Subprime mortgage crisis: Difference between revisions

From Citizendium
Jump to navigation Jump to search
imported>Nick Gardner
No edit summary
imported>Nick Gardner
No edit summary
Line 3: Line 3:
The '''subprime mortgage crisis''' was a financial shock that originated  from defaults on the United States mortgage markets, and caused serious financial problems among the providers of finance to those markets, including the government-sponsored enterprises ''Fannie Mae'' and ''Fannie Mac'' and several major banks. As  explained by  [[Nobel Prize]]-winning economist [[Paul Krugman]]:
The '''subprime mortgage crisis''' was a financial shock that originated  from defaults on the United States mortgage markets, and caused serious financial problems among the providers of finance to those markets, including the government-sponsored enterprises ''Fannie Mae'' and ''Fannie Mac'' and several major banks. As  explained by  [[Nobel Prize]]-winning economist [[Paul Krugman]]:
<blockquote>The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.<ref>"Gordon Does Good,", Paul Krugman, ''The New York Times'', October 13, 2008, at [http://www.nytimes.com/2008/10/13/opinion/13krugman.html?hp]</ref></blockquote>. The crisis subsequently  spread to other financial markets to lead to the global ''[[Crash of 2008]]''.
<blockquote>The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.<ref>"Gordon Does Good,", Paul Krugman, ''The New York Times'', October 13, 2008, at [http://www.nytimes.com/2008/10/13/opinion/13krugman.html?hp]</ref></blockquote>. The crisis subsequently  spread to other financial markets to lead to the global ''[[Crash of 2008]]''.


:''(for definitions of terms shown in italics, see the glossary on the [[/Related Articles|Related Articles subpage]] and for the sequence of events connected with the crisis, see the [[/Timelines|Timelines subpage]])''.
:''(for definitions of terms shown in italics, see the glossary on the [[/Related Articles|Related Articles subpage]] and for the sequence of events connected with the crisis, see the [[/Timelines|Timelines subpage]])''.


== The Crisis==  
== The Crisis==  
Unexpected defaults by the holders of some mortgages, following sharp falls in house prices, led to  serious financial problems at ''Fannie Mae'' and ''Freddie Mac'' that were major providers of finance to the United States mortgage markets, and to some of the banks who were also important sources of its  finance. An atmosphere of general  uncertainty about the value of some mortgage-backed assets  developed among other providers of finance to those markets, and operators in the financial markets  became reluctant to  lend money  on the security of those assets, placing other  holders of those assets in financial difficulties. There developed a loss of confidence in  organisations  that were suspected of being vulnerable to the falling value of their holdings of all mortgage-related assets, and that created a widespread financial crisis.  
A period of low interest rates, combined with the faulty assumption that house prices would continue to rise -- led  mortgage lenders e to approve  loans  without due regard to  ability to pay, and borrowers to take out larger loans  than they could afford. Optimism about prices also led to a boom in  which  more houses were built than people were willing to buy, so that  prices fell  and  borrowers -  with houses  worth less than they expected and payments they could not afford -  began to default.
That  led to  serious financial problems at the government-sponsored enterprises ''Fannie Mae'' and ''Freddie Mac'' that were major providers of finance to the United States mortgage markets, and to some of the banks who were also important sources of its  finance. An atmosphere of general  uncertainty about the value of some mortgage-backed assets  developed among other providers of finance to those markets, and operators in the financial markets  became reluctant to  lend money  on the security of those assets, placing other  holders of those assets in financial difficulties. There developed a loss of confidence in  organisations  that were suspected of being vulnerable to the falling value of their holdings of all mortgage-related assets, and that created a widespread financial crisis.  


Among the factors that are considered to have contributed to the development of what is considered to have been the house price "bubble", and to the problems that arose from  its collapse,  are the conduct of monetary policy, the inflow of funds from abroad, Government housing policies, the creation of new ways of financing mortgages, the conduct of  providers of mortgage finance; and the consequent behaviour of the housing markets.
Among the factors that are considered to have contributed to the development of what is considered to have been the house price "bubble", and to the problems that arose from  its collapse,  are the conduct of monetary policy, the inflow of funds from abroad, Government housing policies, the creation of new ways of financing mortgages, the conduct of  providers of mortgage finance; and the consequent behaviour of the housing markets.

Revision as of 06:06, 31 October 2008

This article is developed but not approved.
Main Article
Discussion
Related Articles  [?]
Bibliography  [?]
External Links  [?]
Citable Version  [?]
Timelines [?]
 
This editable, developed Main Article is subject to a disclaimer.

The subprime mortgage crisis was a financial shock that originated from defaults on the United States mortgage markets, and caused serious financial problems among the providers of finance to those markets, including the government-sponsored enterprises Fannie Mae and Fannie Mac and several major banks. As explained by Nobel Prize-winning economist Paul Krugman:

The bursting of the housing bubble has led to large losses for anyone who bought assets backed by mortgage payments; these losses have left many financial institutions with too much debt and too little capital to provide the credit the economy needs; troubled financial institutions have tried to meet their debts and increase their capital by selling assets, but this has driven asset prices down, reducing their capital even further.[1]

. The crisis subsequently spread to other financial markets to lead to the global Crash of 2008.


(for definitions of terms shown in italics, see the glossary on the Related Articles subpage and for the sequence of events connected with the crisis, see the Timelines subpage).

The Crisis

A period of low interest rates, combined with the faulty assumption that house prices would continue to rise -- led mortgage lenders e to approve loans without due regard to ability to pay, and borrowers to take out larger loans than they could afford. Optimism about prices also led to a boom in which more houses were built than people were willing to buy, so that prices fell and borrowers - with houses worth less than they expected and payments they could not afford - began to default. That led to serious financial problems at the government-sponsored enterprises Fannie Mae and Freddie Mac that were major providers of finance to the United States mortgage markets, and to some of the banks who were also important sources of its finance. An atmosphere of general uncertainty about the value of some mortgage-backed assets developed among other providers of finance to those markets, and operators in the financial markets became reluctant to lend money on the security of those assets, placing other holders of those assets in financial difficulties. There developed a loss of confidence in organisations that were suspected of being vulnerable to the falling value of their holdings of all mortgage-related assets, and that created a widespread financial crisis.

Among the factors that are considered to have contributed to the development of what is considered to have been the house price "bubble", and to the problems that arose from its collapse, are the conduct of monetary policy, the inflow of funds from abroad, Government housing policies, the creation of new ways of financing mortgages, the conduct of providers of mortgage finance; and the consequent behaviour of the housing markets.

Monetary policy

There is some evidence of a connection between the subprime crisis and the Federal Reserve Bank's conduct of monetary policy. Since the 1980s, the Bank's monetary policy had successfully stabilised the American economy - and its housing market - by the application of the "Taylor Rule" [2] under which changes to the bank's discount rate had been related to the spare capacity in the economy. During the period from 2003 to 2006, however, the discount rate was held well below the level suggested by that rule. The author of the rule, Professor John Taylor of Stanford University, has given an account of the consequences of that departure [3]. He argues that those low interest rates helped to foster the extraordinary surge which occurred in the demand for housing, and that the eventual fall in housing prices would have been less steep, and the following crisis less severe, had the Taylor rule been followed.

The "wall of money"

A connection has also been noted between the housing boom and increases in the availability of finance. However, the funds used to finance the surge in housing investment were obtained largely by borrowing from abroad, rather than from domestic savings [4]. In the early years of the 21st century there were large inflows of money from abroad, corresponding to the country's large current account deficit [5]. That development was attributed by some commentators to increases in the federal budget deficit, but Federal Reserve Bank Chairman Ben Bernanke argued that it was caused mainly by a "savings glut" in China and other developing countries resulting in large purchases of American securities [6] (sometimes referred to as "the wall of money"). A correlation between the growing current account deficit and increases in housing investment had also been noted by the Board's previous Chairman [7].

Housing legislation

Another influence upon the housing market was the Community Reinvestment Act 1977 (CRA), which required the Federal Reserve Bank and other government agencies to encourage banks to provide credit to low-income families ""in ways that are consistent with safe and sound banking operations".[8]. The Act does not provide for grants to individuals, but encourages regulatory authorities to make their authorisations, in response to applications by mortgage-lenders, conditional upon their performance in meeting the aims of the legislation. Since its inauguration, it has been strengthened by a succession of amending enactments, [9], and in 2008 there were reports that it was inducing mortgage-lenders to take greater risks than they had been accustomed to. For example, pressure to conform was reported to have influenced the government-sponsored enterprise known as "Fannie Mae" to undertake more risky investments [10].

Securitisation

A further contribution to the crisis arose from changes in the late 20th century in the way that mortgages are financed. Banks had previously financed their lending mainly by deposits from their customers. That practice was largely replaced by the practice of converting mortgages into graded securities and selling them on the bond markets - a practice that made possible a massive increase in mortgage lending, [11]. Bank mortgages came to account for a substantial proportion of a market that had previously been dominated by the government-sponsored agencies (Fannie Mae and Freddie Mac) [12], and mortgage-related bonds came to occupy an important place in the bond market [13].

Lending policies

Other important factors were the easing of credit terms for loans to low-income borrowers by the government-sponsored enterprises (Fannie Mae and Freddie Mac) [14], and the growing proportion of loans that went to "subprime borrowers" [15] . Subprime borrowers were people who had been given low credit ratings [16] because they had a history of late payments or defaults. Subprime mortgages were much more profitable than normal mortgages because, compared with a typical 5 percent interest rate, subprime borrowers were usually charged about 7 percent. Often they were sold to existing home owners who needed money to pay off other debts [17]. Some were sold by mortgage brokers who adopted "predatory lending "[18] practices, or otherwise misled their clients, [19]. Most of them were "adjustable-rate mortgages" with initially low repayment rates that were due to be raised after the first two or three years.

Housing market developments

In response to the surge in the demand for housing in the period 2003 to 2006, the annual rate of growth of house prices rose to ten percent in the fourth quarter of 2004 and continued at that average rate for two years, reaching twenty percent at times. Expectations of price increases further accelerated the demand for housing, putting further upward pressure on prices. With the consequent development of a major "housing bubble" [20],, there was a fall in the number of defaults and foreclosures of subprime mortgages, leading to increases in the credit ratings of mortgage-backed securities. Those increases turned out to be transitory, however. When interest rates returned to more normal levels in 2007, the demand for housing fell sharply, house prices fell, and there was a surge in defaults by subprime mortgage holders, many of whom then found themselves unable to use their houses as security for further borrowing.

Financial stresses

The surge in defaults in the subprime mortgages market led credit agencies to downgrade their ratings of securities based upon those mortgages, and banks holding such securities found themselves unable to use them as collateral for their borrowing needs. This created financial problems that started with Fannie Mae and Freddie Mac and then shifted to the major banks [21]. Hedge funds guaranteed by the American Bear Stearns bank ran into difficulties as a result of the downgrading, and the bank had to be rescued. Downgrading of their assets led subsequently to the collapse and government rescue of Fannie Mae and Freddie Mac. Uncertainty about the quality of banking assets made banks reluctant to lend to each other and the important interbank market ceased to operate. Banks that had relied upon that source of finance, such as the UK's Northern Rock also ran into difficulties leading to a further loss of confidence. Following severe losses as a result of the subsequent Lehman Brothers bankruptcy, the short-term money market also ceased to operate.

Crisis

The loss of investors' confidence in their assets, combined with the closure of what had been their major sources of short-term borrowing, put banks and other financial institutions throughout the world in severe financial difficulties, leading to the crisis described in the article on the crash of 2008.

References

  1. "Gordon Does Good,", Paul Krugman, The New York Times, October 13, 2008, at [1]
  2. The Taylor rule is explained in the article on macroeconomics.
  3. John Taylor Housing and Monetary Policy Stanford University September 2007
  4. The US saving rate had fallen from 6% in 1993 to about 1% in 2004
  5. The United States current account balance moved from a surplus of $46 billion in 1996 to a deficit of over $600 billion in 2004
  6. The Global Saving Glut and the U.S. Current Account Deficit, Remarks by Governor Ben S. Bernanke At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, Federal Reserve Board March 2005
  7. Current Account, Remarks by Chairman Alan Greenspan at the Advancing Enterprise 2005 Conference, London, England February 4, 2005, Federal Reserve Board 2005
  8. Text of the Community Reinvestment Act 1977
  9. Ben Bernanke The Community Reinvestment Act: Its Evolution and New Challenges Speech at the Community Affairs Research Conference, Washington, D.C. March 30, 2007
  10. Pressured to Take More Risk, Fannie Reached Tipping Point New York Times October 4 2008
  11. The total value of outstanding mortgages increased from $2,500 billion in 1995 to $6,000 billion in 2005
  12. The subprime lending crisis, Report of the Senate Joint Economic Committee October 2007
  13. By 2005 mortgage-related bonds accounted for $6 trillion out of a bond market total of $27 billion [2]
  14. Stephen Holmes: Fannie Mae Eases Credit To Aid Mortgage Lending, New York Times, September 1999
  15. The proportion of mortgages held by subprime borrowers rose from less than 10% in 2000 to 20% in 2006
  16. Typically with a FICO credit rating (which range from 300 to 850) of less than 620.
  17. According to Mary Moore of the Center for Responsible Lending
  18. Predatory Mortgage Lending Center for Responsible Lending January 2005
  19. Keith Ernst, Debbie Bocian, and Wei Li: Steered Wrong: Brokers, Borrowers, and Subprime Loans, Center for Responsible Lending, April 8, 2008
  20. See The Housing Bubble Debate in The Subprime Lending Crisis, Page 7 Report of the Senate Joint Economic Committee October 2007
  21. Financial Stability Report, pages 18 & 19, Bank of England October 28 2008