The Causes and Consequences of the Subprime Crisis Finance Essay

On 7th December 2006, Own It Mortgage Solution Inc., the 100 percent institution that give loan to customer and owned by Merrill Lynch & Co., had decided to close down and told 800 workers not to come to work by next day (Keoun, 2006). At the end of February 2007, HSBC Finance, one of the HSBC bank in England whom specialized in subprime, had recognized the loss around $1.4 billion (Livesey, 2007). On 20 March 2007, People Choice Financial Corporation declared bankruptcy due to the Chapter 11 filing today in U.S. Bankruptcy Court in Santa Ana, California (Kary, 2007). On 24 March 2007, New Century Financial Company, one of the biggest company that give loan to people who have below standard for the credit declare to stop every transaction in loan (Affordable Housing Institute: US, 2007). Following by Goldman Sachs, one of the big financial institutions was aware of their worse financial condition was laid off 3,200 employees (The New York Times, 2008). On July 2007, Chairman of Federal Reserve of U.S.A. declared that Housing Bubble Burst will make the U.S. economy in downturn because of losses from subprime mortgage crisis around $100 billion (Times online, 2007). From all of the consequences, all of these company acknowledged of serious financial situation, hence, they lay off their employees to reduce their cost of capital or even declared for bankruptcy, there are all because of Subprime crisis.

What is Subprime Crisis?

Subprime refers to a classification of borrowers who are less likely to pay back a loan or, in other word, not creditworthy are therefore considered to be high risk for the lenders. These borrowers are classified in subprime due to a variety reasons, for example, low income, tarnished credit history, and poor dept to income ratio (Gwinner, 2009). According to the high risk of lenders on the repayment, as such, the borrowers will have to carry higher interest rate for the subprime loan (Neale, 2008).

Structure of subprime mortgage securitization market

Source: Gwinner, BW. and Sanders, A. (2009), 'The Subprime Crisis: Implications for Emerging Markets', Housing Finance International, vol. 23, no. 4, pp. 8.

Hence, the subprime crisis was a financial crisis which was stimulated by based on the failure in mechanism of subprime mortgage loan. The subprime crisis was the result of a combination of several factors which mainly were regulatory policies, the increasing of subprime lending, the cracked in financial risk models and credit rating, and the housing bubble and its burst.

The Causes of Subprime Crisis

Regulatory Policies

One of the American dreams is to owning the house (Pritchard, n.d.). Thus, many regulatory policies have been stated in order to assist the Americans to obtain the house ownership. Back to 1977, the increment in house ownerships has been stimulated by the Community Reinvestment Act which inspired the commercial banks and any other saving associations to extend loans in order to support the home possession (Mazumder, 2010). Similarly, the American Dream Down Payment Act of 2003 has been announced with an aim to allow about $200 million per year to support the low income Americans and minorities with tarnished credit as well as to expand the limitation of loan for the first time home buyers (Langbert, 2008). These regulatory policies were created with an objective to support and expand the home ownership to low income households. However, they also had drawback consequences which were potentially overlooked, these regulatory policies encouraged the financial institutions to extend their risky by lending to the people who not creditworthy. Furthermore, after dot com crisis and 9/11 tragedy, the policy to boost the troubled economic by reduction of interest rate was continually announced by Federal Reserve Board. Declining in interest rate was reduced from 6.5 percent to eventually to 1 percent in late of 2004 (Bianco, 2008). Despite of the reduction of interest rate played an important role in stimulation of investment and employment, it also encouraged and extended the risk taking behavior of banks and financial institutions (Gwinner, 2009).

The Increasing of Subprime lending

The American house ownership rate increased dramatically from 63 percent in the early of 1990s to an all time high peak of 69 percent in 2005 (Whalen, 2008). The sharp change in house ownership rate of American was influenced by the bunch of regulatory policies which encouraged and supported Americans to owning the house including the speculators who used this loophole for making the profit. Consequently, the higher in demand for housing caused the upswing of housing prices by 124 percent increment between 1997 and 2006 (Bianco, 2008). Simultaneously, subprime lending was boosted up as well in order to expand the American house ownership. However, some homeowners took advantage from the increasing in housing price values by refinancing their homes and taking out the difference between first and second mortgages to use in consumer spending. Alternately, the U.S. household debt increased 30 percent higher than historical average amount (Bianco, 2008). The rising of number of subprime loans as rising of property values induced the lenders to take higher risks as the subprime loans work well when property prices are on the upswing trend and low interest rate (Smith, n.d.). Under this environment, borrowers are assumed to resell the property at higher price rather than default the payment (Amadeo, n.d.). Conversely, once the interest rates rapidly increase and real estate values decline, high default rate would be existed and ripple effect would expand entirely across the industry.

The Cracked in Financial Risk Models and Credit Rating

The financial risk models were driven by the complex mathematics based on enormous of intensive data (Mazumder, 2010). The intensive data was the statistical data in history. Notably, these risk models were run by assumed the regular economic conditions, as such, these models omitted the future write-downs, collateral damages or crisis (Mazumder, 2010). Therefore, the risk models were claimed to be not appropriate to use (Danielsson, 2008). In 2008, according to the Market Data Group Staff Reports of Wall Street Journal, the stock prices of Lehman Brothers and AIG lost more than 90 percent and 80 percent, respectively, mostly due to collateral damages (Mazumder, 2010). These evidences revealed the flawed in financial risk model that it could not predict the future write-downs and provide an inaccurate assessment on the future collateral damages.

The credit rating was significance to the investors, insurance companies and brokers-dealers. They traded the debt securities based on the credit ratings that provided by the credit rating agencies (Mazumder, 2010). However, obviously, the credit rating agencies provided inaccurate credit ratings. Mazumder (2010) argues that credit rating that provided by the agencies used flawed models with inappropriate assumptions under an inadequate data. Many mortgage-backed securities were rated as AAA even it had high risk of default (Bianco, 2008). The inaccurate rating was claimed to be involved with the conflict of interest as rating agencies were paid by the companies who selling the mortgage-backed securities to the investors (Gwinner, 2009). Generally, it is clear that investors were misled by the inaccurate credit ratings provided by the credit rating agencies.

The Housing Bubble and Its Burst

Housing bubble is defined by a swift run-up in valuation, fueled by the demand, of real estate and property, such as housing, until it reached the unsustainable levels with relative to income and other economic indicators of affordability (Bianco, 2008). The housing bubble in U.S. was mainly engendered by the regulatory policies that encourage the house ownership of the Americans as well as the lowering of interest rate by the Fed to encourage the economic boom. The rapidly increasing in house price was appeared. Also, the magnitude of subprime mortgages increased from $35 billion in 1994 to $700 billion in 2006 (Mazumder, 2010). In 2006, after market correction, the increasing in house prices was claimed to be overvalued or, in other word, the house price inflation (Bianco, 2008). House prices began declining since then -- Housing bubble burst. Fed started to increase the interest rate continuously from 1 percent to more than 5 percent in mid of 2007 in order to combat with the inflation (Gwinner, 2009). According to the declining in house prices, the collateral value of mortgages began decreasing, thus, borrowers were forced to put more collaterals or down payments. The borrowers started to confront the problem to pay back the mortgages loan.

The housing bubble burst caused significant high default rate and foreclosures, consequently, made subprime market to be illiquid. These in conjunction with the huge investments which were misled by the agencies including the flawed in financial risk models caused the terribly financial problem spread wider and resulted in the ripple effects that impacted the whole subprime financial chain e.g. borrowers, financial institutions and investors ' so called Subprime crisis.

Effect of Subprime crisis

There are lots of effects that cause from subprime crisis in U.S. that can impact to all of the domestic companies and Americans and also subprime crisis created domino effect to other countries which involved in US economy (Shapiro, 2007). Began from subprime crisis in U.S., it caused domino effect that impacted to world economic crisis.

There are two points of views to divide the effect of subprime crisis in U.S. and also lead to world economic crisis. First is effect to American people and institution in U.S. Second, impact to other countries that involved directly to U.S. economy and also countries that got impact indirectly from U.S. economy crisis.

For the effect to U.S. economy and American People, There are four effects which impact to domestic economy. First, the effect to banking industry in U.S., after Fed increased interest rate as afraid of the acceleration in housing downturn, many borrowers defaulted to pay their loan back to their bank. From these defaults, banks need to foreclosure their house. As the result of numbers of default to pay back the loan, bank got higher rate in foreclosures which lead to higher rate in liquidity risk for bank. Also the price of house crashed down to 4.5 percent (BBC News, 2007).

U.S. House Price Trends

Source: BBC news <https://news.bbc.co.uk/2/hi/business/7073131.stm>

From this result, bank could not sell their foreclosure house easily which led to liquidity risk to many banks in U.S.

Second effect to domestic in US is impact on stock market of U.S. On 19 July 2007 Dow Jones Industry, one of the most important indicator of U.S. market, increased to hit the highest 14,000 for the first time. By the end of 15 August 2007, Dow Jones dropped below 13,000 (Bianco, 2008). From Dow Jones, it caused dropping in all the stock market around the world. For example, Hong Kong's Hang Seng dropped to 7.639 percent, Nikkei index of Japan dropped to 16.158 percent and Shanghai index of China dropped to 19.515 percent (Scribd, 2009).

Third effect to U.S. was the decline in value of U.S. Dollar. As the result of subprime crisis, it made U.S. dollar decline in value against other currency. For example, U.S. dollar declined in value against Indian Rupees from year 2007-2008 (World Bank, 2008).

Declining Value of US Dollar (Jan 07-08)

Source: World Bank

From these dropped in US dollar value, it could affect directly to U.S. exporter that they need to hold their activities because of they need to spend more for their cost because of depreciation of U.S. dollar.

Final effect that went to American people, Fed increased interest higher which mean credit got tighter for American people. When interest higher, American people who wanted to borrow the money for purchasing house or borrow from another bank got more expensive to pay back which some of them may consider that it was very hard to buy house at that time. Also American people needed more money for down payment and also very good credit to buy a house because bank needed to make sure that it would not lead to increase in default risk of their transactions (Silicon Valley Blogger, 2007). On the other hand, people, who wanted to sell the house at subprime crisis situation, got harder to sell their house. As the result, at that time, the value of house was declined to very low level which could be very hard to sell because they could not get higher profit from it. Moreover, people who want to refinance their mortgage could not refinance it because at that time bank stricter refinancing term (Blogger, 2007).

For the effect from subprime crisis to global economy, it effected in two ways. First, it could affect stock market. As seen from the above paragraph that after Subprime crisis, it could make Dow Jones industry average fall. From this result, after global investor fear about the bad signal in U.S. economy, they tended to sell their shares out to hold their cash. As this reason, it would make other stock market around the world turn to fell down. Lastly for the impacted on world economy, due to investor sold their shares to hold their money for serious situation and since U.S. has been being the largest financial market in the world (Wordpress, 2007). From these result, it showed that when US economy turndown, it would affect global economy due to the largest market capitalization of financial market of U.S.

How does securitization worsen the problem?

The meaning of securitization is the structures of financial process which include asset, receivable and financial instrument are acquired and offer as a collateral and sell it to the third party investor (Bianco, 2008). Another idea about securitization is converting mortgage loan to financial security for helping in mismatch between duration of asset and liability (Mazumder, 2010).

Due to the securitization, most of investors desired for mortgage securities and also Credit Rating Agencies such as Standard & Poor's Corp., Moody's Investor Service Inc., Fitch Rating gave triple-A rating to subprime mortgage which made investors felt more confident to invest in these mortgages (Bianco, 2008) However, when housing bubble was going to burst which created subprime crisis, investors tried to sell these securitization to market with difficulty and also Credit Rating Agencies downgraded over $50 billion in highly rate collateral (Bianco, 2008) Moreover, Alan Greenspan, former chairman of Fed, also gave a speech in October 2007 that securitization of home loan to the people who got lower in financial standard which is subprime mortgage were to blamed for the housing bubble which lead to subprime crisis in U.S. (Bianco, 2008).

Conclusion

The research identifies the combination of four main factors, which are regulatory policies, the increasing of subprime lending, the cracked in financial risk models and credit rating, and the housing bubble and its burst, to be the cause of subprime crisis. In addition, the consequences of subprime crisis are exhibited in two main areas, effect on U.S. economy and on global economy. Lastly, explanation of how securitization worsens the problem is presented. Hopefully, this research can help the readers to get more understanding about the subprime crisis and encourage the way to prevent this loophole in financial system in the future.

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