The subprime mortgage crisis is an ongoing financial crisis triggered by a significant decline in housing prices and related mortgage payment delinquencies and foreclosures in the United States. This caused a ripple effect across the financial markets and global banking systems, as investments related to housing prices declined significantly in value, placing the health of key financial institutions and government-sponsored enterprises at risk. Funds available for personal and business spending (i.e., liquidity) declined as financial institutions tightened lending practices. The crisis, which has roots in the closing years of the 21st century but has become more apparent throughout 2007 and 2008, has passed through various stages exposing pervasive weaknesses in the global financial system and regulatory framework.

The crisis began with the bursting of the United States housing bubble[1][2] and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005–2006. Government policies and competitive pressures for several years prior to the crisis encouraged higher risk lending practices.[3][4] Further, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. 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 and foreclosure activity increased dramatically as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.[5]

Financial products called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, had enabled financial institutions and investors around the world to invest in the U.S. housing market. Major banks and financial institutions had borrowed and invested heavily in MBS and reported losses of approximately US$435 billion as of 17 July 2008.[6][7] The liquidity and solvency concerns regarding key financial institutions drove central banks to take action to provide funds to banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets, which are integral to funding business operations. Governments also bailed out key financial institutions, assuming significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent financial market crisis were primary factors in several decisions by central banks around the world to cut interest rates and governments to implement economic stimulus packages. These actions were designed to stimulate economic growth and inspire confidence in the financial markets. Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%.[8] Losses in the stock markets and housing value declines place further downward pressure on consumer spending, a key economic engine.[9] Leaders of the larger developed and emerging nations met in November 2008 to formulate strategies for addressing the crisis.[10]

Factors Contributing to Housing Bubble – Diagram 1 of 2
Domino Effect As Housing Prices Declined – Diagram 2 of 2
A MetaView diagram shows the key subprime mortgage stocks as they undergo a chain reaction.

Contents

Background

Number of U.S. household properties subject to foreclosure actions by quarter.
Main articles: Subprime crisis background information and Subprime crisis impact timeline

Subprime lending is the practice of lending, mainly in the form of mortgages for the purchase of residences, to borrowers who do not meet the usual criteria for borrowing at the lowest prevailing market interest rate. These criteria pertain to the downpayment and the borrowing household's income level, both as a fraction of the amount borrowed, and to the borrowing household's employment status and credit history. If a homeowner is delinquent in making payments to the bank (or other holder of the mortgage loan), that entity can seize the home in a process called foreclosure.

The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, [11] with over 7.5 million first-lien subprime mortgages outstanding.[12] In the third quarter of 2007, subprime ARMs making up only 6.8% of USA mortgages outstanding also accounted for 43% of the foreclosures begun during that quarter.[13] By October 2007, approximately 16% of subprime adjustable rate mortgages (ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly triple the rate of 2005.[14] By January 2008, the delinquency rate had risen to 21%[15] and by May 2008 it was 25%.[16]

The value of all outstanding USA mortgages, owed by households to purchase residences housing at most 4 families, was US$9.9 trillion as of yearend 2006, and US$10.6 trillion as of midyear 2008.[17] During 2007, lenders had begun foreclosure proceedings on nearly 1.3 million properties, a 79% increase over 2006.[18] As of August 2008, 9.2% of all mortgages outstanding were either delinquent or in foreclosure.[19] 936,439 USA residences completed foreclosure between August 2007 and October 2008.[20]

Understanding credit risk

Understanding financial leverage.

Credit risk arises because a borrower has the option of defaulting on the loan he owes. Traditionally, lenders (who were primarily thrifts) bore the credit risk on the mortgages they issued. Over the past 60 years, a variety of financial innovations have gradually made it possible for lenders to sell the right to receive the payments on the mortgages they issue, through a process called securitization. The resulting securities are called mortgage backed securities (MBS) and collateralized debt obligations (CDO). Most American mortgages are now held by mortgage pools, the generic term for MBS and CDOs. Of the $10.6 trillion of USA residential mortgages outstanding as of midyear 2008, $6.6 trillion were held by mortgage pools, and $3.4 trillion by traditional depository institutions. [21]

This "originate to distribute" model means that investors holding MBS and CDOs also bear several types of risks, and this has a variety of consequences. There are four primary types of risk: 1. Credit risk on the underlying mortgages, 2. Asset price risk, 3. Liquidity risk, and 4. Counterparty risk. [22][23] When homeowners default, the payments received by MBS and CDO investors decline and the perceived credit risk rises. This has had a significant adverse effect on investors and the entire mortgage industry. The effect is magnified by the high debt levels (financial leverage) households and businesses have incurred in recent years. Finally, the risks associated with American mortgage lending have global impacts, because a major consequence of MBS and CDOs is a closer integration of the USA housing and mortgage markets with global financial markets.

Investors in MBS and CDOs can insure against credit risk by buying Credit defaults swaps (CDS). As mortgage defaults rose, the likelihood that the issuers of CDS would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered if CDS issuers would honor their commitments.

Causes

The reasons for this crisis are varied and complex.[24] The crisis can be attributed to a number of factors pervasive in both the housing and credit markets, which developed over an extended period of time. There are many different views on the causes,[25][26] including the inability of homeowners to make their mortgage payments, poor judgment by the borrower and/or the lender, speculation and overbuilding during the boom period, risky mortgage products, high personal and corporate debt levels, complex financial innovations that distributed and perhaps concealed default risks, central bank policies, and government regulation (or alternatively lack thereof).[27]

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

“ During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.[28] ”

Boom and bust in the housing market

Main articles: United States housing bubble and United States housing market correction
Existing homes sales, inventory, and months supply, by quarter.
Common indexes used for adjustable rate mortgages (1996–2006).

Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis.[29] The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004.[30] Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing.

This rise in demand fueled rising house prices and consumer spending.[31] Between 1997 and 2006, the price of the typical American house increased by 124%.[32] During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006.[33] This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 142% at the end of 2007, versus 101% in 1999.[34]

A culture of consumerism is a factor "in an economy based on immediate gratification."[35] Americans spent $800 billion per year more than they earned. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income.[36] During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970.[37]

This credit and house price explosion led to a building boom and a surplus of unsold homes. House prices began to decline in the summer of 2006. Easy credit, and a belief that house prices would continue to appreciate, encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

As of March 2008, an estimated 8.8 million homeowners — 10.8% of all homeowners — had zero or negative equity in their homes, meaning their homes were worth less than their mortgages. Homeowners in this situation have an incentive to "walk away" from the homes, even though doing so damages their credit rating for a number of years.[38] The reasons is that unlike what is the case in most other countries, American residential mortgages are non-recourse loans; once the creditor has regained the property purchased with a mortgage in default, he has no further claim against the defaulting borrower's income or assets. By November 2008, an estimated 12 million USA homeowners had negative equity. As more borrowers stop paying their mortgage payments, foreclosures and the supply of homes for sale increase. This places downward pressure on housing prices, which further lowers homeowners' equity. The decline in mortgage payments also reduces the value of mortgage-backed securities, which erodes the net worth and financial health of banks. This vicious cycle is at the heart of the crisis.[39]

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest value of this ratio since 1981.[40] Furthermore, nearly four million existing homes were for sale,[41] of which almost 2.9 million were vacant.[42]

This overhang of unsold homes excess lowered house prices. As prices declined, more homeowners were at risk of default or foreclosure. By November 2007, the S&P/Case-Shiller price index of USA house prices had declined about 8% from its Q2 2006 peak,[43] and by May 2008 it had fallen 18.4%.[44] The price decline between December 2006 and December 2007, was 10.4%, and by May 2008 the index had declined 15.8%.[45] House prices are expected to continue declining until this inventory of unsold homes (an instance of excess supply) declines to normal levels.

Speculation

Speculation in residential real estate has been a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."[46]

While homes had not traditionally been treated as investments, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.[47] Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.[48]

Economist Robert Shiller argues that speculative bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena; until we understand and address the psychology that fuels them, they're going to keep forming."[49] Keynesian economist Hyman Minsky described three types of speculative borrowing that contribute to rising debt and an eventual collapse of asset values:[50][51]

  • The "hedge borrower," who expects to make debt payments from cash flows from other investments;
  • The "speculative borrower," who borrows believing that he can service the interest on his loan, but who must continually roll over the principal into new investments;
  • The "Ponzi borrower," who relies on the appreciation of the value of his assets to refinance or pay off his debt, while being unable to repay the original loan.

Speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.[52]

High-risk mortgage loans and lending practices

Lenders began to offer more and more loans to higher-risk borrowers,[53] including illegal immigrants.[54] Subprime mortgages amounted to $35 billion (5% of total originations) in 1994,[55] 9% in 1996,[56] $160 billion (13%) in 1999,[55] and $600 billion (20%) in 2006.[56][57][58] A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined from 280 basis points in 2001, to 130 basis points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though the credit ratings of subprime borrowers, and the characteristics of subprime loans, both declined during the 2001–2006 period, which should have had the opposite effect. The combination of declining risk premia and credit standards is common to classic boom and bust credit cycles.[59]

In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.[60]

One high-risk option was 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. An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.[61]

Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation.[62] In 2007, 40% of all subprime loans resulted from automated underwriting.[63][64] The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.[65] Outright fraud has also increased.[66]

Securitization practices

Borrowing under a securitization structure.

Securitization is structured finance process in which assets, receivables or financial instruments are acquired, pooled together as collateral for the third party investments (Investment banks).[67] There are many parties involved. Due to the 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. Asset securitization began with the structured financing of mortgage pools in the 1970s.[68] In 1995 the Community Reinvestment Act (CRA) was revised to allow for the securitization of CRA loans into the secondary market for mortgages.

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 traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors through MBS. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.[59] Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The debt associated with the origination of such securities was sometimes placed by major banks into off-balance sheet entities called structured investment vehicles or special purpose entities. Moving the debt "off the books" enabled large financial institutions to circumvent capital reserve requirements, thereby assuming additional risk and increasing profits during the boom period. Such off-balance sheet financing is sometimes referred to as the shadow banking system and is thinly regulated.[69] Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — was to blame for the current global credit crisis.[70]

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.[22]

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.[71][72]

Under the CRA guidelines, a bank gets credit originating loans or buying on a whole loan basis, but not holding the loans. So, this gave the banks the incentive to originate loans and securitize them, passing the risk on others. Since the banks no longer carried the loan risk, they had every incentive to lower their underwriting standards to increase loan volume. The mortgage securitization freed up cash for banks and thrifts, this allowed them to make even more loans. In 1997, Bear Sterns bundled the first CRA loans into MBS. [73]

Inaccurate credit ratings

Main article: Credit rating agencies and the subprime crisis
MBS credit rating downgrades, by quarter.

Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Internal rating agency emails from before the time the credit markets deteriorated, released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce widespread negative results.[74] For example, one 2006 email between colleagues at Standard & Poor's states "Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[75]

High ratings encouraged the flow of investor funds into these securities, helping finance the housing boom. The reliance on ratings by these agencies and the intertwined nature of how ratings justified investment led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities and furthered by SEC removal of regulatory barriers and reduced disclosure requirements in the wake of the Enron scandal.[76] Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.[77] On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.[78]

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressured MBS and stock prices lower.[79]

Government policies

Main article: Government policies and the subprime mortgage crisis

Both government action and inaction have contributed to the crisis. Several critics have commented that the current regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws."[80] The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.[81][82]

Increasing home ownership was a goal of both Clinton and Bush administrations.[83][84][85] There is evidence that the government influenced participants in the mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower lending standards.[86][87][88] The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans.[89][90]

In 1995, the GSE began receiving government incentive payments for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities.[91] Subprime mortgage loan originations surged by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years.[92] These securities were very attractive to Wall Street, and while Fannie and Freddie targeted the lowest-risk loans, they still fueled the subprime market as a result.[93] In 1996 the Housing and Urban Development (HUD) agency directed the GSE to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.[94] By 2008, the GSE owned or guaranteed nearly $5 trillion in mortgages and mortgage-backed securities, close to half the outstanding balance of U.S. mortgages. The GSE were highly leveraged, having borrowed large sums to purchase mortgages. When concerns arose regarding the ability of the GSE to make good on their guarantee obligations in September 2008, the U.S. government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers' expense.[95][96]

Liberal economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree.[97][98] 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.[99]

Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers[100][101][102][103] and defenders claiming a thirty year history of lending without increased risk.[104][105][106][107] Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages.[108][109]

Policies of central banks

Central banks are primarily concerned with managing monetary policy, they are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com 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 a matter of debate among economists.[110][111]

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.[112]

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.[110] From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.[113] The central bank believed that interest rates could be lowered safely primarily because the rate of inflation was low and disregarded other important factors. The Federal Reserve's inflation figures, however, were flawed. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, stated that the Federal Reserve's interest rate policy during this time period was misguided by this erroneously low inflation data, thus contributing to the housing bubble.[114]

Financial institution debt levels and incentives

Leverage Ratios of Investment Banks Increased Significantly 2003–2007

Many financial institutions borrowed enormous sums of money during 2004–2007 and made investments in mortgage-backed securities (MBS), essentially betting on the continued appreciation of home values and sustained mortgage payments. Borrowing at a lower interest rate to invest at a higher interest rate is using financial leverage. This is analogous to an individual taking out a second mortgage on their home to invest in the stock market. This strategy magnified profits during the housing boom period, but drove large losses after the bust. Financial institutions and individual investors holding MBS also suffered significant losses as a result of widespread and increasing mortgage payment defaults or MBS devaluation beginning in 2007 onward.[23]

A SEC regulatory ruling in 2004 greatly contributed to US investment banks' ability to take on additional debt, which was then used to purchase MBS. The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), 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, creating instability in the global financial system. The remaining two converted to commercial bank models, subjecting themselves to much tighter regulation.[115]

In 2006, Wall Street executives took home bonuses totaling $23.9 billion, according to the New York State Comptroller's Office. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."[33]

Credit default swaps

Credit defaults swaps (CDS) are insurance contracts, typically used to protect bondholders or MBS investors from the risk of default. As the financial health of banks and other institutions deteriorated due to losses related to mortgages, the likelihood that those providing the insurance would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered which companies would be forced to pay to cover defaults.

CDS may be used to insure a particular financial exposure or may be used speculatively. Trading of CDS increased 100-fold from 1998 to 2008, with debt covered by CDS contracts ranging from U.S. $33 to $47 trillion as of November 2008.[116] CDS are lightly regulated. During 2008, there was no central clearinghouse to honor CDS in the event a key player in the industry was unable to perform its obligations. Required corporate disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as AIG, MBIA, and Ambac faced ratings downgrades due to their potential exposure due to widespread debt defaults. These institutions were forced to obtain additional funds (capital) to offset this exposure. In the case of AIG, its nearly $440 billion of CDS linked to MBS resulted in a U.S. government bailout.[117]

In theory, because credit default swaps are two-party contracts, there is no net loss of wealth. For every company that takes a loss, there will be a corresponding gain elsewhere. The question is which companies will be on the hook to make payments and take losses, and will they have the funds to cover such losses. When investment bank Lehman Brothers went bankrupt in September 2008, it created a great deal of uncertainty regarding which financial institutions would be required to pay off CDS contracts on its $600 billion in outstanding debts.[118][119] Significant losses at investment bank Merrill Lynch were also attributed in part to CDS and especially the drop in value of its unhedged mortgage portfolio in the form of Collateralized Debt Obligations after American International Group ceased offering CDS on Merril's CDOs. Trading partner's loss of confidence in Merril Lynch's solvency and ability to refinance short-term debt ultimately led to its sale to Bank of America.[120][121]

Impact

Main articles: Financial crisis of 2007–2008 and Global financial crisis of 2008

Financial sector downturn

Main article: List of writedowns due to subprime crisis
FDIC Graph - U.S. Bank & Thrift Profitability By Quarter

Financial institutions from around the world have recognized subprime-related losses and write-downs exceeding U.S. $501 billion as of August 2008.[122] Profits at the 8,533 U.S. banks insured by the FDIC declined from $35.2 billion to $646 million (89%) during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007, these banks earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year, a decline of 46%.[123][124]

The financial sector began to feel the consequences of this crisis in February 2007 with the $10.5 billion writedown of HSBC, which was the first major CDO or MBO related loss to be reported.[125] During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.[126] Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.[127] Various institutions followed up with merger deals.[128]

Market weaknesses, 2007

On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.[129]

On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Through 2008, large daily drops became common, with, for example, the KOSPI dropping about 7% in one day,[130][dead link] 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[131][dead link][132] and home builders[133][134][dead link] 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.[135]

Stock indices worldwide trended downward for several months since the first panic in July–August 2007.

Market downturns and impacts, 2008

The TED spread – an indicator of credit risk – increased dramatically during September 2008.

The crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value".[136] Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle."[137][138] Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.[139]

Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. Poor economic data on manufacturing contributed to the day's panic, but were eclipsed by the severe developments of the financial crisis. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.

The much anticipated passage of the $700 billion bailout plan was struck down by the House of Representatives in a 228–205 vote on September 29. In the context of recent history, the result was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss (7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P 500 fell 8.8%, both of which were the worst losses those indices experienced since the 1987 stock market crash.

Despite congressional passage of historic bailout legislation, which was signed by President Bush on Saturday, Oct. 4, Dow Jones Index tumbled further when markets resumed trading on Oct. 6. The Dow fell below 10,000 points for the first time in almost four years, losing 800 points before recovering to settle at -369.88 for the day.[140] Stocks also continued to tumble to record lows ending one of the worst weeks in the Stock Market since September 11, 2001."[141]

It is also estimated that even with the passing of the so-called bailout package, many banks within the United States will tumble and therefore cease operating. It is estimated that over 100 banks in the United States will close their doors because of the financial crisis. This will have a severe impact on the economy and consumers. It is expected that it will take years for the United States to recover from the crisis .[142]

Indirect economic effects

Main article: Indirect economic effects of the subprime mortgage crisis

The subprime crisis had a series of other economic effects. Housing price declines left consumers with less wealth, which placed downward pressure on consumption.[143] Certain minority groups received a higher proportion of subprime loans and experienced a disproportional level of foreclosures.[144][145] Home related crimes including arson increased.[146] Job losses in the financial sector were significant, with over 65,400 jobs lost in the United States as of September 2008.[147]

Many renters became innocent victims, often evicted from their homes without notice due to foreclosure of their landlord's property.[148] In October 2008, Tom Dart, the elected Sheriff of Cook County, Illinois, criticized mortgage companies for their actions, and announced that he was suspending all foreclosure evictions.[149]

The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. One in five car dealerships are expected to close in Fall of 2008.[150]

Responses

Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.

Legislative and regulatory responses

The Federal Reserve

Main article: Federal Reserve responses to the subprime crisis

The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "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."[15]

  • Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions.[151][152]
  • The Fed and other 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.[153]
  • The Fed is using the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months.
  • In July 2008, the Fed finalized new rules that apply to mortgage lenders.[154]
  • In October 2008, the Fed expanded the collateral it will loan against to include commercial paper, to help address continued liquidity concerns.[155]

Regulation

Main article: Regulatory responses to the subprime crisis

Regulators and legislators have contemplated taking action with respect to lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.[156] Regulations or guidelines can influence the transparency and reporting required of lenders and the types of loans they choose to issue. Congressional committees are also conducting hearings to help identify solutions and apply pressure to the various parties involved.[157]

  • On 31 March 2008, a sweeping expansion of the Fed's regulatory powers was proposed, that would expand its jurisdiction over nonbank financial institutions, and its authority to intervene in market crises.[158]
  • Responding to concerns that lending was not properly regulated, the House and Senate are both considering bills to further regulate lending practices.[159]
  • Countrywide's VIP program has led ethics experts and key senators to recommend that members of Congress be required to disclose information about the mortgages they take out.[160]
  • Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital reserve requirements as depository banks. Many investment banks had limited capital reserves to address declines in their holdings of MBSs, or to support their side of credit default derivative insurance contracts. Nobel prize winner Joseph Stiglitz recommends adopting regulations limiting the extent of leverage permitted, and not allowing companies to become "too big to fail."[161]
  • On 18 September 2008, UK regulators announced a temporary ban on short-selling the stock of financial firms.[162]
  • The Australian federal government has announced an investment of AU$4 billion in non-bank lender mortgage backed securities in an attempt to maintain competition in the mortgage market.[163]

Economic Stimulus Act of 2008

Main article: Economic Stimulus Act of 2008

President Bush also signed into law on 13 February 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth.[164] The economic stimulus package included the mailing of rebate checks to taxpayers. Such mailings started the week of 28 April 2008. These mailings, however, coincided with unexpected all-time jumps in food and gasoline prices. This coincidence prompted some to question whether the stimulus package would have the desired effect or whether consumers would just use it to make up for the gap generated by the higher food and fuel prices. Some Congressmen even contemplated legislation for a second round of stimulus rebate checks to ensure the initial intention of the stimulus package had the expected effect. The Treasury Secretary strongly opposed such initiative.

Housing and Economic Recovery Act of 2008

Main article: Housing and Economic Recovery Act of 2008

The Housing and Economic Recovery Act of 2008 included six separate major acts designed to restore confidence in the domestic mortgage industry.[165] The Act included:

  • Providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners.
  • Establishing a new regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan banks.
  • Raising the dollar limit of the mortgages the government sponsored enterprises (GSEs) can purchase.
  • Providing loans for the refinancing of mortgages to owner-occupants at risk of foreclosure. The original lender or investor reduces the amount of the original mortgage (typically taking a significant loss) and the homeowner shares any future appreciation with the Federal Housing Administration. The new loans must be 30-year fixed loans.
  • Enhancements to mortgage disclosures.
  • Community assistance to help local governments buy and renovate foreclosed properties.

Government bailouts

Main articles: Government intervention during the subprime mortgage crisis, List of bankrupt or acquired banks during the financial crisis of 2007–2008, and Federal takeover of Fannie Mae and Freddie Mac
People queuing outside a Northern Rock bank branch in Birmingham, United Kingdom on September 15, 2007, to withdraw their savings due to fallout from the subprime crisis.
  • Northern Rock had difficulty finding finance to keep the business going and was nationalized on 17 February 2008. As of October 8th, 2008, UK taxpayer liability for the bank had climbed to £87Bn ($150Bn) according to Robert Chote, director of the Institute for Fiscal Studies.[166]
  • Bear Stearns was acquired in March 2008 by J.P. Morgan Chase for $1.2 billion.[167] In order for the deal to go through, the Fed issued a nonrecourse loan of $29 billion to Bear Stearns.[168]
  • In September 2008, the Treasury Department confirmed that both Fannie Mae and Freddie Mac would be placed into conservatorship[169] with the government taking over management of the pair. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt.[170]
  • Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.[171]
  • Scottish banking group HBOS agreed on 17 September 2008 to be acquired by UK rival Lloyds TSB in an emergency takeover after its share price experienced significant falls amid fears over its exposure to toxic debt. The deal was encouraged by the UK government, who agreed to waive competition rules to allow the takeover to go ahead.[172]
  • Lehman Brothers declared bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out.[173] Treasury Secretary Hank Paulson cited moral hazard as a reason for not bailing out Lehman Brothers.[174]
  • In September 2008, The Federal Reserve provided an emergency loan of $85 billion to AIG,[175] which will be repaid by selling off assets of the company.[176] This intervention gave the US government a 79.9% equity stake at AIG.[176] Just over three weeks later the Fed reported that AIG had drawn down $70.3 billion of that $85 billion facility[177] and AIG announced that it may tap an additional $37.8 billion in secured funding from the Federal Reserve.[178]
  • In September 2008, Washington Mutual declared bankruptcy.[179] The United States Office of Thrift Supervision (OTS) announced that it was seizing WaMu and would sell most of its functional assets to J.P. Morgan Chase.[180]
  • On 29 September 2008, British bank Bradford & Bingley was nationalised by the UK government. The government will take control of the bank's £50bn mortgages and loans, while its savings operations and branches are to be sold to Spain's Santander.[181]
  • In October 2008, The Australian government announced that AU$4 billion was to be raised to fund non-bank lenders that are unable to obtain funding to finance new loans. After industry feedback this was increased to AU$8 billion.[182]

Emergency Economic Stabilization Act of 2008

Main article: Emergency Economic Stabilization Act of 2008

As of June 30, 2008, residential mortgages owed by USA households totalled US$10.6 trillion.[183] As of August 2008, 9.2% of these mortgages were either seriously delinquent or in foreclosure.[19]

On 19 September 2008, the U.S. Federal government announced a plan, requiring Congressional approval, to purchase from financial institutions large amounts of MBSs and CDOs back by subprime mortgages.[184] The estimated cost of this plan was at least $700 billion.[185] The plan also banned short-selling the stocks of financial firms.[186] On 29 September 2008, the House of Representatives rejected a revised version of the plan.[187] On 1 October 2008, the U.S. Senate approved an amended version of the plan,[188] which was approved by the House on October 3, and immediately signed into law by President Bush.

Lending industry action

Lenders and borrowers both may both benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have offered troubled borrowers more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Borrowers have also been encouraged to contact their lenders to discuss alternatives.[189]

Corporations, trade groups, and consumer advocates have begun to cite data on the numbers and types of borrowers assisted by loan modification programs. There is some disagreement regarding the data, and the adequacy of measures taken to date. A report January 2008 report stated that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 foreclosures were initiated. Consumer groups claimed these modifications affected less than 1% of the 3 million ARM subprime mortgages outstanding as of the third quarter.[190]

The State Foreclosure Prevention Working Group, a coalition of state attorney generals and bank regulators from 11 states, reported in April 2008 that loan servicers could not keep up with the rising number of foreclosures. 70% of subprime mortgage holders are not getting the help they need. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. In order to slow the growth of foreclosures, the Group has recommended a more automated method of loan modification that can be applied to large blocks of struggling borrowers.[191]

On October 5, 2008, the Bank of America, following on a legal settlement with several states, announced a more aggressive and systematic program intended to help an estimated 400,000 borrowers keep their homes. The program will limit payments as a fraction of household income, and reduce mortgage balances.[192]

In November 2008, Fannie Mae, Freddie Mac and their network of mortgage service providers announced a streamlined loan modification program and foreclosure suspension, designed to help keep borrowers in their homes.[193][194]

Several Australian lenders have amended their policies for low doc, no doc, and no deposit loans, all deemed riskier than standard mortgages. These changes have been relatively minor, with the exception of those nonconforming lenders that lend to credit impaired and subprime borrowers. It remains to be seen if this trend will continue, or if Australian lenders will eventually stop offering riskier loan products.[195]

Hope Now Alliance

Main article: Hope Now Alliance

President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs.[196][197] A refinancing facility called FHA-Secure was also created.[198] These actions are part of the Hope Now Alliance, an ongoing collaborative effort between the US Government and private industry to help certain subprime borrowers.[199] In February 2008, the Alliance reported that during the second half of 2007, it had helped 545,000 subprime borrowers with shaky credit, or 7.7% of 7.1 million subprime loans outstanding as of September 2007. A spokesperson for the Alliance acknowledged that much more must be done.[200]

During February 2008, a program called "Project Lifeline" was announced. Six of the largest USA lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for borrowers 90 or more days delinquent on their mortgage payments. The intent of the program was to reduce foreclosures by encouraging loan adjustments.[201]

Bank capital replenishment from private sources

As of May 2008, major financial institutions had obtained over $260 billion in new capital, taking the form of bonds or preferred stock sold to private investors in exchange for cash.[202] This new capital has helped banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to losses on subprime loans or CDO investments. Raising additional capital has been advocated by the leadership of the U.S. Federal Reserve and the Treasury Department.[203] Well-capitalized banks are in a better position to lend at favorable interest rates, and to offset the falling liquidity and rising uncertainty in credit markets.

That certain banks and securities firms have been able to sell large amounts of debt to investors suggests that these firms will survive the credit crisis.[204] The last independent investment banks, Goldman Sachs and Morgan Stanley, responded to the crisis by electing to become bank holding companies, in order to gain access to the Federal Reserve System as lender of last resort.[205]

Banks have obtained some of their new capital from the sovereign wealth funds of developing countries, whose aggregate value is estimated at nearly $2.9 trillion, much of it derived from exports of oil and gas. From mid-2007 to mid-2008, such funds have invested an estimated US$69 billion in large USA financial institutions. On January 15, 2008, sovereign wealth funds supplied a total of $21 billion to two major American financial institutions. As sovereign wealth funds are ultimately controlled by some government, their willingness to supply new capital to American financial firms is suspected of having an unstated political motive.[206]

Certain major banks have also reduced their dividend payouts[207] to increase liquidity, and some analysts expect further dividend reductions in 2008.[208] Of the 3776 FDIC insured institutions that paid a dividend on their common stock in the first quarter of 2007, almost half (48%) paid a lower dividend in the first quarter of 2008, and 666 institutions reduced their dividend to zero. Insured institutions paid $14.0 billion in total dividends in the first quarter of 2008, down $12.2 billion (46.5%) from the first quarter of 2007.[209]

Litigation

Litigation related to the subprime crisis is underway. A study released in February 2008 indicated that 278 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts was not quantified but is also believed to be significant. The study found that 43% of the cases were class actions brought by borrowers, such as those that contended they were victims of discriminatory lending practices. Other cases include securities lawsuits filed by investors, commercial contract disputes, employment class actions, and bankruptcy-related cases. Defendants included mortgage bankers, brokers, lenders, appraisers, title companies, home builders, servicers, issuers, underwriters, bond insurers, money managers, public accounting firms, and company boards and officers.[210]

Former Bear Stearns managers were named in civil lawsuits brought in 2007 by investors, including Barclays Bank PLC, who claimed they had been misled. Barclays claimed that Bea