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The U.S. Federal Deposit Insurance Corporation (FDIC) has defined subprime
borrowers and lending: "The term subprime refers to the credit characteristics of
individual borrowers. Subprime borrowers typically have weakened credit histories
that include payment delinquencies, and possibly more severe problems such as
charge-offs, judgments, and bankruptcies. They may also display reduced repayment
capacity as measured by credit scores, debt-to-income ratios, or other criteria that may
encompass borrowers with incomplete credit histories. Subprime loans are loans to
borrowers displaying one or more of these characteristics at the time of origination or
purchase. Such loans have a higher risk of default than loans to prime borrowers."[1] If
a borrower is delinquent in making timely mortgage payments to the loan servicer (a
bank or other financial firm), the lender may take possession of the property, in a
process called foreclosure.
A plain-language overview[edit]
lawsuits and complaints from consumer advocates, who accused the subprime
industry of engaging in predatory lending. The impact was slight compared to the later
bubble.
Subprime I was smaller in size in the mid-1990s $30 billion of mortgages
constituted "a big year" for subprime lending, by 2005 there were $625 billion in
subprime mortgage loans, $507 billion of which were in mortgage backed securities
and was essentially "really high rates for borrowers with bad credit". Mortgages
were mostly fixed-rate, still required borrowers to prove they could pay by
documenting income, etc.[6] By 2006, 75% of subprime loans were some form of
floating-rate, usually fixed for the first two years." [7]
ramifications. Financial institutions have seen their capital depleted by losses and
writedowns and their balance sheets clogged by complex credit products and other
illiquid assets of uncertain value. Rising credit risks and intense risk aversion have
pushed credit spreads to unprecedented levels, and markets for securitized assets,
except for mortgage securities with government guarantees, have shut down.
Heightened systemic risks, falling asset values, and tightening credit have in turn
taken a heavy toll on business and consumer confidence and precipitated a sharp
slowing in global economic activity. The damage, in terms of lost output, lost jobs,
and lost wealth, is already substantial."[16]
Thomas Friedman summarized the causes of the crisis in November 2008:
Governments are having a problem arresting this deflationary downward spiral
maybe because this financial crisis combines four chemicals we have never seen
combined to this degree before, and we dont fully grasp how damaging their
interactions have been, and may still be. Those chemicals are: 1) massive leverage
by everyone from consumers who bought houses for nothing down to hedge funds
that were betting $30 for every $1 they had in cash; 2) a world economy that is so
much more intertwined than people realized, which is exemplified by British police
departments that are financially strapped today because they put their savings in
online Icelandic banks to get a little better yield that have gone bust; 3) globally
intertwined financial instruments that are so complex that most of the C.E.O.s dealing
with them did not and do not understand how they work especially on the
downside; 4) a financial crisis that started in America with our toxic mortgages. When
a crisis starts in Mexico or Thailand, we can protect ourselves; when it starts in
America, no one can. You put this much leverage together with this much global
integration with this much complexity and start the crisis in America and you have a
very explosive situation.[17]
Subprime market data[edit]
In 1981, US private debt was 123 per cent of gross domestic product (a measure of the
size of the economy); by the third quarter of 2008, it was 290 per cent. In 1981,
household debt was 48 per cent of GDP; in 2007, it was 100 per cent. [42]
While housing prices were increasing, consumers were saving less [43] and both
borrowing and spending more. A culture of consumerism is a factor "in an economy
based on immediate gratification."[44]Starting in 2005, American households have
spent more than 99.5% of their disposable personal income on consumption or interest
payments.[45] If imputations mostly pertaining to owner-occupied housing are removed
from these calculations, American households have spent more than their disposable
personal income in every year starting in 1999.[46]
Household debt grew from $705 billion at year-end 1974, 60% of disposable personal
income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008,
134% of disposable personal income.[47] During 2008, the typical USA household
owned 13 credit cards, with 40% of households carrying a balance, up from 6% in
1970.[48] U.S. home mortgage debt relative to GDP increased from an average of 46%
during the 1990s to 73% during 2008, reaching $10.5 trillion. [49]
Financial sector debt statistics[edit]
Martin Wolf wrote: "In the US, the state of the financial sector may well be far more
important than it was in Japan. The big US debt accumulations were not by nonfinancial corporations but by households and the financial sector. The gross debt of
the financial sector rose from 22 per cent of GDP in 1981 to 117 per cent in the third
quarter of 2008, while the debt of non-financial corporations rose only from 53 per
cent to 76 per cent of GDP. Thus, the desire of financial institutions to shrink balance
sheets may be an even bigger cause of recession in the US." [42]
Credit risk[edit]
Traditionally, lenders (who were primarily thrifts) bore the credit risk on the
mortgages they issued. Over the past 60 years, a variety of financial innovations have
gradually made it possible for lenders to sell the right to receive the payments on the
mortgages they issue, through a process called securitization. The resulting securities
are called mortgage-backed securities (MBS) and collateralized debt
obligations(CDO). Most American mortgages are now held by mortgage pools, the
generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages
outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4
trillion by traditional depository institutions. [50] This "originate to distribute" model
means that investors holding MBS and CDOs also bear several types of risks, and this
has a variety of consequences. In general, there are five primary types of risk: [51][52]
By the beginning of the 21st century, these innovations had created an "originate to
distribute" model for mortgages, which means that mortgage became almost as much
securities as they were loans. Because subprime loans have such high repayment risk,
the origination of large volumes of subprime loans by thrift institutions or commercial
banks was not possible without securitization.
From a systemic perspective, the dominance of securitization has made the risks of the
mortgage market similar to the risks of other securities markets, particularly nonregulated securities markets. In general, there are five primary types of risk in these
markets:[51][52]
[53]
Name
Description
the risk that the borrower will fail to make payments and/or that the
Credit risk
collateral behind the loan will lose value.
the risk that asset itself (MBS or underlying mortgages in this case)
Asset price risk will depreciate in value, resulting in financial
losses, markdowns and possibly margin calls
the risk that a party to an MBS or derivative contract other than the
Counterpartyrisk
borrower will be unable or unwilling to uphold their obligations.
The aggregate effect of these and other risks has recently been
called systemic risk, which refers to sudden perceptual, or material
Systemic risk
changes across the entire financial system, causing highly
"correlated" behavior and possible damage to that system
At the institutional level, this is the risk that money in the system
Liquidity risk
will dry up quickly and a business entity will be unable to obtain
cash to fund its operations soon enough to prevent an unusual loss.
This means that in the mortgage market, borrowers no longer have to default and
reduce cash flows very significantly before credit risk rises sharply. Any number of
factors affecting material or perceived risk - declines in the price of real estate or the
bankruptcy of a major counterparty - can cause systemic risk and liquidity risk for
institutions to rise and have significant adverse effect on the entire mortgage industry.
The risk may be magnified by high debt levels (financial leverage) among households
and businesses, as has incurred in recent years. Finally, the risks associated with
American mortgage lending have global impacts because the market for MBS is a
huge, global, financial market.
Of particular concern is the fairly new innovation of credit default swaps (CDS).
Investors in MBS can insure against credit risk by buying CDS, but as risk rises,
substantial losses as they revalue their MBS downward. Several companies that
borrowed money using MBS or CDO assets as collateral have facedmargin
calls, as lenders executed their contractual rights to get their money back.
[55]
There is some debate regarding whether fair value accounting should be
suspended or modified temporarily, as large write-downs of difficult-to-value
MBS and CDO assets may have exacerbated the crisis. [56]
3. Liquidity risk: Many companies rely on access to short-term funding markets
for cash to operate (i.e., liquidity), such as the commercial paper and
repurchase markets. Companies and structured investment vehicles (SIV) often
obtain short-term loans by issuing commercial paper, pledging mortgage assets
or CDO as collateral. Investors provide cash in exchange for the commercial
paper, receiving money-market interest rates. However, because of concerns
regarding the value of the mortgage asset collateral linked to subprime and AltA loans, the ability of many companies to issue such paper has been
significantly affected.[57] The amount of commercial paper issued as of 18
October 2007 dropped by 25%, to $888 billion, from the 8 August level. In
addition, the interest rate charged by investors to provide loans for commercial
paper has increased substantially above historical levels. [58]
4. Counterparty risk: Major investment banks and other financial institutions have
taken significant positions in credit derivative transactions, some of which
serve as a form of credit default insurance. Due to the effects of the risks above,
the financial health of investment banks has declined, potentially increasing the
risk to their counterparties and creating further uncertainty in financial markets.
The demise and bailout of Bear Stearns was due in-part to its role in these
derivatives.[59]
5. Systemic risk: The aggregate effect of these and other risks has recently been
called systemic risk. According to Nobel laureate Dr. A. Michael Spence,
"systemic risk escalates in the financial system when formerly uncorrelated
risks shift and become highly correlated. When that happens, then insurance
and diversification models fail. There are two striking aspects of the current
crisis and its origins. One is that systemic risk built steadily in the system. The
second is that this buildup went either unnoticed or was not acted upon. That
means that it was not perceived by the majority of participants until it was too
late. Financial innovation, intended to redistribute and reduce risk, appears
mainly to have hidden it from view. An important challenge going forward is to
better understand these dynamics as the analytical underpinning of an early
warning system with respect to financial instability." [60]
Leverage ratios of investment banks increased significantly between 2003 and 2007.
Average investors and corporations face a variety of risks due to the inability of
mortgage holders to pay. These vary by legal entity. Some general exposures by entity
type include:
Commercial / Depository bank corporations: The earnings reported by major
banks are adversely affected by defaults on various asset types, including loans
made for mortgages, credit cards, and auto loans. Companies value these assets
(receivables) based on estimates of collections. Companies record expenses in
the current period to adjust this valuation, increasing their bad debt reserves
and reducing earnings. Rapid or unexpected changes in asset valuation can lead
to volatility in earnings and stock prices. The ability of lenders to predict future
collections is a complex task subject to a multitude of variables.
[61]
credit risk. Like corporations, SPE are required to revalue their mortgage assets
based on estimates of collection of mortgage payments. If this valuation falls
below a certain level, or if cash flow falls below contractual levels, investors
may have immediate rights to the mortgage asset collateral. This can also cause
the rapid sale of assets at unfavorable prices. Other SPE called structured
investment vehicles (SIV) issue commercial paper and use the proceeds to
purchase securitized assets such as CDO. These entities have been affected by
mortgage asset devaluation. Several major SIV are associated with large banks.
SIV legal structures allowed financial institutions to remove large amounts of
debt from their balance sheets, enabling them to use higher levels of leverage
and increasing profitability during the boom period. As the value of the SIV
assets was reduced, the banks were forced to bring the debt back onto their
books, causing an immediate need for capital (to achieve regulatory minimums)
thereby aggravating liquidity challenges in the banking system. [66] Some argue
this shifting of assets off-balance sheet reduces financial statement
transparency; SPE came under scrutiny as part of the Enron debacle, as well.
Financing through off-balance sheet structures is thinly regulated. SIV and
similar structures are sometimes referred to as the shadow banking system.[67]
Investors: Stocks or bonds of the entities above are affected by the lower
earnings and uncertainty regarding the valuation of mortgage assets and related
payment collection. Many investors and corporations purchased MBS or CDO
as investments and incurred related losses.
together with currency, make up the narrowest definition of money, the monetary
base; as you would expect, this measure of money has risen significantly as the Fed's
balance sheet has expanded. However, banks are choosing to leave the great bulk of
their excess reserves idle, in most cases on deposit with the Fed. Consequently, the
rates of growth of broader monetary aggregates, such as M1 and M2, have been much
lower than that of the monetary base. At this point, with global economic activity
weak and commodity prices at low levels, we see little risk of inflation in the near
term; indeed, we expect inflation to continue to moderate." [16]
Vicious Cycles[edit]
purchased with a mortgage in default, he has no further claim against the defaulting
borrower's income or assets. As more borrowers stop paying their mortgage payments,
foreclosures and the supply of homes for sale increase. This places downward
pressure on housing prices, which further lowers homeowners' equity. The decline in
mortgage payments also reduces the value of mortgage-backed securities, which
erodes the net worth and financial health of banks. This vicious cycle is at the heart of
the crisis.[83]
Cycle Two: Financial Market and Feedback into Housing Market[edit]
The second vicious cycle is between the housing market and financial market.
Foreclosures reduce the cash flowing into banks and the value of mortgage-backed
securities (MBS) widely held by banks. Banks incur losses and require additional
funds (recapitalization). If banks are not capitalized sufficiently to lend, economic
activity slows and unemployment increases, which further increases foreclosures.
As of August 2008, financial firms around the globe have written down their holdings
of subprime related securities by US$501 billion. [84] Mortgage defaults and provisions
for future defaults caused profits at the 8533 USA depository institutions insured by
the FDIC to decline from $35.2 billion in 2006 Q4 billion to $646 million in the same
quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly
performance since 1990. In all of 2007, insured depository institutions earned
approximately $100 billion, down 31% from a record profit of $145 billion in 2006.
Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline
of 46%.[85][86]
Federal Reserve data indicates banks have significantly tightened lending standards
throughout the crisis.[87]
financing, they were forced to sell these long-term assets into very depressed markets
at fire-sale prices, making credit more difficult to obtain system-wide. The 1998Longterm Capital Management crisis was a precursor to this aspect of the current crisis, as
a highly leveraged shadow banking entity with systemic implications collapsed during
that crisis.
In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President and
CEO of the NY Federal Reserve Bank, placed significant blame for the freezing of
credit markets on a "run" on the entities in the "parallel" banking system, also called
the shadow banking system. These entities became critical to the credit markets
underpinning the financial system, but were not subject to the same regulatory
controls. Further, these entities were vulnerable because they borrowed short-term in
liquid markets to purchase long-term, illiquid and risky assets. This meant that
disruptions in credit markets would make them subject to rapid deleveraging, selling
their long-term assets at depressed prices. [88]
He described the significance of these entities: "In early 2007, asset-backed
commercial paper conduits, in structured investment vehicles, in auction-rate
preferred securities, tender option bonds and variable rate demand notes, had a
combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo
grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The
combined balance sheets of the then five major investment banks totaled $4 trillion. In
comparison, the total assets of the top five bank holding companies in the United
States at that point were just over $6 trillion, and total assets of the entire banking
system were about $10 trillion." He stated that the "combined effect of these factors
was a financial system vulnerable to self-reinforcing asset price and credit cycles." [88]
Nobel laureate economist Paul Krugman described the run on the shadow banking
system as the "core of what happened" to cause the crisis. "As the shadow banking
system expanded to rival or even surpass conventional banking in importance,
politicians and government officials should have realized that they were re-creating
the kind of financial vulnerability that made the Great Depression possibleand they
should have responded by extending regulations and the financial safety net to cover
these new institutions. Influential figures should have proclaimed a simple rule:
anything that does what a bank does, anything that has to be rescued in crises the way
banks are, should be regulated like a bank." He referred to this lack of controls as
"malign neglect."[89]