INTERNATIONAL FINANCE

THE SUBPRIME LENDING CRISIS

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THE SUBPRIME LENDING CRISIS

Introduction
The subprime mortgage crisis, popularly known as the mortgage mess or mortgage meltdown. Subprime crisis came to attention when a steep rise in home foreclosures in 2006 spiraled seemingly out of control in 2007 triggering a national financial crisis that went global within the year. More than 20% of subprime loans originated in 2005 and 2006 are seriously delinquent 13% of the loans originated in 2007 were delinquent. One result has been a sharp contraction in credit for mortgage borrowers, down 38% from the fourth quarter of 2006 and down 90% for subprime borrowers. Home prices have fallen by 12.5% since their high in July 2006. Projections are that 43% of subprime loans were lost to foreclosure. It was also estimated that 14 million households had negative equity.

CAUSES OF THE SUBPRIME CRISIS

The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other in late 2007. As the crisis deepened, more and more financial firms either merged, or announced that they were negotiating seeking merger partners.. During 2007, the crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value. Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle. Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.

CAUSES OF THE SUBPRIME CRISIS

One of the major factors contributed to the crisis was the fact that interest rates were below 3% continuously from September 2001 to May 2005 having been below 3% for only 5 months of the previous decade. Demand for A rated paper by institutional investors .70% of the loans originated by New Century had low initial teaser rates. More than 40% of the loans were underwritten on a stated income basis. These are so called liar loans because there is no need to verify claimed income. Another common loan product which offered a high degree of risk was so called 80-20 loans which are involved two separate loans to do the same transaction: a first lien of 80% and a second lien of 20% resulting in a combined finance of 100% of the value of the property.

CAUSES OF THE SUBPRIME CRISIS

Ignoring the backlog from older loans and interest which needed to be paid to investors. . Understated the repurchase reserves by more than 104 Million dollars in the third quarter of 2006. . Classic problems in corporate governance including a dysfunctional board, an audit committee which failed to focus on issues, a lack of internal controls and a flawed internal audit function .

ROOTS OF SUBPRIME LENDING CRISIS

1. Housing Bubble 2. Historically Low Interest Rates 3. The Rise of Subprime Lending 4. The Bubble Bursts 5. Housing Market Correction 6. Declining Risk Premiums 7. Risky Mortgage Products and Lax Lending Standards 8. Securitization 9. Credit Rating Agencies 10. Financial institution debt levels and incentives 11. Government policies 12. Credit default swaps 13. US Balance of Payments 14. Boom and collapse of the shadow banking system
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EFFECTS OF SUBPRIME LENDING CRISIS

Consumer spending went down, the housing market has plummeted, foreclosure numbers continue to rise and the stock market has been shaken. The subprime crisis and resulting foreclosure fallout has caused opposition among consumers, lenders and legislators and laid furious debate over the causes and possible fixes of the mess.

In its semiannual Global Financial Stability Report released on April 8, 2008, the International Monetary Fund (IMF) said that falling U.S. housing prices and rising delinquencies on the residential mortgage market could lead to losses of $565 billion dollars.
Combining these factors with losses from other categories of loans originated and securities issued in the United States related to commercial real estate, IMF puts potential losses at about $945 billion.

EFFECTS OF SUBPRIME LENDING CRISIS

It was the first time that IMF has made an official estimate of the global losses suffered by banks and other financial institutions in the U.S. credit crunch that began in 2007 amid the rising number of defaults on subprime home loans. The crisis had a shocking effect on the U.S. auto industry. New vehicle sales, which peaked at 17 million in 2005, recovered to only 12 million by 2010. Americans' second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost $1.3 trillion.

CREDIT RATING AGENCIES

Rating agencies appear to have seriously underestimated that amount that needed to be placed in junior tranches in order to secure senior tranches. The disparity in default between structured finance ratings and firm specific ratings has been a major cause. CRAs are immune from liability as the publishers of financial information. Since rating agencies are paid to issue a rating, they have a weak incentive to update that rating. The CRA is relying on the statements of mortgage originators and underwriters.

Seven out of ten mortgages not in any workout plan.

2/3 of loan modifications not completed in the following month.