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Subprime mortgage crisis

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The subprime mortgage financial crisis refers to the sharp rise in foreclosures in the subprime mortgage market that began in the United States in 2006 and became a global financial crisis in July 2007. Rising interest rates increased newly-popular adjustable rate mortgage and property values suffered declines from the demise of the housing bubble, leaving home owners unable to meet financial commitments and lenders without a means to recoup their losses.

The sharp rise in foreclosures after the housing bubble caused several major subprime mortgage lenders, such as New Century Financial Corporation, to shut down or file for bankruptcy, with some accused of actively encouraging fraudulent income inflation on loan applications, leading to the collapse of stock prices for many in the subprime mortgage industry, and drops in prices for some large lenders like Countrywide Financial and Washington Mutual.

This has led to major declines in stock markets worldwide, several multi-billion dollar hedge funds becoming worthless, record dollar devaluation, coordinated national bank interventions, contractions of retail profits, and bankruptcy among several different mortgage lenders.

Observers of the meltdown have cast blame widely. Some, like Senate Banking, Housing, and Urban Affairs Committee chairman Chris Dodd of Connecticut and President George W. Bush, have highlighted the predatory lending practices of subprime lenders and the lack of effective government oversight.[1] Others have charged mortgage brokers with steering borrowers to unaffordable loans, appraisers with inflating housing values, and Wall Street investors with backing subprime mortgage securities without verifying the strength of the portfolios. Borrowers have also been criticized for over-stating their incomes on loan applications[2] and entering into loan agreements they could not meet. [3]

The effects of the meltdown spread beyond housing and disrupted global financial markets (see financial contagion) as investors, largely deregulated foreign and domestic hedge funds, were forced to re-evaluate the risks they were taking and consumers lost the ability to finance further consumer spending, causing increased volatility in the fixed income, equity, and derivative markets.

Background information

Subprime lending, also called "B-Paper", "B-C Paper", "near-prime" or "second chance" lending, is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the ability to prove that they have enough income to support the monthly payment on the loan for which they are applying. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky financial situations often associated with subprime applicants. A subprime loan is one that is offered at a rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody's or other rating firms, albeit for an "alternative" means.

In the 20th century, collateralized debt obligations became popular investment vehicles, in use world-wide. Traditionally, when payments on a mortgage were late, the personal relationship between debtor and creditor allowed some leeway when paying off a mortgage. But when subprime mortgage-backed securities were collateralized, the traditional links between lenders and their creditors were severed. This created a vicious circle when subprime loan payers defaulted on their obligation, leaving foreclosure of their mortgages as the only perceived recourse for investors in the loan. When other homeowners with mortgages also attempt to meet their financial obligations, some of them put their homes up for sale, which drags down the price of other houses in their neighborhood, not merely those houses with subprime mortgages.

History

  • 1995–2001: Dot-com bubble
  • 2000–2003: Early 2000s recession (exact time varies by country)
  • 2001–2005: United States housing bubble (part of the world housing bubble)
  • 2005–ongoing: Market correction ("bubble bursting")
    • 2005: Boom ended August 2005. The booming housing market halted abruptly for many parts of the U.S. in late summer of 2005.
    • 2006: Substantial market correction. U.S. Home Construction Index was down over 40% as of mid-August 2006 compared to a year earlier. At the same time about $400B of ARMs were reset according to a NY Times report.
    • 2007: Home sales and prices both continue to fall. The plunge in existing-home sales is the steepest since 1989. The subprime mortgage industry collapsed, and a surge of foreclosure activity (twice as bad as 2006[4]) and rising interest rates threaten to depress prices further as problems in the subprime markets spread to the near-prime and prime mortgage markets.[5] About $1 trillion of ARMs were to reset in 2007. [6] Investors lost billions of dollars in securities tied to subprime mortgage assets, triggering turmoils in global financial markets.

United States housing bubble (2001-2005)

Main article: United States housing bubble

There was an economic bubble in many parts of the U.S. housing market from 2001 to 2005, especially in populous areas such as California, Florida, New York, the BosWash megalopolis, and the Southwest markets. The real estate bubble in these and other parts of the U.S. was caused by historically low interest rates (meant to soften the blow of the massive collapse of the dot-com bubble), poor lending standards, and a mania for purchasing houses.[7] This bubble is related to the stock market or dot-com bubble of the 1990s.

A housing bubble is characterized by rapid increases in the valuations of real property such as housing until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability. This in turn is followed by decreases in home prices that can result in many owners holding negative equity, a mortgage debt higher than the value of the property.

Bubbles may be definitively identified only in hindsight, after a market correction,[8] which began for the U.S. housing market in 2005–2006. In the wake of the subprime mortgage crisis in 2007, which was caused by a large number of home owners unable to pay the mortgage as their home values declined, Freddie Mac CEO Richard Syron concluded, "We had a bubble,"[9] and concurred with Yale economist Robert Shiller's warning that home prices appear overvalued and that the correction could last years with trillions of dollars of home value being lost.[9]. Problems for home owners with good credit surfaced in mid-2007, causing the U.S.'s largest mortgage lender Countrywide Financial to warn that a recovery in the housing sector is not expected to occur at least until 2009 because home prices are falling “almost like never before, with the exception of the Great Depression.”[5] The impact of booming home valuations on the U.S. economy since the 2001–2002 recession was an important factor in the recovery because a large component of consumer spending came from the related refinancing boom, which simultaneously allowed people to reduce their monthly mortgage payments with lower interest rates and withdraw equity from their homes as values increased.[10] The collapse of the U.S. Housing Bubble has a direct impact not only on home valuations, but the nation's mortgage markets, home builders, home supply retail outlets, and Wall Street hedge funds held by large institutional investors, increasing the risk of a nationwide recession.[5][10]

Role of homeowners

Homeowners had been using the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending.

In the early 2000s recession that began in early 2001 and was exacerbated by the September 11, 2001 terrorist attacks, Americans were asked to go "shopping because President Bush asked us to and for personal patriotism[11]" and spend their way out of economic decline with "consumerism... cast as the new patriotism[12]". The call linking patriotism to shopping was bipartisan with former President Bill Clinton urging his countrymen to "get out and shop"[13], and corporations like General Motors producing commercials with the same theme.

The housing bubble was largely fed by the lowering of interest rates to record low levels to diminish the blow of the massive collapse of the dot-com bubble. The collapse of the housing bubble, and resultant decline in property values, and increase in defaults has left lenders unable to recover losses.[14]

Additional problems are anticipated in the future from the impending retirement of the baby boomer generation. It is believed a significant portion of the generation are not saving adequately enough for retirement and were planning on using their increased property value as a "piggy bank" or replacement for "a retirement-savings account". This is a departure from the traditional American approach to homes where "people worked toward paying off the family house so they could hand it down to their children"[15].

Role of world central banks in stabilization

Other central banks around the world have begun coordinated efforts of their own to increase liquidity in their own currencies to stabilize foreign exchange rates (thus stemming a further fall in the American dollar and diminishing any incentive to sell them off) and prevent the probable significant global consequences a run on the American dollar would cause. It marks the first time the American, European, and Japanese central banks have taken such actions together since the aftermath of the September 11, 2001 terrorist attacks.[16]

As of August 10, 2007, the United States Federal Reserve has injected a combined 43 billion USD, the Europeans 191 billion USD, and the Japanese 8.4 billion USD. Smaller amounts have come from the central banks of Australia, Hong Kong, and Canada.[16]

  • Thursday, August 9: Fed injected $30B to bail out investors over-extended in risky mortgage investments.
  • Friday, August 10: Injected $38B to bail out investors over-extended in risky mortgage investments.
  • Monday, August 13: Injected another $5B.
  • Tuesday/Wednesday, August 14/15: Injected another $7B to $15B.
  • Thursday, August 16: The Fed added $17 billion.

The European Central Bank (ECB) injected €61 billion[17], and the Federal Reserve injected $68 billion into their respective banking systems on Friday, 10 August 2007 in order to calm their markets, on top of the €95 billion the ECB had injected on Thursday, 9 August 2007.[18][19][20] The Federal Reserve further injected $24 billion into the US financial system that day. On 13 August, the ECB injected another €47.67 billion into the banking system and noted that credit conditions were "normalizing" while the Bank of Japan injected another ¥600 billion.[21]

This is a prime example of the argument that central bank behavior destroys the myth of the free market:

So far, the economic pundits and CEOs have applauded the Fed's intervention as a “constructive” way of staving off an impending credit crisis.


Are these the same “experts” who always sing the praises of unregulated “free markets” while condemning any government intervention?

Yes.

The investment banks and fund mangers love “free markets” when it means eliminating the rules that prevent them from gaming the system. But they don’t like it so much when their shabby Ponzi-rackets start to unravel. Then they’re the first in line to beg for a bailout.

That’s what’s happening right now. The Fed is keeping the stock market afloat by increasing liquidity at the banks. [22]

On August 17, the Federal Reserve cut the discount rate by half a percent to 5.75% from 6.25% while leaving the federal funds rate unchanged in an attempt to stabilize financial markets.[23]

Stock markets

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.[24] By August 15, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Large daily drops became common, with, for example, the KOSPI dropping about 7% in one day.[25]

Mortgage lenders[26][27] and home builders [28][29] fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.[30]

Fund/corporate losses

Wall Street investment banks and other financial institutions around the world have also been affected. On June 20, 2007, Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds that were involved in securities backed by subprime loans. The two funds are now essentially worthless[31].

American Home Mortgage Investment Corporation (AHMI, Melville, New York) filed Chapter 11 bankruptcy on August 6, 2007, after a layoff of its employees the week before. Accredited Home Lenders reported on August 10 that the company expected to see up to a $60 million loss for the first quarter 2007[32].

On 8 August 2007, Mortgage Guaranty Insurance Corporation (MGIC, Milwaukee, Wisconsin) announced it would discontinue its purchase of Radian Group (Philadelphia, Pennsylvania)[33] after suffering a billion-dollar loss[34] of its investment in Credit-Based Asset Servicing and Securitization[35] (C-BASS, New York City). C-BASS is seeking to restructure its financing. The MGIC-Radian transaction would have been a $4.9 billion deal.

Later, on August 9, French bank BNP Paribas stopped valuing three of its funds and suspended all withdrawals by investors after United States subprime mortgage woes had caused "a complete evaporation of liquidity".[36]

Goldman Sachs' $8 billion Global Alpha hedge fund, its largest, reportedly lost 26% in 2007.[37] Later, on August 13, the company announced that a group of investors bailed out its Global Equity Opportunities fund by infusing $3 billion after it lost 28% of its total value in one week.[38] Also, Citigroup has reported taking $700 million in losses in its credit business in July and August 2007.[39]

On August 14, several media outlets reported that another fund, Sentinel Management Group, suspended redemptions for investors and sold off $312 million worth of assets. Three days later, Sentinel filed for Chapter 11 bankruptcy protection amid ongoing legal action with respect to this move. [40] US and European stock indices continued to fall.[41] Later that same day Thornburg Mortgage, a jumbo mortgage lender, announced they were delaying their dividend after facing margin calls and disruptions in funding mortgages in the commercial paper and asset-backed securities markets. Thornburg shares fell over 46% in trading on the NYSE.[42]

On August 15, the stock of Countrywide Financial, which is the largest mortgage lender in the United States, fell around 13% on the New York Stock Exchange, its largest one-day decline since the 1987 stock market crash, on fears that the company could face bankruptcy. This comes a day after Countrywide said foreclosures and mortgage delinquencies had risen to their highest levels since early 2002.[43]

Rams Home Loans Group, an Australian lender, announced on August 16 that the company was unable to refinance short-term debt as buyers stayed away from the credit markets. The company said they were unable to sell AUD$6.17 billion of extendable commercial paper, which is the company's largest source of funding for loans. Rams shares fell as much as 41% on the Australian Stock Exchange.[44]

Retail

Home Depot announced on August 14, 2007, that second quarter profits fell 15% and are expected to drop another 18% by the end of the year citing the "U.S. housing market"[45]. On the same day, Wal-Mart, which is considered "a barometer of the health of the U.S. retail sector", reported that it had a lower than expected second quarter profit and cut its projected full-year earning forecast saying its "customers remain under economic pressure" and that those pressures are now being felt in "Mexico and Canada", adding that it planned to discount heavily on "thousands of items by as much as 50 percent to boost sales" in the months ahead, which would "hurt margins" further[46].

Luxury retailers who cater to those with high-incomes continue to do well. The disconnect between the two retail segments, discount and luxury, are reflective of the growing and large income inequality in the United States[47]. Some economists, including Alan Greenspan, claim the growing inequality and stagnant wages for average Americans despite large productivity gains will eventually result in "significant negative economic consequences"[48] and "trade protectionism". The wealthy are expected to be "insulated" from "the real estate slump"[49].

Political

The housing slump and subprime woes are thought to have played a role in the U.S. 2006 midterm elections. In the weeks before the election Bush administration officials attempted to ease voter concerns with Commerce Secretary Carlos Gutierrez saying America has "a very strong, large resilient economy that can absorb a housing correction[50]". The elections were viewed as a major defeat for the Bush administration.

Many expect the subprime meltdown to have significant ramifications for the 2008 U.S. presidential elections, particularly if it worsens into "a full-blown crisis"[51]. One major contender whom analysts claim may benefit the most in the event of a significant downturn is John Edwards, who is "framing the campaign as a struggle that pits the political and corporate elite against regular people" with one of his top strategists saying "economic disparity will put this nation in the toilet much quicker than a nuke from Iran or North Korea... housing prices are beginning to drop makes the building boom (due to insane lending practices) come to an end, many of you in the middle-class will get a close look at the realities of a system "where democracy is subservient to capitalism, and not the other way around," economic disparity will be coming to a suburb or exurb near you[52][53]".

David Rohde, a political science professor at Duke University, has said "the time might be right for a resurgence of populism" and "what would make it even more plausible is if the economy went into a tailspin[54]". Edwards has already made "fighting predatory mortgages[55]" a central theme of his run.

U.S. dollar turmoil

Subprime woes have been blamed for causing the U.S. dollar to continue its decline. The Daily Telegraph recently reported that "the Chinese government has begun a concerted campaign of economic threats against the United States" and "that Beijing had the power to set off a dollar collapse if it chose to do so" with economic analysts saying it "could have very serious consequences at a time when the credit markets are already afraid of contagion from the subprime troubles"[56]. Reuters has quoted officials at HVB Bank in New York remarking that they "believe that what is going on in the subprime lending market is just hurting the dollar too much... I think overall the fate of the dollar depends on developments in the subprime sector and housing market.[57]" On July 12, 2007, the decline of the dollar "was broad as well as deep", with it reaching "a record low against the Euro... as the U.S. subprime mortgage market crisis damaged sentiment on the greenback"[58].

Expectations and forecasts

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm"[59]. Alan Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s"[60].

The Associated Press described the current climate of the market on August 13, 2007, as one where investors were waiting for "the next shoe to drop" as problems from "an overheated housing market and an overextended consumer" are "just beginning to emerge.[61]" MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse"[62].

See also

Wikinews has related news:

References

  1. ^ Dodd, Christopher. "Hearing on Mortgage Market Turmoil: Causes and Consequences", United States Senate Committee on Banking, Housing, and Urban Affairs, March 22 2007.
  2. ^ Robb, Greg. "Poole: Fraud in subprime loans 'coming home to roost'" MarketWatch.com, Retrieved on August 19, 2007
  3. ^ Christie, Les. "Subprime Blame Game" CNNMoney.com, Retrieved on April 20 2007
  4. ^ "Housing Problems Start to Hit the Financial Sector" by Hale Stewart, Huffington Post, June 24, 2007 quoting Quarterly Banking Profile First Quarter 2007 of the Federal Deposit Insurance Corporation
  5. ^ a b c "Lender Sees Mortgage Woes for 'Good' Risks". New York Times. 25 July 2007. {{cite news}}: Check date values in: |date= (help)
  6. ^ "Re-Refinancing, and Putting Off Mortgage Pain" by Vikas Bijaj and Ron Nixon, New York Times, July 23, 2006
  7. ^ Transcript of Bill Moyers Journal episode first aired 29 June 2007. Also available in streaming video.
  8. ^ "After the fall: Soaring house prices have given a huge boost to the world economy. What happens when they drop?". The Economist. 16 June 2005. {{cite news}}: Check date values in: |date= (help)
  9. ^ a b "Subprime shockwaves". Bloomberg. 19 July 2007. {{cite news}}: Check date values in: |date= (help)
  10. ^ a b "Housing Bubble Trouble: Have we been living beyond our means?". The Weekly Standard. 10 April 2006. {{cite news}}: Check date values in: |date= (help); Unknown parameter |name= ignored (help)
  11. ^ Consumers spend warily, look to Uncle Sam
  12. ^ Shop for Your Country
  13. ^ Shop for Your Country
  14. ^ Liedtke, Michael. "A Primer on Subprime Mortgage Meltdown" The Associated Press, March 12 2007.
  15. ^ A house is not a piggy bank
  16. ^ a b "ECB, Fed Inject Cash to Ease Fears" by Matt Moore, Associated Press, August 10 2007
  17. ^ http://news.bbc.co.uk/1/hi/business/6939757.stm
  18. ^ ECB boosts banking sector amid US subprime worries, AFP via Yahoo UK, 2007-08-09
  19. ^ http://news.xinhuanet.com/english/2007-08/11/content_6511077.htm U.S. Fed injects another $38 bln into financial market
  20. ^ "Stocks Close Down 30 Points After Volatile Day", The Washington Post, August 10, 2007
  21. ^ "ECB injects additional $65.3B". AP. Aug 13, 2007.
  22. ^ "Stock market brushfire; will there be a run on the banks?"
  23. ^ Crutsinger, Martin (Aug 17, 2007). "Fed Approves Cut in Loan Discount Rate". AP.
  24. ^ Finally! Dow finishes above 14,000
  25. ^ Global stocks thumped, yen climbs on credit fears
  26. ^ RAIT Financial Shares Tumble
  27. ^ Thornburg says no bankruptcy as shares sink
  28. ^ Housing starts at decade low
  29. ^ Sector Wrap: Homebuilders Fall
  30. ^ Metals, miners hit by base metal sell-off
  31. ^ http://money.cnn.com/2007/06/20/news/companies/bear_stearns/index.htm
  32. ^ http://www.reuters.com/article/marketsNews/idUKWEN037120070810?rpc=44
  33. ^ MGIC May Abandon Radian, Forbes, 2007-08-10
  34. ^ Milwaukee Journal-Sentinel, August 6, 2007
  35. ^ http://www.c-bass.com/Press/Blackstone%20Announcement%20080307.pdf
  36. ^ Kennedy, Simon (Aug 9, 2007). "BNP suspends funds amid credit-market turmoil". MarketWatch.
  37. ^ Langlois, Shawn (Aug 11, 2007). "Goldman hedge fund reportedly hit hard". MarketWatch.
  38. ^ Bel Bruno, Joe (Aug 13, 2007). "Goldman Hedge Fund Gets $3B Bailout". AP.
  39. ^ Langlois, Shawn (Aug 11, 2007). "Citigroup seen taking $700 million in credit losses". MarketWatch.
  40. ^ "Sentinel makes Chapter 11 filing". Chicago Tribune. Retrieved 2007-08-19.
  41. ^ Bel Bruno, Joe (Aug 14, 2007). "Stocks Fall on Consumer, Credit Worries". AP.
  42. ^ Barr, Alistair (Aug 14, 2007). "Thornburg Mortgage delays dividend amid margin calls". MarketWatch.
  43. ^ Stempel, Jonathan (Aug 15, 2007). "Countrywide plunges on downgrade, bankruptcy fear". Reuters.
  44. ^ Cochrane, Laura (Aug 16, 2007). "Rams Home Loans Fails to Refinance Debt; Shares Slump". Bloomberg.
  45. ^ Home Depot profit slumps on housing weakness
  46. ^ Wal-Mart misses view and cuts full-year forecast
  47. ^ Income levels help identify big holiday shoppers
  48. ^ Income Inequality Threatens Growth
  49. ^ Wealth gap swallows up American dream
  50. ^ Housing market slows economy
  51. ^ Housing bubble bursts into US elections
  52. ^ The Big Sell-Out Must Stop Now
  53. ^ Is John Edwards' Leftward Turn About Populism or Posturing?
  54. ^ Can Edwards win with an 'us vs. them' pitch?
  55. ^ Protecting Homeowners And Fighting Predatory Mortgages
  56. ^ China threatens 'nuclear option' of dollar sales
  57. ^ Dollar sags on subprime troubles
  58. ^ Dollar slips to new low vs euro on subprime scare
  59. ^ Fed rapped over subprime loans
  60. ^ Subprime crisis could pack political punch
  61. ^ Stocks reverse course at finish
  62. ^ Mortgage market in 'downward spiral'
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