The subprime and financial crises

Abstract

The quality of mortgage loans had been deteriorating since 2001, when interest rates were consistently below 3 per cent for several years. Housing prices dropped substantially since their high in 2006. Securitisation involves various tensions between market participants and is based on several different criteria that gauge liquidity and creditworthiness. Most often, liquidity and credit enhancement are part of the deal. Market participants understated risk and they were supported in this approach by the major credit rating agencies (CRAs). The ‘Originate to Distribute’ model provided poor incentives to monitor the quality of loans. Consequently, a significant percentage of tranches of Credit Default Obligation securities became insolvent and has been downgraded by CRAs that appear to have used the same standards for subprime mortgage securities as for corporate bonds. Income of CRAs from subprime ratings increased as much as fivefold at some of the CRAs. Foreclosure is very expensive for securitised lenders, particularly because the mortgages have been spliced and diced. In particular, Pooling and Service Agreements are not always clear and piggyback second liens muddy the waters. At the end of 2007, the Federal Housing Authority (FHA) sponsored a volunteer programme for mortgage modification that has not been too successful, and the Federal Reserve introduced rules for Truth in Lending. The Housing and Economic Reform Act of 2008 introduced national standards for mortgage originators and a programme for FHA purchases of non-performing loans. The problems in the subprime market led directly to the Fed rescue of Bear Stearns, in which it guaranteed $30 billion, although Fed's authority over investment banks is murky. Additionally, a facility to provide credit in exchange for subprime assets as collateral was created. The Financial Stability Forum, an association of international regulators, presented a report in which it called for reforms in banking regulation, including raising capital standards. In September, Lehman Brothers declared bankruptcy, the Fed purchased 80 per cent of AIG, and Goldman Sachs and Morgan Stanley applied to become banks. The Economic Stabilization $700 billion facility for purchasing impaired mortgage assets became law on 3 October. The Fed considers using its authority to buy stakes in banks directly. The government, in cooperation with other rich countries, was considering a direct infusion of capital into banks, resulting in a partial nationalisation.