Professional Documents
Culture Documents
By Shantanu Vashishth BFIA 1B THE BACKGROUND In approximately 20052006. High default rates on "subprime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan incentives such as easy initial terms and a longterm trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. Additionally, the economic incentives provided to the originators of subprime mortgages, along with outright fraud, increased the number of subprime mortgages provided to consumers who would have otherwise qualified for conforming loans. However, once interest rates began to rise and housing prices started to drop moderately in 20062007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices also resulted in 23% of U.S. In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 20022004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers. The value of American subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. Between 20042006 the share of subprime mortgages relative to total originations ranged from 18%21%, versus less than 10% in 20012003 and during 2007. In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures which began during that quarter. By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.[22] By January 2008, the delinquency rate had risen to 21% and by May 2008 it was 25%. THE CAUSES
Mortgage fraud
The Financial Crisis Inquiry Commission reported in January 2011 that: "...mortgage fraud...flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reportsreports of possible financial crimes filed by depository banks and their affiliatesrelated to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities.
EFFECTS
It is three years since Bear Stearns was pushed into the arms of J P Morgan and the fundamental debt problem has not been resolved. The debt has been moved around but not eliminated. This has undoubtedly bought time and I quite understand the point made frequently by my colleague on Free Exchange that governments and central banks have acted to protect workers from losing their jobs and to prevent consumption from collapsing. In this, they have had a fair degree of success. But the debt is still there. It must be eliminated by growth, inflation or default. In the case of Greece, the growth option looks out of the question and the country cannot really generate inflation on its own because it does not control its money supply; default at some stage seems inevitable. Like Greece, Portugal has a competitiveness as well as a debt problem; eliminating the former without depreciating the currency involves force-feeding the population with gruel for many years. At some stage, default may seem the better option. The US has better growth prospects than most European nations and has the "exorbitant privilege" of issuing debt in the world's reserve currency, which keeps the cost down. But it resembles one of those Greek myths when the hero's power is accompanied by a curse; in this case, a political system that is not designed for serious deficit-cutting (the point made by S&P). The world's dominant power tends to think its financial strength will never drain away. But Spain, having absorbed all that gold and silver from Latin America, still defaulted on its debts in the 16th century; Louis XIV, the sun king whom other monarchs dreamed of emulating, set France on the road to financial ruin; and Britain started the 20th century with a huge empire and piles of overseas assets but was rationing food in peacetime by the late 1940s.