Subprime Mortgage Crisis – Its Causes and Future Correction Dissertation

Introduction

Subprime mortgage lending has offered funding to an estimated 5 million home purchasers which includes about 1 million first-time home purchasers. Thus, it has contributed to growth of housing sector in USA. However, cost has outweighed the benefits as predatory lending practices have resulted in creation of housing loans that is very difficult to modify and there is worst ramification due to vast borrowers default.

A subprime borrower is an individual who does have poor track record of debt administration and has a very low credit scores. As such, he has been enticed to pay higher interest rates to pay off the lenders for assuming such extra credit risk. Subsequently, subprime loans were divested to “investment bankers” who employed them later as security for bonds referred as “mortgage backed securities.” Due to default by the homeowners, these bonds supported by the loans have lost noteworthy cost, thereby resulting volatility in financial markets. (Ebony 2008)

This research essay analyses in detail about the causes of the subprime mortgage crisis and offer a regulatory proposal and change to minimise the impact of the current crisis and prevent recurrence in future.

What is subprime mortgage?

If a distinctive homebuyer with blurred credit record avails a home loan for $ 200000 mortgage which carries an interest rate of 7% and say a start monthly instalment of $ 1530. For the last two year, he was able to repay the monthly instalment without any default. However, the trouble started when the interest rate increased to 11.5% at the start of third year. He was forced to pay an additional amount of $625 every month due to hike in interest rates. He was unable to meet his mortgage instalments and as a result, he lost his home as the mortgage company took over the possession of his home. This home loan tragedy amplified by many magnitude triggered the meltdown in U.S.A and commonly known as “subprime mortgage.”

Subprime mortgage loan is known as risky loan as these normally include characteristics that embolden the risk of foreclosure. Such characteristics include balloon payments, adjustable interest rates, loan with no or little documentations and loan prepayment penalties. The main predicament of today’s subprime mortgage is mainly due to adjustable –interest mortgage known as ‘2/28” that includes bi-annual interest rate fine-tuning after completion of a two-year fixed-rate period. The start fixed rate period is always known as “teaser” rate or a discounted rate and hence rate adjustment could pave to a significant higher repayment instalment. This process is known as “payment shock” and this category of loan sometimes known as “exploding ARM’s.”

Further, an increase in share of loan products in the subprime market that actually restrict the quantum of equity a borrower builds and these home loans carry a high risk or payment shock, it may restrict homeowner’s capacity to acquire the equity required to refinance out of an unaffordable loan.

At the end of year 2008, about 2.21 million homeowners in the subprime market either hold subprime mortgages that may fail over the coming years or lost their homes to foreclosure as stated above.

Further, subprime mortgage has affected black community as more than half of the black population was enticed by the mortgage banks in 2005 as compared to just twenty percent of White borrowers. With same credit profile, Blacks were prone to be charged with a high interest bearing home loan than compared to White borrowers. Subprime borrowers are those who have poor credit histories and lower credit scores and in their cases, lenders won’t come forward to refinance their modifiable –rate mortgages, as values of home have gone down and norms for lending have become more strenuous due to housing market predicament. (Ebony 2008)

Moreover, about seventy percent of U.S economy is footed on spending by consumers. About, ten percent of disposable revenue is the direct outcome of residential equity origin and one in eleven employments is straightly associated with the housing. Further, many bonds supported by subprime mortgage and interest payments for these bonds may not be possible in the future and hence, these bonds have become more or less worthless. ( Ebony 2008).

Causes for the Subprime Mortgage Crisis

One of the major causes for the subprime mortgage predicament pertains to lax lending policies of mortgage banks, which can be illustrated that banks did not act as risk taker but acted as an intermediary. It has been estimated that foreclosure will alone cost about $ 164 billion to homeowners which they might be lost in home equity. Subprime lenders who market high-risk loans and exploding ARMs frequently underestimate the capability of homeowner to repay when the loan’s interest rates were reset even if rates remain constant during the first two years of the loan. Lenders increase the predicament of foreclosure even further when they fail to meet the escrow towards the cost of hazard insurance and property taxes and it is still perplex to understand why they have sanctioned loans without looking into credentials of borrower’s employment status and income.

There is an inverse relationship between housing price and foreclosures. If the housing price decline, then there will be increase in the foreclosures. Due to cooling down of the housing boom in U.S.A, fewer default borrowers will have the funds needed to arrange for refinancing their loan or to dispose off their home to forbid foreclosures.

One another reasons for the subprime mortgage issue were the predatory lending process followed by the lenders. These unscrupulous lenders entice the borrowers with a bait of low initial payment at the start irrespective of the fact that whether the borrower has the financial acumen to fulfil his future financial commitments. Gullible borrowers find it arduous to repay due to prepayment penalties and costly fees concerned with predatory loans which strip equity and compel them to foreclose. Further, this foreclosure issue was also triggered with augmented issues relating to foreclosure rescue scams.

Further , attention of the policy makers and activists has come to spotlight on the federal housing association and the Freddie Mac , Fannie Mae as these are prime government –sponsored enterprises associated in shoring up mortgage lending to minorities and those who live below poverty lines. There had been considerable pressure on Freddie and Fannie to lower the loan sanctioning parameters to make mortgages available to these ethnic groups liberally. (Langley: 247).

One another reason citied by the President’s Working Group on Financial Markets (2008) was the securitisation as a primary source of subprime crisis. Due to availability of subprime mortgage securities, it is unbelievable that sophisticated and large institutional investor Lack of Accountability / Third –Party Originators

Majority of the subprime mortgages is originated by the mortgage brokers. These brokers have strong incentive to sanction as many loans as they can commit. Hence, these mortgage brokers are more concerned with their incentives rather than the ability of the borrower to repay the loan. Through the secondary mortgage market, lenders shield themselves from the full impact of cost of foreclosure by selling their loans to investors. Further, risk dispersion and third party origination made possible through the secondary market which helps loan originators from grave adverse outcomes of foreclosures who purchased the subprime mortgage were either negligent or duped.

System wide Effects on Financial Institutions and Markets

The subprime mortgage crisis has not spared both the financial institutions and markets. Due to their maturity –mismatched and highly leveraged investments in subprime CDO’s and MBS, most of the investment banks have suffered substantial losses. Especially, Bear Sterns suffered heavy loss and it had to merge with another institution mainly to forbid a looming bankruptcy and there were strong rumours in the market that other investments banks are also in the red.

The impact on the financial market has been corroborated the almost bankruptcy position of Bear Stearns and other investment banks. It is to be remembered that major investment banks are all central counterparties of OTC derivative market. Thus, chain of reaction will be felt due to the actual failure of a major investment bank and it may lead to financial market catastrophe. Federal Reserve intervention by merging the Bear Streams is a right step in the right direction.

To forbid future reoccurrences, it is important that the major investment banks have to gear themselves for expanded prudential norms. One another serious financial market issue was the lack of liquidity and trading for many of the subprime MBS and CDO instruments. This is being referred as a common symptom of “fight to safety “but it has been magnified in the current predicament by the especially complex and opaque nature of the subprime MBS and CDO instruments. (Spence, Buckley and Annez 2008:31).

Insufficient Oversight

The prime reason for the current subprime mortgage crisis is mainly due to inadequate regulatory and legal outcomes for making home loans that are unaffordable or inappropriate for the borrower. However, both federal and state regulators, alarmed by the subprime mortgage predicament, issued new guidelines concerning lenders to stiffen credit lending parameters on some high-risk home loans. At present, only HOEPA is available which functions as anti-predatory lending law which prohibits the holder-in-due course rule for subprime home loans and this protection is available only to high valued loans alone. (Rubin 2007: 250).

Probable corrections or solutions

American Congress is more concerned about the role of public authority in forbidding an analogous crisis in the future. There has been much calligraphy over the association between predatory and lax lending particularly in the boom and virtually federal supervision and regulatory lack of authority in relation to the activities on non-bank subprime mortgage lenders. There is virtually no control over the activities of non-bank mortgage lenders except they have been covered under the market regulations for secondary mortgage were supervised by “Department of Housing and Urban Development “ and by the consumer safeguard laws imposed by “the Federal Trade Commission. “ (Rushton 2007). Further, adding fire to the fuel, only just fifty percent of states have laws pertaining to predatory lending and only some patchy state –level laws cover to the certifying of brokers, non-banks and services. (Langley 2008: 247)

Correction Measures for the Future

American economy already lost billions of dollars in equity and hence there is an urgent requirement to reduce the foreclosures in the subprime mortgage market and to lessen the losses that families will incur in the near future on unsustainable mortgages.

The first response to the subprime mortgage predicament was an urge for broad regulations including:

• To tighten the underwriting criteria in the U.S mortgage market. It is essential to establish that each and every borrower has the financial acumen to repay the loan without resort to selling the home or availing refinance under pressure. The lender should ascertain that when they offer loan with planned changes in interest rate’s lenders should take into account whether the borrowers will have the capability to repay after the initial fixed ‘teaser’ rate expires. Further, these lenders should need escrow payments and proper verification of the borrower’s income and they should affirm that the loans they offer do have economic rational for a particular borrower’s financial background. (Diane Publishing: 3)
• To streamline the accounting standards particularly modernising off-balance sheet vehicles.
• To streamline the parameters used by the rating agencies due to triple-digit billion downgrades in the structured credit practices.
• To monitor the activities of hedge funds. (Felsenheimer & Gisdakis: 259).

Crisis Intervention

As a revamping of existing financial system, the regulatory agencies and federal government have implemented a set of plans to enhance the present system. On 3^rd October 2008, the “Emergency Economic Stabilisation Act of 2008 “was passed which was commonly known as bailout package for U.S. financial system. This Act empowers the Secretary of Treasury to spend up to $ 700 billion to buy the foreclosed assets particularly mortgage-backed securities from the country’s banking system and to increase the limit on FDIC’s deposit guarantee.

Another initiative by the U.S government is the enactment of HOPE for Homeowners Act of 2008 which establishes a novel, temporary, voluntary scheme within the FHA (Federal Housing Administration) to support FHA –insured mortgages to delinquent borrowers.

Recommendations for policy implementation for prevention of financial meltdown in the future

The recent financial meltdown in U.S.A has exposed the urgency for key revamping of financial laws and regulations. The regulatory authority should be employed to the transformations that have happened in the configuration of financial organism which includes rapid development of non-bank financial organisations and the growth of securitisation and financial products.

For the wider financial system

• It is recommended to shift away from the present disjointed regulatory setup. The new combined overture proposed in the Treasury plan offers a rational origin but many significant facts have to be determined. “Federal Reserve” should be vested with more authority to initiate its new responsibilities so as to effectively manage its role as the market –stability regulator.
• Federal Reserve should increase its supervision more tightly on financial institutions and banks. It should be ensured that banks should maintain adequate capital mainly to meet “off-balance sheet” perils, so as to offset dogmatic arbitrage.
• There is need to introduce counter-cyclical requirements and larger emphasis is to be made on the “leverage ratio” so as to enhance the strength of the financial setup over the sequence.
• It is time to introduce more changes in regulations and laws pertaining to “corporate governance” to offer investors more sway on day-to-day management like empowering shareholders with the privilege to disapprove remuneration packages as now applicable in Netherlands and UK. For instance, so as to assist the negotiation of pay structuring that intermingle incentives of management better with shareholders interests. When the risk is experienced by any given financial organisation, regulators should think of restructuring remuneration packages.
• It is recommended that a federal legislation should be enacted thereby establishing an analogous national responsibility of suitability in subprime mortgage lending. Hence, the proposed law should strictly prohibit any person including a mortgage broker or salesperson to entice incompetent applicants and to recommend only securities that are conform to the requirements of the specific customer. Thus, appropriate federal authority like Federal Trade commission should have authority to enforce the suitability and to minimise services abuses and to initiate action against infringers. (Rubin 2007:248).
• As of today, about sixty percent of all subprime home loans are offered in the secondary market through securitisation. Unless some other regulations get rid of the holder –in-due course concept especially for subprime loans, borrowers harmed by the predatory practices are restricted from availing relief against any securitised trust or investors.( Rubin 200 :250).

For Financial Institutions

Those financial institutions with huge investment banks divisions should be placed under the supervision of a sole watchdog, having adequate power to frame norms for leverage, capital, risk management and “liquidity holdings. “

For GSE’s and mortgage lenders

• For high cost mortgaging, it is essential to implement the new Federal Reserve standards to make sure that underwriting standards for non-prime mortgage are improved.
• It is time for relaxing the obstacles for the restructuring of mortgage on voluntary basis.
• Bankruptcy laws should be amended thereby vesting powers to judges for reduction of mortgage principal for the owner inhabited homes to offer many motivations for lenders to involve in reorganisation agreements.
• Further, it becomes necessary to alter property regulations that second –mortgage holders cannot wantonly impeding the reorganisation agreements between borrowers and “first-mortgage holders. “
• In most of the countries, securitisation of mortgages is being carried over the private sector. The same should be followed in the U.S.A. So as to develop competition and minimise moral peril, the GSE’s are privatised and they should be disintegrated from the probable lending units with the “federal government.” They should be in tune with the same set of supervision and regulations that is being applicable which includes capital adequacy norms. Further, these companies should be alienated into small companies so that they are not too large to fail easily.
• Federal government should come forward to assist the private sector by resolving the agency issues that have impacted the securitisation of mortgages. If the SEC proposed reforms are put in place to enhance the credit rating process which includes prohibition placed on companies to organise the analogous products that they rank and by revealing the information that being employed to finalise a rating. (OCED Economic Surveys 2008:96).

Conclusion

The U.S subprime mortgage has not only affected many in U.S.A but also has spread across the globe. Thus, the direct risk exposure has spread well beyond the U.S.A to Asian and European market. It has become essential to adapt a dynamic risk management tool to contain credit risk from a global view point. Since April 2007, global risks have amplified and underlying scenarios have deteriorated. Economist will experience much instability as economic parameters trend towards more sustainable levels linked with the economic recovery. Global solutions are needed for setting right the global nature of the crisis identified in U.S financial system.

In emerging economies, mortgage securities can perform in a number of valuable functions. Efforts have been initiated to develop mortgage securities to obtain long-run residential funding.

It is probable to extend the mortgage lending market without recurring the errors of the subprime boom and bust in U.S.A. However, there are some pivotal limitations do exist like

• Taxation, regulation and legal structure.
• Infrastructure available for information and data technology transfer
• Resources and tools for predictive analysis.
• Adequate support for liquidity
• Reporting under standardisation form.
• Internal Controls and Risk Management
• Loan programs , products and distribution channels
• Capacity of the investors to invest.
• Availability of adequate lenders and the underwriting system

Federal Reserve should be given ample power and authority to supervise the activities of non-bank mortgage financial providers. An independent market regulator should be established to regulate and supervise subprime mortgage activities in USA so that the mistakes than have been in the recent past can be avoided altogether in the future.

List of References

Diane Publishing. (2008). Losing Ground: Foreclosures in the Subprime Market & Their Cost to Home Owners. New York: Diane Publishing.

Felsenheimer Jochen & Gisdarkis Philip. (2008). Credit Crises. New York: Wiley –VCH.

Langley Paul. (2008) The Everyday Life of Global Finance. Oxford: Oxford University Press.

OECD (2008). Overcoming the Financial Crisis. OECD Economic Surveys: United States 2008. New York: OECD Publishing.

Rubin, Julia Sass. (2007). Financing Low –Income Communities. New York: Russell Sage Foundation.

Spence Michael, Buckley Robert and Annez Patricia Clarke. (2008) Urbanisation and Growth. New York: World Bank Publications.