Subprime crisis background information

This article provides background information helpful to understanding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved are affected by the crisis.

A plain-language overview

The following is excerpted (with some modifications) from President Bush's Address to the Nation on September 24, 2008: [ [http://www.whitehouse.gov/news/releases/2008/09/20080924-10.html President's Address to the Nation] ] Other additions are sourced later in the article or in the main article.

The problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad. This large influx of money to U.S. banks and financial institutions — along with low interest rates — made it easier for Americans to get credit. Easy credit — combined with the faulty assumption that home values would continue to rise — led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on. Both individuals and financial institutions increased their debt levels relative to historical norms during the past decade significantly.

Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or refinance their homes before the adjustments occurred were unable to refinance. As a result, many mortgage holders began to default as the adjustments began.

These widespread defaults (and related foreclosures) had effects far beyond the housing market. Home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Credit rating agencies gave them high-grade, safe ratings. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put the financial system at risk.

The decline in the housing market set off a domino effect across the U.S. economy. When home values declined, borrowers defaulted on their mortgages, and investors globally holding mortgage-backed securities (including many of the banks that originated them and traded them among themselves) began to incur serious losses. Before long, these securities became so unreliable that they were not being bought or sold. Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with large amounts of assets they could not sell. They ran out of the money needed to meet their immediate obligations. And they faced imminent collapse. Other banks found themselves in severe financial trouble. These banks began holding on to their money, and lending dried up, and the gears of the American financial system began grinding to a halt.

The crisis has gone through stages. First, during late 2007, over 100 mortgage lending companies went bankrupt as subprime mortgage-backed securities could no longer be used to acquire funds. Second, starting in Q4 2007 and in each quarter since then, banks have recognized massive losses as they adjust the value of their mortgage backed securities to a fraction of their purchased prices. Third, in Q3 2008, investment banks (which do not have the stability afforded by depositors like a commercial bank) could no longer finance their operations. The top five U.S. investment banks either went bankrupt (Lehman Brothers), merged with other institutions, or became depository banks to improve their ability to secure funds. In addition, two large U.S. banks (Washington Mutual and Wachovia) became insolvent and were sold to stronger banks. [ [http://www.bloomberg.com/apps/news?pid=20601109&sid=aJicDM1cwuZY&refer=home Wachovia & Wamu] ] Fourth, the late September 2008 crisis relates to further seizing of credit markets and has expanded globally somewhat. The interest rates bank charge to each other have increased to record levels and various methods of providing short-term funding are less available to non-financial corporations. It is this newest "credit squeeze" that has prompted the massive bailout proposed by the government in September 2008.

Until the record level of housing inventory currently on the market declines to more typical historical levels, there will be downward pressure on home prices. As long as the uncertainty remains regarding housing prices, mortgage-backed securities will continue to decline in value, placing the health of banks at risk. [ [http://opinionjournal.com/editorial/feature.html?id=110010981 Greenspan Op Ed WSJ] ] This is a contributing factor to the U.S. government's desire to purchase the mortgage-backed securities from the banks, to stabilize them.

ubprime lending and market data

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, [cite news | title = How severe is subprime mess? | url=http://www.msnbc.msn.com/id/17584725 | accessdate=2008-07-13 | work = msnbc.com | publisher = Associated Press | date = 2007-03-13 | accessdate = 2008-07-13 ] with over 7.5 million first-lien subprime mortgages outstanding. [cite speech | title = The Subprime Mortgage Market | author = Ben S. Bernanke | date = 2007-05-17 | location = Chicago, Illinois | url=http://www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm | accessdate=2008-07-13 ] 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. [cite speech | title = The Recent Financial Turmoil and its Economic and Policy Consequences | author = Ben S. Bernanke | date = 2007-10-17 |location = New York, New York | url=http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm | accessdate=2008-07-13 ] By January 2008, the delinquency rate had risen to 21%cite speech | title = Financial Markets, the Economic Outlook, and Monetary Policy | author = Ben S. Bernanke | date = 2008-01-10 | location = Washington, D.C. | url=http://www.federalreserve.gov/newsevents/speech/bernanke20080110a.htm | accessdate=2008-06-05 ] and by May 2008 it was 25%. [cite speech
title = Mortgage Delinquencies and Foreclosures
author = Bernanke, Ben S
date = 2008-05-05
location = Columbia Business School's 32nd Annual Dinner, New York, New York
url = http://www.federalreserve.gov/newsevents/speech/Bernanke20080505a.htm
accessdate=2008-05-19]

Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43% of the foreclosures started during the third quarter of 2007. [cite press release | title = Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey | publisher = Mortgage Bankers Association | date = 2007-06-12 | url=http://www.mbaa.org/NewsandMedia/PressCenter/58758.htm | accessdate=2008-07-13 ] During 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Foreclosure filings including default notices, auction sale notices and bank repossessions can include multiple notices on the same property. [cite news | title=U.S. FORECLOSURE ACTIVITY INCREASES 75 PERCENT IN 2007 | date=2008-01-29 | publisher= RealtyTrac | url=http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=3988&accnt=64847 | accessdate= 2008-06-06] More homeowners continue to receive foreclosure notices, with one in every 519 households receiving a foreclosure filing in April 2008. [cite news |title=FORECLOSURE ACTIVITY INCREASES 4 PERCENT IN APRIL |url=http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=4586&accnt=64847 |work=realitytrac.com |publisher=RealtyTrac Inc |date=2008-05-14 |accessdate=2008-05-19 ]

The mortgage market is estimated at $12 trillion [ [http://www.nytimes.com/2008/07/11/business/11ripple.html?ex=1373515200&en=8ad220403fcfdf6e&ei=5124&partner=permalink&exprod=permalink NY Times] ] with approximately 6.41% of loans delinquent and 2.75% of loans in foreclosure as of August 2008. [ [http://www.mbaa.org/NewsandMedia/PressCenter/64769.htm MBA Survey] ] The estimated value of subprime adjustable-rate mortgages (ARM) resetting at higher interest rates is U.S. $400 billion for 2007 and $500 billion for 2008. Reset activity is expected to increase to a monthly peak in March 2008 of nearly $100 billion, before declining. [cite news | title = ARM resets peaking: Borrowers unprepared - Oct. 17, 2007 | url=http://money.cnn.com/2007/10/16/real_estate/October_resets/index.htm | accessdate=2008-05-19 | year = 2008 ] An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008. [cite web | title = FRB: Testimony--Chairman Bernanke on the economic situation and outlook--8 November 2007 | url=http://www.federalreserve.gov/newsevents/testimony/bernanke20071108a.htm | accessdate=2008-05-19 | year = 2008 ]

An estimated 8.8 million homeowners (nearly 10.8% of the total) have zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provides an incentive to "walk away" from the home, despite the credit rating impact. [ [http://www.nytimes.com/2008/02/22/business/22homes.html Negative Equity] ]

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.cite web | title = New home sales fell by record amount in 2007 - Real estate - MSNBC.com | url=http://www.msnbc.msn.com/id/22880294/ | accessdate=2008-05-19 | year = 2008 ] Further, a record of nearly four million unsold existing homes were for sale, [cite web | title = Housing Meltdown | url=http://www.businessweek.com/magazine/content/08_06/b4070040767516.htm?chan=rss_topStories_ssi_5 | accessdate=2008-05-19 | year = 2008 ] including nearly 2.9 million that were vacant. [ [http://biz.yahoo.com/cnnm/080513/051208_q12008_home_prices.html Vacant homes 2.9MM] ] This excess supply of home inventory places significant downward pressure on prices. As prices decline, more homeowners are 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 peakcite web | title = America's economy | Getting worried downtown | Economist.com | url=http://www.economist.com/world/na/displaystory.cfm?story_id=10134077 | accessdate=2008-05-19 | year = 2008 ] and by May 2008 they had fallen 18.4%. [ [http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,0,0,0,0,0,0,0,1,1,0,0,0,0,0.html Case Shiller Data File] ] The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%. [ [http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_072943.pdf Case Shiller Index May 2008] ] Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.

Understanding the risks types involved in the subprime crisis

The reasons for this crisis are varied and complex.cite web | title = FT.com / Video & Audio / Interactive graphics - Credit squeeze explained | url=http://www.ft.com/cms/s/2/c2c12708-6d10-11dc-ab19-0000779fd2ac.html | accessdate=2008-05-19 | year = 2008 ] Understanding and managing the ripple effect through the worldwide economy poses a critical challenge for governments, businesses, and investors. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by the borrower and/or the lender; and mortgage incentives such as "teaser" interest rates that later rise significantly. Further, declining home prices have made re-financing more difficult. As a result of financialization and innovations in securitization, risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. There are four primary categories of risk involved:

* Credit risk: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is frequently transferred to third-party investors. The rights to mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral has made up a large proportion of issuance. In exchange for purchasing MBS or CDO and assuming credit risk, third-party investors receive a claim on the mortgage assets and related cash flows, which become collateral in the event of default. Another method of safeguarding against defaults is the credit default swap, in which one party pays a premium and the other party pays them if a particular financial instrument defaults.

* Asset price risk: MBS and CDO asset valuation is complex and related "fair value" or "mark to market" accounting is subject to wide interpretation. The valuation is derived from both the collectibility of subprime mortgage payments and the existence of a viable market into which these assets can be sold, which are interrelated. Rising mortgage delinquency rates have reduced demand for such assets. Banks and institutional investors have recognized substantial losses as they revalue their MBS downward. Several companies that borrowed money using MBS or CDO assets as collateral have faced margin calls, as lenders executed their contractual rights to get their money back. [ [http://biz.yahoo.com/e/081010/tma8-k.html Case Study-Mortgage Company Risk Factors] ] There is some debate regarding whether fair value accounting should be suspended or modified temporarily, as large write-downs of difficult-to-value MBS and CDO assets may have exacerbated the crisis. [cite news |authorlink=http://www.newsweek.com/id/32222 |author=Daniel Gross |title=The Mark-to-Market Melee |url=http://www.newsweek.com/id/130029 |work=Newsweek |publisher=Washington Post Company |date=2008-04-01 |accessdate=2008-05-19 ]

* Liquidity risk: Many companies rely on access to short-term funding markets for cash to operate (i.e., liquidity), such as the commercial paper and repurchase markets. Companies and structured investment vehicles (SIV) often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, because of concerns regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the ability of many companies to issue such paper has been significantly affected. [cite web | title =

Subprime mortgage woes infect commercial paper market - MarketWatch
url=http://www.marketwatch.com/news/story/subprime-mortgage-woes-infect-commercial/story.aspx?guid=%7B1989DE0D-9031-46A1-B3C5-8E07436CF37C%7D | accessdate=2008-05-19 | year = 2008 ] The amount of commercial paper issued as of 18 October 2007 dropped by 25%, to $888 billion, from the 8 August level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels. [cite news
author = Neil Unmack
title = Rhinebridge Commercial Paper SIV May Not Repay Debt (Update1)
url = http://www.bloomberg.com/apps/news?pid=20601087&sid=aEacPeg9pmLg&refer=home
publisher = Bloomberg L.P.
location = New York City, United States
date = 2007-10-18
accessdate=2008-07-13 ]

* Counterparty risk: Major investment banks and other financial institutions have taken significant positions in credit derivative transactions, some of which serve as a form of credit default insurance. Due to the effects of the risks above, the financial health of investment banks has declined, potentially increasing the risk to their counterparties and creating further uncertainty in financial markets. The demise and bailout of Bear Stearns was due in-part to its role in these derivatives. [cite web | title = The $2 bail-out | url = http://www.economist.com/finance/displaystory.cfm?story_id=10881453 | work = The Economist | publisher = The Economist Group | location = London | date = 2008-03-19 | accessdate=2008-05-19 ]

Effect on corporations and investors

Average investors and corporations face a variety of risks owing to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:

* Commercial / Depository bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Companies value their mortgage assets (receivables) based on estimates of collections from homeowners. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables. [cite web | title = BofA: The Credit Crunch Takes Its Toll | url=http://www.businessweek.com/investor/content/oct2007/pi20071018_206988.htm?campaign_id=yhoo | accessdate=2008-05-19 | year = 2008 ] Additionally, a bank's mortgage losses may cause it to reduce lending or seek additional funds from the capital markets, if necessary to maintain compliance with capital reserve regulatory requirements.

* Investment banks, mortgage lenders, and real estate investment trusts: These entities face similar risks to banks, yet do not have the stability provided by customer bank deposits. They have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance, borrowing short-term at lower interest rates and lending longer-term at higher interest rates (i.e., profiting from the interest rate "spread.") Such firms generated more profits the more leveraged they became (i.e., the more they borrowed and lent) as housing values increased. For example, investment banks were leveraged around 30 times equity, while commercial banks have regulatory leverage caps around 15 times equity. In other words, for each $1 provided by investors, investment banks would borrow and lend $30. [ [http://www.housingwire.com/2008/09/22/the-death-of-wall-street/ Leverage Info] ] However, due to the decline in home values, the mortgage-backed assets many purchased with borrowed funds declined in value. Further, short-term financing became more expensive or unavailable. Such firms are at increased risk of significant reductions in book value owing to asset sales at unfavorable prices and several have filed bankruptcy or been taken over. [ [http://www.businessweek.com/investor/content/sep2008/pi20080914_124812.htm?chan=top+news_top+news+index+-+temp_top+story Business Week - Lehman & Merrill Lynch] ]

* Insurance companies: Corporations such as AIG provide insurance products intended to protect against credit defaults, in exchange for a premium or fee. They are required to post a certain amount of collateral (e.g., cash or other liquid assets) to be in a position to provide payments in the event of defaults. The amount of capital is based on the credit rating of the insurer. Due to uncertainty regarding the financial position of the insurance company and potential risk of default events, credit agencies may downgrade the insurer, which requires an immediate increase in the amount of collateral posted. This risk-downgrade-post cycle can be circular and destructive across multiple firms and was a factor in the AIG bailout. [ [http://www.time.com/time/business/article/0,8599,1842123,00.html Time Magazine - Financial Madness] ]
* Special purpose entities (SPE): These are legal entities often created as part of the securitization process, to essentially remove certain assets and liabilities from bank balance sheets, theoretically insulating the parent company from credit risk. Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called structured investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks. SIV legal structures allowed financial institutions to remove large amounts of debt from their balance sheets, enabling them to use higher levels of leverage and increasing profitability during the boom period. As the value of the SIV assets was reduced, the banks were forced to bring the debt back onto their books, causing an immediate need for capital (to achieve regulatory minimums) thereby aggravating liquidity challenges in the banking system. [cite web | title = SIVs, next shoe to drop in global credit crisis? - International Business Times - | url=http://www.ibtimes.com/articles/20070828/sivs-credit-crisis_all.htm | accessdate=2008-05-19 | year = 2008 ] Some argue this shifting of assets off-balance sheet reduces financial statement transparency; SPE came under scrutiny as part of the Enron debacle, as well. Financing through off-balance sheet structures is thinly regulated. SIV and similar structures are sometimes referred to as the shadow banking system. [ [http://www.newleftreview.org/?getpdf=NLR28403&pdflang=en Blackburn - Subprime crisis] ]

* Investors: Stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection. Many investors and corporations purchased MBS or CDO as investments and incurred related losses.

Liquidity risk and the money market funding engine

During September 2008, money market mutual funds began to experience significant withdrawals of funds by investors. This created a significant risk because money market funds are integral to the ongoing financing of corporations of all types. Individual investors lend money to money market funds, which then provide the funds to corporations in exchange for corporate short-term securities called asset-backed commercial paper (ABCP). However, a potential bank run had begun on certain money market funds. If this situation has worsened, the ability of major corporations to secure needed short-term financing through ABCP issuance would have been significantly affected. To assist with liquidity throughout the system, the Treasury and Federal Reserve Bank announced that banks could obtain funds via the Federal Reserve's Discount Window using ABCP as collateral. [ [http://wsj.com/article/SB122186683086958875.html?mod=article-outset-box WSJ Article - Bailout of Money Funds] ]

To stop the potential run on money market mutual funds, the Treasury also announced on September 19 a new $50 billion program to insure the investments, similar to the Federal Deposit Insurance Corporation (FDIC) program for regular bank accounts. [Diya Gullapalli and Shefali Anand. [http://wsj.com/article/SB122186683086958875.html?mod=article-outset-box Bailout of Money Funds Seems to Stanch Outflow] . The Wall Street Journal. Markets. 2008-09-20. Retrieved 2008-09-25]

Key risk indicators in September 2008

Key risk indicators became highly volatile during September 2008, a factor leading the U.S. government to pass the Emergency Economic Stabilization Act of 2008. The “TED spread” is a measure of credit risk for inter-bank lending. It is the difference between: 1) the risk-free three-month U.S. treasury bill (t-bill) rate; and 2) the three-month London Interbank Borrowing Rate (LIBOR), which represents the rate at which banks typically lend to each other. A higher spread indicates banks perceive each other as riskier counterparties. The t-bill is considered "risk-free" because the full faith and credit of the U.S. government is behind it; theoretically, the government could just print money so investors get their money back at the maturity date of the t-bill.

The TED Spread reached record levels in late September 2008. The diagram indicates that the Treasury yield movement was a more significant driver than the changes in LIBOR. A three month t-bill yield so close to zero means that people are willing to forego interest just to keep their money (principal) safe for three months--a very high level of risk aversion and indicative of tight lending conditions. Driving this change were investors shifting funds from money market funds (generally considered nearly risk free but paying a slightly higher rate of return than t-bills) and other investment types to t-bills. [ [http://wsj.com/article/SB122186683086958875.html?mod=article-outset-box WSJ Article] ]

In addition, an increase in LIBOR means that financial instruments with variable interest terms are increasingly expensive. For example, adjustable rate mortgages, car loans and credit card interest rates are often tied to LIBOR; some estimate as much as $150 trillion in loans and derivatives are tied to LIBOR. [ [http://www.marketwatch.com/news/story/libor-jump-ted-spread-show/story.aspx?guid={3632A7B4-4B54-4AF5-86C2-78EFA350E927} Markewatch Article - LIBOR Jumps to Record] ] Higher interest rates place additional downward pressure on consumption, increasing the risk of recession.

References

External links

* (Graphic and interactive timeline.)

*

*cite news | url = http://online.wsj.com/public/resources/documents/info-flash08.html?project=PAULSON0808 | title = Fannie, Freddie and Henry | work = Wall Street Journal | date = 2008-09-09 | accessdate = 2008-09-09 | (Interactive timeline of Treasury Secretary Paulson's changing policy actions in relation to Fannie Mae and Freddie Mac – requires Flash.)

* Milken Institute, [http://www.slideshare.net/pkedrosky/making-sense-of-the-mortgage-meltdown-presentation?type=powerpoint Demystifying the Mortgage Meltdown: Slideshow] , October 2, 2008.