Increasing Of The Subprime Mortgage Market

Published Date: 02 Nov 2017

U.S. house price increase substantially since 1990. The Standard Poor’s Case-Shiller Home Price Indices shows a significantly larger increase in house price that starting in 1988 and it peaked in 2006. Between 1997 and 2006, U.S. house price increased by 124% ("Economist")

Lots of things help to bring up the house price. Under the increasing pressure from the Clinton Administration to expand mortgage loans among low income family, Fannie Mae started to encourage financial institutions to offer home loans even to people who do not qualify for traditional loans( STEVEN A ). The Taxpayer Relief Act 1997 offer tax relief for people on the profit gained from the sale of their house, the passes of the American Dream Down Payment Act that provide funds for downpayment and closing cost to fist-time low-income homebuyers("American Dream Downpayment Initiative") which further stimulate the home ownership. As the result, People start spending more and borrowing more, speculators start investing in second homes and investment properties. A report from Bureau of Economic Analysis indicate that saving rate is steadily declining(Figure1) and the consumer and mortgage debts increase to 133% of annual disposable income in 2008(figure 2). U.S. homeownership rate now reaches 66.1% ("State & County QuickFacts").

After 2006, house price began to decline to its present level and housing bubble start bursting. By September 2008, the house price declined by over 20% from the 2006 peak (figer 3). This unexpected decline caused borrowers have zero or negative equity in their houses which means the value of the mortgage loans are less than the house value. About 23% total U.S. mortgage holders their house worth less value than the mortgage loan (Louis ).

Under this situation the probability that borrowers might default on their mortgages increased. According to the Department of Commerce, in 2007 the sales of new house declined by 26.4 % to 774,000("Associated Press").

Realty Trac TM U.S. Foreclosure Market Reports, there are about 846,982 properties entering some stage of foreclosure in 2005 and more than 1.2 million foreclosure filings were reported nationwide in 2006 which means for every 92 U.S. households there is one foreclosure filing(White). The burst of the U.S. housing bubble triggered the subprime mortgage crisis which led to the 2007-2008 financial crisis and subsequent recession.

Increasing of the Subprime Mortgage Market

Increase in high risk subprime mortgage loans during the housing bubble is one of the major causes of the subprime mortgages crisis. With the low interest rates, innovative financing option and the support of the government, mortgages qualification becomes more and more loosely. Banks lend money to the borrowers without concern for whether they have the ability to repay the loans. According to a National Association of realtors report, during the housing bubble period, 43% of first time home buyers purchased their house with a zero down payment loans (Knox ).

Income verified assets loans (SIVA) makes people easier to get a mortgage loan. In order to get SIVA, borrowers only need to verbally state their income status. No income, verified assets loan (NIVA) makes borrowers no longer need to be in employment as long as borrowers show some proofs that they have money in their bank account. No Income No Asset (NINA) loans provide loan to borrowers without proof or even state anything, except a credit score.

Adjustable rate mortgage (ARM), the most popular loan. ARM is a mortgage with an interest rate and monthly payment adjust annually in response to changes in the market conditions. (Kidwell, Blackwell, Whidbee, and Sias 274).ARM has a lower starter rates and interest-only ARM even allows the borrower pay only the interest during an initial period.

American CoreLogic study shows that one-third of ARMs taken out between 2004 to 2006 began with a rates below 4% and payments on these loans will double on average (Arnold). ARM was initially designed to borrower who will live in their homes for few years and then sell at a profit or refinance. Now these loans were made to borrowers with poor credit with higher interest rates to compensate for the risks. A study shows in 2005, almost 23% of all mortgage originated were interest-only ARMs (Arnold). In 2006, the percentage of subprime loan to the total mortgage. originations had increased to about 25% ("2007 Annual Report • The Subprime Mortgage Market" 8). There are about 7.75 million outstanding subprime mortgage loans in later 2007 which counted 14% of the overall mortgage market (Kroszner). From 1994 to 2006, subprime lending increased from an $35 billion to $600 billion which counts 20 percent of total family mortgage originations Figure 4. (Bernanke).

Under such loose mortgages qualification, some borrowers grabbed this opportunity of cheap credit to take on debt that they don’t have the ability to repay. With the housing bubble burst, value of their houses became less compared to the value of their mortgages. This created extremely high default rates in the subprime mortgages market compared to the prime market(figure 5) . In 2007, more than 3.6 million outstanding subprime ARMs were seriously delinquent and 1.5 million foreclosures were initiated by lenders (Bernanke).

Behind the slump of the U.S housing market, growing subprime mortgage market and significant increased delinquencies and foreclosures, a financial crisis gradually formed.

Securitization: Mortgage-Backed Security

In 1934, Congress passed the National Housing Act, which created the Federal housing Administration(FHA) to provide insurance for mortgage which made by approved lender . in order to develop a secondary market for mortgages, Federal National Mortgage Association(FNMA) was created in 1938. (Kidwell, Blackwell, Whidbee, and Sias 283).

In 1968, Federal National Mortgage Association (FNMA) was split into two entities, the Government National Mortgage Association(GNMA-Ginnie Mae) and the Federal National Mortgage Association(FNMA-Fannie Mae) (Kidwell, Blackwell, Whidbee, and Sias 283). GNMA does not originate or purchase mortgages. As a government agency, it provides guarantees on the timely payment of principal and interest payments on MBS issued by approved lender (Kidwell, Blackwell, Whidbee, and Sias 283). FNMA was established as a private hold corporation after 1968. It still considers as a government agency by investors and investers believe federal government will rescue if it became insolvent (Kidwell, Blackwell, Whidbee, and Sias 284).

Like FNMA, Federal Home Loan Mortgage corporation (FHLMC was established by Congress in 1970 to assist savings and loan association and other mortgage lenders to attracting funds and provide competition for FNMA. FNMA and FHLMC there were all referred to as government- sponsored enterprise (GSE ).

Here is a simply example to show how Mortgage-Backed Security works. Banks, mortgage companies or other originators who do not want to wait until the loans been repay will sell their mortgage loans to the government agencies, GSEs or private entity. Then the government agencies, GSEs or private entity will repackage the entire mortgage into a pool and then issue securities that claim on the principal and interest payments made by borrowers on the loans in the pool ("Mortgage-Backed Securities").

Financial institution use securitization as a source of long-term fund which also helps reduce risk of fluctuations in interest rates. And securitization also transferred the loan specific risk such as the default risk of the mortgages from the originator to the buys of collateralized securities. However, the buys or investors of the MBS have less information about the mortgage market which makes them bear most default risk. In order to make MBS attractive to investors, some well capitalized financial institution, government agencies or GSEs provides a guarantee for qualified MBS.

With the mortgage origination start to drop after the slump of the U.S. housing market, the securitization rates keep increasing as financial institutions use securitization as a source of funding. Figure 6 shows that as the mortgage origination volume fell in 2007 and 2008 . Securitization rates keep increasing and reached 85% in 2009(Simkovic) and there were estimated $6.5 trillion in MBS outstanding which make it as large as the Treasury market at that time(Fabozzi , Bhattacharya, and william S 72).

Investment banks pooled risky subprime loans and sold them as nonagency MBS which did not meet the qualification of the GSEs such as Fannie Mae. In order increase liquidity and split the risk of a loan pool, structured finance was created. Structured finance divided MBS into tranches and investors who purchased these bonds will receive a portion of cash flow from the pool (Olender C3). figure 7 shows in 2000, value of non agency (investment banks, commercial banks) mortgage-backed security starts increasing rapidly and overtaking agency mortgage-backed security in 2005(Simkovic).

With the housing bubble burst , due to the extremely increased market value and high default rates of subprime mortgages, value of the MBS declined caused the collapsed of private non GSE securitizes. FNMA and FHLMC were placed into the conservatorship of the Federal Housing Finance Association on September 7, 2008. (Kidwell, Blackwell, Whidbee, and Sias 284).

Rating Agencies

Three large U.S. credit rating agencies, Standard poor’s, Moody’s and Fitch should take responsible for the cause of the financial crisis. These three rating agencies provided favorable ratings on the mortgage-backed securities that made by subprime mortgage loans. During 2000 to 2007, Moody’ s gave Aaa rating to almost 45,000 mortgage-related securities and 83% of the mortgage securities that received an Aaa rating been downgraded("Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States" xxv).The market is heavy reliance on ratings, many regulations and laws require using ratings as a criterion for permissible investments. (Jickling 6). Many major firms and private investors blindly use rating as a guide when making investment decisions. Investors bought the high risk mortgage-backed securities and the CDOs which rated as Triple-A by rating agencies and believed they were investing in low risk bonds. As the result of extremely increased market value and high default rates for subprime mortgages, value of securitized subprime mortgage collapsed, financial institutions which heavily invested in those bonds suffer huge losses.

Inherent conflict of interest that ratings agencies presented is the primary cause of the problem. Rating agencies are paid by their clients to rate their securities and bonds.In order to attract investors, investment banks paid huge fees to the rating agencies to obtain a desired ratings. For rating agencies, their revenues closed related to the performance of those securities they rated.

According to the financial crisis inquiry report, during 2005 to 2007 about half of Moody’s rating revenues come from the rating of structured finance products such as mortgage-backed securities, Moody’s net income rose from $298 milliom in 2002 to $745 million in 2007("Economist" ).

This crisis could be avoided if the rating agencies do the right job. According to the U.S. Securities and Exchange Commission, on December 3, 2008, SEC approves a series of measures to increase transparency and accountability at credit rating agencies. "These comprehensive rules touch every aspect of the credit rating process – from conflicts of interest, to publication of ratings methodologies, to disclosure of ratings track records," said SEC Chairman Christopher Cox. ("SEC Approves Measures to Strengthen Oversight of Credit Rating Agencie")