Us Sub Prime

Yusuf Onur Eker 2004104444

EC 344 MONEY, BANKING AND FINANCIAL INSTITUTIONS TERM PROJECT Topic 17: U.S. MORTGAGE CRISIS BEFORE AND AFTER

US Sub prime Mortgage Crisis

The mortgage crisis is the basis of current bank crisis, emerged in 2006 in U.S. In this paper , the reasons of the crisis, how did it emerged and the regulations after the crisis topics are covered: The Beginning of Everything: Sub prime Mortgage Loans In the past five years the private sector expanded its role in the mortgage bond market, specializing new types of mortgages such as “sub-prime lending” to borrowers who do not have good credit histories, level of income etc. The size of the “sub prime mortgage loans” increased over years, the share of sub prime mortgages to total originations was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006 : 1) The Rise of the Mortgage Bond Market

2) Sub prime Mortgage Market Growth

3) The Share of Sub prime Mortgage in the total Mortgage Bond Market

What are the details of these Subprime Mortgage Loans exactly ? To sum up these were the loans to borrowers with poor credit. As you can see above at chart 2, sub prime mortgage loans existed after 1998 and then gained a great share closer to 2006 and 2007. These loans have higher interest rates to compensate the risk posed by the borrowers, most of these loans are ARM’s (Adjustable rate mortgages ), wıth interest only payment options, penalties for paying off the loan early, and low documentation requirements which borrowers need just a little paperwork to borrow the loans. According to First American LoanPerformance in 2006 %56 of the loans were “liar loans” which borrowers misrepresent information to obtain the mortgage loans. These borrowers are also called mortgage frauds. The increase in the number of mortgage frauds can be viewed from this chart:

As the interest rates are low and house prices are increasing the sub prime market prospered. Home price appreciation gave borrowers a confidence that even if they fail to pay their debt they can cover this debt by selling their home in appreciated prices. During that period (which home prices are increasing over time) delinquency rates were too low which supports what I stated above. This law delinquency rate masked potential problems in the sub prime market convincing lenders and investors that sub prime loans will face defaults and foreclosures at a low rate. The sub prime mortgage market splitted into parts by ABS (asset backed securities) and CDO’s (collateralized debt obligations). The relationship between the borrower and the lender has been divided among various parties which have its own benefits from its specialized role in the cycle. This cycle will play an important role in the future of mortgage crisis which is now turning into a banking crisis that we are seeing currently in 2008.

How the Sub prime Market Collapsed? Everything was going fine, during the early 2000s, interest rates fell, borrowing demand is increased, mortgage lenders were happy that they are expanding their business and making more and more profits, new lenders were entering the market… And the story began, after the increase in US interest rates and decrease in the prices of US housing market the risk of borrowers to default is increased sharply. Defaults and foreclosure activity dramatically increased as ARM interest rates are reset higher. Subprimes started to default and could not pay their debts back. But this crisis was not only a two-sided transaction. As I stated above there are MBS (mortgage backed securities) and CDO (collateralized debt obligations) which lenders passed the rights of the mortgage payments to third parties. After sub primes could not pay back their debt ,

banks has written losses to their accounts. Under you can find some sharts which explains the situation : 1) US interest rates

2) US House Price Trends

3) Percentage of home mortgages foreclosure

What are the effects ? In 2007 the crisis affected the financial markets as Dow Jones dropped sharply during August 2007, which the investors started to escape from the market by taking their money out of risky mortgage bonds and putting their money into commodities. A-Institutions: Banks, hedge funds , mortgage lending institutions suffered great losses. As in 2008 the loss is estimated like 280 billion US Dollars. To give an example UBS AG Bank has suffered $37.7 billion, Citibank – $39.1 billion , Merrill Lynch investment bank – $29.1 billion etc. Expected losses in the next periods are even higher

B-Home prices: Another effect of this crisis is on home prices. At the end of 2007 home prices had fallen approximately %8 from their peak in 2006. Also the consruction of houses dropped in the same period by the collapse of the industry.

C- Jobs Available: There were also some important effects on jobs available. More than 40000 employees had lost their jobs due to the crisis during 2007 & 2008. There are also some announced layoffs in the industry that the expected number off termination of jobs will increase in the next months:

D- Oil Prices & US Dollar: Another effect of the crisis is surely oil prices and the depreciation of US dollars against other currencies. Nowadays oil prices are the highest of all times, US dollar is hitting recording low against euro and yen. Dollar against Yen chart:

After the crisis: Steps and Regulations: After the crisis the most important steps are taken by the Federal Reserve by lowering the federal funds rate from %5.25 to %2 and the discount rate from %5.75 to %2.25 through separate actions. Fed interest rate cuts:

In addition to that The Fed, the European Central Bank, and the Japanese Central bank are all pumping liquidity into the economic global system. The injection of FED can be clearly seen in the Bear Sterns case which is a large financial institution with substantial mortgage-backed securities (MBS) investments and plunged in value. FED helped JP Morgan with its purchase of Bear Stearns. These injections shows how liquidity is an important problem during that period. After the crisis turned into a global banking crisis liquidity become the main problem for the banks. Top ten banking worries Today 1. Liquidity 2. Credit risk 3. Credit spreads 4. Derivatives 5. Macroeconomic trends 6. Risk management 7. Equities 8. Too much regulation 9. Interest rates 10. Hedge funds 2006 1. Too much regulation 2. Credit risk 3. Derivatives 4. Commodities 5. Interest rates 6. High dependence on tech 7. Hedge funds 8. Corporate governance 9. Emerging markets 10. Risk management

In addition to Fed there were other institutions who responded to this crisis. The Basel Commitee on Banking Supervision come out with new regulations like proposing higher capital charges for handling asset backed securities, closing loopholes that let banks harbour risks out of regulatory sight and raising costs for holding volatile trading

positions. The Committee thinks that these rules will increase the cost of banking but also will develop much more stable banking system. U.S. President George W. Bush annouced the Hope Now Alliance plan to help to mortgage borrowers. This plan tried to adjust and refinance the mortgage debts of homeowners. Hope Now Alliance Program helped more than %7 of Subprime loans outstanding in 2007. Also the president signed a legislation – a 168 billion rescue package- to booster the economic activity in U.S. But this package lead an increase in oil and food prices in 2008 that the package couldn’t have a good effect.

Expectations: According to the IMF Background Paper on the Update of the Global and Regional Outlook , IMF forecasts the world economy to expand %3.7 in 2008. The IMF gave a %25 chance that global growth will drop to %3 or less ın 2008 and 2009 , which is close to the global recession. IMF forecasts the growth of US economy by % 0.5 in 2008 and %0.6 in 2009. In May, 2008 FED have pulled back their expectations for growth. The most pessimistic of the group expect the U.S. economy not to grow at all this year. But they also expect higher inflation than they did in January, a reason for the reluctance to keep cutting rates. On average most of the Fed members expect the GDP for this year will rane between %0 and %1.5 . Unemployment rates are expected to be between %5.3 and % 6 at the end of the year. After the latests news about the food and oil prices , FED also changed its expectations about the inflation that prices would rise 2,8 to 3.8 percent in 2008 . FED also thinks that cuts in federal funds rate is enough to fight with the current economical situation. Currently there is no need to have a further cut in federal funds rate according to FED.

According to economist Paul Krugman , there will be $1 trillion of losses on mortgage back securities . In addition to that Krugman expects the home prices will drop %25 on average . Despite the announcement from FED, Krugman thinks that federal funds rate will be cut more and more going down to zero.

Getting out of the recession: It is not official but it is a strong belief that U.S. economy is currently in a recession. Home prices are dropping sharply, inflation is rising, people are consuming less, banks are announcing their negative balances and son on. So what should FED do in order to stabilize the financial system again? According to me pumping billions of dollars is not a good way to do it because it can end up with a moral hazard. In addition to that billions of dollars is just a small portion of the securities market so it will not have a good effect in the future. Currently new regulations is the best way to deal with the system, preventing banks to have risky operations will decrease the chance of having crisis in the future. FED should also extend its powers, from banking system to all financial institutions, to intervene the possible crisis quickly.

Reference: 1- Realtytrac.com | US foreclosure activites in 2007. 2- News.bbc.co.uk | Special Report on Global Credit Crunch 3- Fincen.gov | Financial Crimes Enforcement Network | Mortgage Loand Frauds Report 4- Bankrate.com | Subprime Mortgages Volumes 5- Bloomberg.com | Subprime Losses by Banks and Financial Institutions 6- Economist.com | US house prices data 7- Cnn.com & Iht.com | Job cuts in U.S. 8- Whitehouse.gov | Fact Sheet | HOPE NOW details 9- Huffington Post | Rebate Checks information 10- Federalreserve.gov | FED | Press releases 11- Money.cnn.com | CNN | Krugman’s Interview