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Normal loans are dispensed to borrowers who have a good credit history and a good FICO score (Fair Isaac Corporation). Sub-prime mortgages are home loans given to people who are high-risk and cant reasonably afford them. However it was felt that a lot of money could also be made to borrowers who were being denied an opportunity because of poor credit history. Such borrowers are then charged higher interest rates to compensate for the risk and the likelihood of default. Many of the bad mortgages were grouped together with good mortgages and on-sold as a single investment for other banks and organisations to buy these were called Collateralised Debt Obligations (CDOs). Credit rating agencies were paid to put artificially high ratings on these investments to make them appear safer, and easier to sell. The Freddie mac and Fannie mae also had a role to play, these are government sponsored enterprises (GSE) that purchase mortgages, buy and sell mortgage-backed securities (MBS), and guarantee nearly half of the mortgages in the U.S. A variety of political and competitive pressures resulted in the GSE taking on additional risk. HUD loosened mortgage restrictions in the mid-1990s so first-time buyers could qualify for loans that they could never get before. In 1995, the GSE began receiving affordable housing credit for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. The crucial assumption made was that the assets backing such investments e.g. houses would not only maintain, but increase their value the idea that property always goes up. Which is why the banks were willing to lend money to an otherwise dubious group of customers known as NINJAs no income, no job or assets. The assumption was that if the person borrowing the money walked away from their house, the bank would still have an asset worth more than what it was when they lent the money out. Then the housing bubble burst, property prices fell, and mortgage defaults increased. The participants in the loan disbursal process are shown below.
Home Owner
P&I Mortgage

$$ Lender/Conduit Mortage Broker

P&I Mortgage

$$ Trust (SPE)




Rating Agency

Underwriter/Placement Agent


Individuals, Pension Funds, Insurance Companies, Mutual Funds, Hedge Funds

Financial Interest

$$ Individuals

THE PLAYERS IN THE GAME PLAYER 1: Federal Federal kept the interest rate low during much of 1990s and particularly 2001-2005 (low oil prices, and low inflation prompted the policy), fueling the market

PLAYER 2: the 2001-2005, FFR was in the 1% to 3% range, and mostly in the 1% range Federal During encouraged more risky ARM(adjustable rate mortgage) lending PLAYER 2: Mortgage Salespersons Worked on commission based on the number of arms successfully twisted

PLAYER 3: Primary Lenders No incentives for judicious lending Banks no longer needed to hold on to the mortgage, as use of mortgage-backed securities made risk taking more appealing -Use of ARMs with low teaser rates (below market rates for a while, followed by much higher rates tied to index, LIBOR + some %). Teaser rates are popular when long-term interest rates are at historical lows (like much of this period), as they help lenders benefit from ARMs as rates rise Net Effect: Many loans were made to NINJAs (people with No Income, No Jobs or Assets).

PLAYER 4: Other Financial Institutions Freddie Mac and Fannie Mae issued many Mortgage Backed Securities. Other financial institutions that traded in these as well as derivatives based on real estate assets. A variety of political and competitive pressures resulted in the GSE taking on additional risk.

PLAYER 5: Credit rating Agencies and Analysts Lack of market for many of these securities, so models were used to price them Inflated ratings, mostly in A range (similar to T-Bills) Conflict of Interest: Investment bankers analysts were rating investment bankers clients

PLAYER 6: Home Buyers (Taking Excessive Risk) Home buyers were enjoying the ride , new ones were joining the ride, even if unqualified Home ownership up from 60% in 1990s to 70%


Housing market boom

Stimulate the investment enthusiasm. Mortgage lenders make good business

Get big return

Get big return

US Federal Reserve lowers rate 11 times, form 6.5% to 1.75%

Make Loans to Subprime Borrowers Sell AES Mortgage Lenders Investment banks

Sell CDOs Hedge funds and other insurance companies Provide Funds

Housing market

Increases interest rates 17 times ARM increased monthly payments and decreased home prices

Provide Funds

Housing Bubble burst

More and More Subprime Home Owners are unable to meet commitments. Many mortgage lenders shut down or file for bankruptcy

Investments Failed, Huge losses. Get into Crisis

Investments Failed, Huge losses. Get into Crisis

Collapse of stock Prices

Subprime global Financial Crisis

INFORMATION ASSYMETRY AND TRANSPARENCY There should be more transparency about the structured products: One reason behind the market failure relates to information asymmetry. It is argued that sellers have more information than buyers about what they are selling. In the subprime episode, Investors increasingly did not know what they were buying and what the security is worth. The problem with the complex securities is that they do

not trade at all and so market prices are rarely available. The following steps are necessary to ensure more transparency about the structured products: Consistent valuation of such assets across firms to be ensured by the regulator Dissemination of information on the vehicles that issue asset-backed commercial paper and price and performance of privately traded asset-backed instruments. Greater standardization of structured products

RESOLVING THE PRINCIPAL AGENT PROBLEM & ASSET MARKET FAILURE Asset market may fail to recover the dues in case of failed lending. This is true even when the asset is a real estate. Poor lending constitutes the core of subprime crisis. The issue of lending is commonly viewed as a principal-agent problem. There are three aspects of principal agent problem: adverse selection, moral hazard and monitoring. The first and the third aspects are related to the lender and second to the borrower. As for the role of the bank, it should try its best to select its customers judiciously after appropriate screening and this should be followed by a rigorous monitoring because bank will hold this asset on its balance sheet, till it returns duly with interest. One may be tempted to think that adverse selection is not a very big problem, when the bankruptcy procedure is efficient, so that the collateral may enforced with any problem. The need to monitor was considered redundant in a securitized regime, as there was an implicit faith in the ability of the collateral to recover the money lent. There was an implicit assumption that if the borrower in the credit market cannot pay back, it may not be of any significance, when asset markets are functioning. However the collateral may be a risky asset whose value may fluctuate. The subprime crisis demonstrated that relying on the asset market for realization of dues was counterproductive, even when the asset was as solid as a real estate. If the price of the collateral prevailing in the market happens to be low when the asset is sold, then the seller will not be able to recover his dues through selling. However, a very peculiar scenario was observed during the subprime crisis where the same factor which leads to defaults is also forcing the prices of real estate to drop. This variable is rate of interest fixed by Fed, which is a policy variable. Such a variable is found to influence both aspects: demand and supply of real estate. Let us go through the chain of events. A rise in the interest rate caused defaults in subprime category. Faced with this, the investors who bought the securitized instruments attempted to sell them in the market. However, every rise in the rate of interest is also simultaneously leading to drying of demand through a rise in mortgage payments. Thus rise in the rate of interest led leading to widening of the gap between supply and demand and pushed below the price of collateral creating a vicious cycle from which no escape is apparently in sight. This has demolished the myth that real estate is considered a solid security. A bitter lesson emerging out of the crisis is that market of asset does not provide any respite in case of failed lending. NEW MODEL OF BANK WITH MODERN PRINCIPLES OF FINANCE IS FRAGILE: Unwillingness of the mortgage banks to assess the risk profiles of the borrowers and lend on the basis of risk in a regime of low interest rate made financial system very fragile. Many lenders had to relax their credit norms due to competition. In addition, given that most mortgage lenders in the US sell their loans within a month or two, their primary motivation was to generate as many loans as they could and then sell them quick. This was yet another reason they lacked strong incentives for credit checks. It vindicates the old model of banks which provides loan and keeps it on its books till it matures.

DISCIPLING THE RATING AGENCIES Investment bank pays the rating agencies to rate CDO securities. Investment banks and rating agencies work closely in structuring the transactions. Rating agency staff crosses over to dark side "to work for investment banks. Credit Rating Agencies should be subject to rules for disclosures for their activities. One option is for the government itself to regulate rating agencies. DISTORTED INCENTIVES WITHOUT ACCOUNTABILITY CAN SPELL DISASTER The subprime crisis has been the result of individual incentives and the lack of accountability which has caused the present dilemma. The market for MBS created by subprime loans is like lemon markets because of the information asymmetry between the key players and in this situation only low quality lemons would be traded. Under the extreme scenario, such a market should cease to exist however low tranches are backed by multi class MBS and thus the players have managed to survive which has spilled disaster for the US economy and the economies world over. PRUDENT HOUSING POLICY Housing policies for low and moderate income groups should not be excessively weighted towards owner-occupied solutions. Households with low and uncertain incomes may be better off renting than owning housing that meets standards for health and safety. If subsidies are provided, they should be available for either ownership (for example with down payment assistance) or rental (for instance with rental vouchers), and in either case for new or used units. There should be balanced protections in law for mortgage lenders and borrowers, and for rental landlords and tenants. Tax treatment should not unduly favour owning or renting. The challenge for emerging markets is to increase access to housing finance for moderate and low income households while maintaining strong standards for credit risk management. Governments can reduce the cost of housing by increasing efficiency in land markets. Banks may increase the supply and maturity of mortgages by financing themselves with covered bonds or by securitizing portfolios. They may extend credit to lower income households by employing more labour-intensive microfinance management methods. Emerging market lenders can extend credit to moderate income households using alternative documentation methods and credit scoring technology while maintaining strong credit underwriting standards. FINANCIAL REPORTING While stronger financial reporting and disclosure standards were not sufficient to prevent the subprime crisis, they remain crucial for improving efficiency in emerging mortgage markets. The inadequacy of reporting of off-balance sheet entities should be reduced. RESPONSIBLE CENTRAL BANK AND STRONG CORPORATE GOVERNANCE Frequent consultation with risk management advisors and using governance functions such as internal audit, credit review and post close quality assurance can mitigate chances of disaster. The central bank must actively bird watch the market closely and should engage in controlled expansion in credit lending to risky segments.