The Sub-prime crisis in

the USA 2008: Causes

and Features

Submitted by:

Hailey Kasbekar(32220)
Kaushal Lama(32226)
Mohd. Zubair (32237)
Anubhav Sinha(32245)
Rakhee Sinha(32246)
Financial Crisis
Financial Crisis is applied broadly to a variety of situations in which some financial institutions
or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many
financial crises were associated with banking panics, and many recessions coincided with these
panics. Other situations that are often called financial crises include stock market crashes and the
bursting of other financial bubbles, currency crises, and sovereign defaults.

Types of Financial Crisis:

Banking crisis

When a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since
banks lend out most of the cash they receive in deposits (see fractional-reserve banking), it is
difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may
leave the bank in bankruptcy, causing many depositors to lose their savings unless they are
covered by deposit insurance. A situation in which bank runs are widespread is called a systemic
banking crisis or just a banking panic.

Speculative bubbles and crashes

Economists say that a financial asset (stock, for example) exhibits a bubble when its price
exceeds the present value of the future income (such as interest or dividends) that would be
received by owning it to maturity.[4] If most market participants buy the asset primarily in hopes
of selling it later at a higher price, instead of buying it for the income it will generate, this could
be evidence that a bubble is present. If there is a bubble, there is also a risk of a crash in asset
prices: market participants will go on buying only as long as they expect others to buy, and when
many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset's
price actually equals its fundamental value, so it is hard to detect bubbles reliably.

Ex. dot-com bubble, Wall Street Crash of 1929

International financial crises

When a country that maintains a fixed exchange rate is suddenly forced to devalue its currency
because of a speculative attack, this is called a currency crisis or balance of payments crisis.
When a country fails to pay back its sovereign debt, this is called a sovereign default. While
devaluation and default could both be voluntary decisions of the government, they are often
perceived to be the involuntary results of a change in investor sentiment that leads to a sudden
stop in capital inflows or a sudden increase in capital flight.
Wider economic crises

Negative GDP growth lasting two or more quarters is called a recession. An especially prolonged
recession may be called a depression, while a long period of slow but not necessarily negative
growth is sometimes called economic stagnation.

SUB PRIME LOANS:

A Sub-Prime loan is a loan offered to an interest rate above market rate to those who do not
qualify for market-rate (prime rate) loans because of low income or poor credit history. If a
lender thinks that there is an above-average risk involved in giving a loan to a certain individual,
they will sometimes offer them a subprime loan, which has an interest rate higher than the prime
rate. The subprime rate offered by the lender can vary from institution to institution.

Quite often, subprime borrowers are often turned away from traditional lenders because of their
low credit ratings or other factors that suggest that they have a reasonable chance of defaulting
on the debt repayment. Usually sub-prime borrowers have to pay low equated Monthly
Installments (EMIs) in the beginning.

The Workings behind Subprime Loans

Subprime loans often come with higher interest rates, added fees, and fluctuating terms. Most
subprime loans have a low, introductory interest rate for the first two to five years. Then, after
this “introductory period”, the rate goes up to the standard prime rate PLUS 5% or more. For,
example, if the current prime interest rate is 5.25%, when the introductory rate expires, the fully
adjusted mortgage rate will be 10.25% whereas a prime loan would be closer to 5.5%. As you
can see, this drastically affects the loan and the mortgage amount. Those who got in at a low
interest rate didn’t have a enough upfront to get a prime loan – so chances of them affording the
increase rates is unlikely.

How this All Came to Be

A few years ago when the real estate market was booming and rates were low, everyone wanted
a home and lenders were buzzing with business. However, even with low interest rates, not
everyone who wanted a home had a credit score or debt-to-income ratio that allowed for a fixed
prime loan. This is where the game of predatory lending comes into play. Predatory lenders are
loan lenders that take advantage of those will less-than-perfect credit. Basically lenders convince
subprime borrows to get into loans that have hidden added fees, fluctuating interest rates, and
other negative aspects. Unfortunately the idea of owning a home can cloud a borrower’s
judgment and they often get into a loan they don’t fully understand until it’s too late. “Too late”
is now.

It’s been about 5 years since the boom began and lenders starting divvying out subprime loans.
Hence interest rates are fluctuating drastically and subprime borrowers are defaulting on their
loans. It’s all finally come to a head and the market is taking a beating.

How the Subprime Loan Fallout Affects Primes

As was mentioned before, the real estate market is affected by all types of borrowers. Since less-
than-honest lenders were taking advantage of the real estate boom, a significant number of
subprime loans were in the market. Now many of these loans are getting defaulted on, sending
these former homeowners into the rental market rather than maintaining their homeowner status
and ultimately building up enough equity to buy a second house or upgrade to a new home. Less
buyers mean the harder it is to sell a home. The harder it is to sell a home, the less home-owners
will get for their property. This ultimately lowers home prices across the board and the entire
market is affected.

Causes
The crisis can be attributed to a number of factors pervasive in both housing and credit markets,
factors which emerged over a number of years. The factors can be broadly divided into the
following headings:

Government’s role in subprime lending

There were several faulty Government policies which led to a growth in the factors which
ultimately brought about this downfall.

One of the prominent policies of several presidents including Roosevelt, Reagan, Clinton and
G.W.Bush has been increasing house ownership as housing wealth plays a demonstrably
significant role in US consumption. In 1982, the Alternative Mortgage Transactions Parity Act
(AMTPA) was passed by the Congress. This allowed non-federally chartered housing creditors
to write adjustable-rate mortgages. Thus various types of mortgage loan products were created
which replaced the conventional fixed-rate, amortizing mortgages. In 1995, tax incentives were
proposed to the GSEs like Fanny Mae and Freddie Mac who lend to low income borrowers. In
fact, HUD gave them a target that more than 50% of the mortgages they purchase should have
been issued to the poor borrowers. By 2008, the Fannie Mae and Freddie Mac owned, either
directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about
half the total U.S. mortgage market. However, their net worth as of 30 June 2008 was a mere
US$114 billion due to their high leverage. In September 2008, the government had to nationalize
these 2 companies so that they don’t default on their guarantees.

Another Reason understood to be a cause of this crisis was the repeal of the Glass Steagall Act
which was enacted in 1933 after the Great Depression. This repeal has been criticized for
reducing the separation between commercial banks (which traditionally had a conservative
culture) and investment banks (which had a more risk-taking culture).

In a testimony before the US Congress, the Securities Exchange Commission (SEC) and Alan
Greenspan conceded their failure in effective regulation of the shadow banking system in
allowing the self-regulation of Wall Street's investment banks. The SEC relaxed rules in 2004
that enabled investment banks to substantially increase the level of debt they were taking on,
fueling the growth in mortgage-backed securities supporting subprime mortgages. The top five
US investment banks each significantly increased their financial leverage during the 2004-2007
time period (see diagram below), which increased their vulnerability to the MBS losses. These
five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the
size of the U.S. economy. Of these 5, Lehmann Brothers went bankrupt; Bear Sterns and Merrill
Lynch had to be sold off and Goldman Sachs and Morgan Stanley had to convert themselves to
commercial bank models in order to qualify for Troubled Asset Relief Program (TARP) funds.
 Another Act which is accused to have caused this downfall was the Community Reinvestment
Act(CRA), originally enacted under President Carter in 1977. The Act was set in place to
encourage banks to halt the practice of lending discrimination. Detractors of this act say that it
encouraged lending to non-creditworthy consumers. Whereas defenders of this Act cite the thirty
year history of lending without increased risk. However though there is some effect on this Act
on the crisis, it amounts to a very small percentage (6%) of the total subprime loans.

Lending rates and their effect on the market

Because of tax incentives and liberal Government policies, the lending behavior had become so
drastically reckless and unscrupulous that there was a huge surge in the numbers of high-risk
borrowers. Sub-prime mortgages had grown to a tune of $600 billion in 2006. In addition to
considering higher-risk borrowers, lenders have offered increasingly risky loan options and
borrowing incentives. The mortgage qualification guidelines began to change. At first, the stated
income, verified assets (SIVA) loans came out. Proof of income was no longer needed.
Borrowers just needed to "state" it and show that they had money in the bank. Then, the no
income, verified assets (NIVA) loans came out. The lender no longer required proof of
employment. Borrowers just needed to show proof of money in their bank accounts. The
qualification guidelines kept getting looser in order to produce more mortgages and more
securities. This led to the creation of NINA (No Income No Assets). Even people with high
credit scores availed of these loans. Investment banks on Wall Street answered the demand for
relatively safe, income generating investments with innovative financial instruments such as the
Mortgage Backed Security (MBS) and Collateralized Debt Obligation (CDO), which were assigned safe
ratings by the credit rating agencies.

Growth of reality & housing sector in the USA

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years
prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA
home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time
high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership
rates and in the overall demand for housing, which drove prices higher. Between 1997 and 2006, the price
of the typical American house increased by 124%. While housing prices were increasing, consumers were
saving less and both borrowing and spending more. This credit and house price explosion led to a
building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak
and begin declining in mid-2006. Easy credit, and a belief that house prices would continue to appreciate,
had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed
borrowers with a below market interest rate for some predetermined period, followed by market interest
rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once
the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult,
once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to
escape higher monthly payments by refinancing began to default.

As more borrowers stopped paying their mortgage payments, foreclosures and the supply of homes for
sale increased. This placed downward pressure on housing prices, which further lowered homeowners’
equity. The decline in mortgage payments also reduced the value of MBS, which eroded the net worth
and financial health of banks. Now many borrowers found that their homes were worth less than their
mortgages. Thus they defaulted on these mortgages.
Credit Rating Agencies

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization
transactions holding subprime mortgages. Higher ratings theoretically were due to the multiple,
independent mortgages held in the mortgage-backed securities, according to the agencies. Critics claim
that conflicts of interest were involved, as rating agencies are paid by those companies selling the MBS to
investors, such as investment banks.

In a 2007 speech Greenspan made in London he implicitly criticized the role of ratings agencies in the
crisis.

“The problem was that people took that as AAA because ratings agencies said so.”

Yet when they tried to sell the products they ran into difficulties, which shook confidence. “What we saw
was a 180 degree swing from euphoria to fear and what we’ve learned over the generations is that fear is
a very formidable challenge.” As of November 2007, credit rating agencies had downgraded over $50
billion in highly rated collateralized debt obligations and more such downgrades are possible. Since
certain types of institutional investors are allowed to only carry higher-quality assets, there is an increased
risk of forced asset sales, which could cause further devaluation.
Ratings agencies such as Standard & Poor’s Corp., Moody’s Investors Service Inc. and Fitch
Ratings have come under fire for being slow to lower their ratings on securities based on
mortgage loans to U.S. borrowers with poor credit records.

The Sub-Prime Crisis

Heavy Subprime lending from bank and other financial institutions was a major factor in the
increase in home ownership rates and the demand for housing during the bubble years. The U.S.
ownership rate increased from 64 percent in 1994 to an all-time high peak of 69.2 percent in
2004. This increase in demand fuelled the increase in housing prices. It led to increase in home
values of 124 % between 1997 and 2006.

Some homeowners even refinanced their homes with lower interest rates and took second
mortgages. This resulted in rise of US household debt as a percentage of income to 130 percent
in 2007.

As the housing bubble collapsed the default rates of these subprime borrowers and “Alt-A”
borrowers with lower income or bad credit history increased. “Alt-A” is a classification of
mortgages in which the risk profile falls between prime and subprime. The borrowers behind
these mortgages typically will have clean credit histories, but the mortgage itself generally will
have some issues that increase its risk profile.

Some data regarding subprime mortgages and loans

  Subprime mortgages to total originations increased from 9% in 1996 to 20% in 2006
(according to Forbes).

 Subprime mortgages totaled $600 billion in 2006, approximately 20% of US home loan
market.

 An estimated $1.3 trillion in subprime loans will be outstanding.

Securitization of debt

Black’s Law Dictionary defines securitization as a structured finance process in which assets,
receivables or financial instruments are acquired, classified into pools and offered as collateral
for third-party investment. Due to 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. Details regarding MBS can be given by the graph.
The securitized share of subprime mortgages, those passed to third-party investors, increased
from 54 percent in 2001, to 75 percent in 2006.

Role of rating agencies

Credit rating agencies like Standard $ Poor’s Corp., Moody’s Investors Service Inc. and Fitch
ratings were blamed for giving investment-grade ratings to these MBS(Mortgage backed
securities). While Critics claim that conflict of interest were involved, as rating agencies are paid
by those companies selling MBS to investors, rating agencies denied their claim.

Indication of a start of a crisis

Several sub-prime mortgage holders defaulted on their loans and the first sign of a “crisis”
emerged in March 2007 when shares in New Century Financial, one of the largest sub-prime
lenders in the US, were suspended amid fears that the firm could be heading for bankruptcy.
Another US-based sub-prime firm Accredited Home Lenders Holding said it would pass on $2.7
billion of its loans at a heavy discount. On April 2, 2007, New Century Financial filed for
bankruptcy protection after it was forced by its backers to repurchase billions of dollars worth of
bad loans. The sub-prime mortgage crisis went on to affect major global investment banks as
well. Shares in Bear Stearns came under pressure in May 2007 because of the bank’s exposure to
the US sub-prime market. In June, Merrill Lynch seized and sold $800 million of bonds used as
collateral for loans made to Bear Stearns’ hedge funds that were used to bet on the sub-prime
mortgage market.

In July 2007, General Electric decided to sell the WMC Mortgage sub-prime lending business it
bought in 2004. Goldman Sachs also announced financial support for one of its struggling hedge
funds hit by the defaulting sub-prime mortgages.

During 2008, three of the 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). These failures
augmented the instability in the global financial system. The remaining two investment banks,
Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby subjecting
themselves to more stringent regulation.

Features
The Features or repercussions of the Subprime crisis can be divided into the following categories

Effects on the banking sector

Effects on parallel banking sector(Investment banking)

Effects on net wealth and stock market

Effects on the reality sector

Effect on world banking and financial sector

Effects on the Reality Sector

U.S. home prices fell by 11.4 percent .Steepest since 1980

Reported that the percentage of all mortgages nationwide that started the foreclosure process
jumped to a record high of 0.78 percent in the third quarter
Price dropping continuous for last 19 months

Sale of new homes down by 25% to a 13 year low

Equity of houses down by 50% for the first time on FED record

Homeowners’ percentage of equity declined to 47.9 percent

Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35%
potential drop.

Landlords lost their properties, thus forcing tenants out of their homes.

Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had
dropped to $8.8 trillion by mid-2008

Effects on the Net wealth and Stock Market

Global when stock markets around the world plummeted

There is a direct relationship between declines in wealth, and declines in consumption and
business investment, which along with government spending represent the economic engine

Americans lost an estimated average of more than a quarter of their collective net worth

U.S. stock index the S&P 500, was down 45 percent from its 2007 high.

Total retirement assets, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-
2008

States lost nearly $3 billion in property tax revenue and another $1 billion in sales and transfer
tax revenue because of foreclosures

Projected $166 billion in lost gross domestic product growth, stemming from plunging real estate
values.

524,000 fewer jobs being created in 2008 and a potential loss of $6.6 billion in tax revenues

The losses total a staggering $8.3 trillion from the start of the crisis

Household wealth is down $14 trillion.

Effects on the World banking sector

The banking sector lost about $1 Trillion in bad debts

Stock prices fell more than 7 percent in Germany and India, 5.5 percent in Britain, 5.1percent in
China and 3.9 percent in Japan.

Many countries reported their worst market declines since Sept. 11, 2001

Mark-to-market losses on mortgage-backed securities, collateralized debt obligations and related

assets through March 2008 approximate $945b

European financial entities stand to incur $123bn in mortgage-related losses.

British institutions face $40bn in asset write offs, nearly matching the combined losses of the
euro area ($45bn).

The IMF estimates that housing prices in the Netherlands, Ireland and the UK are 30% higher
than justified by economic fundamentals. British housing prices fell by 2.5% in March, the
sharpest monthly fall in the country since 1992.

Growth of GDP, by 0.1 percent, for the countries of the Euro zone

Even negative number for the UK (-1.0 percent)

Worldwide recession by -0.3 percent for 2009, averaged over the developed economies

An unemployment plateau in 2009 and 2010 around 10% Effects on parallel banking
sector(Investment banking)

Effects on parallel banking sector(Investment banking)

Financial firms have written down their holdings of subprime related securities by US$501
billion.

The IMF estimates that financial institutions around the globe will eventually have to write off
$1.5 trillion of their holdings of subprime MBSs

U.S. banks losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion

Lehman in its bankruptcy filings, it held assets worth US$ 639 billion4 whereas its total
liabilities stood at US$ 613 billion.

Lehman filed the biggest bankruptcy ever in the world.

The bank reported a loss of US$ 2.8 billion in the second quarter of 2008 ending May 2008, its
first loss since it went public in the year 1994

The Spread of Risk as the credit crisis unfolded