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11/2/2019

Subprime mortgage crisis - Wikipedia

Subprime mortgage crisis The United States subprime mortgage crisis was a nationwide financial crisis, occurring between 2007 and 2010, that contributed to the U.S. recession of December 2007 – June 2009.[1][2] It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the devaluation of housingrelated securities. Declines in residential investment preceded the recession and were followed by reductions in household spending and then business investment. Spending reductions were more significant in areas with a combination of high household debt and larger housing price declines.[3] The housing bubble preceding the crisis was financed with mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which initially offered higher interest rates (i.e. better returns) than government securities, along with attractive risk ratings from rating agencies. While elements of the crisis first became more visible during 2007, several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.[4] There were many causes of the crisis, with commentators assigning different levels of blame to financial institutions, regulators, credit agencies, government housing policies, and consumers, among others.[5] Two proximate causes were the rise in subprime lending and the increase in housing speculation. The percentage of lower-quality subprime mortgages originated during a given year rose from the historical 8% or lower range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S.[6][7] A high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable-rate mortgages.[4] Housing speculation also increased, with the share of mortgage originations to investors (i.e. those owning homes other than primary residences) rising significantly from around 20% in 2000 to around 35% in 2006–2007. Investors, even those with prime credit ratings, were much more likely to default than noninvestors when prices fell.[8][9][10] These changes were part of a broader trend of lowered lending standards and higherrisk mortgage products,[4][11] which contributed to U.S. households becoming increasingly indebted. The ratio of household debt to disposable personal income rose from 77% in 1990 to 127% by the end of 2007.[12] When U.S. home prices declined steeply after peaking in mid-2006, it became more difficult for borrowers to refinance their loans. As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms globally, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending.[6] Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe. The crisis had severe, long-lasting consequences for the U.S. and European economies. The U.S. entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly 6% of the workforce. The number of jobs did not return to the December 2007 pre-crisis peak until May 2014.[13] U.S. household net worth declined by nearly $13 trillion (20%) from its Q2 2007 pre-crisis peak, recovering by Q4 2012.[14] U.S. housing prices fell nearly 30% on average and the U.S. stock market fell approximately 50% by early 2009, with stocks regaining their December 2007 level during September 2012.[15] One estimate of lost output and income from the crisis comes to "at least 40% of 2007 gross domestic product".[16] Europe also continued to struggle with its own economic crisis, with elevated unemployment and severe banking impairments estimated at €940 billion between 2008 and 2012.[17] As of January 2018, U.S. bailout funds had

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been fully recovered by the government, when interest on loans is taken into consideration. A total of $626B was invested, loaned, or granted due to various bailout measures, while $390B had been returned to the Treasury. The Treasury had earned another $323B in interest on bailout loans, resulting in an $87B profit.[18]

Contents Background and timeline of events Causes Overview Narratives Housing market Boom and bust Homeowner speculation High-risk mortgage loans and lending/borrowing practices Subprime mortgage market Mortgage fraud and predatory lending Financial markets Boom and collapse of the shadow banking system Securitization Financial institution debt levels and incentives Credit default swaps Inaccurate credit ratings Governmental policies Decreased regulation of financial institutions Policies to promote affordable housing Community Reinvestment Act State and local governmental programs Role of Fannie Mae and Freddie Mac Other contributing factors Policies of central banks Mark-to-market accounting rule Globalization, technology and the trade deficit Subprime mortgage crisis phases January 2007 to March 2008 April to December 2008 Impacts Impact in the U.S. Impact on Europe Sustained effects Savings surplus or investment deficit Sectoral financial balances Responses Federal Reserve and other central banks Economic stimulus Bank solvency and capital replenishment Bailouts and failures of financial firms Homeowner assistance Homeowners Affordability and Stability Plan Loan modifications https://en.wikipedia.org/wiki/Subprime_mortgage_crisis

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Regulatory proposals and long-term solutions Law investigations, judicial and other responses Bank fines and penalties In popular culture Implications Post Recession Home Ownership by Millennials Recovery In the United States See also Other housing bubbles References Further reading External links

Background and timeline of events The immediate cause of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.[19][20] An increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume risky mortgages in the anticipation that they would be able to quickly refinance at easier terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., borrowers were unable to refinance. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices fell, and adjustable-rate mortgage (ARM) interest rates reset higher. As housing prices fell, global investor demand for mortgage-related securities evaporated. This became apparent by July 2007, when investment bank Bear

President George W. Bush discusses Education, Entrepreneurship & Home Ownership at the Indiana Black Expo in 2005

Stearns announced that two of its hedge funds had imploded. These funds had invested in securities that derived their value from mortgages. When the value of these securities dropped, investors demanded that these hedge funds provide additional collateral. This created a cascade of selling in these securities, which lowered their value further. Economist Mark Zandi wrote that this 2007 event was "arguably the proximate catalyst" for the financial market disruption that followed.[4] Several other factors set the stage for the rise and fall of housing prices, and related securities widely held by financial firms. In the years leading up to the crisis, the U.S. received large amounts of foreign money from fast-growing economies in Asia and oil-producing/exporting countries. This inflow of funds combined with low U.S. interest rates from 2002 to 2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[21][22] As part of the housing and credit booms, the number of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses were estimated in the trillions of U.S. dollars globally.[23] https://en.wikipedia.org/wiki/Subprime_mortgage_crisis

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While the housing and credit bubbles were growing, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. These entities were not subject to the same regulations as depository banking. Further, shadow banks were able to mask the extent of their risk taking from investors and regulators through the use of complex, off-balance sheet derivatives and securitizations.[24] Economist Gary Gorton has referred to the 2007–2008 aspects of the crisis as a "run" on the shadow banking system.[25] The complexity of these off-balance sheet arrangements and the securities held, as well as the interconnection between larger financial institutions, made it virtually impossible to re-organize them via bankruptcy, which contributed to the need for government bailouts.[24] Some experts believe these shadow institutions had become as important as commercial (depository) banks in

Subprime mortgage lending jumped dramatically during the 2004–2006 period preceding the crisis (source: Financial Crisis Inquiry Commission Report (http://www.gpo.gov/fdsys/pk g/GPO-FCIC/pdf/GPO-FCIC.pdf), p. 70 Figure 5.2).

providing credit to the U.S. economy, but they were not subject to the same regulations.[26] These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.[27] The losses experienced by financial institutions on their mortgage-related securities impacted their ability to lend, slowing economic activity. Interbank lending dried-up initially and then loans to non-financial firms were affected.

Federal funds rate history and recessions

Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments. The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Effects on global stock markets due to the crisis were dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations suffered about $8 trillion in losses, as their

Factors contributing to housing bubble

holdings declined in value from $20 trillion to $12 trillion. Losses in other countries averaged about 40%.[28] Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.[29] Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis.[30] A variety of solutions have been proposed by government officials, central bankers, economists, and business executives.[31][32][33] In the U.S., the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 to address some of the causes of the crisis.

Causes https://en.wikipedia.org/wiki/Subprime_mortgage_crisis

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Overview The crisis can be attributed to several factors, which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting, borrowers overextending, predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, monetary and housing policies that encouraged risk-taking and more debt, international trade imbalances, and inappropriate government

regulation.[6][34][35][36][37]

Excessive

Domino effect as housing prices declined

consumer housing debt was in turn caused by the mortgage-backed security, credit default swap, and collateralized debt obligation sub-sectors of the finance industry, which were offering irrationally low interest rates and irrationally high levels of approval to subprime mortgage consumers due in part to faulty financial models.[38][39] Debt consumers were acting in their rational self-interest, because they were unable to audit the finance industry's opaque faulty risk pricing methodology.[40] Among the important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market, government

policies

aimed

at

expanding

homeownership, speculation by many home buyers, and the predatory lending practices of the mortgage lenders,

Housing price appreciation in selected countries, 2002– 2008

specifically the adjustable-rate mortgage, 2–28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers.[41] On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.[42] In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes: During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.[43]

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Federal Reserve Chair Ben Bernanke testified in September 2010 regarding the causes of the crisis. He wrote that there were shocks or triggers (i.e., particular events that touched off the crisis) and vulnerabilities (i.e., structural weaknesses in the financial system, regulation and supervision) that amplified the shocks. Examples of triggers included: losses on subprime mortgage securities that began in 2007 and a run on the shadow banking system that began in mid-2007, which adversely affected the functioning of money markets. Examples of vulnerabilities in the private sector included: financial institution dependence on unstable sources of short-term funding such as repurchase agreements or Repos; deficiencies in corporate risk management; excessive use of leverage (borrowing to invest); and inappropriate usage of derivatives as a tool

U.S. households and financial businesses significantly increased borrowing (leverage) in the years leading up to the crisis

for taking excessive risks. Examples of vulnerabilities in the public sector included: statutory gaps and conflicts between regulators; ineffective use of regulatory authority; and ineffective crisis management capabilities. Bernanke also discussed "Too big to fail" institutions, monetary policy, and trade deficits.[44] During May 2010, Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically;[45] 2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4) Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed.[46] Economists surveyed by the University of Chicago during 2017 rated the factors that caused the crisis in order of importance: 1) Flawed financial sector regulation and supervision; 2) Underestimating risks in financial engineering (e.g., CDOs); 3) Mortgage fraud and bad incentives; 4) Short-term funding decisions and corresponding runs in those markets (e.g., repo); and 5) Credit rating agency failures.[47] The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve's failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk; An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels."[48]

Narratives There are several "narratives" attempting to place the causes of the crisis into context, with overlapping elements. Five such narratives include: 1. There was the equivalent of a bank run on the shadow banking system, which includes investment banks and other non-depository financial entities. This system had grown to rival the depository system in scale yet was not subject to the same regulatory safeguards.[25][49] https://en.wikipedia.org/wiki/Subprime_mortgage_crisis

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2. The economy was being driven by a housing bubble. When it burst, private residential investment (i.e., housing construction) fell by nearly 4% GDP and consumption enabled by bubble-generated housing wealth also slowed. This created a gap in annual demand (GDP) of nearly $1 trillion. Government was unwilling to make up for this private sector shortfall.[50][51] 3. Record levels of household debt acc...