Assignment - 2

US Subprime Mortgage Crisis

Introduction
The housing market in US boomed during the early 2000s where quick sales happened and
multiple bids were applied for one single house. Attractive mortgage rates and low interest
rates fueled this boom in demand. As a result, house prices increased by 124% in the period
1997-2006 as per the S&P/Case-Shiller national home-price index.
The subprime mortgage is defined as a type of debt instrument that is given to individuals
with poor or no credit history. A higher rate of interest is charged for taking this additional
risk. This made the housing for such borrowers affordable because of low interest rates. The
financial institutions delved into the subprime market as they wanted to generate higher
returns since they were having ample liquidity and low interest rates. Sophisticated financial
products were introduced by institutions to expand the subprime mortgage market. Banks
started selling the mortgages to the bond market and made commission on each mortgage
being sold. Collateral Debt Obligations (CDOs) was popularized where loans were
repackaged and sold as instruments. It was believed by the investment banks that they had
minimized risk by selling pooled assets instead of a lump sum of an individual high-risk loan.
It allowed banks to have higher credit ratings from agencies such as Standard and Poor’s.
Hedge funds bought these innovative mortgage related financial products actively as they
faced lesser regulations and were willing to take higher risk. Not just US hedge funds,
European and Asian counterparts also bought these products thereby expanding the presence
of these products worldwide.
Rise in inflation during the year 2004 was followed by hikes in rates by US Federal Reserve
that continued till June 2006. Homeowners who took the subprime mortgages faced the heat
of the higher rates as they were unable to pay the monthly payments. The number of defaults
and foreclosures on such mortgages went up in the early 2007. The problem had spread
beyond borders and became a global credit crunch. It struck major wall street firms such as
Merrill Lynch and Citibank. This was followed by a financial crisis, most severe recession,
and a massive sell off in equity markets. Big companies such as Lehman Brothers and AIG
faltered. Lehman’s bankruptcy was the biggest corporate bankruptcy and they were unable to
find potential buyers. This sent panic across the market for financial institutions. In addition
to this, Merrill Lynch announced that it would sell itself to Bank of America for $50 billion to
survive the crisis. The government tried to improve the economy by providing a stimulus
package and lending programs for debt-ridden banks. FED played a significant role in JP
Morgan’s purchase of Bear Stearns to handle the subprime mortgage crisis. Following this
deal, it was hoped that there would be signs of improvement in the financial market but
neither the housing market nor the credit market responded to such deals in a positive
manner. More than five million jobs were removed.
There was also a collapse in the consumer demand that triggered another concern – deflation
– persistent fall in the price of goods and services. Weak demand also meant that businesses
would not do new investments or increase production. Prolonged deflation was feared to lead
to a longer and deeper recession. It also raised the real value of debt that was already more
than 140% of household disposable income.
Source – FactSet, US Census Bureau, Harvard University – State of the Nation’s Housing
Report

Key Issues & Case Interpretation

The economists and the financial experts blamed the crisis on the expansionary monetary
policy in the early 2000s that allowed the interest rates to be low even though the asset prices
kept on increasing. It was said that FED was not alert enough on this matter and did not
determine the interest rates properly. The funds rate should have been higher by 3% points
during the early 2000s than what it was actually at the time. FED was slow in raising the
federal fund targets. It was highlighted that when FED started raising the interest rates in
2004, the long term interest rates did not change in accordance to the changes in the short
term interest rates. Possible reasons for this are –
 Consumers expected that the housing prices would continue to increase
 Global Savings Glut - There was a surge in global savings especially by many Asian
countries after the 1997-1998 financial crisis and by oil-exporting nations after the
rise in oil prices in the 2000s. This outpaced the investments and held down the long
term interest rates.It was also argued that the financial crisis began due to the failure
of the central bank to target the asset prices. It is the responsibility of a central bank to
adjust policy for both inflation and asset prices to reduce the likelihood of asset price
bubble.
One of the primary causes of the crisis was poor regulation. It was estimated by Standard &
Poor’s that subprime write downs were nearly $285 billion whereas other investment banks
estimated it to be around $400 billion. There was no supervision over investment banks,
hedge funds, or on firms involved in derivatives and complex financial products. The AAA or
higher credit ratings also that these companies achieved was done by paying the rating
agencies to do so. Because of loose rules and regulations, lenders did not require borrowers to
make a down payment. There was a surge in the number of borrowers who did not provide
documents to prove their assets and income (up to 44% of subprime borrowers in 2006).
Even though some wanted stricter regulations, they were obstructed as the Wall Street was
making profits and idea was to let the financial market operate as freely as possible. Critiques
pushed for more stringent regulations to fully disclose the risks that their loans have. Buyers
had no idea of what the asset-backed securities comprised.
An analysis performed by Raghuram Rajan, professor at the University of Chicago and
former IMF chief economist, raised the issue of flawed system of financial compensation
followed by the investment banks. He critiqued the idea of giving huge bonuses to employees
on the basis of short-term performance even though banks were making losses and
considered it to be the reason for financial outbreaks.
The FED was more concerned about weak economic growth than price stability and
overlooked inflation, which was at a 16 year high. Experts suggested that if the country does
not accept the chances of a smaller recession, then it would end up paying a larger cost of
inflation. Also, FED injected $35 billion into the market to soothe fears about credit crunch.
This move was questioned as it pushed forward the mentality that banks may escape from
taking responsibility for their actions. Bailing out of financial institutions by FED contributed
to moral hazard.
It was proposed that the expansionary monetary policy should be accompanied with a fiscal
stimulus as well to impact the people facing the brunt of recession because the monetary
policies focused more on the financial institutions. The fiscal stimulus should be targeted,
temporary, and timely to be effective. The administration sent out a fiscal package of $150
billion that included tax rebates for individuals and households and tax cuts for businesses.
But there were issues with this fiscal stimulus package –

 Time lag – Tax rebates were for early 2008, creating a time lag. The need was to
implement it quickly to maximize the effectiveness.
 The government aid was targeted incorrectly that led US into the subprime crisis in
the form of a huge trade deficit and low national savings. It was aimed at maintain
unsustainable high rates of personal consumption, whereas it should have been at
unemployed workers or low-income consumers who can play a role in boosting the
demand by spending money that they had received. It was also worried that the rebate
received was used for paying off the debts instead of spending.
 It was believed that tax cuts worsened the nation’s budget deficits instead of being a
short-term temporary measure.
Despite taking some measures, there was no sign of improvements. FED, in 2008, set a target
FED funds rate range of 0-0.25%. The new policy measure was aimed creating liquidity to
increase the central bank’s balance sheet. This is also known as last resort, where the policy
allowed direct buying of government and other bank assets. This new policy was not without
risks – the central bank had to be vigilant to take rapid actions to withdraw the dollars
pumped into the economy once there is an improvement. This measure was just as
quantitative easing approach followed by Japan.
The FED also tried to encourage banks to begin lending again by expanding the kinds of
assets that the FED would buy from the financial organizations. Debt, mortgage backed
securities, long term bonds, and consumer loans are some of the unconventional asset
purchases that the FED’s balance sheet included. It auctioned short term collateral backed
loans to allow institutions to borrow money at rates lower than the discount rate.
Another program launched by FED was Term Asset-Backed Securities Loan Facility (TALF)
that would lend up to $200 billion to support the problems of new securities backed by
student, auto, credit card loans.
In March 2008, Troubled Asset Relief Program (TARP) – a $700 billion financial bailout
program which was initially launched to purchase toxic financial assets at a premium rate
over the current value to provide liquidity to banks. However, with markets not improving,
the plan was scraped and the treasury decided to invest $250 billion in banks directly rather
than buying preferred shares. Some other provisions under this plan were to provide a
guarantee of new debt issued by banks to three years and unlimited insurance by FDIC
(Federal Deposit Insurance Corp) on non-interest-bearing accounts. Lot of top banks and
businesses showed interest in getting this aid such as Citibank, Bank of America, General
Motors, and Chrysler. This policy faced backlash as it rewarded institutions that played a
major role in creating the crisis in the first place. The criticism was around the fact that
nothing was being done for home foreclosures and average taxpayers. TARP had been
executed in a poor fashion.
In Feb 2009, TARP2 was announced that was known as Financial Stability Plan. A public
and private fund of $2 trillion was called up to rescue the financial system. Following are the
details –

 The government would offer low-cost financing to buy toxic bank assets in a public-
private partnership and raise $500 billion and $1 trillion for this purpose.
 TALF to be extended by $1 trillion to buy new home, car, and student loans.
 Before extending direct help to banks, involve a stress test to understand which banks
with assets over $100 billion to create better oversight and accountability over the
funds.
The issue with this plan was how to encourage private players to buy bad loans. There was
difference in valuing the distressed assets and huge gap in what the private players wanted to
pay and what the financial institutions deemed. To motivate the private investors, government
announced that it would lend upto 85% of the purchase price for bank’s mortgage sakes.
In March 2009, FED announced to buy long term treasury securities to bring down yields.
The dire situation of the financial sector triggered a debate over whether the banking sector
should be nationalized. Experiences of both Japan and Sweden were taken into account in
this matter. This idea was not taken forward because US financial secotr was much larger and
more complex. Also, there was a general consensus that the government did not have the
guidance and experience to run banks.
The scope of the crisis and the scale at which it had impacted everyone, forced policy makers
to club monetary tools and fiscal stimulus package to pull the economy out of the recession.
Declining housing prices and rise in unemployment continued for more than 5-6 years even
after the recession ended.

Learnings from the crisis

 Financial crises can have huge consequences that can linger over for many years for
the economy and the nation. The road to recovery is also slow in such cases. Despite
the policies oriented towards supporting the recovery, it took more than eight years to
push the unemployment rate downwards. It also leads to a damage to public trust in
the country’s government and financial institutions.
 A resilient financial system is needed to ensure enough safeguards are in place. For
example – a complete workable regime for solving if a complex and global firm
becomes insolvent. We have to ensure that our financial systems provide critical
services during good and bad times.
 We as regulators should continuously evaluate the financial system and monitor the
new developments and innovations happening in the landscape. We have to
understand that the financial sector is a complex plus a very unstable one.
 We should temper the potential excesses that may threaten the financial stability.
During the financial crisis, tools such as a closer evaluation of the incomes of the
borrowers or requiring larger down payments could have been implemented to restrict
the demand for housing. If this was implemented, home prices would not have
increased so dramatically and the resulting bust would have been less severe.
 The structure of the compensation should reward attention to compliance. The
incentives should be in alignment with the institution’s values and policies. Chasing
risky or bad short-term profits should be discouraged. Technology should be used
optimally to make sure that compliances are followed.
 It brought light on the importance of having strong international cooperation to not
just mitigate the effects of the crisis but also when it comes to prevent the risks. A
more comprehensive methodology of information sharing and insights will help in
such cases.
 Better collaboration between public and private partners is required to deal with the
complex challenges and the unintended consequences. The political process also has
to play a significant role during such crises.

Sources –
 FaceSet - https://www.factset.com/
 US Census Bureau, Harvard University – State of the Nation’s Housing Report
.