US Housing Market and Securitization in 2007

Overview of the Subprime Problem

The housing problem that peaked up in 2007 was the result of continued unprecedented borrowings and mortgage foreclosures the previous years. It happened due to lack of economic and financial policy to guard against this situation. The policymakers were not able to predict that an economic quagmire could result from the slump in the housing sector. The activities of subprime lending institutions were unchecked by the government and only when the negative effect was felt economically that the government and regulating agencies embarked on investigation to determine the factors that created the chaos.

Equally concerned with the crisis were economists, mortgage firms and associations, academe, etc. that not only probes into root causes but also propose solutions to buttress the impact of the crisis. The negative state of real estate will have a long-time effect in the economy and is predicted to stay for many years to come.

Root of the Crisis

In the regular process of granting mortgage loans, borrowers can avail of loans if they possess good credit standing. However, an unconventional method, called subprime loans, allows borrowing despite poor credit by the borrower. A borrower with bad credit is one with excessive credit card spendings and has incurred other debts despite a minimal income (Blanton 2005). Although many subprime borrowers were classified with bad credit, all income brackets avail of this type of loan (Blanton 2005). Freddie Mac, a mortgage investor company, estimated that 15 percent of subprime borrowers were really qualified for regular loans, but, as elaborated by its vice president Peter Zorn, the complicated loan procedures and need for immediate refinancing force the borrowers to avail of subprime lending (Blanton 2005).

The unconventional practice in subprime lending that requires no downpayment and documentary proof of income contributed to its fast increase (Papadimitriou et al 2007). This alternative to conventional mortgages enabled 69 percent of home ownership in the United States (Blanton 2005). Lending institutions reason out that easing the borrowing requirements resulted from the new and automated credit evaluation process (Papadimitriou et al 2007).

Subprime lendings account for 14 percent of total mortgages for 2007 and utilised in “home-equity withdrawal” for second-time purchase of home (Bernanke 2007c cited in Papadimitriou et al 2007). Subprime lending companies charge excessive fees and interest rates from borrowers who have lesser choice than those with good credit standing (Blanton 2005). But excessive fees and rates would eventually lead to foreclosures since the borrowers who avail of subprime loans are those already hard-up financially and immersed with previous loans, that disable them to qualify for conventional loans.

The fall of prices in real estate in Greater Boston may be attributed to “overleveraged homeowners” who sell their houses or lenders who offer foreclosed houses at a less competitive price (Blanton 2005, p. 1). In a study conducted by the University of North Carolina Kenan-Flagler Business School, 20 percent of the 1998 to 2000 refinancings ended up in foreclosed (Blanton 2005). ForeclosuresMass Corp. reported that 31 percent of the Land Court foreclosure cases for 2005 consist of subprime mortages (Blanton 2005). Generally, the US rate of foreclosure for subprime loans is estimated at 3.5 percent (Blanton 2005). On the other hand, the rate for conventional loans and refinancing is only 1.1 percent (Blanton 2005).

The increase in subprime lending at a time when housing price is on the rise presses the flexible mortgage rates upon the borrowers who have to pay amounts that might be beyond their capacity and risk foreclosure (Schumer & Maloney 2007). As housing capital declines, consumer expenditure will likewise decline, while the massive sale of homes pulls down the general prices in real estate (Schumer & Maloney 2007).

According to Schumer and Maloney (2007), the depreciation in subprime performance is inevitable. The fast expansion of subprime segment in 2001 likewise increased the share of adjustable rate hybrid loans granted to defenseless borrowers (Schumer & Maloney 2007). Hybrid mortgages are sustained by appreciation in house prices, and with the flattening and decline of prices, subprime borrowers lose their ability to refinance their mortgages (Schumer & Maloney 2007). The increase in foreclosures further damaged the “already weak housing market” (Schumer & Maloney 2007, p. 2). Eventually, the decline in housing wealth would “reduce consumer spending and economic growth” (Schumer & Maloney 2007, p. 2).

As subprime crisis extends to bond insurers, bond rating firms are forced to investigate the internal processes to identify the factors that caused the financial crisis (Gasparino 2008). Initial result of the study showed that placing an “AAA rating on collateral debt obligations (CDO)” disabled the recognition of the exposure of bond insurers to “risky securities” (Gasparino 2008, para. 2).

It is also becoming clear that a number of subprime borrowers entered into the contract without clear knowledge of the loan type they are entering into, the interest rates, etc. which only mean that mortgage lenders might have made misrepresentations of their ability to pay (Gasparino 2008).

Since foreclosed houses from subprime loans only allow banks to recover 30 percent of the amount borrowed, it means that the appraised worth of houses purchased with subprime loans was not realistic (Gasparino 2008). Rating firms also utilised erroneous statistics without probing further into the data used in the analysis, such as the long-time irregularity in the housing growth (Gasparino 2008). Thus, it is a blow to rating firms to have overlooked the “CDO meltdown” and exposure of bond insurers to risky securities (Gasparino 2008, para. 6).

The Financial Services Authority (FSA) study that concentrated on a segment termed as “impaired credit mortgages” showed that they are those who bought houses with county court decisions issued against them, with arrears in payments, or declared bankruptcies (Seib 2007, para. 6). The FSA review revealed an anomalous sales practice for both lenders and borrowers (Seib 2007). FSA said that several borrowers were advised by mortgage intermediaries “to remortgage their houses, incurring early repayment charges, without good reason. Half of the intermediaries did not check whether their customer could afford to repay their mortgage” (Seib 2007, para. 4).

Lending firms did not confirm the veracity of the information supplied by borrowers and grant excessive loans (Seib 2007). Mortgage intermediaries receive high commissions of 1 to 1.5 percent in selling subprime commodities than selling prime mortgage products which offer a 0.35 percent commission (Seib 2007).

Beginning 1998, over 7 million borrowers purchased houses from subprime lenders, of which one million had already failed to pay the amortizations (Atlas & Dreier 2007). Financial experts forecast another 2 million homeowners will default in payment for the coming years (Atlas & Dreier 2007). Common clients of subprime lending are middle-class families plagued by excessive debt or with low income but wanted to purchase a house (Atlas & Dreier 2007). The high-risk faced by lenders is covered by high interest rates or “adjustable rates” which are offered at low rates but makes sharp increase after a few years (Atlas & Dreier 2007).

Subprime lending surged in the middle of 1990s, comprised 8.6 percent of total mortgages by 2001, to 20.1 percent by 2006 (Atlas & Dreier 2007). More than 90 percent of the total subprime lending was offered with excessive adjustable rates (Atlas & Dreier 2007). Graph 1 shows the percentage increase of subprime loans in 2001 and 2006 as against other types of mortgage loans.

The percentage increase of subprime loans in 2001 and 2006 as against other types of mortgage loans

Effect of Subprime Lending Crisis: Government and Private Sector Response

The losses from subprime lending creep into the greater financial sphere (Schumer & Maloney 2007) and affected other financial variables. Policymakers are becoming aware that continued foreclosure of mortgages would negatively affect the economy at large (Schumer & Maloney 2007). The alarming increase in mortgage foreclosures caused the attorneys-general from different jurisdictions to investigate the subprime lenders (Blanton 2005).

The gloomy projection for subprime foreclosures and property and tax losses for the last half of 2007 up to 2009 would result to: a) capital destruction amounting to $71 billion during the foreclosure process, b) destruction of more than $32 billion in “housing wealth” due to “spillover effect of foreclosures” which has the effect of reducing the prices in adjacent properties, and c) loss of $917 million in revenues by the state and local governments from property taxes due to housing wealth destruction resulting from subprime foreclosures (Schumer & Maloney 2007).

The foreclosures caused havoc in the “housing and stock markets, the banking industry, and the global money markets, not to mention upending families and neighborhoods” (Atlas & Dreier 2007, para. 1). Florida and Nevada were among the first hit the most by the housing crisis (Atlas & Dreier 2007).

The increase in demand for homes was motivated by the rise in subprime borrowings that may eventually end up in default (Papadimitriou et al 2007). Subprime borrowings swelled five times from 2001 to 2005 with a total of $625 billion per year (The Economist 2006 cited in Papadimitriou et al 2007). Delinquency payments have doubled of up to 12 percent, being late for at least 90 days, which situation is dispersing to “Alt-A mortgages”, a less risky mortgage than subprime (Shenn 2007; Bernanke 2007b cited in Papadimitriou et al 2007, p. 2). A number of securities supported by subprime mortgages received low rating from bond rating institutions (Ng 2007; Howley 2007 cited in Papadimitriou et al 2007).

Nicolas Retsinan, director of the Joint Center for Housing Studies at Harvard University, commented that another economic slump would result to unemployment of a number of people, already tied to loan payments, and eventually to a rise in foreclosure (Blanton 2005).

With the pressure tilting the boiling point, US Pres. George W. Bush (Republican) announced the plan to freeze the interest rates for about five years in houses bought under the “high-risk adjustable rate mortgages (ARMs)” pegged for “‘reset’ at higher rates, which in many cases, by hundreds of dollars a month” (Atlas & Dreier 2007, para. 2). This was criticized by former Texas Rep. Dick Armey (right-wing Republican), currently running FreedomWorks (a think tank firm), on the ground that the call of Pres. Bush for a free market runs counter to freezing of interest rates (Atlas & Dreier 2007). However, the call of Pres. Bush is voluntary, involving no legislation, and it is even unclear if investors in mortgage secured by securities would allow resetting of interest rates by lenders (Atlas & Dreier 2007). (Atlas & Dreier 2007).

Barclay capital pointed out, as reported in New York Times, that only 12 percent or 240,000 of 2 million ARMs would be reset until 2009 (Atlas & Dreier 2007). An estimate made by Center for Responsible Lending, a nonprofit organization, that 145,000 homes would be eligible to rate freeze while other borrowers must negotiate on their own (Atlas & Dreier 2007). Despite the tentative freeze some families had negotiated with banks, they may still be unable to pay and meet possible foreclosure (Atlas & Dreier 2007).

Michael Shea, executive director of ACORN Housing, an association that counsels consumers belonging to low-income bracket, commented that while Wall Street earned billions in subprime transactions, “now they’re hardly paying anything at all” (Atlas & Dreier 2007, para. 5).

The Federal Reserve and Conference of State Bank Supervisors will undertake a review of “companies’ underwriting standards and risk-management practices” to ensure compliance with laws protecting consumer rights (Schroeder 2007, para 1).

Federal and state regulating agencies likewise released guidelines in order to cushion the subprime crisis (Schroeder 2007). Federal Reserve Governor Randall Kroszner commented that close cooperation of state and federal institutions in the enforcement of consumer regulations upon “non-depository institutions” will “better weed out abuses” (Schroeder 2007, para. 3). Classified as non-depository firms are not regulated mortgage-lending entities such as banks, thrifts, savings and loan associations, and credit unions (Schroeder 2007). The July survey of National Association of Home Builders showed declining confidence of home builders in the housing market due to continued subprime crisis (Schroeder 2007).

Of the 11 lending firms and 34 intermediaries reviewed by FSA, five were sanctioned with fine or banned from further engaging in the business, while the rest should collaborate with FSA to improve their practice (Seib 2007). On the other hand, the Association of Mortgage Intermediaries promised to coordinate with the Council of Mortgage Lenders in looking into the problem (Seib 2007).

Banks that provide financial support to mortgage lending institutions begin to push for more documentary evidence of income, demanding for downpayment, and more strict borrowing requirements (Shenn 2007 cited in Papadimitriou et al 2007). However, this move by the banks will further lessen the demand for homes and lower their prices (Papadimitriou et al 2007).

Further complicating the situation is the rise in earnest mortgage interest rates and “variable-rate mortgages” adjustment in interest in the future (Papadimitriou et al 2007, p. 2). For instance, Howley (2007 cited in Papadimitriou et al 2007) said that the half percentage point rise in rate during the first five weeks that started in May for a 30-year mortgage would result to an additional of $116 for the monthly amortization of a $300,000 mortgage.

This increase, according to the study conducted by First American CoreLogic would result to a million foreclosures on mortgages initiated during the year 2004-2006 (Cagan 2007 cited in Papadimitriou et al 2007). These homes will further overcrowd the housing market, thus depressing the prices more (Papadimitriou et al 2007). The minority group who avail of subprime lending would be susceptible to the ongoing foreclosures.

The subprime crisis has reached unprecedented proportion that IMF, in association with other international bodies embarked on study, monitoring and surveillance to remedy the situation which has affected the international economy (IMF Intensifies 2008). The crisis ruptured during the middle part of 2007 that has caused havoc in the international arena and financial firms that require new “capital injection” from stockholders and even from the government (IMF Intensifies 2008 para. 1). In response, central banks adopted lower interest rates and new lending terms to keep the interbank market liquid (IMF Intensifies 2008). The Financial Sector Assessment Program was undertaken by the IMF-World Bank joint effort among member countries to assess the crisis situation (IMF Intensifies 2008).

Leaders are likewise becoming conscious of the crucial link between the financial segment and macroeconomy (IMF Intensifies 2008). The Monetary Capital Markets Department (MCM) of the IMF stepped up the creation of tools that could test the probable reach of the crisis and investigate the national and international flexibility of the financial system (IMF Intensifies 2008).

Upon the prodding of International Monetary and Financial Committee upon IMF, MCM created five working groups that would study crisis related concerns, to wit:

  1. “risk management practices related to complex financial products, including in the biggest financial institutions,”
  2. “treatment of complex products by rating agencies and their impact on investor behavior,”
  3. “basic principles of prudential oversight for regulated financial entities,”
  4. “valuation and accounting for off-balance-sheet instruments,” and
  5. “liquidity management” (IMF Intensifies 2008 para. 12).

The housing median price showed an eventual slow down, beginning with the 15-year stability, the 19 percent rise during 1995 to first quarter of 2000 at a time when GDP growth eased down, another increase of 20 percent during the third quarter of 2005, then followed by 9 percent decline during the first quarter of 2007, and another decline in April 2007 (Papadimitriou et al 2007). Graph 2 shows the increase and decline in the housing median price from 1980 up to the first quarter of 2007.

The increase and decline in the housing median price from 1980 up to the first quarter of 2007

As noted by Whitehouse (2007 cited in Papadimitriou et al 2007) of Wall Street Journal and Eckholm (2007 cited in Papadimitriou et al 2007) of New York Times, vacant houses already scatter in some cities and settlements. Economically, the costs of foreclosures even if low as against the total loans or national GDP, would affect that segment of the population and thereby lose access to credit (Papadimitriou et al 2007). Fed Chief Ben Bernanke declared in his speeches from May to June 2007 that the check on subprime lending and the rise in foreclosures will diminish housing demand, which has the ultimate effect of pushing the prices down (Papadimitriou et al 2007).

He is of the opinion that other subprime lenders perform satisfactorily and that the subprime crisis will not escalate to the general financial system and the economy as regulation is imposed (Papadimitriou et al 2007). He also mentioned the need to buttress the capital of government-backed firms having billions of dollars of investment in mortgages and “bundle them into securities” (Bernanke 2007a cited in Papadimitriou et al 2007). Infusion of large capital, however, hints of a “major financial crisis” those firms will have to undergo (Papadimitriou et al 2007, p. 3)

State attorneys general and government banking regulating agencies created the State Foreclosure Prevention Working Group during the summer of 2007 to determine processes that would avert further foreclosures (Analysis 2008). The Working Group collaborated with companies involved with subprime loans in this study targeting primarily borrowers with the possible capacity to pay the mortgage loan and investors owning the mortgage loan that can receive financial incentive to amend the loan package instead of incurring big losses resulting from foreclosures (Analysis 2008).

The Working Group reported that a number of foreclosures occurred because the subprime system is incapable of entertaining huge loan modifications that would assist distressed homeowners (Analysis 2008). Although loan servicers attempted to create outreach programs to increase interaction with homeowners, a wide chasm remains with regard to borrowers that need mitigation and assistance (Analysis 2008).

The increasing “loan delinquencies” outmaneuver the increase in efforts to mitigate the loss (Analysis 2008, p. 1). There is also an increase in borrowers having contact with loan servicers, about 45 percent of them, opting for long-term loan modification rather than “short-term repayment or forbearance agreements” (Analysis 2008, p. 1). The Working Group also found out that a number of adjustable rate mortgage loans are already delinquent before they underwent payment adjustment, revealing a “weak underwriting or fraud in the origination of the loan” (Analysis 2008, pp. 1-2).

Thus, with numerous homeowners fighting to remain sound before resetting of rates, the issue of hybrid adjustable rate mortgages should be addressed immediately to avert “payment shock” resulting from the reset (Analysis 2008, p. 2). The Working Group also found out that averted foreclosures as of October 2007 were the result of arrears payments by homeowners, not on the effort of services (Analysis 2008).

The last analysis of the Working Group revealed that even with the present cut in interest rates, refinancing is no longer viable to save delinquent borrowers from the subprime crisis (Analysis 2008). Industry initiated study to determine loans that can be subjected to modifications, according to the Working Group would be shallow and suggested a more in-depth and systematic study (Analysis 2008). Unless each delinquent payer is addressed individually, millions of borrowers will ultimately lose their homes (Analysis 2008).

References

Analysis of Subprime Mortgage Servicing Performance 2008, Data Report 1. State Foreclosure Prevention Working Group.

Atlas, J & Dreier, P 2007, The Conservative Origins of the Sub-Prime Mortgage Crisis. The American Prospect. Web.

Blanton, K 2005, Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate. Globe. Web.

Gasparino, C 2008, Agencies Review Subprime Rating Practices. CNBC. Web.

IMF Intensifies Work on Subprime Fallout 2008. IMF Survey Magazine: In the News. Web.

Papadimitriou, DB, Hannsgen, G, & Zezza, G 2007, Cracks in the Foundations of Growth. The Levy Economics Institute, Band College.

Schroeder, R 2007, U.S., states to conduct subprime-lender reviews. MarketWatch. Web.

Schumer, C & Maloney, CR 2007, The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here, Report and Recommendations by the Majority Staff of the Joint Economic Committee.

Seib, C 2007, Sub-prime mortgage lenders fail FSA review. TimesOnLine. Web.

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