Causes and consequences of the 2007-2008 subprime mortgage crisis

The Subprime Mortgage Crisis of 2007-2008
Introduction
The disastrous happenings and circumstances resulting from the issues in the subprime mortgage segment in US have come as a shock to the global financial markets since August 2007. The financial institutions were compelled to give a list of billions of losses in euro, swiss Francs, and dollars. The main markets became stagnant, stock markets went through a massive recession and their liquidity almost got lost. Central banks intervened to and originated many loans in order to bear the exchange rate, and also rescue the collapsing institutions. The US and European governments came through to support financial institutions in large scale. As a result of huge losses, majority of the financial institutions were forced to recapitalize, the financially stronger institutions took some of them while the rest ran bankrupt. The International Monetary Fund (IMF) estimated the total losses to go up to USD 1 trillion in August 2008 but they went to USD 1.4 trillion in October (Purnanandam, 2010; Thakor, 2015). Therefore, the price of the most present global financial and credit crisis for the global economy was among the highest ever in the history
Background of what happened
Some lenders funded mortgages by repackaging them into pools and then sold them to investors in the early and mid-2000s when the availability of high-risk mortgages became defined. To allocate these risks, new financial products were used where private-label mortgage backed securities (PMBS) provided most of the financial assistance to subprime mortgages. The demand that resulted bid up the prices of houses especially in places where there was tight supply in housing. This brought up more expectations of house price gains, leading to increased housing prices and demands (Case, Shiller, and Thompson 2012). The mortgages were expanded to high risk borrowers, together with increasing house prices which led to a period of agony in financial markets between 2007 and 2010.
When the house prices got to the peak, refinancing mortgages and selling homes became a less reliable method of paying mortgage debt and the rates of mortgage loss began increasing for investors and lenders. New Century Financial Corp which is a leading subprime mortgage lender applied for bankruptcy in April 2007. After a short time, big numbers of PMBS and its backed securities were pronounced high-risk, and many subprime lenders closed (Thakor, 2015). As a result of the collapse of the bond funding of the subprime mortgages, lenders could no longer make subprime as well as non-subprime risky mortgages. This led to low housing demand, causing house prices to slide and this resulted to expectations of more declined. The prices lowered so much that troubled borrowers found it hard to put their homes for sell in order to pay their mortgages in full even if they had put a sizeable down payment in place.
The outcome was two government-sponsored enterprises, Fannie Mae and Freddie Mac, went through high losses and the federal government seized them in 2008 summer (Frame et al., 2015). In order to meet the goals mandated by the federal government, Freddie Mac and Fannie Mae had a debt issued to be used for purchase of subprime mortgage-backed securities, which later became valuable. Moreover, the two enterprises suffered losses on the prime mortgages which were failing as they had bought them earlier, put them up for insurance and then packaged them into prime mortgage-backed securities which were put up to investors for sale.
To respond to these developments, lenders made it hard even for the qualifying applicants to get mortgages, making its demand go down further. As foreclosures became more, repossessions increased, enhancing the sale of homes to a weak housing market. This got worse when delinquent borrowers tried to sell their homes in order to escape foreclosure where lenders agree to limited losses if the mortgages were sold at a lower price.
In these methods, the downfall of subprime lending boosted a downgrade on house prices that revealed more of the increases experienced in the subprime boom. The crisis experienced in housing gave out a great impetus for the 2007-2009 recession by negatively affecting the general economy in four ways. It led to low construction, decreased wealth and therefore consumer spending, reduced the financial firms from being able to lend, and reduced the financial firm’s ability to get funds from securities markets (Duca and Muellbauer, 2013).
What caused the subprime mortgage crisis?
The financial turmoil was directly caused by the increased and subsequent reduction of house prices which resulted to poor lending practices, and led to losses on mortgages which were large (Moran, 2009). Although the most present financial crisis was as a result of the burst in mortgage market bubble when a huge default on the instructions in the subprime mortgage market began, but the financial illusion of the housing market was the outcome of the growth of financial creativity for the last 30 years, which is basically among the major causes of the subprime mortgage crisis (Mah-Hui, 2008).
Growth of subprime lending was enhanced by increased highly bargaining lending which was against a background of highly increasing house prices. The appetite for a higher-yielding securities by a strong investor led to granting of loans more loosely and mortgaging standards. However, safeguards which were to ensure prudent lending got weaker by combining remunerations and bonuses at each level of securitization, and dispersing credit risk which led to a weak monitoring of loans control incentives. Therefore, intermediaries were rewarded primarily by creating loan volume instead of quality (Pajarskas & Jo?ien?, 2015).
As long as prices for housing kept increasing, triggered by the always increasing levels of bargaining and debt, these problems always remained concealed. Increasing prices for houses gave the affected borrowers incentives to sell their homes and be able to pay off their mortgages beforehand. In 2006, as house prices began to increase, issues started revealing themselves. After many years of housing pricing appreciation which was not sustainable, and lending practices which were not prudent, the bubble bursting was necessary and inevitable. The rates of the interests got high, and the house prices flattened together with the loan value and later on resulted negative in various regions, many stretched borrowers did not have a choice but to offer no payment because refinancing and prepayment choices were not realizable with or without housing equity (Pajarskas & Jo?ien?, 2015). This crisis for subprime mortgages, represented by home foreclosures for large scale and mortgage related securities which were liquid, led to big capital spaces on the balance sheets of institutions and banks and has spread over to the worldwide economy leading to a long, deep, and painful recession (Moran, 2009).
What party (ies) (aka individuals, companies/firms, government agencies) were responsible for causing the subprime mortgage crisis?
Hedge funds, insurance companies and banks led to the subprime mortgage disaster. Banks and hedge funds founded the mortgage-backed securities. They were covered by insurance companies with credit default swaps. The mortgage demand caused an asset illusion in housing (Sorkin, 2010) which was known as the Too Big To Fail.
Bear Stearns was the first bank which was too big to fail. The JPMorgan Chase borrowed $30 billion from the Federal Reserve in March 2008 in order to purchase the failing investment bank. This was a small bank which was well-known (Ivashina & Scharfstein, 2010). The Fed had a worry that if Bear failed, confidence with other banks would be destroyed.
Lehman Brothers was a small company. However, the impact of its bankruptcy was frightening. The Treasury Secretary Hank Paulson declined its bailout in 2008. It signed up for bankruptcy. The next Monday, 350 points were dropped by the Dow. By Wednesday, there was panic among the financial markets. This intimidated the overnight lending which was required to keep businesses running (Sorkin, 2010). The challenge was out of the monetary policy’s hands to handle as it meant $700 billion bailout was required to recapitalize the big banks
Citigroup got a cash infusion of $20billion from treasury. The government got a return of 8%. Again, it received warrants to buy less than 5% of the common shares for Citi at $10 per share (Sorkin, 2010). Morgan Stanley and Goldman Sachs investment banks were also among the too big to fail. They were bailed out by the Fed giving them a chance to become commercial banks. This gave them the mandate to borrow from Fed's discount window. They could make use of other guarantee programs from Fed which were meant for retail banks. That brought to an end the era investment banking which had been made famous by a movie called “Wall Street”. The true colors of the 1980s mantra “Greed is good” were now revealed. The greed from Wall Street resulted to the pain of the homeowner and the taxpayer
Fannie and Freddie Mortgage Companies
Fannie and Freddie were mortgage giants who were too big to fail. This is because they gave a guarantee to 90 percent of all home mortgages by 2008. $100 million was underwrote by the Treasury in their mortgages, then returning them to be owned by the government (Sorkin, 2010; Frame et al., 2015). In case Freddie and Fannie had signed up for bankruptcy, it would have caused a collapse in housing market. This was government guarantees were required for banks to lend.

AIG Insurance Company
AIG is among the world’s largest insurers. Its business mostly entailed traditional insurance products. When it engaged into default swaps for credit, trouble was brewed up. These swaps made the assets which were in support of mortgages and corporate debt get insured. If AIG ran bankrupt, the financial institutions which brought these swaps would fail.
The swaps of AIG against subprime mortgages was propelled to verge of bankruptcy. AIG was compelled to bring up millions of capital as the mortgages connected to these swaps became default. As stockholders got to know about the situation, they put up their shares for sale ,creating a challenge for the AIG to cover the swaps (Moran, 2009).AIG could not sell the swaps before they were due despite that they had enough assets to cover the swaps.
AIG received an $85billion loan for two years from the Federal Reserve to increase their emphasis on the global economy. The government was given 79.9 % of AIG’s equity and they were given the right to management replacement. It was also given veto power above all vital decisions like payment of dividends and asset sales. In October 2008, Edward Liddy was hired by the Fed as the CEO and chairman to oversee the company’s management (Moran, 2009).
Fed’s plan was to break up AIG and sell the pieces to refund the loan. However, the stock market plunge which happened in October made that difficult. The potential buyers required any extra cash to be included in their balance sheets. The treasury department bought $40 billion from AIG’s Capital Repurchase Plan. $52.5 billion in securities backed by mortgage was bought by the Fed. The money enabled AIG to retrieve its credit swaps saving a large percentage of the financial industry from collapsing. The bailout of AIG was identified as one of the biggest financial rescues in the US history.
What ethical misconduct did these individuals and/or entities engage in that caused the subprime mortgage crisis?
Hedge funds are ever trying to perform better than the market. They made demand for mortgage-backed securities by joining them with credit default swaps guarantees. What would be the negative effect? Nothing, until fed began to increase their interest rates. Those with mortgages whose rates could be adjusted couldn't make these larger payment. Demand and housing prices decreased. They defaulted when they were not in a position to sell their homes. AIG almost ran bankrupt in their attempt to cover the insurance (Mishkin, 2011).
Deregulation was also another major cause for subprime mortgage crisis. In the year 1999, banks were given permission to work as Hedge funds. They as well put depositor’s funds into investment. That is what resulted to Savings and Loans Crisis in 1989 (Davidson, 2008). A couple of lenders used millions of dollars to influence state legislatures to freeze laws. Those laws would have prevented borrowers from having unaffordable mortgages.
Hedge funds and banks got so much money from selling securities which were mortgage-backed resulting to a high demand for the latent mortgages. That is what made mortgage lenders reduce standards and rates for their borrowers continually (Davidson, 2008). The mortgage-backed securities gave lenders permission to package loans into bundles and sell them. Banks were permitted to have extra funds for lending in the time of conventional loans. Availability of advent of interest-only loans made it possible to transfer the lender’s risk to defaulting upon the interest rates resetting. The risk was small as long as there was continuous rise in the housing markets.
The advent of interest-only loans together with mortgage-backed securities led to another problem. Access to the market was highly improved that it led to a boom in housing (Davidson, 2008; Mishkin, 2011). The advent of interest-only loans assisted in bringing down monthly payments in order to make it affordable for the subprime borrowers. However, it increased the lender’s risk because the primary rates always reset after one, three or five years. But, the increasing housing markets gave comfort to lenders, who made an assumption that borrowers could sell the house again at a higher price than the default.
The risk was not limited to mortgages. All forms of debts were put together and sold parallel to debt obligations. As housing prices went down, multiple home owners who were using their homes as ATMs discovered that they could support their lifestyle no more. Non-payments in all types of debts started creeping up slowly (Mishkin, 2011). CDO holders were inclusive of both hedge funds and lenders. They also entailed pension funds, mutual funds, and corporations. That increased the individual investors’ risk (Mishkin, 2011; Davidson, 2008). The main issue with CDOs was the buyers’ ignorance in pricing them because they were so new and complicated.
Stock market booming was another reason. Everyone had a lot of pressure to create money that they frequently bought the products depending on only word of mouth. CDOs were majorly purchased by banks. As non-payments began to increase, banks were not in a position to sell the CDOs and they also had less money to lend (Davidson, 2008). Those who could get funds did not want to lend banks which could not pay. By the time 2007 ended, Fed was forced to come in as a last resort lender. The crisis arrived in full circle. The banks resolved in lending too little rather than too freely causing further decline in housing market.


How could the subprime mortgage crisis have been prevented and how can a similar catastrophe be prevented in the future?
Regulation of hedge funds and mortgage brokers who bargained too much and made bad loans respectively, could have halted the crisis. Early recognition of the credibility problem could have helped too. The only available solution was the government to purchase the bad loans. The crisis was also as a result of outstripped human intellect and financial innovation. The prospective effect of new products like derivatives and MBS were not clear even to those who created them. Regulation could have toned down the downtime by decreasing a bit of the leverage. It couldn’t have made it possible to prevent new financial products creation. Fear and greed will always result to an illusion.
The following strategies should be put in place to prevent a similar crisis
Improved Credit Ratings
Agencies for credit rating are to boost the method in which they “grade” securities. Presently, both structured credit products and traditional securities have the same grade (Adrian and Shin, 2010; John, 2008). Structured credit products are advanced and often more complex packages inclusive of elements like tranches of mortgages representing a certain level of risk for repayment. They are made to meet specific need for investors.
Credit rating agencies are recommended to make their procedures more clear. This entails publishing enough information about the assumptions for latent credit rating models and methodologies and distinctively differentiating complex products ratings from traditional instruments (John, 2008).


Improving Mortgage Origination
This paper suggests better standards for underwriting by mortgage originators. An important recommendation oversees mortgage brokers better by federal and state regulators inclusive of state licensing of mortgage brokers who are not being supervised (John, 2008). This important step would ensure a continuous weakness in mortgage originations. Requirements for licensing are well enforced to aid in improving mortgages quality created by brokers
Moreover, the paper suggests a more consistent oversight or meet the least of standards, inclusive of enforcement mechanisms which are effective. This would boost the current regulation rather than bring a new item that would make matters more complicated (John, 2008).
Ultimately, Federal Reserve issue is recommended to create consumer-protection rules which are inclusive of affordability of various mortgages types and better disclosure to make it possible for customers to make a comparison between different products before making a purchase (Adrian and Shin, 2010). Federal and state regulators will ensure that the rules are enforced in all types of mortgages.
Improved Risk Management and Regulation
In subprime crisis, major financial institutions are not able to approximate their real exposure to losses coming up as a result of these securities. The range from poor understanding of the true risk related to individual investments to the inability to collect the different holdings’ investments properly in all business lines for all firms (John, 2008). Consequently, financial institutions have been more exposed to risks and prospective problems in liquidity than they expected, because credit conditions have gone down.
Federal regulators will take up fast steps to have firms improve their systems for managing information such that this information will always be available. They will also make sure that firm's governance systems have improved their management for risks practices. Individuals should be encouraged to follow the firm’s guidelines using compensations (John, 2008). Finally, firms will be expected to start and meet capital and liquidity standards that are strict enough to make the firm thrive even then the economy is severely stressed
Improved management for risks in a firm will be represented by regulatory improvements made to encourage firms to improve liquidity and capital basis and enhance guidelines for the risks related to firms which distribute financial products to sellers and investors (John, 2008). Recommendations for disclosure of off-balance sheet requirements like the precise value for illiquid or complex investments are equally important. Federal regulators will also get to understand the duty of standards in accounting when making the current instability in finances.

References
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