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Prof. Minwoo Song Marcus Tan ECO-1002H Subprime Mortgage Crisis The subprime housing crisis happened between 2007 and 2010 when financial institutions sold countless mortgages to meet the need for mortgage-backed securities sold via the secondary markets. Notably, a subprime loan is typically a loan for a house purchase to people who have a poor credit history (unsafe to lend to). Therefore, to reward for risk, financial institutions charge high-interest rates by issuing a subprime mortgage (Adelino p.18). It is widely accepted that the subprime mortgage boom in the early 2000s fuelled the crisis, and it was the primary fuel that ignited the worldwide financial crisis of 2007/2008. During this time (the 2000s), house prices rose quite strongly, resulting in a general perception among lenders that the risk of sub-prime loaning had fallen (Kolb p.441). As a result, in search of higher returns, many commercial banks were prepared to begin lending mortgages to people of higher risk, and borrowers were contented as they would be able to trade their houses for a high price compared to how they purchased them. They reasoned that this would help them repay their mortgages if they experienced difficulties. However, when the housing boom came to an end, such that house prices began to fall, homeowners found themselves unable to pay their mortgage debt (Foote p.1668). This is because houses became unaffordable, and house mortgage interest rates started to go up, causing many people to be in negative equity. Notably, negative equity implied that houses were worth more than the mortgage borrowers had taken. As a result, many domestic and international commercial banks suffered significant losses on their lending, leading to banks' failure. So, the sub-prime

housing crisis spread quickly, as banks that had sold the sub-prime mortgage to people had to repackage those loans into new forms of debt that they sold as financial derivatives. Effectively, commercial banks had sliced up the sub-prime debts and the safe debts and repacked them in a package, selling them for a high price than they would have obtained for just selling on the prime debts. Essentially, this scenario is a vast information failure because individuals were buying these repackaged loans, e.g., pension funds and insurance companies, and didn't understand the risk being attached to them (Adelino p.50). This is partly because the rating agency such as Standards and Poor's, given this newly repackaged mortgage debt tripled later. As a result, many financial institutions were hanging onto a massive amount of debts in the sub-prime mortgage market, which became explosive when house prices started to fall, and nonperforming debt rates started to rise. In the end, the US government ended up supporting Freddie Mac and Fannie-Mae, and the United Kingdom government bailed out several UK banks taking a few into the state of ownership (Foote p.1645). The graph below shows the mortgage delinquency rates for the US's conventional subprime debts from 2000 to 2014. Features of the US Sub-Prime Mortgage Loaning Crisis

Mortgage delinquency rate for sub-prime loans in the US (2000-2016 7.00% 6.00% 5.00% delinquencyrates

4.00% 3.00% 2.00% 1.00% 0.00%

2000 2005 2008 2009 2010 2011 2012 2013 2014 2015 2016 Year

Source: OECD The figure above shows the number of loans or the delinquency rates that are 30 or more days behind in repayments. The figure indicates the annual average of quarterly figures. However, it does not include the loans in the presence of full closure, that is, when individuals fail to meet repayments such that they are having the houses reposed (Foote p.1655). Between 2005 and 2009, many people were falling behind with their mortgage loans from 10.8 in 2005 percent to 25 percent in 2009 (Demyanyk, p.1868). As a result, the level of non-performing debts in the United States' bank institutions surged. The chart below shows bad debts on which creditors

Share of non-performing Debts in total debts

haven't made payments within 90 days and more.

Bad debts of Sub-prime Housing debts 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

Year

Source: US Federal Reserve Bank Visibly, from 2007 to 2010, there was a considerable rise in non-performing debts in the United States from 2 percent to about 5 percent of loans. Furthermore, since the banks had lent out so much to the booming housing market, a 5.06 percent non-performing debt rates was enough to reflect huge losses on the banks (Demyanyk, p.1878). This event can be termed as one of the significant economic shocks on the US economy.

Further, due to this economic shock, the foreclosure rates shot up. Foreclosure is a situation where the lenders take desperate last step measures to get their houses back, so people left the keys at the doors and disappeared, resulting in many houses being repossessed by the mortgage lenders and some sold in the action enterprise (Demyanyk, p.1849). Therefore, in 2008 there were 13.7 percent of sub-prime loans being pulled back together, and size went burst in 2009 to 15.1 percent, and in subsequent years the rates were way above 10 percent. The chart below further shows the collapse of the housing market in the US.

Foreclosure rates of Sub-prime Conventional mortgage 16.00% 14.00% Foreclosure Rate

12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Year

Source: Author’s calculations of statistics on sample representation of debts from MSAs The sub-prime mortgage crisis resulted from excessive lending to individuals who had a poor credit history and had no realistic prospects of meeting the hefty interests' payments over a mortgage lifetime. Eventually, the sub-prime boom came to an end. The US housing markets suffered heavy losses, thereby creating a credit and liquidity crunch in the broader financial and credit markets (Adelino p.38). Consequently, this financial crisis prompted a more expansive economic recession in the US.

During an economic recession, aggregate supply and demand fall. This fall resulted from shortages the bank funds and credit crisis, which consequently reduced bank lending. The decline in bank lending reduced consumer spending and investment, which are aggregate Demand components. Additionally, the credit crisis reduced houses' accessibility and therefore decreased demand for purchasing homes (Foote p.1670). So with fewer houses available, a significant fall in prices was witnessed. The fall in mortgage prices lead to a negative wealth effect; this has caused consumer confidence to lower, equity withdrawal to reduce, and reduced consumer spending. These causes have led to a leftward shift of the aggregate demand curve from AD 1 AD2, as shown below. Effects of Demand Shocks on AD Price

L-RAS

P1 P2 AD2 Q2

Q1

AD1 Real Output (Q)

However, at the beginning of 2008, oil prices shot up, leading to cost-push inflation. As a result, the short-run aggregate supply curve shifted upward and motivated Central Banks to maintain interest rates moderately high. The figure below shows the shift of the short-term from S-RAS1 to S-RAS2.

Effects of Increase in Oil Prices on the AD curve.

Price

P2 P1

Being among the world's biggest economies, the US's economic crisis triggered the contraction in global investment and trade, leading to a downturn in the most industrialized countries, including the UK, Western Europe, etc. Notably, once these economies got into recession, tax incomes shrunk rapidly, leading them to pledge to spend more benefits. So the British administration moved from a deficit of 3 percent of GDP in 2007 to approximately 11 percent of GDP in 2009 (Demyanyk, p.1853). This sovereign debt crisis resulted in a high rise in national debt, and eventually, a great recession blossomed in 2008/2009. Essentially, the economic recession finalized in the 2009 second quarter, however in the second quarter of 2011, the economy was still described as that in economic disorder. Various economists described the subsequent years after the recession as the feeblest recovery ever since World War II and the Great Depression (Kolb p.443). As a result, many people termed it as Zombie Economy, implying that the economy was neither alive nor dead. As of August 2012, household incomes had declined more after the recession than during the recession. Additionally, September 2012 recorded the highest long-term unemployment ever since the Second World War. According to research, recovery from financial crises is attached to long periods of substandard economic growth and high unemployment rates.

For instance, Carmen Reinhart argued that debt reduction takes approximately seven years. In the subsequent years after a severe financial crisis, the economy grows by 1 to 1.6 percent less than before (Foote p.1665). Notably, the growth before the crisis is attributed to massive private borrowing. In this recovery road, Keynesian economists proposed deficit government expenditure to offset reductions in business investment and consumer spending to help raise economic activity. Some economists, such as Paul Krugman, claimed that the US should approximately use $ 1.3 trillion worth of stimulus within three years, which is more than the $ 850 billion signed into laws by the former president Obama. Markedly, $ 1.3 trillion worth of stimulus accounted for about 4 percent of GDP per year for roughly 2 to 3 years (Demyanyk, p.1868). Notably, Krugman advocated for a harsh stimulus to address the risk of a recurrent deflation and depression, where prices, economic growth, and wages sprung downward in a self-strengthening cycle. Further, some other economists proposed short-term stimulus expenditure in 2009 to ensure that the economy does not go into a profound recession, but reinstating fiscal discipline both in medium- and long-term periods. In conclusion, there is no little explanation for the sub-prime mortgage crisis other than fraud, Ponzi schemes, lengthy periods of low rates of interest, lax regulations, enforcement, and supervision, economic shocks, and moral failure. Therefore, to eliminate the financial crisis, the federal government requires eliminating liquidity requirements, discouraging the use of fixedexchange-rate, enhancing consumer literacy, restricting consumer power, and concentrating on bank culture and governance (Kolb p.443). However, political unwillingness to handle consumer illiteracy financial issues, insufficient appreciation of bank culture, etc., have made it impossible for some of these alterations to be put in place.

Work Cited Adelino, Manuel, Antoinette Schoar, and Felipe Severino. "Loan originations and defaults in the mortgage crisis: The role of the middle class." The Review of Financial Studies 29.7 (2016) Foote, Christopher L., and Paul S. Willen. "subprime mortgage crisis, the." Banking Crises. Palgrave Macmillan, London, 2016. 324-336.): 1635-1670. Kolb, Robert W. "Disclosure’s failure in the subprime mortgage crisis." Lessons from the Financial Crisis (2010): 443. Demyanyk, Yuliya, and Otto Van Hemert. "Understanding the subprime mortgage crisis." The review of financial studies 24.6 (2011): 1848-1880....