Subprime Burst .Com

FEB 18, 2009

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SUBPRIME FALLOUT

I will begin this article by extending my heartfelt sympathies and prayers to the families of those affected by the southern storms that devastated their lives on Super Tuesday, the night of the biggest primaries. I will also take this opportunity to apologize to those who might take offense from this article for it is not meant to belittle their loss nor that of the Katrina victims, the southern California fire storm victims or any other victims of disasters here in America.

America and more so the Administration has to wake up to the realization that the mortgage crisis is just as big and devastating as the above mentioned calamities with the major difference of lives lost or people getting injured. The economic loss from hurricane Katrina was estimated at $89 billion. The damage from the California fires came in at a moderate $2 billion while the damage in the south is still being assessed but is widely expected to be under $10 billion. Today, with over 6,000,000 homes in distress, the estimated loss from these defaulted loans is quickly approaching $3.5 trillion. While these homes will eventually be sold hence offsetting this ridiculously high figure, they are not expected to fetch half their market value because they were bought when the market was heavily, one might argue fraudulently inflated. The scary reality is this is the first wave; the Alt A and primes are on the way. Americans are being rendered homeless while perfectly good homes sit uninhabited.

There was a massive fraud that occurred in the last 5 years when the subprime market was in its prime. Cities as well as county planning commissions are most to blame for encouraging and permitting the home builders and developers to flood the market with luxurious and unaffordable homes at the expense of the affordable and family friendly homes. New subdivisions sprung up in orchards and farmlands and in the case of Nevada and Arizona homes grew up in the deserts with home size averaging 2800 square feet, a luxury most of us dreamt of, but could not afford. The above mentioned authorities have the obligation of ensuring that mega development projects take into consideration the plight of the average man as well as the poor and not just cater for the rich. In the last 5 years this City and County officials failed their respective citizens in this regard and should lead the charge on imposing a moratorium to prevent foreclosures which ultimately lead to evictions as well as vandalism, a sore sight in any neighborhood. Both the Federal and State legislators failed their respective citizens by not acting to slow down the greed driven exploitation of Americans by the banks. Both these august bodies have the economic data readily available to them that clearly states the average income in each state, congressional district and constituency. Rather than gloat over the fact that the new developments were beautifying their respective geopolitical bases, they should have really acted to check the wanton fraud that was going on. When you have burger-flippers at McDonalds buying $½ million homes, and in some cases two or three at a time, just because the banks are looking at their credit reports and relying on their stated incomes, and doing very little if anything at all to verify the buyer’s ability to keep their obligations then there is a big problem. Everyone was in on it, from the home buyer, to the realtor showing the home, to the loan officer preparing the loan applications, to the brokers brokering the loans, to the underwrites at the banks and above all, the heads of the banks who also have access to the average incomes of all the states in the union. Indeed the scenario was so bad that after identifying a home, people were literally talked out of buying within their range to buying what the matrices said they would qualify for based on their credit reports. In most cases, their incomes were immaterial for they were asked to sign blank statements and the loan officers would fill out the rest for them. This is the biggest fraud in history and should be mitigated as that. Anything else is an insult to our intelligence.

So bad was this fraud that those who had paid off their mortgages woke up one morning to realize that they were sitting on a fortune of accrued equity. This coupled with the bombardment of refinance offers received in the mail and the ease of getting credit and unprecedented amounts of money without actually showing the ability to repay it, suckered many hardworking American home owners to make the deal with the devil and refinance their homes and now are faced with the resetting interests and possibility of loosing the homes they had come to love. This is a disaster of unproportional magnitude. This is equivalent to 50 cat-5 hurricanes hitting each state in the union simultaneously. This is as bad as it gets. These are toxic mortgages whose true value, or lack-there-of is a secret most economists and the administration do not care to divulge to the public because the magnitude will definitely bring down the mighty empire, the USA. To add insult to injury, the job migration that began in the 90s and escalated in the last 5 years when Americans were really amassing all these mortgage debts, set us up for a hostile take over by those who masquerade as friends and yet take pride and joy in bleeding us at every opportune. Indeed they find pleasure in squeezing us as is evidenced by the OPEC which increases or decreases the amount of oil in the market by the snap of their fingers effectively determining the cost per barrel of oil.

The school of thought that is of the opinion that we are systematically loosing our country to the foreigners is increasingly gaining credibility especially with every major cash influx into an ailing bank. The theory goes further to say that just like the terrorists used our planes to hit us on 911, so are these foreigners using our economy against us to take away our country from us. We must never forget that some countries took offense in the Louisiana purchase of 1869 and would love a shot at repealing it. The Government should be very wary of the sovereign investment funds especially those coming from the not so friendly Arabian and Asian Countries. The Chinese, Saudis, Qatari, Kuwaiti and UAE have several trillion dollars set aside for investing in the US; these governments have noticed a limp in our gait and are literally rushing for our jugular. If these religious fanatics are squeezing our balls with the oil in their countries, what will they do when they take over our country? Are they going to institute Sharia? Will we actually see the President being sworn in on the Koran by 2016?

I’m neither a racist, a fear monger, nor a pessimist; nevertheless this school of thought is gaining credibility by the day and until I hear otherwise, you may need a caterpillar to move me from it. Unless the Government does something dramatic to mitigate the housing disaster, then nothing else really makes a lot of sense at this point. Of course this is just an informed opinion, you can form yours.

COMMENTS

Subprime lending

(also known as B-paper, near-prime, or second chance lending) is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The phrase also refers to banknotes taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals.

Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal), not the interest rate on the loan itself.

Subprime lending is highly controversial. Opponents have alleged that the subprime lending companies engage in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. There have also been charges of mortgage discrimination on the basis of race. Proponents of the subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market.

The controversy surrounding subprime lending has expanded as the result of an ongoing lending and credit crisis both in the subprime industry, and in the greater financial markets which began in the United States. This phenomenon has been described as a financial contagion which has led to a restriction on the availability of credit in world financial markets. Hundreds of thousands of borrowers have been forced to default and several major American subprime lenders have filed for bankruptcy. <

History

Subprime lending evolved with the realization of a demand in the marketplace and businesses providing a supply to meet it. With bankruptcies and consumer proposals being widely accessible, a constantly fluctuating economic environment, and consumer debt loan on the rise, traditional lenders are more cautious and have been turning away a record number of potential customers. Statistically, approximately 25% of the population of the United States falls into this category.

In the third quarter of 2007, Subprime ARMs only represent 6.8% of the mortgages outstanding in the US, yet they represent 43.0% of the foreclosures started. Subprime fixed mortgages represent 6.3% of outstanding loans and 12.0% of the foreclosures started in the same period.

American Dialect Society voted subprime the Word of the year for 2007 on January 04, 2008.

Definition

While there is no official credit profile that describes a subprime borrower, most in the United States have a credit score below 723. Fannie Mae has lending guidelines for what it considers to be "prime" borrowers on conforming loans. Their standard provides a good comparison between those who are "prime borrowers" and those who are "subprime borrowers." Prime borrowers have a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more than 75% of net income pays for housing and other debt), and a combined loan to value ratio of 90%, meaning that the borrower is paying a 10% downpayment. Any borrower seeking a loan with less than those criteria is a subprime borrower by Fannie Mae standards.

Subprime lenders

To access this increasing market, lenders often take on risks associated with lending to people with poor credit ratings. Subprime loans are considered to carry a far greater risk for the lender due to the aforementioned credit risk characteristics of the typical subprime borrower. Lenders use a variety of methods to offset these risks. In the case of many subprime loans, this risk is offset with a higher interest rate. In the case of subprime credit cards, a subprime customer may be charged higher late fees, higher over limit fees, yearly fees, or up front fees for the card. Subprime credit card customers, unlike prime credit card customers, are generally not given a "grace period" to pay late. These late fees are then charged to the account, which may drive the customer over their credit limit, resulting in over limit fees. Thus the fees compound, resulting in higher returns for the lenders. These increased fees compound the difficulty of the mortgage for the subprime borrower, who is defined as such by their unsuitability for credit.

Subprime borrowers

Subprime offers an opportunity for borrowers with a less than ideal credit record to gain access to credit. Borrowers may use this credit to purchase homes, or in the case of a cash out refinance, finance other forms of spending such as purchasing a car, paying for living expenses, remodeling a home, or even paying down on a high interest credit card. However, due to the risk profile of the subprime borrower, this access to credit comes at the price of higher interest rates. On a more positive note, subprime lending (and mortgages in particular), provide a method of "credit repair"; if borrowers maintain a good payment record, they should be able to refinance back onto mainstream rates after a period of time. Credit repair usually takes twelve months to achieve; however, in the UK, most subprime mortgages have a two or three-year tie-in, and borrowers may face additional charges for replacing their mortgages before the tie-in has expired.

Generally, subprime borrowers will display a range of credit risk characteristics that may include one or more of the following:

• Two or more loan payments paid past 60 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months;
• Judgment, foreclosure, repossession, or non-payment of a loan in the prior 48 months;
• Bankruptcy in the last 7 years;
• Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 620 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood.

Types

Subprime mortgages

As with subprime lending in general, subprime mortgages are usually defined by the type of consumer to which they are made available. According to the U.S. Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment deliquencies, 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."

In addition, many subprime mortgages have been made to borrowers who lack legal immigration status in the United States

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranges from 300 to 850. Subprime mortgage loans have a much higher rate of default than prime mortgage loans and are priced based on the risk assumed by the lender.

Although most home loans do not fall into this category, subprime mortgages proliferated in the early part of the 21st Century. About 21 percent of all mort¬gage originations from 2004 through 2006 were subprime, up from 9 percent from 1996 through 2004, says John Lonski, chief economist for Moody's In¬vestors Service. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the U.S. home loan market.
There are many different kinds of subprime mortgages, including:

• interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5–10 years);
• "pick a payment" loans, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);
• and initial fixed rate mortgages that quickly convert to variable rates.

This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group include the "2-28 loan", which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the "2-28" include the "3-27" and the "5-25".

Subprime credit cards

Credit card companies in the United States began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the 1990s. These cards usually begin with low credit limits and usually carry extremely high fees and interest rates as high as 30% or more. In 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased dramatically, and many subprime credit card issuers were forced to scale back or cease operations.

In 2007, many new subprime credit cards began to sprout forth in the market. As more vendors emerged, the market became more competitive, forcing issuers to make the cards more attractive to consumers. Interest rates on subprime cards now start at 9.9% but in some cases still range up to 24% APR.

Subprime credit cards however can help a consumer improve poor credit scores. Most subprime cards report to major credit reporting agencies such as TransUnion and Equifax. Consumers that pay their bills on time should see positive reporting to these agencies within 90 days.

Proponents

Individuals who have experienced severe financial problems are usually labelled as higher risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually these events were unforeseen and cause a major setback in finances. As a result, late payments, charge-offs, repossessions and even foreclosures may result.

Due to these previous credit problems, these individuals may also be precluded from obtaining any type of loan for an automobile. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to pay a higher interest rate, may allow loans which otherwise may not occur.

From a servicing standpoint, these loans have higher collection defaults and experience higher repossessions and charge offs. Lenders use the higher interest rate to offset these anticipated higher costs.

Provided a consumer will enter into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be underserved. The consumer must purchase an automobile which is well within their means, and carries a payment well within their budget.

Criticism

Capital markets operate on the basic premise of risk versus reward. Investors taking a risk on stocks expect a higher rate of return than do investors in risk-free Treasury bills, which are backed by the full faith and credit of the United States. The same goes for loans. Less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan.

To avoid the initial hit of higher mortgage payments, most subprime borrowers take out adjustable-rate mortgages (or ARMs) that give them a lower initial interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up charging much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,470. A 6-percentage-point increase in the rate caused slightly more than an 85% increase in the payment.

On the other hand, interest rates on ARMs can also go down - in the US, the interest rate is tied to federal government-controlled interest rates, so when the Fed cuts rates, ARM rates go down, too. ARM interest rates usually adjust once a year, and the rate is based on an average of the federal rates over the last 12 months. Also, most ARMs limit the amount of change in a rate.

The cycle of increased fees due to default-prone borrowers defaulting is a vicious cycle. Though some subprime borrowers may be able to repair their credit rating, many default and enter the vicious cycle. While this enhances the profits of the subprime lender, it also leads to further vicious cycling as the subprime lenders are unable to recover what has been lent to subprime borrowers. Hence the current subprime mortgage crisis.

Mortgage discrimination

Main article: Mortgage discrimination Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race. African Americans and other minorities disproportionately fall into the category of "subprime borrowers" because of lower credit scores, higher debt-to-income ratios, and higher combined loan to value ratios. Because they are higher risk borrowers, they are more likely to seek subprime mortgages with higher interest rates than their white counterparts. Even when median income levels were comparable, home buyers in minority neighborhoods were more likely to get a loan from a subprime lender. Interest rates and the availability of credit are often tied to credit scores, and the results of a 2004 Texas Department of Insurance study found that of the 2 million Texans surveyed, "black policyholders had average credit scores that were 10% to 35% worse than those of white policyholders. Hispanics' average scores were 5% to 25% worse, while Asians' scores were roughly the same as whites." African-Americans are in the aggregate less likely to have a higher than average credit score and so take on higher levels of debt with smaller down-payments than whites and Asians of similar incomes.

The subprime mortgage financial crisis of 2007 was a sharp rise in home foreclosures which started in the United States during the fall of 2006 and became a global financial crisis within a year.

The crisis began with the bursting of the housing bubble in the U.S. and high default rates on "subprime", adjustable rate, "Alt-A", and other mortgage loans made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. The share of subprime mortgages to total originations increased from 9% in 1996, to 20% in 2006. Further, loan incentives including "interest only" repayment terms and low initial teaser rates (which later reset to higher, floating rates) encouraged borrowers to assume mortgages believing they would be able to refinance at more favorable terms later. While U.S. housing prices continued to increase during the 1996-2006 period, refinancing was available. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically. By October 2007, 16% of subprime loans with adjustable rate mortgages (ARM) were 90-days into default or in foreclosure proceedings, roughly triple the rate of 2005. Subprime ARMs only represent 6.8% of the loans outstanding in the US, yet they represent 43.0% of the foreclosures started during the third quarter of 2007.

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Due to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS). Individual and institutional investors holding MBS faced significant losses, as the value of the underlying mortgage assets and payment streams declined and became difficult to predict. In addition, certain legal entities designed to isolate this risk from the originating lenders, called collateralized debt obligations (CDO) and structured investment vehicles (SIV), held substantial amounts of MBS. As the value of payments into these entities declined, their value also declined, forcing the sale of MBS at fire sale prices in some instances.

The widespread dispersion of credit risk and the unclear impact on large banks, MBS, CDO, and SIV caused banks to reduce their loans to each other or make them at higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was impacted. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage the lending of funds to worthy borrowers and to re-invigorate the commercial paper markets. The combination of impacts due to credit risk and liquidity risk caused several major corporations and hedge funds to shut down or file for bankruptcy. Stock market declines among both depository and non-depository financial corporations were dramatic. Many hedge funds and other institutional investors holding MBS also incurred significant losses.

With interest rates on a large number of subprime mortgages due to adjust upward during the 2008 period, U.S. legislators and the U.S. Treasury Department are taking action. A systematic program to limit or defer interest rate adjustments was implemented to limit the impact. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Restrictions on lending practices are under consideration. Many lenders have stopped subprime lending or dramatically curtailed it.

Main article: Subprime lending

Subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for market interest rates because of problems with their credit history or the inability to prove that they have enough income to support the monthly payment on the loan for which they are applying. Subprime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky personal financial situations often associated with subprime applicants. A subprime loan is one that is offered at an interest rate higher than A-paper loans due to the increased risk. Subprime, therefore, is not the same as "Alt-A", because Alt-A loans qualify for the "A-rating" by Moody's or other rating firms, albeit for an "alternative" means.

The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding. 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. By January of 2008, the delinquency rate had risen to 21%. A total of nearly 447,000 U.S. housing units were subject to some sort of foreclosure action from July to September 2007, including those with prime, alt-A and subprime loans. This is nearly double the 223,000 properties in the year-ago period and 34% higher than the 333,000 in the prior quarter. The estimated value of subprime adjustable-rate mortages (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. An average of 450,000 subprime ARM are scheduled to undergo their first rate increase each quarter in 2008.

Understanding the causes and risks of the subprime crisis

The reasons for this crisis are varied and complex. Understanding and managing the ripple effect through the world-wide economy pose a critical challenge for governments, businesses, and investors. Due to innovations in securitization, the risks related to the inability of homeowners to meet mortgage payments have been distributed broadly, with a series of consequential impacts. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments; poor judgment by either the borrower or the lender; inappropriate mortgage incentives, and rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. There are three primary risk categories involved:

• Credit risk: Traditionally, the risk of default (called credit risk) would be assumed by the bank originating the loan. However, due to innovations in securitization, credit risk is now shared more broadly with investors, because the rights to these mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized 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 the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. Further, the MBS investor has the right to cash flows related to the mortgage payments. To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create separate legal entities, called special-purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively sell the mortgage assets (i.e., banking accounts receivable, which are the rights to receive the mortgage payments) to these SPE. In turn, the SPE then sells the MBS to the investors. The mortgage assets in the SPE become the collateral.

In addition to the shifting of the credit risk from loan originator to purchasers of complicated instruments, there were also fundamental errors in assessing both the probability and consequences of default. Historical default rates of borrowers with certain types of credit ratings turned out to underestimate the default rates in a declining real estate markets, particularly with respect to non-owner occupied homes. As real estate values fell amid predictions of further drops and as the average time to sell an existing home increased dramatically, some lenders agreed to "short sales" in which they forgave a percentage of the loan to facilitate a quick sale. This happened even with respect to loans which when made were, for example, only 80% of the then estimated value of the home. (In ordinary times, in this example, the 20% of the value of the home not subject to the loan would give the lender confidence that the lender could foreclose and obtain full repayment of the loan.)

• Asset price risk: CDO valuation is complex and related "fair value" accounting for such "Level 3" assets is subject to wide interpretation. This valuation fundamentally derives from the collectibility of subprime mortgage payments, which is difficult to predict due to lack of precedent and rising delinquency rates. Banks and institutional investors have recognized substantial losses as they revalue their CDO assets downward. Most CDOs require that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows, collateral ratings, or market values. For deals with market value tests, if the valuation falls below certain levels, the CDO may be required by its terms to sell collateral in a short period of time, often at a steep loss, much like a stock brokerage account margin call. If the risk is not legally contained within an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types of assets, as well, to satisfy the terms of the deal. In addition, credit rating agencies have downgraded over U.S. $50 billion in highly-rated CDO and more such downgrades are possible. Since certain types of institutional investors are allowed to only carry higher-quality (e.g., "AAA") assets, there is an increased risk of forced asset sales, which could cause further devaluation.


• Liquidity risk: A related risk involves the commercial paper market, a key source of funds (i.e., liquidity) for many companies. Companies and SPE called structured 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. The amount of commercial paper issued as of October 18, 2007 dropped by 25%, to $888 billion, from the August 8 level. In addition, the interest rate charged by investors to provide loans for commercial paper has increased substantially above historical levels.

Understanding the impact on corporations and investors

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:

• Bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Companies value their mortgage assets (receivables) based on estimates of collections from homeowners. Companies record expenses in the current period to adjust this valuation, increasing their bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage 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.
• Mortgage lenders and Real Estate Investment Trusts: These entities face similar risks to banks. In addition, they have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance secured by mortgages. Investors have become reluctant to fund such investments and are demanding higher interest rates. Such lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy.
• Special purpose entities (SPE): 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 called structured 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.
• Investors: The stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection.

Causes of the crisis

Role of borrowers

Some homeowners had been using the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. Between 1997 and 2006, American home prices increased by 124%. The overall U.S. homeownership rate increased from 64 percent in 1994 (about where it was since 1980) to a peak in 2004 with an all time high of 69.2 percent. Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs they could not afford after the initial incentive period. With housing prices now depreciating moderately in many parts of the U.S., refinancing has become difficult, leaving homeowners with higher payments than anticipated.

In the early 2000s recession that began in early 2001 and which was exacerbated by the September 11, 2001 terrorist attacks, Americans were asked to spend their way out of economic decline with "consumerism... cast as the new patriotism". This call linking patriotism to shopping echoed the urging of former President Bill Clinton to "get out and shop" , and corporations like General Motors produced commercials with the same theme.

The housing bubble was largely fed by the lowering of interest rates to record low levels to diminish the blow of the massive collapse of the dot-com bubble.

In a January 13, 2008 column in the New York Times, George Mason University economics professor Tyler Cowen wrote, "There has been plenty of talk about 'predatory lending,' but 'predatory borrowing' may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study. The research was done by BasePoint Analytics, which helps banks and lenders identify fraudulent transactions; the study looked at more than three million loans from 1997 to 2006, with a majority from 2005 to 2006. Applications with misrepresentations were also five times as likely to go into default. Many of the frauds were simple rather than ingenious. In some cases, borrowers who were asked to state their incomes just lied, sometimes reporting five times actual income; other borrowers falsified income documents by using computers."

Role of financial institutions

A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers. The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 , 9% in 1996 , 13% ($160 billion) in 1999 , and 20% in 2006. A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "subprime markup" or "risk premium") declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower and loan characteristics declined overall during the 2001-2006 period, which should have had the opposite effect. The combination is common to classic boom and bust credit cycles.

Due to securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 54% in 2001, to 75% in 2006.

In addition to considering higher-risk borrowers, lenders have offered increasingly high risk loan options and incentives to them. One example is the interest-only adjustable-rate mortgage (ARM), 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. Further, an estimated one-third of ARM originated between 2004-2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.

Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.

Role of mortgage brokers

Mortgage brokers don't lend their own money. There isn't a direct correlation between loan performance and compensation. They have big financial incentives for selling riskier loans, since they earn higher commissions.

According to a study by Wholesale Access Mortgage Research & Consulting Inc., in 2004 Mortgage brokers originated 68% of all residential loans in the U.S., with subprime and Alt-A loans accounting for 42.7% of brokerages' total production volume.

The chairman of the Mortgage Bankers Association claimed brokers profited from a home loan boom but didn't do enough to examine whether borrowers could repay.

Role of mortgage underwriters

Underwriters determine if the risk of lending to a particular borrower under certain parameters is acceptable. Most of the risks and terms that underwriters consider fall under the three C’s of underwriting: credit, capacity and collateral. See mortgage underwriting.

In 2007, 40 percent of all subprime loans were generated by automated underwriting. An Executive vice president of Countrywide Home Loans Inc. stated in 2004 "Prior to automating the process, getting an answer from an underwriter took up to a week. "We are able to produce a decision inside of 30 seconds today. ... And previously, every mortgage required a standard set of full documentation." Some think that users whose lax controls and willingness to rely on shortcuts led them to approve borrowers that under a less-automated system would never have made the cut are at fault for the subprime meltdown.

Role of government and regulators

Some observers claim that government policy actually encouraged the development of the subprime debacle through legislation like the Community Reinvestment Act, which they say forces banks to lend to otherwise uncreditworthy consumers. Economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act as contributing to the subprime meltdown. A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans.

In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.

Role of credit rating agencies

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings are theoretically due to the multiple, independent mortgages held in the MBS per the agencies, but critics claim that conflicts of interest were in play.

Role of central banks

Central banks are primarily concerned with managing the rate of inflation and avoiding recessions. They are also the “lenders of last resort” to ensure liquidity. They are less concerned with avoiding asset bubbles, such as the housing bubble and dotcom bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are not proven concepts. There is significant debate among economists regarding whether this is the optimal strategy.

Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf.

Impacts

Impact on stock markets

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time. By August 15, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Large daily drops became common, with, for example, the KOSPI dropping about 7% in one day, although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis.

Mortgage lenders and home builders fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.

Impact on financial institutions

Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of January 15, 2008 financial institutions had recognized subprime-related losses or writedowns exceeding U.S. $102 billion.

Other companies from around the world, such as IKB Deutsche Industriebank , have also suffered significant losses and scores of mortgage lenders have filed for bankruptcy. Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other. Various institutions follow-up with merger deals.

Impact on home owners

As home prices have declined following the rise of home prices caused by speculation and as re-financing standards have tightened, a number of homes have been foreclosed and sit vacant. These vacant homes are often poorly maintained and sometimes attract squatters and/or criminal activity with the result that increasing foreclosures in a neighborhood often serve to further accelerate home price declines in the area. Rents have not fallen as much as home prices with the result that in some affluent neighborhoods homes that were formerly owner occupied are now occupied by renters. In select areas falling home prices along with a decline in the U.S. dollar have encouraged foreigners to buy homes for either occasional use and/or long term investments. Additional problems are anticipated in the future from the impending retirement of the baby boomer generation. It is believed that a significant proportion of baby boomers are not saving adequately for retirement and were planning on using their increased property value as a "piggy bank" or replacement for a retirement-savings account. This is a departure from the traditional American approach to homes where "people worked toward paying off the family house so they could hand it down to their children"

Impact on minorities

There is a disproportionate level of foreclosures in some minority neighborhoods.

About 46% of Hispanics and 55% of blacks who obtained mortgages in 2005 got higher-cost loans, compared with about 17% of whites and Asians, according to Federal Reserve data.

Actions to manage the crisis

• Central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans. Both measures effectively lubricate the financial system, in two key ways. First, they help provide access to funds for those entities with illiquid mortgage-backed assets. This helps lenders, SPE, and SIV avoid selling mortgage-backed assets at a steep loss. Second, the available funds stimulate the commercial paper market and general economic activity. Specific responses by central banks are included in the subprime crisis impact timeline.
• Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives.
• Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt.
• Regulators and legislators can take action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders. Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings help identify solutions and apply pressure to the various parties involved.
• The media can help educate the public and parties involved. It can also ensure the top subject material experts are engaged and have a voice to ensure a reasoned debate about the pros and cons of various solutions.

Bush Administration plan

President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs, declaring "I have a message for every homeowner worried about rising mortgage payments: The best you can do for your family is to call 1-800-995-HOPE (sic)" The correct number is 1-888-995-HOPE). A refinancing facility called FHA-Secure was also created. This is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance. The U.S. Treasury Department is working directly with major banks to develop a systematic means of modifying loans for a significant portion of borrowers facing ARM increases, rather than working through loans on a case-by-case basis.

The Federal Reserve

Within the Federal Reserve, Chairman Ben Bernanke signals towards making interest rate cuts. Financial markets expect the interest rate reduced to 3.75%. In early 2008, Ben Bernanke said: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy."

Expectations and forecasts

As early as the 2003 Annual Report issued by Fairfax Financial Holdings Limited, Prem Watsa was raising concerns about securitized products: "We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds) eliminates the incentive for the originator of the loan to be credit sensitive. Take the case of an automobile dealer. Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard)... This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S.... Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Unlike..." :

The legacy of Alan Greenspan has been cast into doubt with Senator Chris Dodd claiming he created the "perfect storm" Alan Greenspan has remarked that there is a one-in-three chance of recession from the fallout. Nouriel Roubini, a professor at New York University and head of Roubini Global Economics, has said that if the economy slips into recession "then you have a systemic banking crisis like we haven't had since the 1930s" .

On September 7, 2007, the Wall Street Journal reported that Alan Greenspan has said that the current turmoil in the financial markets is in many ways "identical" to the problems in 1987 and 1998. The Associated Press described the current climate of the market on August 13, 2007, as one where investors were waiting for "the next shoe to drop" as problems from "an overheated housing market and an overextended consumer" are "just beginning to emerge. " MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse"

As of November 22, 2007, analysts at a leading investment bank estimated losses on subprime CDO would be approximately U.S. $148 billion. As of December 22, 2007, a leading business periodical estimated subprime defaults between U.S. $200-300 billion.

As described in the background section above, 16% of the estimated U.S. $1.3 trillion in subprime mortgages were in default as of October 2007, or approximately $200 billion. Considering that $500 billion in subprime mortgages will reset to higher rates over the next 12 months (placing additional pressure on homeowners) and recent increases in the payment default rate cited by the Federal Reserve, direct loss exposure would likely exceed the $200 billion figure. This figure may be increased significantly by "Alt-A" defaults. The impact will continue to fall most directly on homeowners and those retaining mortgage origination risk, primarily banks, mortgage lenders, or those funds and investors holding mortgage-backed securities. As cited above, many such entities have reported significant losses from both revising the valuation of mortgage assets and the sale of MBS at steep losses. Regulators are carefully monitoring this exposure.

Timeline

Timeline 1985–ongoing

• 1985–1991: Savings and Loan crisis
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• January 1989: One-month drop sales of 12.6 percent.
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• 1986–1991: New homes constructed dropped from 1.8 to 1 million, the lowest rated since World War II.
• 1991–1997: Flat Housing prices
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• 1991: US recession, new construction prices fall, but above inflationary growth allows them to return by 1997 in real terms.
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• 1997: Mortgage denial rate of 29 percent for conventional home purchase loans
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• September 23, 1998: New York Fed brings together consortium of investors to bail out Long-Term Capital Management
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• 1998: Inflation-adjusted home price appreciation exceeds 10%/year in most West Coast metropolitan areas
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• 1999: Gramm-Leach-Bliley Act, repealed the Glass-Steagall Act of 1933, allowed commercial and investment banks to consolidate.
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• 1995–2001: Dot-com bubble
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• March 10, 2000: Dot-com bubble collapse NASDAQ Composite index peaked
• 2000–2003: Early 2000s recession (exact time varies by country)
• 2001–2005: United States housing bubble (part of the world housing bubble)
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• 2001: US Federal Reserve lowers Federal funds rate 11 times, from 6.5% to 1.75%.
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• 2002–2003: Mortgage denial rate of 14 percent for conventional home purchase loans, half of 1997
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• 2002: Annual home price appreciation of 10% or more in California, Florida, and most Northeastern states.
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• 2004: U.S. homeownership rate peaked with an all time high of 69.2 percent.
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• 2004–2005: Arizona, California, Florida, Hawaii, and Nevada record price increases in excess of 25% per year.
• 2005–ongoing: United States housing market correction ("bubble bursting")
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• 2005: Boom ended August 2005. The booming housing market halted abruptly for many parts of the U.S. in late summer of 2005.
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• 2006: Continued market slowdown. Prices are flat, home sales fall, resulting in inventory buildup. U.S. Home Construction Index is down over 40% as of mid-August 2006 compared to a year earlier.
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• 2007: Year-to-year decreases in both U.S. home sales and home prices accelerates rather than bottoming out, with U.S. Treasury secretary Paulson calling the "the housing decline ... the most significant risk to our economy."

Timeline 2007

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• 2007: Home sales continue to fall. The plunge in existing-home sales is the steepest since 1989. In Q1/2007, S&P/Case-Shiller house price index records first year-over-year decline in nationwide house prices since 1991 The subprime mortgage industry collapses, and a surge of foreclosure activity (twice as bad as 2006 ) and rising interest rates threaten to depress prices further as problems in the subprime markets spread to the near-prime and prime mortgage markets. The U.S. Treasury secretary calls the "ongoing housing correction" "the most significant risk to our economy." ?
• February–ongoing: 2007 Subprime mortgage financial crisis Subprime industry collapse; more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.
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• April 2: New Century Financial, largest U.S. subprime lender, files for chapter 11 bankruptcy.
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• August: worldwide "credit crunch" as subprime mortgage backed securities are discovered in portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stop offering home equity loans and "stated income" loans. Federal Reserve injects about $100B into the money supply for banks to borrow at a low rate.
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• August 6: American Home Mortgage files for chapter 11 bankruptcy.
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• August 7: Democratic presidential front-runner Hillary Clinton proposes a $1 billion bailout fund to help homeowners at risk for foreclosure.
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• August 16: Countrywide Financial Corporation, the biggest U.S. mortgage lender, narrowly avoids bankruptcy by taking out an emergency loan of $11 billion from a group of banks.
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• August 17: Federal Reserve lowers the discount rate by 50 basis points to 5.75% from 6.25%.
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• August 31: President Bush announces a limited bailout of U.S. homeowners unable to pay the rising costs of their debts.[14] Ameriquest, once the largest subprime lender in the U.S., goes out of business;
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• September 1–3: Fed Economic Symposium in Jackson Hole, WY addressed the housing recession that jeopardizes U.S. growth. Several critics argued that the Fed should use regulation and interest rates to prevent asset-price bubbles, blamed former Fed-chairman Alan Greenspan's low interest rate policies for stoking the U.S. housing boom and subsequent bust, , and Yale University economist Robert Shiller warned of possible home price declines of 50 percent.
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• September 17: Former Fed Chairman Alan Greenspan said "we had a bubble in housing" and warns of "large double digit declines" in home values "larger than most people expect."
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• September 18: The Fed lowers interest rates by half a percent (50 basis points) to 4.75% in an attempt to limit damage to the economy from the housing and credit crises.
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• September 28: Television finance personality Jim Cramer warns Americans on The Today Show, "don't you dare buy a home—you'll lose money," causing a furor among realtors.
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• September 30: Affected by the spiraling mortgage and credit crises, Internet banking pioneer NetBank goes bankrupt, the first FDIC-insured bank to fail since the savings and loan crisis, , and the Swiss bank UBS announced that it lost US$690 million in the third quarter.
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• September 30:Prices fell 4.9 percent from September 2006 in 20 large metropolitan areas, according to Standard & Poor’s/Case-Shiller indexes. This is the 9th straight month priced have fallen.
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• October 10: US Government and private industry created Hope Now Alliance to help some sub-prime borrowers.
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• October 15–17: A consortium of U.S. banks backed by the U.S. government announced a "super fund" or super-SIV" of $100 billion to purchase mortgage backed securities whose mark-to-market value plummeted in the subprime collapse. Fed chairman Ben Bernanke expressed alarm about the dangers posed by the bursting housing bubble;) Secretary of the Treasury Paulson said "the housing decline is still unfolding and I view it as the most significant risk to our economy. … The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth."
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• October 31: Federal Reserve lowers the federal funds rate by 25 basis points to 4.5 percent and the discount window rate by 25 basis points to 5 percent.
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• October 31: Prices fell 6.1 percent from October 2006 in 20 large metropolitan areas, according to Standard & Poor’s/Case-Shiller indexes. This is the 10th straight month priced have fallen.
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• October 31: The Department of Housing and Urban Development adopted new regulations banning so-called "seller-funded" downpayment programs.
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• November 1: Federal Reserve injects $41B into the money supply for banks to borrow at a low rate. The largest single expansion by the Fed since $50.35B on September 19, 2001.
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• December 6: President Bush announced a plan to voluntarily freeze the mortgages of a limited number of mortgage debtors holding ARMs for 5 years. The plan run by the Hope Now Alliance. Its phone number is 1-888-995-HOPE. Some experts criticized the plan as "a Band-Aid when the patient needs major surgery" , a "teaser-freezer", and a "bail-out".
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• December 11: Federal Reserve lowers the federal funds rate by 25 basis points to 4.25 percent and the discount window rate by 25 basis points to 4.75 percent.
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• December 12: Federal Reserve injects $40B into the money supply for banks to borrow at a low rate and coordinates such efforts with central banks from Canada, United Kingdom, Switzerland and European Union.
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• December 24: A consortium of banks officially abandons the U.S. government-supported "super-SIV" mortgage crisis bail-out plan announced in mid-October, citing a lack of demand for the risky mortgage products on which the plan was based, and widespread criticism that the fund was a flawed idea that would have been difficult to execute .
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• December 26: Standard & Poor’s/Case-Shiller indexes of housing prices in 20 large metropolitan areas for October 2007 is released showing that for the 10th straight month priced have fallen, but most worrying is that the decline in home prices accelerated and spread to more regions of the country in October. "Since their peak in July 2006, home prices in the 20 regions have dropped 6.6 percent. Economists' predictions of the total amount of home price declines from the bubble's peak range from moderate 10–15 percent to larger 30–50 percent price declines in some areas.
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• December 28: The U.S. Commerce Department reported that November 2007 new home sales were down 9 pct to a seasonally-adjusted annual rate of 647,000 the lowest sales rate since April 1995.

Market correction predictions

Based on the historic trends in valuations of U.S. housing, many economists and business writers have predicted a market correction, ranging from a few percentage points, to 50% or more from peak values in some markets, and, in spite of the fact that this cooling has not affected all areas of the U.S., some have warned that it could and that the correction would be "nasty" and "severe". Chief economist Mark Zandi of the research firm Moody's Economy.com predicted a "crash" of double-digit depreciation in some U.S. cities by 2007–2009.

Bubble bursts

The booming housing market appears to have halted abruptly for many parts of the U.S. in late summer of 2005, and as of summer 2006, several markets are facing the issues of ballooning inventories, falling prices, and sharply reduced sales volumes. In August 2006, Barron's magazine warned, "a housing crisis approaches", and noted that the median price of new homes has dropped almost 3% since January 2006, that new-home inventories hit a record in April and remain near all-time highs, that existing-home inventories are 39% higher than they were just one year ago, and that sales are down more than 10%, and predicts that "the national median price of housing will probably fall by close to 30% in the next three years … simple reversion to the mean." Fortune magazine labelled many previously strong housing markets as "Dead Zones;" other areas are classified as "Danger Zones" and "Safe Havens." Fortune also dispelled "four myths about the future of home prices." In Boston, year-over-year prices are dropping, sales are falling, inventory is increasing, foreclosures are up, and the correction in Massachusetts has been called a "hard landing". The previously booming housing markets in Washington DC, San Diego CA, Phoenix AZ, and other cities have stalled as well. Searching the Arizona Regional Multiple Listing Service (ARMLS) shows that in summer 2006, the for-sale housing inventory in Phoenix has grown to over 50,000 homes, of which nearly half are vacant (see graphic). Several home builders have revised their forecasts sharply downward during summer 2006, e.g., D.R. Horton cut its yearly earnings forecast by one-third in July 2006, the value of luxury home builder Toll Brothers' stock fell 50% between August 2005 and August 2006, and the Dow Jones U.S. Home Construction Index was down over 40% as of mid-August 2006. CEO Robert Toll of Toll Brothers explained, "builders that built speculative homes are trying to move them by offering large incentives and discounts; and some anxious buyers are canceling contracts for homes already being built." Homebuilder Kara Homes, known for their construction of "McMansions", announced on 13 September 2006 the "two most profitable quarters in the history of our company", yet filed for bankruptcy protection less than one month later on 6 October. Six months later on 10 April 2007, Kara Homes sold unfinished developments, causing prospective buyers from the previous year to lose deposits, some of whom put down more than $100,000.

As the housing market began to soften in winter 2005 through summer 2006, NAR chief economist David Lereah predicted a "soft landing" for the market. However, based on unprecedented rises in inventory and a sharply slowing market throughout 2006, Leslie Appleton-Young, the chief economist of the California Association of Realtors, said that she is not comfortable with the mild term "soft landing" to describe what is actually happening in California's real estate market. The Financial Times warned of the impact on the U.S. economy of the "hard edge" in the "soft landing" scenario, saying "A slowdown in these red-hot markets is inevitable. It may be gentle, but it is impossible to rule out a collapse of sentiment and of prices. … If housing wealth stops rising … the effect on the world's economy could be depressing indeed." "It would be difficult to characterize the position of home builders as other than in a hard landing", said Robert Toll, CEO of Toll Brothers. Angelo Mozilo, CEO of Countrywide Financial, said "I've never seen a soft-landing in 53 years, so we have a ways to go before this levels out. I have to prepare the company for the worst that can happen." Following these reports, Lereah admitted that "he expects home prices to come down 5% nationally", and said that some cities in Florida and California could have "hard landings." National home sales and prices both fell dramatically again in March 2007 according to NAR data, with sales down 13% to 482,000 from the peak of 554,000 in March 2006 and the national median price falling nearly 6% to $217,000 from the peak of $230,200 in July 2006 . The plunge in existing-home sales is the steepest since 1989 . The new home market is also suffering. The biggest year over year drop in median home prices since 1970 occurred in April of 2007. Median prices for new homes fell 10.9 percent according to the Commerce Department.

Based on slumping sales and prices in August 2006, economist Nouriel Roubini warned that the housing sector is in "free fall" and will derail the rest of the economy, causing a recession in 2007.[76] Joseph Stiglitz, winner of the Nobel Prize in economics in 2001, agreed, saying that the U.S. may enter a recession as house prices decline. The extent to which the economic slowdown, or possible recession, will last depends in large part on the resiliency of the U.S. consumer spending, which now makes up approximately 70% of the US$13.7 trillion economy. The evaporation of the wealth effect amid the current housing downturn could negatively affect the consumer confidence and provide further headwind for the U.S. economy and that of the rest of the world. The World Bank recently lowered the global economic growth rate due to a housing slowdown in the United States, but it does not believe that the U.S. housing malaise will further spread to the rest of the world. The Fed chairman Benjamin Bernanke said in October 2006 that there is currently a "substantial correction" going on in the housing market and that the decline of residential housing construction is one of the "major drags that is causing the economy to slow"; he predicted that the correcting market will decrease U.S. economic growth by about one percent in the second half of 2006 and remain a drag on expansion into 2007.

Others speculate on the negative impact of the retirement of the Baby Boom generation and the relative cost to rent on the declining housing market. In many parts of the United States, it is significantly cheaper to rent the same property than to purchase it; the national median mortgage payment is $1,687 per month, nearly twice the median rent payment of $868 per month.

Subprime mortgage industry collapse

Main article: 2007 Subprime mortgage financial crisis In March 2007, the United States' subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.[82] The stock of the country's largest subprime lender, New Century Financial, plunged 84% amid Justice Department investigations, before ultimately filing for Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding $100 million.[83] The manager of the world's largest bond fund PIMCO, warned in June 2007 that the subprime mortgage crisis was not an isolated event and will eventually take a toll on the economy and whose ultimate impact will be on the impaired prices of homes.[84] Bill Gross, "a most reputable financial guru", sarcastically and ominously criticized the credit ratings of the mortgage-based CDOs now facing collapse:

AAA? You were wooed Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a “tramp stamp.” Many of these good looking girls are not high-class assets worth 100 cents on the dollar. … And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone? … AAAs? [T]he point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. The subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times … The flaw lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere … except for their mortgages that is. Mortgage payments are going up, up, and up … and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ¾ of which are subprimes … This problem—aided and abetted by Wall Street—ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address—Main Street.

Financial analysts predict that the subprime mortgage collapse will result in earnings reductions for large Wall Street investment banks trading in mortgage-backed securities, especially Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch, and Morgan Stanley. The solvency of two troubled hedge funds managed by Bear Stearns was imperliled in June 2007 after Merrill Lynch sold off assets seized from the funds and three other banks closed out their positions with them. The Bear Stearns funds once had over $20 billion of assets, but lost billions of dollars on securities backed by subprime mortgages. H&R Block reported that it made a quarterly loss of $677 million on discontinued operations, which included subprime lender Option One, as well as writedowns, loss provisions on mortgage loans and the lower prices available for mortgages in the secondary market for mortgages. The units net asset value fell 21% to $1.1 billion as of April 30 2007. The head of the mortgage industry consulting firm Wakefield Co. warned, "This is going to be a meltdown of unparalleled proportions. Billions will be lost." Bear Stearns pledged up to US$3.2 billion in loans on 22 June 2007 to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages. Peter Schiff, president of Euro Pacific Capital, argued that if the bonds in the Bear Stearns funds were auctioned on the open market, much weaker values would be plainly revealed. Schiff added, "This would force other hedge funds to similarly mark down the value of their holdings. Is it any wonder that Wall street is pulling out the stops to avoid such a catastrophe? … Their true weakness will finally reveal the abyss into which the housing market is about to plummet." The New York Times report connects this hedge fund crisis with lax lending standards: "The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes."

In the wake of the mortgage industry meltdown, Senator Chris Dodd, Chairman of the Banking Committee held hearings in March 2007 and asked executives from the top five subprime mortgage companies to testify and explain their lending practices; Dodd said, "predatory lending practices" endangered the home ownership for millions of people. Moreover, Democratic senators such as Senator Charles Schumer of New York are already proposing a federal government bailout of subprime borrowers in order to save homeowners from losing their residences. Opponents of such proposal assert that government bailout of subprime borrowers is not in the best interests of the U.S. economy because it will simply set a bad precedent, create a moral hazard, and worsen the speculation problem in the housing market. Lou Ranieri of Salomon Brothers, inventor the mortgage-backed securities market in the 1970s, warned of the future impact of mortgage defaults: "This is the leading edge of the storm. … If you think this is bad, imagine what it's going to be like in the middle of the crisis." In his opinion, more than $100 billion of home loans are likely to default when the problems in the subprime industry appear in the prime mortgage markets. Fed Chairman Alan Greenspan praised the rise of the subprime mortgage industry and the tools with which it uses to assess credit-worthiness in an April 2005 speech:

Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country … With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. … Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s. Because of these remarks, along with his encouragement for the use of adjustable-rate mortgages, Greenspan has been criticized for his role in the rise of the housing bubble and the subsequent problems in the mortgage industry.

Alt-A mortgage problems

Subprime and Alt-A (including "stated income" or "liar's loans" which are basically loans made to home buyers without the verification of borrowers' incomes; home buyers tend to overstate their incomes in order to get the loan amounts they desire to purchase their dream homes, thus called the "liar's loans") loans account for about 21 percent of loans outstanding and 39 percent of mortgages made in 2006. In April 2007, financial problems similar to the subprime mortgages began to appear with Alt-A loans made to homeowners who were thought to be less risky. American Home Mortgage said that it would earn less and pay out a smaller dividend to its shareholders because it was being asked to buy back and write down the value of Alt-A loans made to borrowers with decent credit; causing company stocks to tumble 15.2 percent. The delinquency rate for Alt-A mortgages has been rising in 2007. In June 2007, Standard & Poor's warned that U.S. homeowners with good credit are increasingly falling behind on mortgage payments, an indication that lenders have been offering higher risk loans outside the subprime market; they said that rising late payments and defaults on Alt-A mortgages made in 2006 are "disconcerting" and delinquent borrowers appear to be "finding it increasingly difficult to refinance" or catch up on their payments. Late payments of at least 90 days and defaults on 2006 Alt-A mortgages have increased to 4.21 percent, up from 1.59 percent for 2005 mortgages and 0.81 percent for 2004, indicating that "subprime carnage is now spreading to near prime mortgages."

Foreclosure rates increase

The 30-year mortgage rates increased by more than a half a percentage point to 6.74 percent during May–June 2007 , affecting borrowers with the best credit just as a crackdown in subprime lending standards limits the pool of qualified buyers. The national median home price is poised for its first annual decline since the Great Depression, and the NAR reported that supply of unsold homes is at a record 4.2 million. Goldman Sachs and Bear Stearns, respectively the world's largest securities firm and largest underwriter of mortgage-backed securities in 2006, said in June 2007 that rising foreclosures reduced their earnings and the loss of billions from bad investments in the subprime market imperiled the solvency of several hedge funds. Mark Kiesel, executive vice president of a California-based Pacific Investment Management Co. said,

It's a blood bath. … We're talking about a two- to three-year downturn that will take a whole host of characters with it, from job creation to consumer confidence. Eventually it will take the stock market and corporate profit.

According to Donald Burnette of Knight Mortgage Company in Florida, one of the states hit hardest by the bursting housing bubble, the corresponding loss in equity from the drop in housing values has caused new problems. "It is keeping even borrowers with good credit and solid resourses from refinancing to better terms. Even with tighter restrictions on ALT A and the dissappearance of most subprime programs, their are many borrowers who would qualify as "A" borrowers who can't qualify to refinance as they no longer have the equity in their homes that they had in 2005 or 2006. They will have to wait for the market to recover to refinance to the terms they deserve."
Source: wikipedia

The Aftermath

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