The subprime mortgage crisis

The SubprimeThe Subprime
Mortgage CrisisMortgage Crisis
By XioBy Xio

What are subprime mortgages?What are subprime mortgages?
 Typically, those who qualify for the most idealTypically, those who qualify for the most ideal
mortgages with the best interest rates are those withmortgages with the best interest rates are those with
good credit scores and minimal debt.good credit scores and minimal debt.
 A subprime mortgage is a type of loan granted toA subprime mortgage is a type of loan granted to
individuals with poor credit histories (typicallyindividuals with poor credit histories (typically
below 600), who would not be able to qualify forbelow 600), who would not be able to qualify for
conventional mortgages.conventional mortgages.
 Subprime mortgages charge interest rates that areSubprime mortgages charge interest rates that are
above the typical interest rate because of the riskabove the typical interest rate because of the risk
that is involved on the part of the lender.that is involved on the part of the lender.

What are subprime mortgages?What are subprime mortgages?
 There are several different types of subprimeThere are several different types of subprime
mortgages, but the most common is themortgages, but the most common is the
adjustable rate mortgage (ARM).adjustable rate mortgage (ARM).
 ARMs can be misleading to subprimeARMs can be misleading to subprime
borrowers because they initially pay a lowerborrowers because they initially pay a lower
interest rate. After the given period of time,interest rate. After the given period of time,
their mortgages are set to a much higher rate.their mortgages are set to a much higher rate.
Therefore, their mortgage paymentsTherefore, their mortgage payments
increase dramatically.increase dramatically.

What happens to your mortgage?What happens to your mortgage?
 A mortgage is a “stream of cash flows”A mortgage is a “stream of cash flows”
 Mortgage originators consist of banks, mortgage bankersMortgage originators consist of banks, mortgage bankers
and mortgage brokers.and mortgage brokers.
 The mortgage broker connects the family with the lender.The mortgage broker connects the family with the lender.
The broker collects commission. The family is then able toThe broker collects commission. The family is then able to
buy the house that they went.buy the house that they went.
 After the mortgage is sold, it is usually put in a group withAfter the mortgage is sold, it is usually put in a group with
other mortgages into a mortgage backed security, or MBS.other mortgages into a mortgage backed security, or MBS.
 The riskier portions of these securities are made intoThe riskier portions of these securities are made into
collateralized debt obligations, or CDOs. These are thecollateralized debt obligations, or CDOs. These are the
portion of the MBS that other investors do not want.portion of the MBS that other investors do not want.
 Private sector commercial and investment banks developedPrivate sector commercial and investment banks developed
new ways of securing subprime mortgages: by packagingnew ways of securing subprime mortgages: by packaging
them into CDOs and then dividing the cash flows intothem into CDOs and then dividing the cash flows into
different "tranches" to appeal to different classes of investorsdifferent "tranches" to appeal to different classes of investors
with different tolerances for risk.with different tolerances for risk.

Leading up to the crisisLeading up to the crisis
 Dean Baker, an analyst, identified the housingDean Baker, an analyst, identified the housing
bubble in August 2002 that led up to the crisis. Hebubble in August 2002 that led up to the crisis. He
said that between 1953 and 1995 the prices ofsaid that between 1953 and 1995 the prices of
houses reflected inflation, after 1995 however thehouses reflected inflation, after 1995 however the
price increases in houses were well over inflation.price increases in houses were well over inflation.
He predicted that a crisis would result from this butHe predicted that a crisis would result from this but
no one in the Federal Reserve would listen to him.no one in the Federal Reserve would listen to him.
 Baker’s analysis was confirmed by economist RobertBaker’s analysis was confirmed by economist Robert
Shiller who had proven that the real price of housesShiller who had proven that the real price of houses
had not changed from 1895 to 1995.had not changed from 1895 to 1995.

How was the housing bubble identified?How was the housing bubble identified?
 According to Shiller, the real price of houses was relativelyAccording to Shiller, the real price of houses was relatively
flat from 1890 to 1997, but since 1998, they have climbed 6flat from 1890 to 1997, but since 1998, they have climbed 6
percent per year in the aggregate.percent per year in the aggregate.
 He determined this by looking at housing price data heHe determined this by looking at housing price data he
obtained from multiple sourcesobtained from multiple sources
 1890–1934 from Grebler, Blank, and Winnick (1956)1890–1934 from Grebler, Blank, and Winnick (1956)
 1953–1975 from the home-purchase component of the CPI-U1953–1975 from the home-purchase component of the CPI-U
 1975–1987 from the1975–1987 from the Office of Federal Housing EnterpriseOffice of Federal Housing Enterprise
OversightOversight
 1987–2005 from the Case-Shiller-Weiss index1987–2005 from the Case-Shiller-Weiss index
 To fill in the gap, Shiller constructs an index of house pricesTo fill in the gap, Shiller constructs an index of house prices
from 1934 to 1953 by compiling data on the sales price offrom 1934 to 1953 by compiling data on the sales price of
houses from five major cities based on newspaperhouses from five major cities based on newspaper
advertisements.advertisements.

Case-Shiller IndexCase-Shiller Index
 The Home Prices line you see in the followingThe Home Prices line you see in the following
graph comes from the Case-Shiller Pricegraph comes from the Case-Shiller Price
Index. This Index is based on data collectedIndex. This Index is based on data collected
on repeat sales of single family homes. It wason repeat sales of single family homes. It was
developed by economists Karl Case, Robertdeveloped by economists Karl Case, Robert
Shiller, and Allan Weiss. The index isShiller, and Allan Weiss. The index is
normalized to have a value of 100 in the firstnormalized to have a value of 100 in the first
quarter of 2000.quarter of 2000.

How did the housing bubble develop?How did the housing bubble develop?
 The housing bubble grew alongside the stock bubble in theThe housing bubble grew alongside the stock bubble in the
mid 1990s. The stock bubble increased the wealth of people,mid 1990s. The stock bubble increased the wealth of people,
which led them to spend money on consumption includingwhich led them to spend money on consumption including
bigger and better houses.bigger and better houses.
 The increased demand led house prices to rise. Then theThe increased demand led house prices to rise. Then the
stock bubble burst, which only caused the housing bubble tostock bubble burst, which only caused the housing bubble to
grow more. This is because people lost faith in the stockgrow more. This is because people lost faith in the stock
market and thought investing in a home would be a muchmarket and thought investing in a home would be a much
safer alternative.safer alternative.
 Also going on at this time was the slow recovery from theAlso going on at this time was the slow recovery from the
2001 recession. This led the Federal Reserve Board to cut2001 recession. This led the Federal Reserve Board to cut
interest rates in an effort to stimulate the economy. Fixed-rateinterest rates in an effort to stimulate the economy. Fixed-rate
mortgages, as well as other interest rates hit 50 year lows.mortgages, as well as other interest rates hit 50 year lows.
This was a huge incentive to buy a home.This was a huge incentive to buy a home.

Some statistics of the housing bubbleSome statistics of the housing bubble
 The USA home ownership rate increased from 64% inThe USA home ownership rate increased from 64% in
1994 (about where it had been since 1980) to an all-1994 (about where it had been since 1980) to an all-
time high of 69.2% in 2004.time high of 69.2% in 2004.
 Between 1997 and 2006, the price of the typicalBetween 1997 and 2006, the price of the typical
American house increased by 124%American house increased by 124%
 In 2006 the national median home price was 4.6 timesIn 2006 the national median home price was 4.6 times
the national median household income.the national median household income.
 The housing bubble resulted in quite a fewThe housing bubble resulted in quite a few
homeowners refinancing their homes at lower interesthomeowners refinancing their homes at lower interest
rates, or financing consumer spending by taking outrates, or financing consumer spending by taking out
second mortgages secured by the price appreciation.second mortgages secured by the price appreciation.
USA household debt as a percentage of annualUSA household debt as a percentage of annual
disposable personal income was 127% at the end ofdisposable personal income was 127% at the end of
2007, versus 77% in 1990.2007, versus 77% in 1990.

 "The financial market crisis that erupted in
August 2007 has developed into the largest
financial shock since the Great Depression,
inflicting heavy damage on markets and
institutions at the core of the financial system."
International Monetary Fund, World Economic
Outlook, April 2008
And then the bubble burst…

The Subprime Mortgage Crisis Explained:The Subprime Mortgage Crisis Explained:
 Up until 2006, the housing market in the UnitedUp until 2006, the housing market in the United
States was flourishing due to the fact that it was soStates was flourishing due to the fact that it was so
easy to get a home loan.easy to get a home loan.
 Individuals were taking on subprime mortgages,Individuals were taking on subprime mortgages,
with the expectations that the price of their homewith the expectations that the price of their home
would continue to rise and that they would be ablewould continue to rise and that they would be able
to refinance their home before the higher interestto refinance their home before the higher interest
rates were to go into effect. 2005 was the peak of therates were to go into effect. 2005 was the peak of the
subprime boom. At this time, 1 in 5 mortgages wassubprime boom. At this time, 1 in 5 mortgages was
subprime.subprime.
 However, the housing bubble burst and housingHowever, the housing bubble burst and housing
prices had reached their peak. They were now on aprices had reached their peak. They were now on a
decline.decline.

 At this point, many who had taken on theseAt this point, many who had taken on these
subprime mortgages and their interest ratessubprime mortgages and their interest rates
were beginning to “reset” to the higher rates,were beginning to “reset” to the higher rates,
making their monthly mortgage paymentsmaking their monthly mortgage payments
much higher than before.much higher than before.
 People then began to sell their homes – butPeople then began to sell their homes – but
there was a problem to doing this. Since thethere was a problem to doing this. Since the
price of homes had severely decreased, theyprice of homes had severely decreased, they
did not have enough money after selling todid not have enough money after selling to
cover the amount of the mortgage.cover the amount of the mortgage.

 If a person could not sell their home, thisIf a person could not sell their home, this
ultimately left the homeowner with oneultimately left the homeowner with one
option, and that was to DEFAULT.option, and that was to DEFAULT.
 When a home is defaulted, this is the first stepWhen a home is defaulted, this is the first step
towards foreclosure.towards foreclosure.
 After the notice of default, there is aAfter the notice of default, there is a
reinstatement period before the home is putreinstatement period before the home is put
up for auction by the bank.up for auction by the bank.
 If the defaulted loan isn’t taken care of in aIf the defaulted loan isn’t taken care of in a
given amount of time, the bank resumesgiven amount of time, the bank resumes
responsibility of the home and is put up forresponsibility of the home and is put up for
auction.auction.

 However, when put in an auction, the bank usuallyHowever, when put in an auction, the bank usually
sells the home at a price that is much lower thansells the home at a price that is much lower than
what it is worth. The amount that they receive in thiswhat it is worth. The amount that they receive in this
process gets put towards the borrower’s loan, butprocess gets put towards the borrower’s loan, but
the borrower still has to account for the differencethe borrower still has to account for the difference
that they owe towards the loan.that they owe towards the loan.
 The process of auctioning off these houses creates aThe process of auctioning off these houses creates a
increase in supply of homes in the market, whichincrease in supply of homes in the market, which
will decrease the home prices.will decrease the home prices.

 One of the major problems that came out of this crisis wasOne of the major problems that came out of this crisis was
that:that: BillionsBillions of dollars were lost in mortgage backedof dollars were lost in mortgage backed
securities.securities.
 What is a mortgage backed security? “Once a bank hasWhat is a mortgage backed security? “Once a bank has
made thousands of mortgage loans, they often package up allmade thousands of mortgage loans, they often package up all
the loans together and sell them to investors as bonds.”the loans together and sell them to investors as bonds.”
 It was believed that these bonds were very safe investmentsIt was believed that these bonds were very safe investments
due to the fact that home prices were on the rise. If andue to the fact that home prices were on the rise. If an
individual was unable to pay the mortgage, it was thoughtindividual was unable to pay the mortgage, it was thought
that the homes would easily just be seized and sold.that the homes would easily just be seized and sold.
 Investors continued to buy these mortgage backed securitiesInvestors continued to buy these mortgage backed securities
because they continued to make a great amount of money.because they continued to make a great amount of money.
 However, real estate prices began to fall, and theHowever, real estate prices began to fall, and the
homeowners began to default their mortgages. This “safe”homeowners began to default their mortgages. This “safe”
investment was turning out to be one that was of great riskinvestment was turning out to be one that was of great risk
and therefore, costing investors billions of dollars.and therefore, costing investors billions of dollars.

 The ratings of mortgage backed securitiesThe ratings of mortgage backed securities
began to decline, to AA or even lower. Thisbegan to decline, to AA or even lower. This
was a clear indicator of how these securitieswas a clear indicator of how these securities
were thought of as a risky investment.were thought of as a risky investment.
 The downgraded mortgage bonds wereThe downgraded mortgage bonds were
suddenly worth much less. A bank who wassuddenly worth much less. A bank who was
initially holding $100 billion in assets foundinitially holding $100 billion in assets found
that these assets could now be sold for muchthat these assets could now be sold for much
less, assuming they could even find someoneless, assuming they could even find someone
to buy them. No investors wanted to take onto buy them. No investors wanted to take on
this risk.this risk.

 Major banks suffered from huge losses.Major banks suffered from huge losses.
 Lehman Brothers went out of business.Lehman Brothers went out of business.
 Merrill Lynch had to sell itself to Bank of America forMerrill Lynch had to sell itself to Bank of America for
a fraction of its former valuea fraction of its former value
 Countrywide Financial Corporation, the biggest U.S.Countrywide Financial Corporation, the biggest U.S.
mortgage lender, eventually gets taken over bymortgage lender, eventually gets taken over by
Bank of America.Bank of America.
 The Federal Reserve began guaranteeing loans toThe Federal Reserve began guaranteeing loans to
Bear Stearns and other banks to prevent an all-outBear Stearns and other banks to prevent an all-out
financial failure.financial failure.
 Mortgage defaults led subsequently to the collapseMortgage defaults led subsequently to the collapse
and government rescue of Fannie Mae and Freddieand government rescue of Fannie Mae and Freddie
Mac.Mac.
Impacts of the Subprime MortgageImpacts of the Subprime Mortgage
Crisis:Crisis:

The AftermathThe Aftermath
 There was a total of 2.2 millionThere was a total of 2.2 million
foreclosures in 2007, up 75% from theforeclosures in 2007, up 75% from the
roughly 1.26 million RealtyTrac reportedroughly 1.26 million RealtyTrac reported
in 2006. RealtyTrac said 1% of all USin 2006. RealtyTrac said 1% of all US
households were in 'some stage ofhouseholds were in 'some stage of
foreclosure' in 2007, up from 0.58% inforeclosure' in 2007, up from 0.58% in
2006.2006.
 By the end of 2008, home prices hadBy the end of 2008, home prices had
dropped 20% from their 2006 peak.dropped 20% from their 2006 peak.

Responses to the CrisisResponses to the Crisis
 Many programs have been enacted and legislation passed toMany programs have been enacted and legislation passed to
help those who have been hit the hardest by the crisis. Somehelp those who have been hit the hardest by the crisis. Some
examples include the Emergency Economic Stabilization Actexamples include the Emergency Economic Stabilization Act
of 2008 and the Homeowners Affordability and Stability Plan.of 2008 and the Homeowners Affordability and Stability Plan.
 Former President Bill Clinton and former Federal ReserveFormer President Bill Clinton and former Federal Reserve
Chairman Alan Greenspan indicated they did not properlyChairman Alan Greenspan indicated they did not properly
regulate derivatives, including credit default swaps. A billregulate derivatives, including credit default swaps. A bill
called the Derivatives Markets Transparency andcalled the Derivatives Markets Transparency and
Accountability Act of 2009 has been proposed to furtherAccountability Act of 2009 has been proposed to further
regulate the CDS market. This bill would provide theregulate the CDS market. This bill would provide the
authority to suspend CDS trading under certain conditions.authority to suspend CDS trading under certain conditions.

Where do we go from here?Where do we go from here?
 Five main topics are important to consider when discussing solutions to theFive main topics are important to consider when discussing solutions to the
crises: liquidity, solvency, economic stimulus, homeowner assistance, andcrises: liquidity, solvency, economic stimulus, homeowner assistance, and
regulation.regulation.
 Liquidity: Central banks have expanded their lending and money supplies, toLiquidity: Central banks have expanded their lending and money supplies, to
offset the decline in lending by private institutions and investors.offset the decline in lending by private institutions and investors.
 Solvency: Some financial institutions are facing risks regarding their solvency, orSolvency: Some financial institutions are facing risks regarding their solvency, or
ability to pay their obligations. Alternatives involve restructuring throughability to pay their obligations. Alternatives involve restructuring through
bankruptcy, bondholder haircuts, or government bailoutsbankruptcy, bondholder haircuts, or government bailouts
 Economic stimulus: Governments have increased spending or cut taxes to offsetEconomic stimulus: Governments have increased spending or cut taxes to offset
declines in consumer spending and business investment.declines in consumer spending and business investment.
 Homeowner assistance: Banks are adjusting the terms of mortgage loans to avoidHomeowner assistance: Banks are adjusting the terms of mortgage loans to avoid
foreclosure, with the goal of maximizing cash payments. Governments areforeclosure, with the goal of maximizing cash payments. Governments are
offering financial incentives for lenders to assist borrowers.offering financial incentives for lenders to assist borrowers.
 Regulation: rules designed help stabilize the financial system (such as regulatingRegulation: rules designed help stabilize the financial system (such as regulating
derivatives)derivatives)
 Discussions on theses topics are central to deciding what actions should be takenDiscussions on theses topics are central to deciding what actions should be taken
with regard to monetary policy, legislation, and potential programs.with regard to monetary policy, legislation, and potential programs.

Sources:Sources:
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 "Financial crisis of 2007-2009.""Financial crisis of 2007-2009." Wikipedia.Wikipedia. 20 Apr. 2009.20 Apr. 2009.
<http://en.wikipedia.org/wiki/Financial_crisis_of_2>.<http://en.wikipedia.org/wiki/Financial_crisis_of_2>.
 "How Robert Shiller measured housing prices back to 1890.""How Robert Shiller measured housing prices back to 1890." Bubble Meter.Bubble Meter. 24 Feb. 2009. 2024 Feb. 2009. 20
Apr. 2009. <http://bubblemeter.blogspot.com/2009/02/how-robert>.Apr. 2009. <http://bubblemeter.blogspot.com/2009/02/how-robert>.
 "Subprime mortgage crises.""Subprime mortgage crises." Wikipedia.Wikipedia. 20 Apr. 2009.20 Apr. 2009.
<http://en.wikipedia.org/wiki/Subprime_mortgage_cri>.<http://en.wikipedia.org/wiki/Subprime_mortgage_cri>.
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<http://en.wikipedia.org/wiki/Subprime_mortgage_cri>.<http://en.wikipedia.org/wiki/Subprime_mortgage_cri>.
 "The Subprime Mortgage Crisis Explained.""The Subprime Mortgage Crisis Explained." Stock Market Investors.Stock Market Investors. 18 Apr. 2009.18 Apr. 2009.
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<http://news.bbc.co.uk/2/hi/business/7073131.stm>.<http://news.bbc.co.uk/2/hi/business/7073131.stm>.
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 "Understanding the Foreclosure Process.""Understanding the Foreclosure Process." AOL Real Estate.AOL Real Estate. 18 Apr. 2009.18 Apr. 2009.
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The subprime mortgage crisis

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