Table of Contents Introduction... 3 Definitions... 3 Subprime loan... 3 Mortgage loan... 3 Real estate and subprime lending in the US... 4 Politics... 4 The rise of subprime mortgages... 4 Risks with Subprime Loans... 5 The Financial Subprime Market... 6 Collateralized Debt Obligations... 6 Credit Default Swaps... 7 The Burst of the Bubble... 8 Discussion... 8 Reading guide... 10 References... 11 2
Introduction In 2008 a financial crisis known as the Subprime Crisis was imminent in the USA freezing the credit market and causing instability internationally. This collapse of the US real estate market caused the biggest financial crisis in 80 years leaving the world still trembling due to its consequences. In this rapport we will explain the fundamentals of the major factors leading up to the subprime crises as well as a discussion on the matter. Definitions Subprime loan A subprime loan is generally a loan or a mortgage with less favourable terms than an ordinary prime loan. The amortization requirements are often very small or none but the interest rates are significantly higher and often rises gradually over time. These loans target borrowers with low creditworthiness, which are associated with bigger risks. Mortgage loan A mortgage loan is a loan secured by property. When speaking about subprime mortgages and the likes, it is in fact mortgage loans that are being referred to even though there is a substantial juridical difference between a mortgage and a mortgage loan. A mortgage itself represents the bond owned by the lender and the terms of the security interest it holds. In most economies there is a very small part of the population with the means to purchase real estate with cash or cash equivalents. This implicates that in most real estate purchases a mortgage loan is required. 3
Real estate and subprime lending in the US Politics During the late nineties the Clinton administration gave the two government- sponsored enterprises commonly known as Fannie Mae and Freddie Mac explicit directives on how to conduct their future lending. As a part of the political initiative to increase house ownership in the US theses banks were to dedicate 48% on the loans to people with a wage lower than the median. This threshold was later raised under the Bush administration. This is combination with Alan Greenspan s (former Chairman of the Federal Reserve) laissez- faire policy of keeping the interest rates at a minimum led to a peak in subprime mortgages. The rise of subprime mortgages Among the variety of loans most commonly used in subprime lending is as previously mentioned real estate mortgages. Due to political regulations getting a subprime mortgage for real estate became available to more potential borrowers. Subprime lending was one of the primary factors to the rise of the real estate prices in North America in the early two thousands (Nordberg 2009). So what does one consider when closing a deal on a loan or a house? One primary looks at the development of that particular market. Since house prices in the USA had risen unquestioned for decades it was considered a very safe investment. The real estate prices develop in cycles just like the economy in general, however the housing cycles are somewhat longer and seem to follow the rest of the economic development with a lag. A peak in economy generates in general a peak in housing with a two years lag. That the cycle of real estate prices is slower in reaction could partly be a consequence of the fact that buyers consider buying them according to their historical development rather than their present situation in relation to their current context. 4
Risks with Subprime Loans The subprime borrowers are usually clients with no or limited security. This is undoubtedly a risk when considering the probability of the loan being repaid. In order to compensate for this increased risk taking the subprime loan is often correlated with less favourable terms such as higher interest rates. Also the originator and the repayment plan of the loan have to be taken into consideration when defining the risk of a subprime loan. Therefore, a typical prime client with all over good credit rating could be taking a loan classified as a subprime loan due to the characteristics of the repayment plan and the originator. The justification behind the idea of a subprime mortgage is that the asset acquired by the debt is to have an increasing or equal value over time as security and a possibility of the borrower being able to upgrade his loan- term further on. The various articles acquired by the mortgage is thus to be determined whether they possess these characteristics or not, hence this conclusion is drawn on the basis of various assumptions which itself presents a risk of being inaccurate. Since the most common type of subprime loan is the subprime mortgage for clients with an interest in acquiring real estate. The prerequisites of these loans are (amongst other factors) a question of what expectations one might have on the future of the real estate market. A rise in interest rates would lead to the cost of borrowing rising as well and implications concerning mortgage payments might occur such as potential defaults. These aspects too has to be taken into account With such great uncertainty why would a lender, e.g. a bank, submit itself to subprime lending? They are simply more profitable as long as they are repaid. This is due to the conditions of a subprime loan, which holds higher interest rates than its comparison. In the long run subprime loans are an increasing risk, which in combination with low liquidity could lead to bankruptcy for the lender. If the lender happens to be an influential bank this also poses a systematic risk as seen in 2008 (Schiller 2008). With Alan Greenspan (former Chairman of FED USA) keeping the interest rates at very low rates in the early 2000s and with a real estate market that kept flourishing lenders believe the circumstances for subprime lending was good. 5
The Financial Subprime Market The subprime crisis, or the subprime mortgage crisis as it s also referred to, is the underlying reason for the global economic global regression in 2008. It was one of the world s most extensive economic regressions in modern time and has had an impact on almost every country in the world. Collateralized Debt Obligations In 2000 the USA banned regulation of derivatives in the infamous Commodity Futures Modernization Act. With very limited regulation, banks saw great profitability in new financial instruments. This resulted in an increase in innovative derivatives, which allowed the market to speculate on a vast variety of objectives such as the return of subprime mortgages. The lenders therefore sold on the subprime mortgages to investment banks. The investment banks then packaged the subprime mortgages together with other subprime debt in highly advanced derivatives called Collateralized Debt Obligations, CDO. The CDOs were then introduced to the market where bought by investors. Debt obligations of this kind are also referred to as securities and are rated by a credit rating agency, CRA. The CRA is then to take into account the credit worthiness of the security in question as well as the issuer itself, namely an investment bank. The CRA usually don t have liability of any kind if the loans were unproven to be performing in accordance to the given rating, and since the most credit rating agencies in the USA are compensated financially by the investment bank themselves there was a great conflict of interests in this matter before 2008 (Nordberg 2009). This led to that most CDO s obtained AAA rating which is the highest security rating, the equivalent security of USA government bonds in 2008. Such a high rating enabled pension funds, which are obliged only to invest in the highest of security papers, to invest in CDOs. In fact the CDOs posed a much bigger risk to investors than the AAA rating mirrored. This would later on have grave consequences. The reason for that subprime loans became such a demanded commodity with the investment banks was mainly due to the higher interest rates and for the sake of greater short- term profits. With low national interest rates the investors sought more profitable investments such as CDOs. In order to supply the demanded quantity of CDOs investment banks took on extensive leverage. In 2007 many of the major investment banks had a leverage ratio of about 1:30. Such a level of liquidity would suggest that a drop in total assets of a few percent could lead to a pressing liquidity crisis and indeed pose a great systematic risk (Schiller 2008). 6
Credit Default Swaps Investment banks were aware of the risks that CDOs posed so they insured themselves against this by something called Credit Default Swaps or CDS. These are not regular insurances but derivatives meant to transfer credit risk from one or several parts to another. In exchange for a quarterly premium the insurance company would compensate the buyer of the CDS if the insured securities prove to be none performing and defaults. CDS also allows independent speculators to insure securities such as CDOs, which they do not own. This being the case, a default in insured derivatives could lead to losses multiple the size of its actual net worth. One insurance bank in particular issued more CDS than any other insurance bank before 2008 and that was AIG (American International Group). AIG is still the largest insurance company in the world and was ranked the 29 th largest company in the world by Forbes Global 2000 list. When such big companies hold extensive positions in CDS it poses a systematic risk as well. In the years before 2008 when the real- estate prices began to fall and investment firms began to buy multiple positions in credit default swaps allowing them to profit from defaults in the CDO- market. This presented incentives to continue to sell CDOs even though they were thought to be bad investments (Nordberg 2009). 7
The Burst of the Bubble In 2002 the national interest rates were very low, at 0,75%, in an attempt to boost the US economy. When the rent gradually rose to 6,25% in 2006 house mortgages became increasingly costly, especially the subprime mortgages. Many of the subprime mortgages began to default, which led to CDOs beginning to go bad. Since the financial sector was now trying to lose all risky securities the real estate prices began to drop due to an increase in supply, namely the real estate the banks were trying to sell. This combined with a decreasing demand lead to a mass escape from the credit market that made even more CDOs and other similar securities went bad and the economy began to spiral downwards. The credit default swaps that had been a prime source of income for insurance companies like AIG but become unaffordable as more securities defaulted and AIG was on the verge of collapse. AIG being the single largest insurance company in the world with ties to most of the world s economies the Federal Reserve stepped in as a part owner preventing disaster. However many of the investment banks were severely hurt and the credit market froze completely preventing the investment banks from acquire capital to deal with the imminent liquidity crisis. Major banks such as Lehman Brothers filed for bankruptcy while the government bailed others out. As the USA being the largest economy in the world, by far measured in GDP (IMF 2011), almost every country was affected by the drop in demand and the unstable credit market. In the aftermath of the crisis the US real estate market collapsed leaving newly built houses to degenerate due to lack of demand even though many had lost their homes. Several pension funds were also hurt badly financially by the crisis, further adding to the collateral damage of 2008. Discussion Who is to blame for the subprime crisis? As Johan Nordberg puts it we indeed believe that it was; everyone. The government because of how they managed the interest rates and gave banks incentives to take on bigger credit risk but also the individual subprime borrowers for taking loans they in the long run couldn t afford. Perhaps the most important actors of them all still are the financial institutions that made excessive short- term profits out of exploiting the subprime- bubble. Investment banks such as Merrill Lynch and Goldman Sachs distributed CDOs and other derivatives in a systematic manor even though they were aware of the potential risk they posed. This was made lucrative by the credit default swaps supplied by insurance companies such as AIG. The reason for the peak in demand of the CDO was it s impressive credit rating, which in fact didn t, reflects it s actual credit risk. Therefore credit rating agencies such as Moody s, Standard and Poor s and others played a vial role in making the subprime crisis possible. They were later criticized for not fully understanding the risk with the new complex securities, which leads us back to the deregulation of financial instruments in 2000. One could in fact argue that this was the origin of the crisis. As Schiller states in his book the Subprime 8
Solution; if financial regulations limiting risk and leverage for the investment banks were implemented the exposure to fluctuations in the markets could have been reduced. The securitization chain didn t reduce credit risk as securities were spread over the financial sector as it merely gave incentives to make decisions with short- term horizons. Fannie Mae and Freddie Mac could take on huge credit risk by being secured as partly owned by the government knowing they would be bailed out. This enabled private shareholders to profit form the earnings and leave the deficit to the government. Perhaps it was the incentives themselves that posed the biggest systematic risk. There has been a lot of discussion about whether it was fair for the government to bail out financial institutions that had taken on excessive risk in an irresponsible manor. As it was considered a necessity to prevent a total meltdown of the financial system there is reason for scepticism due to mistrust in the management of the financial institutions. In 2006 Wall Street executives received a summative bonus of about 24 billion dollars according to the Office of the New York State Comptroller. 9
Reading guide Litterature As for books describing the financial crises in whole Johan Nordberg s En Perfekt Storm (Financial Fiasco) given out by Hydra Förlag. It gives a clear view of what went on politically as well as financially during the period and traces the causes of the crises of 2008 back to the late nineties. The book has also got very well specified sources for further research. Another book of, perhaps, more analytical character is Robert J. Schiller s The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It. This book is an international bestseller that also takes a step into the future. In order to learn more about the derivatives involved and their complex structure a great book on the subject is; Collateralized Debt Obligations and Structured Finance : New Developments in Cash and Synthetic Securitization, written by Janet M. Tavakoli. It was given out in the 2000snd and actually presents some of the risks the increasing CDO- market poses. Fairly technical reading but gives you a very good insight into various debt securities. Other media The Inside job (documentary 2010) with director by Charles Ferguson is a commercial documentary that explains the subprime crisis in whole. However doesn t cover the implications the crisis will have on the future and is fairly informal. 10
References Definitions BBC News (2007) Subprime Lending http://news.bbc.co.uk (2011-11- 16) DiMartino D. (2007), Economic letter; Insight from the Federal Reserve Bank of Dallas. Dallas, USA Real estate and subprime lending in the US Standard and Poor s (2011) Shiller Home Price Indiceshttp://www.standardandpoors.com (2011-11- 16) Global Property Guide (2011) What explains house prices http://www.globalpropertyguide.com (2011-11- 16) Personal Home Loan Mortgages (2011) Subprime mortgages http://www.personalhomeloanmortgages.com (2011-11- 16) The Mortgage Professor s Website (2011) What is a subprime lenderhttp://www.mtgprofessor.com (2011-11- 16) The Financial Subprime Market Nordberg J. (2009), En Perfekt Storm; Hur staten, kapitalet och du och jag sänkte världsekonomin Schiller R. J. (2008), The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It The burst of the bubble IMF Data (2011) World Gross Domestic Product http://elibrary- data.imf.org/ (2011-11- 16) Nordberg J. (2009), En Perfekt Storm; Hur staten, kapitalet och du och jag sänkte världsekonomin Schiller R. J. (2008), The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It 11