The U.S. subprime mortgage crisis-- the late-2000s financial crisis

The U.S. subprime mortgage crisis was a set of events and conditions that led to the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages.

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The percentage of new lower-quality subprime mortgages rose from the historical 8% or lower range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S.[1][2] A high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable-rate mortgages.[3] Sony VAIO PCG-3D1M Battery

These two changes were part of a broader trend of lowered lending standards and higher-risk mortgage products.[3][4] Further, U.S. households had become increasingly indebted, with the ratio of debt to disposable personal income rising from 77% in 1990 to 127% at the end of 2007, much of this increase mortgage-related.[5] Sony VAIO PCG-3G2M Battery

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After U.S. house sales prices peaked in mid-2006 and began their steep decline forthwith, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, Sony VAIO PCG-5R1M Battery

Sony VAIO PCG-71312M Battery widely held by financial firms, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending.[1]

Sony VAIO PCG-7153M BatteryConcerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe.

Main articles: Subprime crisis background information, Subprime crisis impact timeline, United States housing bubble, and United States housing market correction

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The immediate cause or trigger of the crisis was the bursting of the United States housing bubble which peaked in approximately 2005–2006.[6][7] High default rates on "subprime" and adjustable rate mortgages (ARM), began to increase quickly thereafter. Sony VAIO PCG-7141M Battery

Lenders began originating large numbers of high risk mortgages from around 2004 to 2007, and loans from those vintage years exhibited higher default rates than loans made either before or after.[1]

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An increase in loan incentives such as easy initial terms and a long-term 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.

Sony VAIO PCG-7162M Battery Additionally, the increased market power of originators of subprime mortgages and the declining role of Government Sponsored Enterprises as gatekeepers increased the number of subprime mortgages provided to consumers who would have otherwise qualified for conforming loans.[1]

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The worst performing loans were securitized by private investment banks, who generally lacked the GSE's market power and influence over mortgage originators.[1] Once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult.

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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. homes worth less than the mortgage loan by September 2010, providing a financial incentive for borrowers to enter foreclosure.[8] Sony VAIO PCG-7143M Battery The ongoing foreclosure epidemic, of which subprime loans are one part, that began in late 2006 in the U.S. continues to be a key factor in the global economic crisis, because it drains wealth from consumers and erodes the financial strength of banking institutions. Sony VAIO PCG-3C1M Battery

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 2002–2004 contributed to easy credit conditions, which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, Sony VAIO PCG-3F1M Battery

credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.[9][10]

As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined,

Sony VAIO PCG-7186M Batterymajor global financial institutions that had borrowed and invested heavily in MBS reported significant losses. Defaults and losses on other loan types also increased significantly as the crisis expanded from the housing market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars globally.[11] Sony VAIO PCG-3H1M Battery

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While the housing and credit bubbles were growing, a series of factors caused the financial system to become increasingly fragile. Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system.

Sony VAIO PCG-9Z1M Battery Shadow banks were able to mask their leverage levels from investors and regulators through the use of complex, off-balance sheet derivatives and securitizations.[12]

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These instruments also made it virtually impossible to reorganize financial institutions in bankruptcy, and contributed to the need for government bailouts.[12] Some experts believe these institutions had become as important as commercial (depository) banks in providing credit to the U.S. economy,

Sony VAIO PCG-5P1M Battery but they were not subject to the same regulations.[13] These institutions as well as certain regulated banks had also assumed significant debt burdens while providing the loans described above and did not have a financial cushion sufficient to absorb large loan defaults or MBS losses.[14]

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These losses impacted the ability of financial institutions to lend, slowing economic activity. Concerns regarding the stability of key financial institutions drove central banks to take action to provide funds to encourage lending and to restore faith in the commercial paper markets, which are integral to funding business operations.

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Governments also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. Sony VAIO PCG-3J1M Battery

Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.[15] Sony VAIO PCG-8141M Battery

Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.[16] Leaders of the larger developed and emerging nations met in November 2008 and March 2009 to formulate strategies for addressing the crisis.[17] Sony VAIO PCG-8161M Battery

A variety of solutions have been proposed by government officials, central bankers, economists, and business executives.[18][19][20] In the U.S., the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 to address some of the causes of the crisis. Sony VAIO PCG-8161M Battery

[edit]Mortgage market

Number of U.S. residential properties subject to foreclosure actions by quarter (2007–2010).

Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers.[21Sony VAIO PCG-81112M Battery

] 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 called foreclosure.

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The value of American subprime mortgages was estimated at $1.3 trillion as of March 2007, [22] with over 7.5 million first-lien subprime mortgages outstanding.[23] Between 2004–2006 the share of subprime mortgages relative to total originations ranged from 18%–21%, versus less than 10% in 2001–2003 and during 2007.[24][25] Sony VAIO PCG-31111M Battery

Sony VAIO PCG-7195M BatteryThe boom in mortgage lending, including subprime lending, was also driven by a fast expansion of non-bank independent mortgage originators which despite their smaller share (around 25 percent in 2002) in the market have contributed to around 50 percent of the increase in mortgage credit between 2003 and 2005.[2Sony VAIO PCG-31311M Battery

Sony VAIO PCG-7194M Battery6] 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.[27] Sony VAIO PCG-8152M Battery

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.[28] By January 2008, the delinquency rate had risen to 21%[29] and by May 2008 it was 25%.[30] Sony VAIO PCG-61111M Battery

According to RealtyTrac, the value of all outstanding residential mortgages, owed by U.S. households to purchase residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6 trillion as of midyear 2008.[3Sony VAIO PCG-51112M Battery

Sony VAIO PCG-7192M Battery1] During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[32] This increased to 2.3 million in 2008, an 81% increase vs. 2007,[33] and again to 2.8 million in 2009, a 21% increase vs. 2008.[34]

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By August 2008, 9.2% of all U.S. mortgages outstanding were either delinquent or in foreclosure.[35] By September 2009, this had risen to 14.4%.[36] Between August 2007 and October 2008, 936,439 USA residences completed foreclosure.[37] Foreclosures are concentrated in particular states both in terms of the number and rate of foreclosure filings.[38Sony VAIO PCG-51212M Battery

] 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.[39]

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[edit]Causes

Further information: Causes of the 2007–2012 global financial crisis

The crisis can be attributed to a number of factors pervasive in both housing and credit markets, factors which emerged over a number of years. Causes proposed include the inability of homeowners to make their mortgage payments (due primarily to adjustable-rate mortgages resetting,

Sony VAIO PCG-81212M Battery borrowers overextending, predatory lending, and speculation), overbuilding during the boom period, risky mortgage products, increased power of mortgage originators, high personal and corporate debt levels, financial products that distributed and perhaps concealed the risk of mortgage default, bad monetary and housing policies, international trade imbalances, and inappropriate government regulation.[1][40][41][42][43] Sony VAIO PCG-41111M Battery

Three important catalysts of the subprime crisis were the influx of money from the private sector, the banks entering into the mortgage bond market and the predatory lending practices of the mortgage lenders, specifically the adjustable-rate mortgage, Sony VAIO PCG-41112M Battery

Sony VAIO PCG-81111M Battery2–28 loan, that mortgage lenders sold directly or indirectly via mortgage brokers.[44] On Wall Street and in the financial industry, moral hazard lay at the core of many of the causes.[45]

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In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008, leaders of the Group of 20 cited the following causes:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices,

Sony VAIO PCG-61412M Battery increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, Sony VAIO PCG-51212M Battery did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.[46]

During May 2010, Warren Buffett and Paul Volcker separately described questionable assumptions or judgments underlying the U.S. financial and economic system that contributed to the crisis. These assumptions included: 1) Housing prices would not fall dramatically;[47] Sony VAIO PCG-5G2M Battery

2) Free and open financial markets supported by sophisticated financial engineering would most effectively support market efficiency and stability, directing funds to the most profitable and productive uses; 3) Concepts embedded in mathematics and physics could be directly adapted to markets, in the form of various financial models used to evaluate credit risk; 4) Sony VAIO PCG-5J1M Battery

Economic imbalances, such as large trade deficits and low savings rates indicative of over-consumption, were sustainable; and 5) Stronger regulation of the shadow banking system and derivatives markets was not needed.[48] Sony VAIO PCG-5J4M Battery

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The U.S. Financial Crisis Inquiry Commission reported its findings in January 2011. It concluded that "the crisis was avoidable and was caused by: Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk;

Sony VAIO PCG-8112M Battery An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis; Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw; and systemic breaches in accountability and ethics at all levels.“[49] Sony VAIO PCG-5K1M Battery

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Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption.[50]

Sony VAIO PCG-7131M BatteryThe USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.[51] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Sony VAIO PCG-5K2M Battery

Between 1997 and 2006, the price of the typical American house increased by 124%.[52] During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[53] Sony VAIO PCG-5J5M Battery

This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.[5][54]

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While housing prices were increasing, consumers were saving less[55] and both borrowing and spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income.[56] During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.[57] Sony VAIO PCG-5L2M Battery

Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period.[58][59][60]

Sony VAIO PCG-7121M Battery 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.[61] From 2001 to 2007, U.S. mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63%, from $91,500 to $149,500, with essentially stagnant wages.[62] Sony VAIO PCG-6S4M Battery

This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006.[63] Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. Sony VAIO PCG-6W1M Battery

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Sony VAIO PCG-7113M BatteryThese mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term.

Borrowers who would not be able to make the higher payments once the initial grace period ended, were planning to refinance their mortgages after a year or two of appreciation. But refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

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As more borrowers stop paying their mortgage payments (this is an on-going crisis), foreclosures and the supply of homes for sale increases. This places downward pressure on housing prices, which further lowers homeowners' equity.

Sony VAIO PCG-8Z2M BatteryThe decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.[64]

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By September 2008, average U.S. housing prices had declined by over 20% from their mid-2006 peak.[65][66] This major and unexpected decline in house prices means that many borrowers have zero or negative equity in their homes, meaning their homes were worth less than their mortgages.

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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. By September 2010, 23% of all U.S. homes were worth less than the mortgage loan.[8]

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Borrowers in this situation have an incentive to default on their mortgages as a mortgage is typically nonrecourse debt secured against the property.[67] Economist Stan Leibowitz argued in the Wall Street Journal that although only 12% of homes had negative equity, they comprised 47% of foreclosures during the second half of 2008. Sony VAIO PCG-6W2M Battery

He concluded that the extent of equity in the home was the key factor in foreclosure, rather than the type of loan, credit worthiness of the borrower, or ability to pay.[68]

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981.[69] Sony VAIO PCG-7Z1M Battery Furthermore, nearly four million existing homes were for sale,[70] of which almost 2.9 million were vacant.[71]

This overhang of unsold homes lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.[72]

Sony VGP-BPS26A BatteryA report in January 2011 stated that U.S. home values dropped by 26 percent from their peak in June 2006 to November 2010, more than the 25.9 percent drop between 1928 to 1933 when the Great Depression occurred.[73]

[edit]Homeowner speculation

Main article: Speculation

Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis.[74]

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During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, Sony PCG-61211M Battery

a record level of nearly 40% of homes purchased were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."[75]

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Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, Sony PCG-71213M Battery

Sony PCG-91111M Battery this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.[76] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.[77]

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Nicole Gelinas of the Manhattan Institute described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment.[78]

Sony PCG-61714M Battery Economist Robert Shiller argued that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."[79Sony PCG-71311M Battery

Sony PCG-91211M Battery] Keynesian economist Hyman Minsky described how speculative borrowing contributed to rising debt and an eventual collapse of asset values.[80][81]

Warren Buffett testified to the Financial Crisis Inquiry Commission: "There was the greatest bubble I've ever seen in my life...The entire American public eventually was caught up in a belief that housing prices could not fall dramatically."[47] Sony PCG-71313M Battery

[edit]High-risk mortgage loans and lending/borrowing practices

A mortgage brokerage in the US advertising subprime mortgages in July 2008.

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers,[1][8

Sony PCG-71911M Battery2] including undocumented immigrants.[83] Lending standards particularly deteriorated in 2004 to 2007, as the GSEs market share declined and private securitizers accounted for more than half of mortgage securitizations.[1] Sony PCG-71212M Battery

Subprime mortgages amounted to $35 billion (5% of total originations) in 1994,[84] 9% in 1996,[85] $160 billion (13%) in 1999,[84] and $600 billion (20%) in 2006.[85][86][87] A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and 2007. Sony PCG-71811M Battery

The combination of declining risk premiums and credit standards is common to boom and bust credit cycles.[88]

In addition to considering higher-risk borrowers, lenders had offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.[89] By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences.[90]

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Growth in mortgage loan fraud based upon US Department of the Treasury Suspicious Activity Report Analysis.

The mortgage qualification guidelines began to change. At first, the stated income, verified assets (SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to "state" it and show that they had money in the bank. Then, the no income, verified assets (NIVA) loans came out.

Sony VGP-BPS26A Battery The lender no longer required proof of employment. Borrowers just needed to show proof of money in their bank accounts. The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA. NINA is an abbreviation of No Income No Assets (sometimes referred to as Ninja loans).

Sony VGP-BPS26 BatteryBasically, NINA loans are official loan products and let you borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score.[91]

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Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal.

Sony VGP-BPS22A Battery Nearly one in 10 mortgage borrowers in 2005 and 2006 took out these “option ARM” loans, which meant they could choose to make payments so low that their mortgage balances rose every month.[62] An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[85] Sony Vaio PCG-31111M Battery

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The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. However, there are many factors other than credit score that affect lending. Sony Vaio PCG-31112M Battery

In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARM's even to those with credit ratings that merited a conforming (i.e., non-subprime) loan.[92]

Mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation.[93]

Sony PCG-91111M BatteryIn 2007, 40% of all subprime loans resulted from automated underwriting.[94][95] The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.[96] Mortgage fraud by lenders and borrowers increased enormously.[97] Sony Vaio PCG-31113M Battery

The Financial Crisis Inquiry Commission reported in January 2011 that many mortgage lenders took eager borrowers’ qualifications on faith, often with a "willful disregard" for a borrower’s ability to pay. Nearly 25% of all mortgages made in the first half of 2005 were "interest-only" loans. Sony Vaio PCG-31114M Battery

During the same year, 68% of “option ARM” loans originated by Countrywide Financial and Washington Mutual had low- or no-documentation requirements.[62]

So why did lending standards decline? At least one study has suggested that the decline in standards was driven by a shift of mortgage securitization from a tightly controlled duopoly to a competitive market in which mortgage originators held the most sway.[1] Sony Vaio PCG-31111M Battery

The worst mortgage vintage years coincided with the periods during which Government Sponsored Enterprises were at their weakest, and mortgage originators and private label securitizers were at their strongest.[1]

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Why was there a market for these low quality private label securitizations? In a Peabody Award winning program, NPR correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Sony Vaio PCG-31112M Battery

Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies.

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In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them.

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By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable. NPR described it this way:[98] Sony Vaio PCG-31113M Battery

The problem was that even though housing prices were going through the roof, people weren't making any more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the more tenuous the whole thing became. Sony Vaio PCG-31114M Battery

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No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they couldn't possibly afford, no matter what the mortgage machine tried, the people just couldn't swing it. By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times.
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And mortgage lenders noticed something that they'd almost never seen before. People would close on a house, sign all the mortgage papers, and then default on their very first payment. No loss of a job, no medical emergency, they were underwater before they even started. And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped. Sony Vaio PCG-31112M Battery

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[edit]Mortgage fraud

In 2004, the Federal Bureau of Investigation warned of an "epidemic" in mortgage fraud, an important credit risk of nonprime mortgage lending, which, they said, could lead to "a problem that could have as much impact as the S&L crisis".

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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 reports – reports of possible financial crimes filed by depository banks and their affiliates – related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. Sony Vaio PCG-31113M Battery

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."[62] Sony Vaio PCG-31114M battery

New York State prosecutors are examining whether eight banks hoodwinked credit ratings agencies, to inflate the grades of subprime-linked investments. The Securities and Exchange Commission,

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the Justice Department, the United States attorney’s office and more are examining how banks created, rated, sold and traded mortgage securities that turned out to be some of the worst investments ever devised. As of 2010, virtually all of the investigations, criminal as well as civil, are in their early stages.[103]

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Further information: Securitization and Mortgage-backed security

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining the credit (default) risk. Securitization is a process whereby loans or other income generating assets are bundled to create bonds which can be sold to investors. The modern version of U.S.
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Sony PCG-71213M Battery mortgage securitization started in the 1980s, as Government Sponsored Enterprises (GSEs) began to pool relatively safe conventional conforming mortgages, sell bonds to investors, and guarantee those bonds against default on the underlying mortgages.[1]

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A riskier version of securitization also developed in which private banks pooled non-conforming mortgages and generally did not guarantee the bonds against default of the underlying mortgages.[1] In other words,

Sony VAIO PCG-9Z1M BatteryGSE securitization transferred only interest rate risk to investors, whereas private label (investment bank or commercial bank) securitization transferred both interest rate risk and default risk.[1]

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With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which banks essentially sell the mortgages and distribute credit risk to investors through mortgage-backed securities and collateralized debt obligations (CDO). Sony VAIO PCG-3C1M Battery

The sale of default risk to investors created a moral hazard in which an increased focus on processing mortgage transactions was incentivized but ensuring their credit quality was not.[104][105]

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In the mid-2000s, GSE securitization declined dramatically as a share of overall securitization, while private label securitization dramatically increased.[1] Most of the growth in private label securitization was through high-risk subprime and Alt-A mortgages.[1] As private securitization gained market share and the GSEs retreated, mortgage quality declined dramatically.[1] Sony VAIO PCG-3F1M Battery

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Sony VAIO PCG-31111M Battery The worst performing mortgages were securitized by the private banks, whereas GSE mortgages continued to perform better than the rest of the market, including mortgages that were not securitized and were instead held in portfolio.[1]

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Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.[88

Sony VAIO PCG-7171M Battery] A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007.[106]

American homeowners, consumers, and corporations owed roughly $25 trillion during 2008. American banks retained about $8 trillion of that total directly as traditional mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. Sony VAIO PCG-3H1M Battery

Sony VAIO PCG-9Z1M BatteryThe remaining $10 trillion came from the securitization markets. The securitization markets started to close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private credit markets thus became unavailable as a source of funds.[107][108

Sony VAIO PCG-8131M Battery] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.[109]

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A more direct connection between securitization and the subprime crisis relates to a fundamental fault in the way that underwriters, rating agencies and investors modeled the correlation of risks among loans in securitization pools.

Sony VAIO PCG-5P1M BatteryCorrelation modeling – determining how the default risk of one loan in a pool is statistically related to the default risk for other loans – was based on a "Gaussian copula" technique developed by statistician David X. Li. This technique, widely adopted as a means of evaluating the risk associated with securitization transactions, used what turned out to be an overly simplistic approach to correlation.

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Unfortunately, the flaws in this technique did not become apparent to market participants until after many hundreds of billions of dollars of ABSs and CDOs backed by subprime loans had been rated and sold. By the time investors stopped buying subprime-backed securities – which halted the ability of mortgage originators to extend subprime loans – the effects of the crisis were already beginning to emerge.[110]

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Nobel laureate Dr. A. Michael Spence wrote: "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." [111]

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[edit]Inaccurate credit ratings

Main article: Credit rating agencies and the subprime crisis

MBS credit rating downgrades, by quarter.

Credit rating agencies are now under scrutiny for having given investment-grade ratings to MBSs based on risky subprime mortgage loans. These high ratings enabled these MBSs to be sold to investors, thereby financing the housing boom.

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These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty.[112] Sony VAIO PCG-3J1M Battery

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.[113] On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities.[114] Sony VAIO PCG-3D1M Battery

On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.[115]

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Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage-backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios.

Sony VAIO PCG-71312M Battery If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.[116]

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The Financial Crisis Inquiry Commission reported in January 2011 that: "The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them,

Sony VAIO PCG-41112M Battery often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms." Sony VAIO PCG-3G2M Battery

The Report further stated that ratings were incorrect because of "flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight."[62]

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[edit]Government policies

Main article: Government policies and the subprime mortgage crisis

U.S. Subprime lending expanded dramatically 2004–2006.

Government over-regulation, failed regulation and deregulation have all been claimed as causes of the crisis. In testimony before Congress both the Securities and Exchange Commission (SEC) and Alan Greenspan claimed failure in allowing the self-regulation of investment banks.[117][118]

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In 1982, Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to write adjustable-rate mortgages. Among the new mortgage loan types created and gaining in popularity in the early 1980s were adjustable-rate, option adjustable-rate,

Sony VAIO PCG-7154M Battery balloon-payment and interest-only mortgages. These new loan types are credited with replacing the long standing practice of banks making conventional fixed-rate, amortizing mortgages. Among the criticisms of banking industry deregulation that contributed to the savings and loan crisis was that Congress failed to enact regulations that would have prevented exploitations by these loan types.

Sony VAIO PCG-7151M Battery Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate mortgages.[44][119] Approximately 90% of subprime mortgages issued in 2006 were adjustable-rate mortgages.[3]

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Although a number of politicians, pundits, and financial industry-funded think tanks have claimed that government policies designed to promote affordable housing were an important cause of the financial crisis, detailed analyses of mortgage data by the Financial Crisis Inquiry Commission, Federal Reserve Economists,

Sony VAIO PCG-7141M Battery and independent academic researchers suggest that this claim is probably not correct.[1] [120] Community Reinvestment Act loans outperformed other "subprime" mortgages, and GSE mortgages performed better than private label securitizations.

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Increasing home ownership has been the goal of several presidents including Roosevelt, Reagan, Clinton and George W. Bush.[121] In 1995, the GSEs like Fannie Mae began receiving government tax incentives for purchasing mortgage backed securities which included loans to low income borrowers.[122]

Sony VAIO PCG-7194M Battery In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.[123]

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From 2002 to 2006, as the U.S. subprime market grew 292% over previous years, Fannie Mae and Freddie Mac combined purchases of subprime securities rose from $38 billion to around $175 billion per year before dropping to $90 billion per year,

Sony VAIO PCG-51111M Batterywhich included $350 billion of Alt-A securities. Fannie Mae had stopped buying Alt-A products in the early 1990s because of the high risk of default. By 2008, the Fannie Mae and Freddie Mac owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market.[124]

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The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion.[125] When concerns arose in September 2008 regarding the ability of the GSE to make good on their guarantees, the Federal government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers' expense.[126][127]

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The Financial Crisis Inquiry Commission reported in 2011 that Fannie & Freddie "contributed to the crisis, but were not a primary cause."[128][1

Sony VAIO PCG-71112M Battery29] GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders into subprime lending.[62]

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The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act.

Sony VAIO PCG-51212M BatteryHe called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.[130]

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