INTRODUCTION
The subprime mortgage crisis, popularly known as the “mortgage mess” or “mortgage
meltdown,” came to the public’s attention when a steep rise in home foreclosures in 2006
spiraled seemingly out of control in 2007, triggering a national financial crisis that went
global within the year. Consumer spending is down, the housing market has plummeted,
foreclosure numbers continue to rise and the stock market has been shaken. The subprime
crisis and resulting foreclosure fallout has caused dissension among consumers, lenders
and legislators and spawned furious debate over the causes and possible fixes of the
“mess.” International Monetary Fund Report In its semiannual Global Financial Stability Report released on April 8, 2008, the
International Monetary Fund (IMF) said that falling U.S. housing prices and rising
delinquencies on the residential mortgage market could lead to losses of $565 billion
dollars. When combining these factors with losses from other categories of loans
originated and securities issued in the United States related to commercial real estate,
IMF puts potential losses at about $945 billion.
This was the first time that IMF has made an official estimate of the global losses
suffered by banks and other financial institutions in the U.S. credit crunch that began in
2007 amid the rising number of defaults on subprime home loans.
The incredible $945 billion estimate of losses, made in March, represents approximately
$142 per person worldwide and 4 percent of the $23.21-trillion credit market. IMF noted
in its report that global banks likely will carry about half of these losses. The report
cautioned that the loss estimates are just that, estimates, and the actual numbers may be
even higher.
In March, Standard & Poor’s had predicted that global banking firms would write off
approximately $285 billion dollars in various securities linked to U.S. subprime real
estate, with more than half the losses already recognized. Some analysts have put the
figure higher for the subprime market and related losses.
The IMF, whose stated core mission is to promote global financial stability, said there
was "a collective failure to appreciate the extent of leverage taken on by a wide range of
institutions—banks, monoline insurers, government-sponsored entities, hedge funds—
and the associated risks of a disorderly unwinding."
“It is now clear that the current turmoil is more than simply a liquidity event, reflecting
deep-seated balance sheet fragilities and weak capital bases, which means its effects are
likely to be broader, deeper, and more protracted," the report said.
Unique Situation
As recently as mid-2007, many experts believed that the crisis would be contained within
the arena of mortgage issuers who had overloaded on subprime loans. Few would have
predicted that the subprime fallout would be so severe as to threaten the economy to the
extent that it has thus far.
While downturns in the mortgage and housing markets have caused economic problems
before, experts explain that the current situation is unique. In a 2007 interview, Susan M.
Wachter, professor of real estate and finance at Wharton, University of Pennsylvania,
said that in the past such events have created downturns in the overall economy through a
credit crunch in the banking sector. This would be the first time downturns are driven by
a credit crunch in the non-banking sector of finance.
ROOTS OF THE SUBPRIME CRISIS
There are a number of theories as to what led to the mortgage crisis. Many experts and
economists believe it came about though the combination of a number of factors in which
subprime lending played a major part.
Housing Bubble
The current mortgage meltdown actually began with the bursting of the U.S. housing
“bubble” that began in 2001 and reached its peak in 2005. A housing bubble is an
economic bubble that occurs in local or global real estate markets. It is defined by rapid
increases in the valuations of real property until unsustainable levels are reached in
relation to incomes and other indicators of affordability. Following the rapid increases are
decreases in home prices and mortgage debt that is higher than the value of the property.
Housing bubbles generally are identified after a market correction, which occurred in the
United States around 2006. Former Chairman of the Federal Reserve Board, Alan
Greenspan, said in 2007 that “we had a bubble in housing,” and that he “really didn’t get
it until very late in 2005 and 2006.”
Freddie Mac CEO Richard Syron agreed with Greenspan that the United States had a
housing bubble and concurred with Yale economist Robert Shiller’s 2007 warning that
home prices “appeared overvalued” and that the necessary correction could “last years
with trillions of dollars of home value being lost.” Greenspan also warned of “large
double digit declines” in home values, much larger than most would expect.
Historically Low Interest Rates
Many economists believe that the U.S. housing bubble was caused in part by historically
low interest rates. In response to the crash of the dot-com bubble in 2000 and the
subsequent recession that began in 2001, the Federal Reserve Board cut short-term
interest rates from about 6.5 percent to 1 percent. Greenspan admitted in 2007 that the
housing bubble was “fundamentally engendered by the decline in real long-term interest
rates.”
Mortgage rates typically are set in relation to 10-year Treasury bond yields, which, in
turn, are affected by federal funds rates. The Fed has acknowledged the connection
between lower interest rates, higher home values and the increased liquidity that the
higher home values bring to the overall economy. In a 2005 report by the Fed,
“International Finance Discussion Papers, Number 841, House Prices and Monetary
Policy: A Cross-Country Study,” the agency said that house prices, like other asset prices,
are influenced by interest rates, and in some countries the housing market is a key
channel of monetary policy transmission.
Criticism of Greenspan
Some have criticized then-Chairman Greenspan for “engineering” the housing bubble,
saying it was the Fed’s decline in rates that inflated the bubble. In a December 2007
interview, Greenspan disputes that claim, stating that the housing bubble had far less to
do with the Fed’s policy on interest rates than on a global surplus in savings that drove
down interest rates and pushed up housing prices in countries around the world.
In March 2007, Greenspan led a Q&A session at the Futures Industry Association’s
annual convention. In answer to a question about the causes of the subprime crisis,
Greenspan said that it was more an issue of house prices than mortgage credit. The
former Fed Chairman said that the increase in subprime lending was new. Subprime
borrowers who “came late in the game,” borrowing after prices had already gone up,
were not able to build enough equity before interest rates rose.
Despite Greenspan’s argument that low interest rates did not contribute to the housing
bubble, Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas,
has stated that the Fed’s interest rate policy during the period of 2000–2003 was
misguided by erroneously low inflation data, thus contributing to the housing bubble.
Speaking before the New York Association for Business Economics in November 2006,
Fisher said:
A good central banker knows how costly imperfect data
can be for the economy. This is especially true of inflation
data. In late 2002 and early 2003, for example, core PCE
measurements were indicating inflation rates that werecrossing below the 1 percent “lower boundary.” At the
time, the economy was expanding in fits and starts. Given
the incidence of negative shocks during the prior two years,
the Fed was worried about the economy's ability to
withstand another one. Determined to get growth going in
this potentially deflationary environment, the FOMC
adopted an easy policy and promised to keep rates low. A
couple of years later, however, after the inflation numbers
had undergone a few revisions, we learned that inflation
had actually been a half point higher than first thought.
In retrospect, the real fed funds rate turned out to be lower
than what was deemed appropriate at the time and was held
lower longer that it should have been. In this case, poor
data led to a policy action that amplified speculative
activity in the housing and other markets. Today, as
anybody not from the former planet of Pluto knows, the
housing market is undergoing a substantial correction and
inflicting real costs to millions of homeowners across the
country. It is complicating the task of achieving our
monetary objective of creating the conditions for
sustainable non-inflationary growth.
The Bubble Bursts
Between 2004 and 2006, the Federal Reserve Board raised interest rates 17 times,
increasing them from 1 percent to 5.25 percent. The Fed stopped raising rates because of
fears that an accelerating downturn in the housing market could undermine the overall
economy. Some economists, like New York University economist Nouriel Roubini, feel
that the Fed should have tightened up on the rates earlier than it did “to avoid a festering
of the housing bubble early on.”
Roubini also warned that because of slumping sales and prices in August 2006, the
housing sector was in “free fall” and would derail the rest of the economy, causing a
recession in 2007.
In August 2006, Barron’s magazine warned that a housing crisis was approaching and
noted that the median price of new homes had dropped about 3 percent since January
2006. At that time the magazine also predicted that the national median price of housing
would fall about 30 percent in the next three years.
Housing Market Correction
Adding to the growing crisis was the prediction by many economists and business writers
in 2006 and 2007 that there would be a housing market correction because of the over
valuation of homes during the bubble period. Estimates ranged from a correction of a few
points to 50 percent or more from peak values.
Chief economist Mark Zandi of the economic research firm Moody’s Economy.com,
predicted a “crash” of double-digit depreciation by 2007-2009. In August 2007, in a
paper presented at a Fed economic symposium, Yale University economist Robert Shiller
warned that “past cycles indicate that major declines in real home prices—even 50
percent declines in some places—are entirely possible going forward from today or from
the not too distant future.”
The Rise of Subprime Lending
Subprime borrowing was a major factor in the increase in home ownership rates and the
demand for housing during the bubble years. The U.S. ownership rate increased from 64
percent in 1994 to an all-time high peak of 69.2 percent in 2004. The demand helped fuel
the rise of housing prices and consumer spending, creating an unheard of increase in
home values of 124 percent between 1997 and 2006. Some homeowners took advantage
of the increased property values of their home to refinance their homes with lower
interest rates and take out second mortgages against the added value to use for consumer
spending. In turn, U.S. household debt as a percentage of income rose to 130 percent in
2007, 30 percent higher than the average amount earlier in the decade.
With the collapse of the housing bubble came 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. Alt-A is a classification of mortgages in
which the risk profile falls between prime and subprime. The borrowers behind these
mortgages typically will have clean credit histories, but the mortgage itself generally will
have some issues that increase its risk profile. These issues include higher loan-to-value
and debt-to-income ratios or inadequate documentation of the borrower's income.
The share of subprime mortgages to total originations increased from 9 percent in 1996 to
20 percent in 2006 according to Forbes. Subprime mortgages totaled $600 billion in
2006, accounting for approximately one-fifth of the U.S. home loan market. An estimated
$1.3 trillion in subprime loans are outstanding.
The number of subprime loans rose as rising real estate values led to lenders taking more
risks. Some experts believe that Wall Street encouraged this type of behavior by bundling
the loans into securities that were sold to pension funds and other institutional investors
seeking higher returns.
the arena of mortgage issuers who had overloaded on subprime loans. Few would have
predicted that the subprime fallout would be so severe as to threaten the economy to the
extent that it has thus far.
While downturns in the mortgage and housing markets have caused economic problems
before, experts explain that the current situation is unique. In a 2007 interview, Susan M.
Wachter, professor of real estate and finance at Wharton, University of Pennsylvania,
said that in the past such events have created downturns in the overall economy through a
credit crunch in the banking sector. This would be the first time downturns are driven by
a credit crunch in the non-banking sector of finance.
ROOTS OF THE SUBPRIME CRISIS
There are a number of theories as to what led to the mortgage crisis. Many experts and
economists believe it came about though the combination of a number of factors in which
subprime lending played a major part.
Housing Bubble
The current mortgage meltdown actually began with the bursting of the U.S. housing
“bubble” that began in 2001 and reached its peak in 2005. A housing bubble is an
economic bubble that occurs in local or global real estate markets. It is defined by rapid
increases in the valuations of real property until unsustainable levels are reached in
relation to incomes and other indicators of affordability. Following the rapid increases are
decreases in home prices and mortgage debt that is higher than the value of the property.
Housing bubbles generally are identified after a market correction, which occurred in the
United States around 2006. Former Chairman of the Federal Reserve Board, Alan
Greenspan, said in 2007 that “we had a bubble in housing,” and that he “really didn’t get
it until very late in 2005 and 2006.”
Freddie Mac CEO Richard Syron agreed with Greenspan that the United States had a
housing bubble and concurred with Yale economist Robert Shiller’s 2007 warning that
home prices “appeared overvalued” and that the necessary correction could “last years
with trillions of dollars of home value being lost.” Greenspan also warned of “large
double digit declines” in home values, much larger than most would expect.
Historically Low Interest Rates
Many economists believe that the U.S. housing bubble was caused in part by historically
low interest rates. In response to the crash of the dot-com bubble in 2000 and the
subsequent recession that began in 2001, the Federal Reserve Board cut short-term
interest rates from about 6.5 percent to 1 percent. Greenspan admitted in 2007 that the
housing bubble was “fundamentally engendered by the decline in real long-term interest
rates.”
Mortgage rates typically are set in relation to 10-year Treasury bond yields, which, in
turn, are affected by federal funds rates. The Fed has acknowledged the connection
between lower interest rates, higher home values and the increased liquidity that the
higher home values bring to the overall economy. In a 2005 report by the Fed,
“International Finance Discussion Papers, Number 841, House Prices and Monetary
Policy: A Cross-Country Study,” the agency said that house prices, like other asset prices,
are influenced by interest rates, and in some countries the housing market is a key
channel of monetary policy transmission.
Criticism of Greenspan
Some have criticized then-Chairman Greenspan for “engineering” the housing bubble,
saying it was the Fed’s decline in rates that inflated the bubble. In a December 2007
interview, Greenspan disputes that claim, stating that the housing bubble had far less to
do with the Fed’s policy on interest rates than on a global surplus in savings that drove
down interest rates and pushed up housing prices in countries around the world.
In March 2007, Greenspan led a Q&A session at the Futures Industry Association’s
annual convention. In answer to a question about the causes of the subprime crisis,
Greenspan said that it was more an issue of house prices than mortgage credit. The
former Fed Chairman said that the increase in subprime lending was new. Subprime
borrowers who “came late in the game,” borrowing after prices had already gone up,
were not able to build enough equity before interest rates rose.
Despite Greenspan’s argument that low interest rates did not contribute to the housing
bubble, Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas,
has stated that the Fed’s interest rate policy during the period of 2000–2003 was
misguided by erroneously low inflation data, thus contributing to the housing bubble.
Speaking before the New York Association for Business Economics in November 2006,
Fisher said:
A good central banker knows how costly imperfect data
can be for the economy. This is especially true of inflation
data. In late 2002 and early 2003, for example, core PCE
measurements were indicating inflation rates that werecrossing below the 1 percent “lower boundary.” At the
time, the economy was expanding in fits and starts. Given
the incidence of negative shocks during the prior two years,
the Fed was worried about the economy's ability to
withstand another one. Determined to get growth going in
this potentially deflationary environment, the FOMC
adopted an easy policy and promised to keep rates low. A
couple of years later, however, after the inflation numbers
had undergone a few revisions, we learned that inflation
had actually been a half point higher than first thought.
In retrospect, the real fed funds rate turned out to be lower
than what was deemed appropriate at the time and was held
lower longer that it should have been. In this case, poor
data led to a policy action that amplified speculative
activity in the housing and other markets. Today, as
anybody not from the former planet of Pluto knows, the
housing market is undergoing a substantial correction and
inflicting real costs to millions of homeowners across the
country. It is complicating the task of achieving our
monetary objective of creating the conditions for
sustainable non-inflationary growth.
The Bubble Bursts
Between 2004 and 2006, the Federal Reserve Board raised interest rates 17 times,
increasing them from 1 percent to 5.25 percent. The Fed stopped raising rates because of
fears that an accelerating downturn in the housing market could undermine the overall
economy. Some economists, like New York University economist Nouriel Roubini, feel
that the Fed should have tightened up on the rates earlier than it did “to avoid a festering
of the housing bubble early on.”
Roubini also warned that because of slumping sales and prices in August 2006, the
housing sector was in “free fall” and would derail the rest of the economy, causing a
recession in 2007.
In August 2006, Barron’s magazine warned that a housing crisis was approaching and
noted that the median price of new homes had dropped about 3 percent since January
2006. At that time the magazine also predicted that the national median price of housing
would fall about 30 percent in the next three years.
Housing Market Correction
Adding to the growing crisis was the prediction by many economists and business writers
in 2006 and 2007 that there would be a housing market correction because of the over
valuation of homes during the bubble period. Estimates ranged from a correction of a few
points to 50 percent or more from peak values.
Chief economist Mark Zandi of the economic research firm Moody’s Economy.com,
predicted a “crash” of double-digit depreciation by 2007-2009. In August 2007, in a
paper presented at a Fed economic symposium, Yale University economist Robert Shiller
warned that “past cycles indicate that major declines in real home prices—even 50
percent declines in some places—are entirely possible going forward from today or from
the not too distant future.”
The Rise of Subprime Lending
Subprime borrowing was a major factor in the increase in home ownership rates and the
demand for housing during the bubble years. The U.S. ownership rate increased from 64
percent in 1994 to an all-time high peak of 69.2 percent in 2004. The demand helped fuel
the rise of housing prices and consumer spending, creating an unheard of increase in
home values of 124 percent between 1997 and 2006. Some homeowners took advantage
of the increased property values of their home to refinance their homes with lower
interest rates and take out second mortgages against the added value to use for consumer
spending. In turn, U.S. household debt as a percentage of income rose to 130 percent in
2007, 30 percent higher than the average amount earlier in the decade.
With the collapse of the housing bubble came 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. Alt-A is a classification of mortgages in
which the risk profile falls between prime and subprime. The borrowers behind these
mortgages typically will have clean credit histories, but the mortgage itself generally will
have some issues that increase its risk profile. These issues include higher loan-to-value
and debt-to-income ratios or inadequate documentation of the borrower's income.
The share of subprime mortgages to total originations increased from 9 percent in 1996 to
20 percent in 2006 according to Forbes. Subprime mortgages totaled $600 billion in
2006, accounting for approximately one-fifth of the U.S. home loan market. An estimated
$1.3 trillion in subprime loans are outstanding.
The number of subprime loans rose as rising real estate values led to lenders taking more
risks. Some experts believe that Wall Street encouraged this type of behavior by bundling
the loans into securities that were sold to pension funds and other institutional investors
seeking higher returns.
