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The US Sub-Prime Mortgage Crisis Causes and Implications


The 2008 financial crisis has wiped an enormous about of shareholder money and right to this day the exact amount has not been estimated. By IMF pegs the total loss of the financial crisis of 2008 at $4.1 trillion which is more than three times our GDP. Many of the world economies were severely affected by the crisis and to this date havent completely recovered, including USA and now there is talk of a double dip.

The Bubble Part I

If the cause of the crisis has to be explained in just one word, then that word would be deregulation. After the Great Depression of 1929, President Franklin Roosevelt introduced a variety of measures to combat the crisis and also to prevent the recurrence of such devastating bubbles. So USA started the process of regulation and one sector that saw stiff regulation slapped on them was the financial sector. In 1933, Congress passed the Glass-Steagall Act which banned commercial banks from underwriting securities and participating in the securities market, forcing banks to choose between being a simple lender (commercial bank) or a brokerage (investment banks). The years that followed there was growing pressure on Congress from the commercial banks to make changes to the Glass-Steagall Act on 1933 which had resulted in Shadow Banking. This involved banking with funds from short term borrowings, money market mutual funds, repos and others. Depositors started to withdraw funds from commercial banks which offered about 6% on deposits, while the investment banks offered double digit returns. Another reason for the dissatisfaction of the commercial banks was that initially they were only authorised to provide 30 year fixed mortgages. But the banks found it extremely difficult to cover their costs due to high inflation rates during 1970s and 1980s. In 1982, Congress passed the Garn-St. Germain Act which permitted banks to issue other types of mortgages such as Interest Only (IO), Balloon payment mortgages and Adjustable Rate Mortgages, so thus began the process of deregulation. In 1999, the effort of the lobbyists who had spent $187 million at the federal level and also donated $202 million towards the election campaigns was

rewarded then the Congress passed the Financial Service Modernization Act, otherwise known as the Gramm-Leach-Bliley Act. This allowed banks to participate in activities forbidden by Glass-Steagall Act and its modifications.

The Bubble Part II

During this period another bubble was created by the government which was not only exploited by the commercial banks (with more powers) and investments banks but also by Government Sponsored Enterprises (GSE-Fannie Mae & Freddie Mac). This was the bubble of Federal Housing Policies which was intended to increase homeownership and encouraged every American to bring to reality the American Dream. In 1938, Congress created Fannie Mae (Federal National Mortgage Association) to support the mortgage market by buying mortgages (30 year fixed rate mortgages) insured by FHA (Federal Housing Administration) and VA (Veteran Affairs). This ensured supply of mortgage credit that banks could provide to homebuyers. Fannie Mae could either hold the mortgages or sell it to investors thereby reducing their mortgage portfolio. In 1968, Fannie Maes mortgage portfolio was estimated at $7.2 billion and reflected as a debt on the governments balance sheet. This resulted in creation of a new Fannie Mae (a publicly traded company) and Ginnie Mae (Government National Mortgage Association). In 1970, Freddie Mac was created to help sell mortgages bought by Fannie Mae which included those not backed by FHA and VA. Fannie and Freddie had a dual mission, that is, to promote lending and maximizing shareholder returns which ultimately led to their downfall.

Securitization Food Chain

In 1968 1970, laws were made which gave the GSE a superpower: Securitization. Ginnie was the first to exercise this power in 1970 followed by Freddie in 1971. This allowed the lenders to assemble the mortgages in what is called pooling and issuing securities backed by the asset, which in this case is the mortgage, hence the term MBS (mortgage backed securities). Since Ginnie guaranteed the principal and interest payment (for a fee) many investors bought huge chunks of these MBS. Lenders found it profitable to sell and securitize loans than to hold on to them, thus resulting in increased debt

obligations of GSE which grew from $759 billion in 1990 to $1.4 trillion in 1995 and $2.4 trillion in 2000. Early in 2000 the US securitized subprime mortgage market was less than 2.5% of the total home mortgage serviced. The market for subprime mortgage was relatively small which comprised of US homeowner population who couldnt come up with the 20% down payment which is a norm of prime mortgages. In 2006-2007 all most all subprime mortgages were being securitized and the subprime MBS was valued at more than $900 billion, a six-fold rise since 2001.

The subprime market was extremely lucrative as the high interest rates could be charged as it involved lending to subprime borrowers, that is, borrowers with poor credit history and FICO scores. And since the lenders had to power to securitise and diversify the risk they adopted bad lending practices to churn out as many as subprime mortgages as possible. With excessive cash flowing in from Wall Street and with high leverage (30:1) there was no dearth for funds that could be lent to borrowers. With the subprime market reaching almost saturation the lenders started to lend to borrowers with no income, no job and no assets (Ninja Loans) and without any verification of income (Liar Loans). By

relaxing the eligibility of these borrowers the lenders were able to expand the market to such an extent that homeownership rose from 62% in 2000 to 69% by 2007. The loans sold by lenders were bought by separate entities named Special Purpose Vehicles (SPV) which occupied an important position in what was called the Securitization Food Chain. The SPV had two major functions (i) Pooling (ii) Tranching/Splicing. Depending on the degree of risk different tranches were created to suit the customized needs to investors the world over. Risk-averse investors bought tranches that were least risky but low on returns, while return oriented investors bought riskier loans with high yields. This resulted in the SPV creating structured financial products but highly complex through financial engineering. One such complex product is Collateralized Debt Obligations (CDO), wherein the debt could be mortgages, automobile loans, credit card loans and others.

In order to make the CDOs attractive the SPV required an attractive package which was provided by the Credit Rating Agency (CRA). The big three CRAs that exist till date are Standard & Poors, Moodys and Fitch stamped the CDOs with a AAA rating irrespective of their risk component in return for a

juicy fee. This created the almost perfect superior value proposition to need to needs of all types of investors. The investment banks joined the game as they started to market these CDOs backed by the CRAs to investors globally. The investment banks such as Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley received a fat commission for their service of pricing the CDOs and selling it to investors. Due to the huge market and the constant flow of funds resulting from sales of CDOs the investment banks started to undertake proprietary lending, that is, they started to use their own shareholders funds to by the CDOs. Then the insurance agencies enter the Securitization Food Chain by issuing Credit Default Swaps (CDS). CDS is an OTC derivative sold to investors to protect them against any defaults or depreciating value of MBS backed by risky loans. The value of underlying assets for these CDS grew from $6.4 trillion in 2004 to $58.2 trillion in 2007.

The biggest issuer of CDS was American Insurance Group (AIG) with a notional value of its OTC derivative portfolio in 2008 pegged at $2.7 trillion. So in case the MBS were to go back the CDS would come to the rescue of the investors and speculators. AIGs huge portfolio was built on an almost too good to be true assumption that the MBS wouldnt go bad which is what started in 2007.

The Burst
The borrowers with phoney income started to default on their mortgages both fresh ones and refinanced owing to their inability to make contractual payments which exceeded their present as well as possible future incomes. This caused the inflated mortgage bubble to burst and most of the commercial and investment banks which were up to that point of time considered Too Big To Fail failed. This financial maze led to the coining of the term Ill be gone, youll be gone (IBGYBG). Borrowers who had blindly signed for ARM loans were the biggest defaulters as the interest rates had sky rocketed after the initial few years of fixed. The subprime ARM mortgage delinquencies arose to almost 40% and the worst affected states were Arizona, California, Florida and Nevada. Lenders foreclosed on most of the mortgages on which borrowers either were unable to make payments or just left without a word. Foreclosures rose steeply and the lenders portfolio of foreclosed properties grew with absolute no takers though the fell to half of their initial value.

Now all the investors in MBS who had speculated that the mortgage boom would continue started to make huge losses as the MBS and the CDOs issued by the SPV had turned into what is now commonly terms as toxic assets. The biggest casualty of this crisis was AIG with losses from the CDS portfolio

estimated to be pegged at $26.5 billion which was immediately bailed out by the Federal Reserve. The Fed understood the importance to keep AIG afloat, if AIG were to fail that would have resulted in wiping out its $835 billion securities portfolio, which was a much bigger treat than Lehman Brothers. But the fall of Lehman would have resulted in the fall of the others if it was not for the governments intervention program TARP (Troubled Asset Relief Program). TARP pledged to assist the different sectors through capital infusion of $700 billion and summing up the national debt to $12 trillion. The Indian Scenario The effect of subprime mortgage crisis in US on India and the governments response to it: Effects: India was growing in the import-export business from 90s. The subprime mortgage crisis just hit it so badly that only the imports were increasing by Jan 2008, and the exports well dropping down. And this affected the foreign exchange, the per dollar Indian price was around Rs.43 by then. Though this helped the importers, the exporters were affected with the price as well as the business. Then there was a fall in stock market with BSE Sensex below 9000(since July 2005). By October stock markets fell by over 33 per cent with 23.59 per cent in October alone and also Nifty by 22.18 per cent The sectoral indices have reported sharp declines and many sectors facing liquidity squeeze due to heavy redemptions from mutual funds of Rs.12,191 crore. The CRR rate also increased from 5 % (June 2006) to 8.25 % (present)

Unemployment is on the decline due to improving economy and better job market.

Indian Government response: (Central Government, RBI and SEBI) Banks are allowed to participate in the foreign exchange market. The RBI has increased the interest rate on term deposits in foreign currency Nonresident Deposit and Non Resident External Account. The overseas borrowing limit for infrastructure companies including mining, exploration and refining companies has been increased from $100 million to $500 million. The restriction on issue of Participatory Notes (PNs) by FIIs which was in force from October 25, 2007 has been lifted by SEBI To infuse liquidity and confidence into the system with banks, financial institutions and corporate sector, the Government has reduced the CRR by 250 basis points and the repo rate by 100 basis points i.e. CRR at 6.5 per cent and repo rate at 8 per cent To help mutual funds which have faced huge redemptions, banks have been allowed to borrow for 14 days at 9 per cent interest per annum and these funds have to be lent to mutual funds against their holding of Certificate of Deposits (CDs) in public sector banks.