THE US SUB-PRIME CRISIS: HOW DID IT HAPPEN?

The US sub-prime mortgage crash created economic reverberations across the world, impacting
treasury in the form of a liquidity crunch. But what conditions in the US caused the sub-prime crisis?

In response to the ‘dot com collapse’ in 2000 and the September 11 terrorist attacks in 2001, the
Federal Reserve decided to create capital liquidity by lowering interest rates. The objective was to boost
the US economy by encouraging borrowing, spending and investments. It worked and the economy
began to stabilize in 2002. However, this went on to provide a thrust to the ever-increasing real estate
prices, and later resulted in the sub-prime mortgage meltdown.

Analysis of the events has focused on potential dynamics among the number of different dynamics that
contributed to the US sub-prime mortgage crisis. The house prices appreciated following the general
principle of demand and supply - when demand is more than the supply, price increases. Everyone
predicted that housing values would always appreciate and therefore when customers wanted to buy as
an investment, banks also started lending to sub-prime borrowers, as they receive higher profits over
high mortgage rates associated with sub-prime lending. Financial institutions thought it was a safe
product, as even if a sub-prime customer entered into delinquency, banks could always sell the property
at much higher price and earn more profits. Banks were further reducing the risk by selling the
repackaged mortgage product to other financial institutions worldwide. But then why did investors put
their money in such a risky portfolio? Well, simply, even they believed house prices would continue to
increase.

The house prices did increase and reached such a level that it was completely out of buyers affordability
limit. Again the general demand and supply principle was followed - when the supply is more than
demand, price depreciates. When the house prices begin to fall, not only did the borrowers fail to make
the high interest-based payments but the financial institutions also stopped investing in the mortgage-
based investment products. In order to compensate for losses, banks increased the mortgage rates,
which made the conditions even worse and resulted in higher delinquency rates.

Why Sub-prime?

Sub-prime lending is the practice of providing loans to borrowers who do not qualify for the best market
rates, or have a deficient credit history (credit score less than 620). This is a risky proposition for both
borrowers and lenders due to the high interest rates on the loans; poor credit history; higher fees and
pre-payment penalties; balloon payment and adverse financial situations usually associated with sub-
prime borrowers. A number of factors and causes gave rise to the 2007 US mortgage crisis.

Housing Bubble in the US

The US housing bubble is an economic bubble that began in 2001, reached its peak in 2005, and then
started to plummet in 2006 (Figure 1). The US home construction index was down by over 40% in mid-
August 2006, compared to 2005.
 Figure 1: US Home Sales in Millions

Source: National Association of Realtors

The main reasons for the increase in housing sales could be:

 Low interest rates - After the dot com crash and recession in 2001-02, the Federal
Reserve cut short-term interest rates from 6.5% to 1%. This reduced the cost of
borrowing, but resulted in an increase in housing prices.
 Risky mortgage products and lax lending standards - Products like sub-prime
mortgages, adjustable rate mortgages, and interest-only mortgages, were tempting
due to their low introductory prices and minimal down payment. This encouraged
borrowers to invest in homes/real estate.
 Purchasing homes as an investment - It is also believed that the stock market crash in
2000, which subsequently led to a 70% drop in the NASDAQ, could also be one of the
factors. People pulled out their money from the stock market and invested in housing,
which then seemed like a more reliable source of investment.
Despite the rise in housing prices in US, there were differing prices in across the various states of the
country. This gave rise to the argument that the US didn't have a nationwide bubble, but a number of
local bubbles (Figure 2).

Figure 2: Inflation Adjusted Housing Prices in the US (by state - 1998-2006)

Source: Office of Federal Housing Enterprise Oversight

Seven metropolitan areas (Tampa, Miami, San Diego, Los Angeles, Las Vegas, Phoenix, and Washington
DC) appreciated more than 80%. Since we know that the above-mentioned areas witnessed significant
rise in house prices, let us also review the ethnic groups that dominate these regions.

Figure 3: Sub-prime Lending Across Different US Cities

Source: FFIEC

Although examining the sub-prime crisis with respect to geography and race could be misleading, it can
help us in analyzing a common pattern. Looking at all mortgages reported to the federal government
(Table 1), we can infer that the rate of sub-prime lending is far higher for ethnic minorities than for
white people, even at higher income levels.

Table 1: Ethnicity and Sub-prime Lending in the US

Earnings Ethnicity %
Non-Hispanic Whites 24
US$125,000 - 150,000 Hispanics 52
Non-Hispanic Blacks 63
Non-Hispanic Whites 20
US$150,000 - 250,000 Hispanics 50
Non Hispanic Blacks 62

According to the Federal Reserve data, about 46% of Hispanics and 55% of the black population who
took purchase mortgages in 2005 got higher-cost loans, compared to about 17% of whites and Asians.

It can also be understood that the minority community immigrants (who don't have sufficient credit
rating or document proof) were targeted for high-cost, high-risk mortgages in a kind of reverse red-
lining.
High Default Rates on Sub-prime
Loan incentives like 'interest-only' repayment terms and low initial teaser rates (which later reset to
higher, floating rates) encouraged borrowers to assume mortgages more than their affording limit,
believing they would be able to refinance later when house prices appreciated. When the US house
prices continued to increase during the 1996-2006 period, refinancing was available. However, once
house prices started to drop moderately in 2006-2007 (due to the increased interest rates) in many
parts of the US, refinancing became more difficult (as there was no equity being created), making
interest payments unaffordable for borrowers, which caused a dramatic increase in defaults and
foreclosure activity.

By October 2007, 16% of sub-prime loans with adjustable rate mortgages (ARMs) were 90-days into
default or in foreclosure proceedings - roughly triple the rate of 2005. Sub-prime 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.

Role of Financial Institutions

A variety of factors have caused lenders to offer increasingly high-risk loans to high-risk borrowers. The
share of sub-prime mortgages to total mortgages from 1994 - 2006 is as follows:

 1994 - 5%
 1996 - 9%
 1999 - 13%
 2006 - 20%
Figure 4: Sub-prime Mortgage Originations

A study by the Federal Reserve indicated that the average difference in mortgage interest rates between
sub-prime and prime mortgages declined from 2.8% (280 basis points) in 2001 to 1.3% in 2007. In other
words, the risk premium required by lenders to offer a sub-prime loan declined, which left banks with
ample capital to lend, and increased willingness to undertake additional risk to increase their investment
returns.
Also, due to securitization, lending institutions thought that they were managing liquidity, capturing the
market share, and passing the risk to third-party investors. The securitized share of sub-prime
mortgages (i.e. those passed to third-party investors) increased from 54% in 2001, to 75% in 2006. Each
link in the mortgage chain thought they were collecting profits, while believing it was passing on risk.

Apart from considering higher-risk borrowers, lenders have offered risky mortgage products and
incentives to borrowers. One example is the interest-only adjustable-rate mortgage, which allows the
homeowner to pay just the interest (not principal) during an initial period. Another example is a
'payment option' loan, in which the homeowner can pay a variable amount, but any interest not paid is
added to the principal.

Role of Mortgage Brokers

Mortgage brokers receive incentives and higher commissions for selling riskier loans. According to a
study by Wholesale Access Mortgage Research & Consulting, in 2004 mortgage brokers originated 68%
of all residential loans in the US, with sub-prime and Alt-A loans accounting for 42.7% of brokerages
total production volume. Brokers definitely received profits from the home buying boom, but didn't do
enough to calculate if borrowers would repay in case the interest rates increased.

Role of Mortgage Underwriters

Underwriters determine if the risk of lending to a particular borrower under certain parameters is
acceptable or not. To help them, the bank creates guidelines, which help them to analyze various
aspects of mortgage and make recommendations.

In 2007, 40% of all sub-prime loans were generated by automated underwriting. This was because, prior
to automating the process, getting an answer from an underwriter took up to a week. With automated
systems, lending institutions were able to generate a decision within 30 seconds.

Role of Credit Rating Agencies

A lot of criticism has been directed towards the rating agencies for giving high AAA ratings, signaling
relative safety as an investment to the collateralized debt obligations and other mortgage-backed
securities that included sub-prime loans in their mortgage pools. Had the ratings been more accurate,
would fewer investors have bought into these securities?

Conclusion
All economies are complex and can be hard to predict. High fragility leads to a higher risk of crisis. After
the 2001 recession in the US, more loans definitely led to more investments and the economy started
growing. This encouraged lenders to offer credit, even without sufficient guarantees. The US economy
took on far too risky credit and it was only a matter of time for this risk to appear in the form of financial
and economic crisis.