Predatory Lending and the Subprime Seminar Paper

Excerpt from Seminar Paper :

And we must take into consideration what would happen if, somewhere down the line, we encountered the very real possibility of changed financial circumstances.

The financial knots we're tying ourselves into now, as we scramble to purchase homes and wind up owning less of them, can have serious long-term ramifications. Because today's overall tighter finances often necessitate putting off major purchases, many adults don't buy their first home until they're well into their thirties or even forties.

As a result, those thirty-year mortgage payments follow us right into retirement, hanging around even as rising health care and tuition expenses for college-aged children begin to spike. As a result, we discover too late that the asset we gambled everything to acquire because it was going to see us through retirement is instead pushing that retirement further and further away. Already, an increasing number of seniors are borrowing against their homes, accumulating more debt just at the time when they're supposed to be shaking themselves free. In 1983 only 5% of households headed by someone age sixty-five to seventy-four had debt on a primary residence, and only 3.7% of those age seventy-five and older.

V) "Knee-jerk" reactions to the Unaffordability Crisis

Interest rates fell in the early part of the decade, fell drastically in the United States, giving rise to unparalleled appreciation of home prices. Some of the markets such as the coasts, witnessed astronomical appreciation. In some areas, annual increases were above 10%, while some saw as much as 50% aggregate increases over the last ten years, before the 2008 subprime mortgage crisis.

Some homeowners experienced a windfall of massive capital gains due to this appreciation in values and became millionaires and billionaires. However, this also led to serious unaffordability problems for renters who were looking to buy houses, especially in the coasts, while the rich became richer.

The mortgages were actually more widespread during these times of heavy appreciation, also increasing consumption of properties, which would have been unthinkable otherwise. Non-traditional loan products like subprime mortgages were offered to these low income people, in order to make it more affordable for them, which actually worsened the problem of high appreciation value.

Consumer who could previously think about purchasing and owning homes, were able to take out mortgages, regardless of how low their income was, allowing them to make artificially low monthly payments, despite shot up credit scores. Unknowingly they put themselves at great risk by picking up such loans as we can clearly see now.

There is also the possibility that a few of the mortgage borrowers might have been fraudsters by simply going for it, because they could, even though they knew that they could not afford the house. For instance, it has been uncovered recently that inflated their salaries on fake loans intentionally, used identity theft or simply rented identities of people with higher credit scores, got themselves added to credit cards of people with good credit histories by paying them a flat amount, or purchased fraudulent pay stubs.

First time owners, on the other hand, seemed to be shocked, because of their naivety, unsophistication, upon learning that they would be stuck with their houses and unable to sell after the subprime mortgage crisis hit the economy and the housing market. Refinancing their expensive homes was also not an option available for some, and again they were surprised to be in that position. In the end, the lack of information and disparity of available knowledge to them, might have been the root cause for them ending up with subprime mortgages, and expensive, non-traditional mortgage products which they simply did not understand the terms and conditions of. They might have been simply disqualified in other, more traditional times of the housing market.

The down payment requirement usually deterred people renting homes in low income areas from attempting to become homeowners, because of the nationally low and for extended periods, negative U.S. rates of savings. Several of these people also found that they could not afford the payments every month for the traditional fifteen and thirty year fixed rate mortgages and also they simply could not come up with the hefty down payment requirements. This was the cue for the U.S. government to offer up nontraditional subprime mortgage products in order for these people to change their lives, and thus diversifying the regulated mortgage industry. The lending banks were quick to jump to this opportunity, and came up with exotic or alternative products, and approving previously denied or stalled loan application in droves.

A product in particular, which is led to the collapse of the U.S. subprime mortgage market in 2008, is often blamed to be the main cause. This product started as a traditional 30-year fixed mortgage but with a lower and short-term interest rate, which was very tempting but a ruse to lure the people, which then changed into an ARM after three of four years.

This was a crossbred ARM of sorts. The borrowers monthly payments after the initial years would be reconfigured, based on the rate of interest when the loan rate was reset. The interest rate on these 3/27 and 2/28 were changed invariably over the years.

VI) Basic features of sales and repurchase agreements

Sales and repurchase agreements are deals under which assets are sold by one party to another on terms that provide for the seller to repurchase the asset under certain conditions. Many institutions consider securities borrowing and lending and generally repo operations as being strategically important.

This is particularly true of those able to capitalize on AAA or AA credentials, and those who have access to substantial custodial holdings of customers' securities.

A variation of a repurchase agreement is an arrangement under which one party holds an asset on behalf of another. Another form of repo is outright forward purchases. They are less common than the more classical repurchase agreements, but the full credit risk remains; therefore it is not considered prudent to offset forward sales against forward purchases in assessing credit risk unless the transactions are with the same party. Even then there may be legal issues to be considered before netting.

Combined with the globality of their operations, the activity in securities borrowing and lending enables financial institutions to deliver more diversified services to customers in different financial markets. This policy capitalizes on the fact that a bank or investor holding an inventory of assets (for instance, bonds) can fund his position in the repo market, doing so either on term or overnight.

Since repurchase will take place on a specified day in the future, this effectively means that the seller is borrowing money. The repo operation connects the underlying cash market and the futures market. The sale price may be market value, but it could also be another mutually agreed price. The difference between the buy-back price and the selling price is, for any practical purpose, the interest. Basically, repurchase agreements are a form of collateralized lending by which one party sells securities and agrees to buy them back in the future at a higher price. For instance, to enhance its liquidity, a bank may be borrowings against U.S. Treasury bonds or bills, mortgage-backed securities, or collateralized mortgage obligations (CMOs) which it holds. These securities are temporarily given by the bank as collateral to the lender, but the bank then retains the right to buy back the securities at a fixed price. The repurchase is usually within a day or two of the 'sale', though it may extend over a number of months.

Because typically the resale price is in excess of the purchase price, reflecting an agreed rate of return effective for the period of time the purchaser's money is at play, it introduces two key variables to the repurchase agreement: the mutually agreed time and price. The repurchase price may:

be fixed at the outset;

vary with the period for which the asset is held by the buyer; or • be equal to the market price at time of repurchase.

The repurchase price can also be calculated to permit the buyer to recover incidental holding costs (such as insurance). Another crucial variable is the nature of repurchase provision. Whether this is an unconditional commitment for both parties, an option for the seller to repurchase (call option), an option for the buyer to resell to the seller (put option), or a combination of put and call, repurchased provisions are integral part of the repo. The repo market is growing steadily although, not exponentially. Market expansion impacts on risk. Therefore, prudent policy must see to it that repurchase agreements are at all times fully collateralized in an amount at least equal to the purchase price, including accrued interest earned on the underlying securities. Instruments held as collateral should be valued daily, and if the value of repo instrument(s) declines, then the bank…

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