicated that 278 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts was not quantified but is also believed to be significant. The study found that 43% of the cases were class actions brought by borrowers, such as those that contended they were victims of discriminatory lending practices. Other cases include securities lawsuits filed by investors, commercial contract disputes, employment class actions, and bankruptcy-related cases. Defendants included mortgage bankers, brokers, lenders, appraisers, title companies, home builders, servicers, issuers, underwriters, bond insurers, money managers, public accounting firms, and company boards and officers.

Former Bear Stearns managers were named in civil lawsuits brought in 2007 by investors, including Barclays Bank PLC, who claimed they had been misled. Barclays claimed that Bear Stearns knew that certain assets in the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear Stearns managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." The lawsuit said Bear Stearns told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."

In 2006, the OFHEO announced a suit against Franklin Raines, former chairman and chief executive officer of Fannie Mae, which was eventually settled.

Law enforcement

The number of FBI agents assigned to mortgage-related crimes increased by 50% between 2007 and 2008. In June 2008, the FBI stated that its mortgage fraud caseload has doubled in the past three years to more than 1,400 pending cases. Between 1 March and 18 June 2008, 406 people were arrested for mortgage fraud in an FBI sting across the country. People arrested include buyers, sellers and others across the wide-ranging mortgage industry. On 19 June 2008, two former Bear Stearns managers were arrested by the FBI, and were the first Wall Street executives arrested related to the subprime lending crisis. They were suspected of misleading investors about the risky subprime mortgage market.

On 23 September 2008, two government officials stated that the Federal Bureau of Investigation was looking into the possibility of fraud by mortgage financing companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International Group.

Ethics investigation

Further information: [[:Countrywide financial political loan scandal]]

On 18 June 2008, a Congressional ethics panel started examining allegations that Democrat Senators Christopher Dodd of Connecticut (the sponsor of a major $300 billion housing rescue bill) and Kent Conrad of North Dakota received preferential loans by troubled mortgage lender Countrywide Financial Corp.

Effect on the financial condition of the U.S. government

See also: United states public debt

Deficit and Debt Increases 2001-2008

The U.S. federal government has made significant additional financial commitments through efforts to support the financial system. This includes pledges of up to $200 billion to protect Fannie Mae and Freddie Mac, an $85 billion bridge loan for AIG, and a $29 billion loan guarantee for Bear Stearns. As the crisis has progressed, the Fed has expanded the collateral against which it loans, including higher-risk assets and (in certain cases) equity. Through June 2008, the Fed had provided approximately $1.2 trillion in loans to various financial institutions through its Term auction facility. The extent to which the federal government will suffer losses on these investments is not presently clear.

In addition, an estimated $1.2 trillion reduction in housing prices and slowing of the economy are expected to significantly reduce state and local property tax revenues.

The expectation of the falling state and local property tax revenues is affecting the ability of state governments to finance their operations through bond sales. Both the State of California and the State of Massachusetts have requested loans from the U.S. Federal Reserve to fund their operations since the credit markets have seized up.

The U.S. national debt increased by over $1 trillion during a single year for the first time in FY 2008, versus an average of $550 billion during the previous five years. The total debt reached $10 trillion in September 2008.

Expectations and forecasts

Several years before the crisis Fairfax Financial's Prem Watsa warned: "We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds eliminates the incentive for the originator of the loan to be credit sensitive... With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard)... This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S.... Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket?

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm". Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s".

The Associated Press described the current climate of the market on 13 August 2007, as one where investors were waiting for "the next shoe to drop" as problems from "an overheated housing market and an overextended consumer" are "just beginning to emerge." MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse".

As of 22 November 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion. As of 22 December 2007, a leading business periodical estimated subprime defaults between U.S. $200–300 billion. As of 1 March 2008 analysts from three large financial institutions estimated the impact would be between U.S. $350–600 billion.

On 20 March 2008, the Organization for Economic Cooperation and Development downgraded its economic forecasts for the United States, the Eurozone and Japan for the first half of 2008.

Because of the global economy, and the huge subprime "pool" of mortgages that was bought by investors world wide, the International Monetary Fund (IMF) "says that the worldwide losses stemming from the US subprime mortgage crisis could run to $945 billion."

Francis Fukuyama has argued that the crisis represents the end of Reaganism in the financial sector, which was characterized by lighter regulation, pared-back government, and lower taxes. Significant financial sector regulatory changes are expected as a result of the crisis.

Fareed Zakaria believes that the crisis may force Americans and their government to live within their means. Further, some of the best minds may be redeployed from "financial engineering" to more valuable business activities, or to science and technology.

Greenspan, the former Chairman of the Federal Reserve, stated:

"The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business."

See also

• Emergency Economic Stabilization Act of 2008
• Federal takeover of Fannie Mae and Freddie Mac
• Subprime crisis impact timeline
• Savings and Loan crisis
• Hope Now Alliance
• United States housing market correction
• Subprime lending
• Predatory lending
• Real estate bubble
• Nationalisation of Northern Rock
• Collateralized debt obligation subprime meltdown
• Bear Stearns subprime mortgage hedge fund crisis
• List of entities involved in 2007–2008 financial crises
• January 2008 stock market volatility
• United States public debt
• Economic crisis of 2008
• Oil price increases since 2003
• Diamond-Dybvig model
• Ninja loans
• Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis
• Countrywide financial political loan scandal
• Shadow banking system
• Panic of 1837
• Names used to describe the Subprime Mortgage Crisis

The world housing bubble

• Indian property bubble
• Irish property bubble
• Japanese asset price bubble
• Spanish property bubble
• United States housing bubble
• United Kingdom housing bubble

Further reading

• "A House of Cards - from fantasy finance to global crash". Gerry Gold & Paul Feldman (2007: London, Lupus Books), ISBN 9780952345435

External links

• Subprime Crisis Research Council "White Paper".September 15, 2008 (Hudson Institute, Washington, DC)
• "The US sub-prime crisis in graphics". BBC. 21 November 2007.
• Yuliya Demyanyk (FRB St. Louis) and Otto Van Hemert (NYU Stern, "Understanding the Subprime Mortgage Crisis", Working paper published at Social Science Research Network, August 19, 2008 draft.
• Carmen M. Reinhart and Kenneth S. Rogoff, Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison, Harvard University, February 5, 2008.
• Danielle DiMartino and John V. Duca, The Rise and Fall of Subprime Mortgages, Federal Reserve Bank of Dallas "Economic Letter," Vol. 2, No. 11, November 2007.
• Robin Blackburn, The Subprime Mortgage Crisis, New Left Review #50, March–April 2008.
• Milken Institute, Demystifying the Mortgage Meltdown: Slideshow, October 2, 2008.
• Market Mayhem and Meltdown: What is at Stake?. October, 2008 (Geopolicity)