Subprime lending[edit]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 ofdefaultthan 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 calledforeclosure.A
plain-language overview[edit]
Factors Contributing to Housing Bubble - Diagram 1 of 2
Domino Effect As Housing Prices Declined - Diagram 2 of 2The
following is excerpted (with some modifications) from former U.S.
PresidentGeorge W. Bush's Address to the Nation on September 24,
2008:[2]Other additions are sourced later in the article or in the
main article.The problems we are witnessing today developed over a
long period of time. For more than a decade, a massive amount of
money flowed into the United States from investors abroad. This
large influx of money to U.S. banks and financial institutions
along with low interest rates made it easier for Americans to get
credit. Easy credit combined with the faulty assumption that home
values would continue to rise led to excesses and bad
decisions.Many mortgage lenders approved loans for borrowers
without carefully examining their ability to pay. Many borrowers
took out loans larger than they could afford, assuming that they
could sell or refinance their homes at a higher price later on.
Both individuals and financial institutions increased their debt
levels relative to historical norms during the past decade
significantly.Optimism about housing values also led to a boom in
home construction. Eventually the number of new houses exceeded the
number of people willing to buy them. And with supply exceeding
demand, housing prices fell. And this created a problem: Borrowers
with adjustable rate mortgages (i.e., those with initially low
rates that later rise) who had been planning to sell or refinance
their homes before the adjustments occurred were unable to
refinance. As a result, many mortgage holders began to default as
the adjustments began.These widespread defaults (and related
foreclosures) had effects far beyond the housing market. Home loans
are often packaged together, and converted into financial products
called "mortgage-backed securities". These securities were sold to
investors around the world. Many investors assumed these securities
were trustworthy, and asked few questions about their actual
value.Credit rating agencies gave them high-grade, safe ratings.
Two of the leading sellers of mortgage-backed securities wereFannie
MaeandFreddie Mac. Because these companies were chartered by
Congress, many believed they were guaranteed by the federal
government. This allowed them to borrow enormous sums of money,
fuel the market for questionable investments, and put the financial
system at risk.The decline in the housing market set off a domino
effect across the U.S. economy. When home values declined and
adjustable rate mortgage payment amounts increased, borrowers
defaulted on their mortgages. Investors globally holding
mortgage-backed securities (including many of the banks that
originated them and traded them among themselves) began to incur
serious losses. Before long, these securities became so unreliable
that they were not being bought or sold.Investment banks such
asBear StearnsandLehman Brothersfound themselves saddled with large
amounts of assets they could not sell. They ran out of the money
needed to meet their immediate obligations and faced imminent
collapse. Other banks found themselves in severe financial trouble.
These banks began holding on to their money, and lending dried up,
and the gears of the American financial system began grinding to a
halt.Precursor, "Subprime I"[edit]Although most references to the
Subprime Mortgage Crisis refer to events and conditions that led to
the financial crisis and subsequent recession that began in 2008, a
much smaller bubble and collapse occurred in the mid- to
late-1990s, sometimes dubbed "Subprime I"[3]or "Subprime 1.0".[4]It
ended in 1999 when the rate of subprime mortgage securitization
dropped from 55.1% in 1998 to 37.4% in 1999. In the two years
following the1998 Russian financial crisis, "eight of the top ten"
subprime lenders "declared bankruptcy, ceased operations, or sold
out to stronger firms."[5]The crisis is said to have had "had all
the earmarks of a classic bubble" with enthusiasm over rising stock
prices replacing caution over shoddy business practices and concern
over whether the earnings of the companies were sustainable. Loans
were made to borrowers who were unable to pay them back. The
subprime mortgage companies began taking unexpected write-downs as
mortgages were refinanced at lower interest rates. Much of the
reported profits turned out to be illusory and companies such as
Famco went under. Along with the bankruptcies came a wave of
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]Background to the
crisis[edit]In 2006,Lehman BrothersandBear Stearns, whose
fixed-income franchises benefitted from having integrated mortgage
origination businesses, were seen as runaway success stories. Many
more investment banks had already built large mortgage desks, and
invested heavily in subprime platforms. Mortgage origination and
securitization generated lucrative fees during the time when the US
market developed away from the traditional agency/CMO
model.[8]Fannie MaeandFreddie Macshrunk their balance sheets
substantially as conforming mortgage origination volumes
diminished, and private label securitization grew substantially
from 2002.[8]Large-scale defaults from subprime lending had yet to
hit headlines in 2006; rating agencies began sounding early alarm
bells in the summer of 2006 but it was anticipated delinquencies
would go up with the biggest rollovers on the new loans (around
2008).[8]Stages of the crisis[edit]The crisis has gone through
stages. First, during late 2007, over 100 mortgage lending
companies went bankrupt as subprime mortgage-backed securities
could no longer be sold to investors to acquire funds. Second,
starting in Q4 2007 and in each quarter since then, financial
institutions have recognized massive losses as they adjust the
value of their mortgage backed securities to a fraction of their
purchased prices. These losses as the housing market continued to
deteriorate meant that the banks have a weaker capital base from
which to lend. Third, during Q1 2008, investment bankBear
Stearnswas hastily merged with bank JP Morgan with $30 billion in
government guarantees, after it was unable to continue borrowing to
finance its operations.[9]Fourth, during September 2008, the system
approached meltdown. In early SeptemberFannie MaeandFreddie Mac,
representing $5 trillion in mortgage obligations, were nationalized
by the U.S. government as mortgage losses increased. Next,
investment bankLehman Brothersfiled for bankruptcy. In addition,
two large U.S. banks (Washington Mutual and Wachovia) became
insolvent and were sold to stronger banks.[10]The world's largest
insurer,AIG, was 80% nationalized by the U.S. government, due to
concerns regarding its ability to honor its obligations via a form
of financial insurance calledcredit default swaps.[11]These
sequential and significant institutional failures, particularly the
Lehman bankruptcy, involved further seizing of credit markets and
more serious global impact. The interconnected nature of Lehman was
such that its failure triggered system-wide (systemic) concerns
regarding the ability of major institutions to honor their
obligations to counterparties. The interest rates banks charged to
each other (see theTED spread) increased to record levels and
various methods of obtaining short-term funding became less
available to non-financial corporations.[11]It was this "credit
freeze" that some described as a near-complete seizing of the
credit markets in September that drove the massive bailout
procedures implemented by worldwide governments in Q4 2008. Prior
to that point, each major U.S. institutional intervention had been
ad-hoc; critics argued this damaged investor and consumer
confidence in the U.S. government's ability to deal effectively and
proactively with the crisis. Further, the judgment and credibility
of senior U.S. financial leadership was called into
question.[11]Since the near-meltdown, the crisis has shifted into
what some consider to be a deep recession and others consider to be
a "reset" of economic activity at a lower level, now that enormous
lending capacity has been removed from the system. Unsustainable
U.S. borrowing and consumption were significant drivers of global
economic growth in the years leading up to the crisis. Record rates
of housing foreclosures are expected to continue in the U.S. during
the 2009-2011, continuing to inflict losses on financial
institutions. Dramatically reduced wealth due to both housing
prices and stock market declines are unlikely to enable U.S.
consumption to return to pre-crisis levels.[12]Thomas
Friedmansummarized how the crisis has moved through stages:When
these reckless mortgages eventually blew up, it led to a credit
crisis. Banks stopped lending. That soon morphed into an equity
crisis, as worried investors liquidated stock portfolios. The
equity crisis made people feel poor and metastasized into a
consumption crisis, which is why purchases of cars, appliances,
electronics, homes and clothing have just fallen off a cliff. This,
in turn, has sparked more company defaults, exacerbated the credit
crisis and metastasized into an unemployment crisis, as companies
rush to shed workers.[13]Alan Greenspanhas stated that until the
record level of housing inventory currently on the market declines
to more typical historical levels, there will be downward pressure
on home prices. As long as the uncertainty remains regarding
housing prices, mortgage-backed securities will continue to decline
in value, placing the health of banks at risk.[14]The subprime
mortgage crisis in context[edit]EconomistNouriel Roubiniwrote in
January 2009 that subprime mortgage defaults triggered the
broaderglobal credit crisis, but were part of multiple credit
bubble collapses: "This crisis is not merely the result of the U.S.
housing bubbles bursting or the collapse of the United States
subprime mortgage sector. The credit excesses that created this
disaster were global. There were many bubbles, and they extended
beyond housing in many countries to commercial real estate
mortgages and loans, to credit cards, auto loans, and student
loans.[15]There were bubbles for the securitized products that
converted these loans and mortgages into complex, toxic, and
destructive financial instruments. And there were still more
bubbles for local government borrowing, leveraged buyouts, hedge
funds, commercial and industrial loans, corporate bonds,
commodities, and credit-default swaps." It is the bursting of the
many bubbles that he believes are causing this crisis to spread
globally and magnify its impact.[15]Fed ChairmanBen
Bernankesummarized the crisis as follows during a January 2009
speech:"For almost a year and a half the global financial system
has been under extraordinary stress--stress that has now decisively
spilled over to the global economy more broadly. The proximate
cause of the crisis was the turn of the housing cycle in the United
States and the associated rise in delinquencies on subprime
mortgages, which imposed substantial losses on many financial
institutions and shook investor confidence in credit markets.
However, although the subprime debacle triggered the crisis, the
developments in the U.S. mortgage market were only one aspect of a
much larger and more encompassing credit boom whose impact
transcended the mortgage market to affect many other forms of
credit. Aspects of this broader credit boom included widespread
declines in underwriting standards, breakdowns in lending oversight
by investors and rating agencies, increased reliance on complex and
opaque credit instruments that proved fragile under stress, and
unusually low compensation for risk-taking. The abrupt end of the
credit boom has had widespread financial and economic
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
Friedmansummarized 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]
Number of U.S. Household Properties Subject to Foreclosure
Actions by Quarter.The value of U.S. subprime mortgages was
estimated at $1.3 trillion as of March 2007,[18]with over 7.5
million first-liensubprime mortgages outstanding.[19]Approximately
16% of subprime loans with adjustable rate mortgages (ARM) were
90-days delinquent or in foreclosure proceedings as of October
2007, roughly triple the rate of 2005.[20]By January 2008, the
delinquency rate had risen to 21%[21]and by May 2008 it was
25%.[22]Between 2004 and 2006 the share of subprime mortgages
relative to total originations ranged from 18%-21%, versus less
than 10% in 2001-2003 and during 2007.[23][24]Subprime ARMs only
represent 6.8% of the loans outstanding in the US, yet they
represent 43% of the foreclosures started during the third quarter
of 2007.[25]During 2007, nearly 1.3 million properties were subject
to 2.2 million foreclosure filings, up 79% and 75% respectively
versus 2006. Foreclosure filings including default notices, auction
sale notices and bank repossessions can include multiple notices on
the same property.[26]During 2008, this increased to 2.3 million
properties, an 81% increase over 2007.[27]Between August 2007 and
September 2008, an estimated 851,000 homes were repossessed by
lenders from homeowners.[28]Foreclosures are concentrated in
particular states both in terms of the number and rate of
foreclosure filings.[29]Ten states accounted for 74% of the
foreclosure filings during 2008; the top two (California and
Florida) represented 41%. Nine states were above the national
foreclosure rate average of 1.84% of households.[30]
U.S. Subprime lending expanded dramatically 2004-2006.The
mortgage market is estimated at $12 trillion[31]with approximately
6.41% of loans delinquent and 2.75% of loans in foreclosure as of
August 2008.[32]The estimated value of subprime adjustable-rate
mortgages (ARM) resetting at higher interest rates is U.S. $400
billion for 2007 and $500 billion for 2008. Reset activity is
expected to increase to a monthly peak in March 2008 of nearly $100
billion, before declining.[33]An average of 450,000 subprime ARM
are scheduled to undergo their first rate increase each quarter in
2008.[34]An estimated 8.8 million homeowners (nearly 10.8% of the
total) have zero or negative equity as of March 2008, meaning their
homes are worth less than their mortgage. This provides an
incentive to "walk away" from the home, despite the credit rating
impact.[35]By January 2008, the inventory of unsold new homes stood
at 9.8 months based on December 2007 sales volume, the highest
level since 1981.[36]Further, a record of nearly four million
unsold existing homes were for sale,[37]including nearly 2.9
million that were vacant.[38]This excess supply of home inventory
places significant downward pressure on prices. As prices decline,
more homeowners are at risk of default and foreclosure. According
to the S&P/Case-Shiller price index, by November 2007, average
U.S. housing prices had fallen approximately 8% from their Q2 2006
peak[39]and by May 2008 they had fallen 18.4%.[40]The price decline
in December 2007 versus the year-ago period was 10.4% and for May
2008 it was 15.8%.[41]Housing prices are expected to continue
declining until this inventory of surplus homes (excess supply) is
reduced to more typical levels.Household debt statistics[edit]In
1981, US private debt was 123 per cent ofgross 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 theirdisposable personal
incomeon 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% ofdisposable 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
Wolfwrote: "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 non-financial 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 primarilythrifts) bore
the credit risk on the mortgages they issued. Over the past 60
years, a variety offinancial innovationshave gradually made it
possible for lenders to sell the right to receive the payments on
the mortgages they issue, through a process calledsecuritization.
The resulting securities are calledmortgage-backed securities(MBS)
andcollateralized 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
non-regulated securities markets. In general, there are five
primary types of risk in these markets:[51][52][53]
NameDescription
Credit riskthe risk that the borrower will fail to make payments
and/or that the collateral behind the loan will lose value.
Asset price riskthe risk that asset itself (MBS or underlying
mortgages in this case) will depreciate in value, resulting in
financial losses,markdownsand possiblymargin calls
Counterpartyriskthe risk that a party to an MBS or derivative
contract other than the borrower will be unable or unwilling to
uphold their obligations.
Systemic riskThe aggregate effect of these and other risks has
recently been calledsystemic risk, which refers to sudden
perceptual, or material changes across the entire financial system,
causing highly "correlated" behavior and possible damage to that
system
Liquidity riskAt the institutional level, this is the risk that
money in the system 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 ofcredit default
swaps(CDS). Investors in MBS can insure against credit risk by
buying CDS, but as risk rises, counterparties in CDS contracts have
to deliver collateral and build up reserves in case more payments
become necessary. The speed and severity with which risk rose in
the subprime market created uncertainty across the system, with
investors wondering whether huge CDS counterparties like AIG might
be unable to honor their commitments.Understanding the risks types
involved in the subprime crisis[edit]The reasons for this crisis
are varied and complex.[54]Understanding and managing the ripple
effect through the worldwide economy poses a critical challenge for
governments, businesses, and investors. The crisis can be
attributed to a number of factors, such as the inability of
homeowners to make theirmortgagepayments; poor judgment by the
borrower and/or the lender; and mortgage incentives such as
"teaser" interest rates that later rise significantly.Further,
declining home prices have madere-financingmore difficult. As a
result offinancializationand innovations insecuritization, risks
related to the inability of homeowners to meet mortgage payments
have been distributed broadly, with a series of consequential
impacts. There are five primary categories of risk involved:1.
Credit risk: Traditionally, the risk of default (calledcredit risk)
would be assumed by the bank originating the loan. However, due to
innovations in securitization, credit risk is frequently
transferred to third-party investors. The rights to mortgage
payments have been repackaged into a variety of complex investment
vehicles, generally categorized asmortgage-backed securities(MBS)
orcollateralized debt obligations(CDO). A CDO, essentially, is a
repacking of existing debt, and in recent years MBS collateral has
made up a large proportion of issuance. In exchange for purchasing
MBS or CDO and assuming credit risk, third-party investors receive
a claim on the mortgage assets and related cash flows, which become
collateral in the event of default. Another method of safeguarding
against defaults is thecredit default swap, in which one party pays
a premium and the other party pays them if a particular financial
instrument defaults.2. Asset price risk: MBS and CDO asset
valuation is complex and related "fair value" or "mark to market"
accounting is subject to wide interpretation. The valuation is
derived from both the collectibility of subprime mortgage payments
and the existence of a viable market into which these assets can be
sold, which are interrelated. Rising mortgage delinquency rates
have reduced demand for such assets. Banks and institutional
investors have recognized substantial losses as they revalue their
MBS downward. Several companies that borrowed money using MBS or
CDO assets ascollateralhave 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 thecommercial
paperand repurchase markets. Companies andstructured 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
Alt-A 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 incredit derivativetransactions, 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
theircounterpartiesand creating further uncertainty in financial
markets. The demise and bailout ofBear Stearnswas due in-part to
its role in these derivatives.[59]5. Systemic risk: The aggregate
effect of these and other risks has recently been calledsystemic
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]Effect on corporations and
investors[edit]
Understanding Financial Leverage.
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]Additionally,
a bank's mortgage losses may cause it to reduce lending or seek
additional funds from the capital markets, if necessary to maintain
compliance with capital reserve regulatory requirements. Many banks
also bought mortgage-backed securities and suffered losses on these
investments. Investment banks, mortgage lenders, and real estate
investment trusts: These entities face similar risks to banks, yet
do not have the stability provided by customer bank deposits. They
have business models with significant reliance on the ability to
regularly secure new financing through CDO orcommercial
paperissuance, borrowing short-term at lower interest rates and
lending longer-term at higher interest rates (i.e., profiting from
the interest rate "spread.") Such firms generated more profits the
moreleveragedthey became (i.e., the more they borrowed and lent) as
housing values increased. For example, investment banks were
leveraged around 30 times equity, while commercial banks have
regulatory leverage caps around 15 times equity. In other words,
for each $1 provided by investors, investment banks would borrow
and lend $30.[62]However, due to the decline in home values, the
mortgage-backed assets many purchased with borrowed funds declined
in value. Further, short-term financing became more expensive or
unavailable. Such firms are at increased risk of significant
reductions in book value owing to asset sales at unfavorable prices
and many have filed bankruptcy or been taken over.[63] Insurance
companies: Corporations such asAIGprovide insurance products
calledcredit default swaps, which are intended to protect against
credit defaults, in exchange for a premium or fee. They are
required to post a certain amount of collateral (e.g., cash or
other liquid assets) to be in a position to provide payments in the
event of defaults. The amount of capital is based on the credit
rating of the insurer. Due to uncertainty regarding the financial
position of the insurance company and potential risk of default
events, credit agencies may downgrade the insurer, which requires
an immediate increase in the amount of collateral posted. This
risk-downgrade-post cycle can be circular and destructive across
multiple firms and was a factor in the AIG bailout. Further, many
major banks insured their mortgage-backed assets with AIG. Had AIG
been allowed to go bankrupt and not pay these banks what it owed
them, these institutions could have failed, causing risk to the
entire financial system. Since September 2008, the U.S. government
has since stepped in with $150 billion in financial support for
AIG, much of which flows through AIG to the banks.[64][65] Special
purpose entities(SPE): These are legal entities often created as
part of the securitization process, to essentially remove certain
assets and liabilities from bank balance sheets, theoretically
insulating the parent company from 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 calledstructured 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 theEnron debacle, as well.
Financing through off-balance sheet structures is thinly regulated.
SIV and similar structures are sometimes referred to as theshadow
banking system.[67] Investors: Stocks orbondsof 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.Understanding financial institution
solvency[edit]Critics have argued that due to the combination of
high leverage and losses, the U.S. banking system is
effectivelyinsolvent(i.e., equity is negative or will be as the
crisis progresses),[68]while the banks counter that they have the
cash required to continue operating or are "well-capitalized." As
the crisis progressed into mid-2008, it became apparent that
growing losses onmortgage-backed securitiesat large,
systemically-important institutions were reducing the total value
of assets held by particular firms to a critical point roughly
equal to the value of their liabilities.A bit of accounting theory
is helpful to understanding this debate. It is an
accountingidentity(i.e., an equality that must hold true by
definition) thatassetsequals the sum ofliabilitiesandequity. Equity
consisted primarily of thecommonorpreferred stockand theretained
earningsof the company and is also referred to ascapital.
Thefinancial statementthat reflects these amounts is called
thebalance sheet.If a firm is forced into a negative equity
scenario, it is technically insolvent from a balance sheet
perspective. However, the firm may have sufficient cash to pay its
short-term obligations and continue operating.Bankruptcyoccurs when
a firm is unable to pay its immediate obligations and seeks legal
protection to enable it to either re-negotiate its arrangements
with creditors or liquidate its assets. Pertinent forms of the
accounting equation for this discussion are shown below: Assets =
Liabilities + Equity Equity = Assets - Liabilities = Net worth or
capital Financial leverage ratio = Assets / EquityIf assets equal
liabilities, then equity must be zero. While asset values on the
balance sheet aremarked downto reflect expected losses, these
institutions still owe thecreditorsthe full amount of liabilities.
To use a simplistic example, Company X used a $10 equity or capital
base to borrow another $290 and invest the $300 amount in various
assets, which have fallen 10% in value to $270. This firm was
"leveraged" 30:1 ($300 assets / $10 equity = 30) and now has assets
worth $270, liabilities of $290 and equity ofnegative$20. Such
leverage ratios were typical of the larger investment banks during
2007. At 30:1 leverage, it only takes a 3.33% loss to reduce equity
to zero.Banks use various regulatory measures to describe their
financial strength, such astier 1 capital. Such measures typically
start with equity and then add or subtract other measures. Banks
and regulators have been criticized for including relatively
"weaker" or less tangible amounts in regulatory capital measures.
For example, deferred tax assets (which represent future tax
savings if a company makes a profit) and intangible assets (e.g.,
non-cash amounts like goodwill or trademarks) have been included in
tier 1 capital calculations by some financial institutions. In
other cases, banks were legally able to move liabilities off their
balance sheets viastructured investment vehicles, which improved
their ratios. Critics suggest using the "tangible common equity"
measure, which removes non-cash assets from these measures.
Generally, the ratio of tangible common equity to assets is lower
(i.e., more conservative) than the tier 1 ratio.[69]Banks and
governments have taken significant steps to improve capital ratios,
by issuing new preferred stock to private investors or to the
government via bailouts, and cutting dividends.Understanding the
events of September 2008[edit]Liquidity risk and the money market
funding engine[edit]
How Money Markets Fund CorporationsDuring September 2008, money
market mutual funds began to experience significant withdrawals of
funds by investors in the wake of theLehman Brothersbankruptcy
andAIGbailout. This created a significant risk because money market
funds are integral to the ongoing financing of corporations of all
types. Individual investors lend money to money market funds, which
then provide the funds to corporations in exchange for corporate
short-term securities calledasset-backed commercial
paper(ABCP).[70]However, a potentialbank runhad begun on certain
money market funds. If this situation had worsened, the ability of
major corporations to secure needed short-term financing through
ABCP issuance would have been significantly affected. To assist
with liquidity throughout the system, the Treasury and Federal
Reserve Bank announced that banks could obtain funds via the
Federal Reserve's Discount Window using ABCP as collateral.[70]To
stop the potential run on money market mutual funds, the Treasury
also announced on September 19 a new $50 billion program to insure
the investments, similar to theFederal Deposit Insurance
Corporation(FDIC) program for regular bank accounts.[71]Key risk
indicators[edit]
TheTED spread an indicator of credit risk increased dramatically
during September 2008.Key risk indicators became highly volatile
during September 2008, a factor leading the U.S. government to pass
theEmergency Economic Stabilization Act of 2008. The TED spread is
a measure of credit risk for inter-bank lending. It is the
difference between: 1) the risk-free three-month U.S. treasury bill
(t-bill) rate; and 2) the three-month London Interbank Borrowing
Rate (LIBOR), which represents the rate at which banks typically
lend to each other. A higher spread indicates banks perceive each
other as riskier counterparties. The t-bill is considered
"risk-free" because the full faith and credit of the U.S.
government is behind it; theoretically, the government could just
print money so investors get their money back at the maturity date
of the t-bill.The TED Spread reached record levels in late
September 2008. The diagram indicates that the Treasury yield
movement was a more significant driver than the changes in LIBOR. A
three-month t-bill yield so close to zero means that people are
willing to forego interest just to keep their money (principal)
safe for three monthsa very high level of risk aversion and
indicative of tight lending conditions. Driving this change were
investors shifting funds from money market funds (generally
considered nearly risk free but paying a slightly higher rate of
return than t-bills) and other investment types to t-bills.[72]In
addition, an increase in LIBOR means that financial instruments
with variable interest terms are increasingly expensive. For
example, adjustable rate mortgages, car loans andcredit card
interestrates are often tied to LIBOR; some estimate as much as
$150 trillion in loans andderivativesare tied to LIBOR.[73]Higher
interest rates place additional downward pressure on consumption,
increasing the risk of recession.Credit default swaps and the
subprime mortgage crisis[edit]Credit defaults swaps(CDS) are
insurance contracts, typically used to protect bondholders from the
risk of default, calledcredit risk. As the financial health of
banks and other institutions deteriorated due to losses related to
mortgages, the likelihood that those providing the insurance would
have to pay their counterparties increased. This created
uncertainty across the system, as investors wondered which
companies would be forced to pay to cover defaults.For example,
Company Alpha issues bonds to the public in exchange for funds. The
bondholders pay a financial institution an insurance premium in
exchange for it assuming the credit risk. If Company Alpha goes
bankrupt and is unable to pay interest or principal back to its
bondholders, the insurance company would pay the bondholders to
cover some or all of the losses. In effect, the bondholder has
"swapped" its credit risk with the insurer. CDS may be used to
insure a particular financial exposure as described in the example
above, or may be used speculatively. Because CDS may be traded on
public exchanges like stocks, or may be privately negotiated, the
exact amount of CDS contracts outstanding at a given time is
difficult to measure. Trading of CDS increased 100-fold from 1998
to 2008. Estimates for the face value of debt covered by CDS
contracts range from U.S. $33 to $47 trillion as of November
2008.[74]Many CDS covermortgage-backed securitiesorcollateralized
debt obligations(CDO) involved in the subprime mortgage crisis. CDS
are lightly regulated. There is no central clearinghouse to honor
CDS in the event a key player in the industry is unable to perform
its obligations. Required corporate disclosure of CDS-related
obligations has been criticized as inadequate. Insurance companies
such as AIG, MBIA, and Ambac faced ratings downgrades due to their
potential exposure due to widespread debt defaults. These
institutions were forced to obtain additional funds (capital) to
offset this exposure. In the case of AIG, its nearly $440 billion
of CDS linked to CDO resulted in a U.S. government bailout.[74]In
theory, because credit default swaps are two-party contracts, there
is no net loss of wealth. For every company that takes a loss,
there will be a corresponding gain elsewhere. The question is which
companies will be on the hook to make payments and take losses, and
will they have the funds to cover such losses. When investment
bankLehman Brotherswent bankrupt in September 2008, it created a
great deal of uncertainty regarding which financial institutions
would be required to pay off CDS contracts on its $600 billion in
outstanding debts.[75][76]Significant losses at investment bank
Merrill Lynch due to "synthetic CDO" (which combine CDO and CDS
risk characteristics) played a prominent role in its takeover by
Bank of America.[77]Effect on the Money Supply[edit]
Money Supply (M1) Increased During Crisis.One measure of the
availability of funds (liquidity) can be measured by themoney
supply. During late 2008, the most liquid measurement of the U.S.
money supply (M1) increased significantly as the government
intervened to inject funds into the system.The focus on managing
the money supply has been de-emphasized in recent history as
inflation has moderated in developed countries. Historically, a
sudden increase in the money supply might result in an increase in
interest rates to ward off inflation or inflationary
expectations.[78]Should the U.S. government create large quantities
of money to help it purchase toxic mortgage-backed securities and
other poorly-performing assets from banks, there is risk of
inflation and dollar devaluation relative to other countries.
However, this risk is of less concern to the Fed than deflation and
stagnating growth as of December, 2008.[79]Further, the dollar has
strengthened as other countries have lowered their own interest
rates during the crisis. This is because demand for a currency is
typically proportional to interest rates; lowering interest rates
lowers demand for a currency and thus it declines relative to other
currencies.During a January 2009 speech, Fed Chairman Ben Bernanke
described the strategy of lending against various types of
collateral as "Credit Easing" and explained the risks of inflation
as follows: "Some observers have expressed the concern that, by
expanding its balance sheet, the Federal Reserve is effectively
printing money, an action that will ultimately be inflationary. The
Fed's lending activities have indeed resulted in a large increase
in the excess reserves held by banks. Bank reserves, 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]
Vicious Cycles in the Subprime Mortgage CrisisCycle One: Housing
Market[edit]The firstvicious cycleis within the housing market and
relates to the feedback effects of payment delinquencies and
foreclosures on home prices. By September 2008, average U.S.
housing prices had declined by over 20% from their mid-2006
peak.[80][81]This major and unexpected decline in house prices
means that many borrowers have zero ornegative equityin their
homes, meaning their homes were worth less than their mortgages. As
of March 2008, an estimated 8.8 million borrowers 10.8% of all
homeowners had negative equity in their homes, a number that is
believed to have risen to 12 million by November 2008. Borrowers in
this situation have an incentive to "walk away" from their
mortgages and abandon their homes, even though doing so will damage
their credit rating for a number of years.[82]The reason is that
unlike what is the case in most other countries, American
residential mortgages arenon-recourse loans; once the creditor has
regained the property 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 ofmortgage-backed securities, which erodes the net worth
and financial health of banks. Thisvicious cycleis 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
firmsaround the globe havewritten downtheir holdings of subprime
related securities by US$501 billion.[84]Mortgage defaults and
provisions for future defaults caused profits at the 8533
USAdepository institutionsinsured 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 Reservedata indicates banks have significantly
tightened lending standards throughout the crisis.[87]Understanding
the shadow banking system[edit]A variety of non-bank entities have
emerged throughfinancial innovationover the past two decades to
become a critical part of the credit markets. These entities are
often intermediaries between banks or corporate borrowers and
investors and are called theshadow banking system. These entities
were not subject to the same disclosure requirements and capital
requirements as traditional banks. As a result, they became highly
leveraged while making risky bets, creating what critics have
called a significant vulnerability in the underpinnings of the
financial system.These entities also borrowed short-term, meaning
they had to go back to the proverbial well frequently for
additional funds, while purchasing long-term, illiquid (hard to
sell) assets. When the crisis hit and they could no longer obtain
short-term 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 1998Long-term
Capital Managementcrisis 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 SecretaryTimothy 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 theshadow 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
economistPaul Krugmandescribed 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]