Subprime Crisis

Guys now everybody knows about Subprime crisis and its ripple effects (stock market down crashes, bankruptcies economic troubles like fear of recession, rupee depreciation, job cutting & etc) to whole world & India. So let’s have look at it from microscopic view.

What is Subprime lending?

Subprime lending is the practice of giving loans to borrowers who do not qualify for market interest rates owing to various risk factors, such as income level, size of the down payment made, credit history, and employment status.

So the person who is credit worthy, receive the loan from the bank for say example 10% and lend it to non credit worthy person say for 15%.

Traditionally, banks lent money to homeowners for their mortgage and retained the risk of default, called credit risk. However, due to financial innovations, banks can now sell rights to investors, through a process called securitization. The securities the investors purchase are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). [CDO are financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. CDO's were created to provide more liquidity in the economy. It allows banks and corporations to sell off debt, which frees up more capital to invest or loan. The creation of CDO's is one reason why the U.S. economy has been so robust in the last five years].

This means credit risk has been distributed broadly to investors, with a series of consequential impacts. There are four primary categories of risk involved: credit risk, asset price risk, liquidity risk, and counterparty risk.

There is a greater interdependence now than in the past between the U.S. housing market and global financial markets due to MBS. When homeowners default, the amount of cash flowing into MBS declines and becomes uncertain. Investors and businesses holding MBS have been significantly affected. The effect is magnified by the excessive leveraging.

When it started?

The crisis began with the bursting of the housing bubble and high default rates on "Subprime" beginning in approximately 2005–2006.

For a number of years prior to that, declining lending standards, an increase in loan incentives and a long-term trend of rising housing prices had encouraged borrowers & they assume that they would be able to quickly refinance at more favorable terms. However, once interest rates began to rise and housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and interest rates reset higher.

What are the main causes for crisis?

1. Boom and bust in the housing market

A combination of low interest rates and large inflows of foreign funds helped to create easy credit conditions for many years leading up to the crisis. Subprime borrowing was a major contributor to an increase in home ownership rates and the demand for housing. This demand helped fuel housing price increases and consumer spending. Between 1997 and 2006, American home prices increased by 124%.

Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline, beginning in the summer of 2006. Easy credit encouraged many Subprime borrowers to obtain loan they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S., refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.

2. Speculation

Speculation in real estate was a contributing factor. The role of speculative borrowing has been cited as a contributing factor to the Subprime mortgage crisis.

While homes had not traditionally been treated as investments like stocks, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of properties purchased in Miami were for investment purposes & selling them for profit without ever living there. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.

3. High-risk mortgage loans and lending practices

The share of Subprime mortgages to total original loan was 5% ($35 billion) in 1994, 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006. A study by the Federal Reserve indicated that the average difference in mortgage interest rates between Subprime and prime mortgages declined from 2.8% in 2001, to 1.3% in 2007. In other words, the risk premium required by lenders to offer a Subprime loan declined.

In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans.

Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.

4. Securitization practices

Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, pooled together as collateral for the third party investments (Investment banks).

The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining credit (default) risk. With the advent of securitization, the credit risk is transferred (distributed) to investors through MBS. The securitized share of Subprime mortgages increased from 54% in 2001, to 75% in 2006.

The debt associated with such securities was placed by off-balance sheet entities called special purpose entities. Moving the debt "off the books" enabled large financial institutions to evade capital reserve requirements, thereby assuming additional risk and increasing profits during the boom period.

However, instead of distributing mortgage-backed securities to investors, many financial institutions retained significant amounts. The credit risk remained concentrated within the banks instead of fully distributed to investors outside the banking sector. Some argue this was not a flaw in the securitization concept itself, but in its implementation.

5. Inaccurate credit ratings

6. Government policies
 Mortgage restrictions
 Capital requirements played an important role in stimulating mortgage securitization. Mortgages originated and held by banks are put into an arbitrary risk classification that requires more capital than similar mortgages originated by third parties but held as securities. Freddie Mac and Fannie Mae are regulated differently, and for all but the riskiest loans Freddie and Fannie face lower capital requirements and hence lower costs.
 The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans.

7. Policies of central banks

A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation. From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.

8. Financial institution debt levels

Many financial institutions borrowed enormous sums of money during 2004–2007 and made investments in mortgage-backed securities (MBS). Borrowing at a lower interest rate to invest at a higher interest rate is using financial leverage. This strategy magnified profits during the housing boom period, but drove large losses after the bust.

The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period, which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during September 2008. The remaining two converted to commercial bank models, subjecting themselves to much tighter regulation.

Effects

I don’t think I need to mention the effects of the crisis, since we are all facing heat of this. Like
 Financial sector down
 Stock market crash
 Indirect Economic problems……


Sources…
Wikipedia & other sites…