Change in the Price of the Commodity - Essay Example

Running Head: CHANGE IN THE “PRICE” OF THE COMMODITY IN RELATION TO THE US SUBPRIME CRISIS Change In the “Price” Of the Commodity In Relation To the Us Subprime Crisis [Writer’s Name] [Institution’s Surname] Change in the “Price” of the commodity in relation to the US Subprime crisis Chapter 1 Introduction This proposal will be divided into 3 chapters, first will be introduction. This chapter will consist of and general over view of sub prime lending as well as its history. It will even consist of the purpose of the study the research question, and significance of the study. The second chapter will be the literature review which will consist of all the literature related to sub prime rating and credit crunch. The third chapter will be the methodology section which will state what exactly will be done research and which theories will be used. The proposal does not include a conclusion, as the concluding statements can only be used after a complete analysis is carried out. The expansion of sub prime lending can be attributed to many factors: federal legislation stopping restrictions of the state on permissible rates as well as loan features, the tax reform act of 1986, increase in the demand for and accessibility of consumer debt, as well as an raise in subprime securitization. In October 2000, the U.S. Department of Housing and Urban Development (HUD) set forth a new rule that increased the affordable housing goals of government sponsored agencies such as Freddie Mac and Fannie Mae. In the rule, HUD identifies the subprime market as a way for Fannie Mae and Freddie Mac to meet their goals, and as an area in which more standardization can be created. A subprime loan is offered to people who have gone through really bad financial problems, are generally labelled as being high risk customers and thus they have to face a lot of hardships in gaining credit, particularly for big purchases like cars or property . These individuals might have lost their job, past debt or problems of marital nature, or unanticipated medical problems generally unexpected. Due these reason payments are made late, charge-offs, repossessions as well as bankruptcy or foreclosures might occur. Because these prior credit problems, these individuals might also might not be allowed to get kind of conventional loan. The rates and fees for subprime loans are generally higher than prime loans. This is to cover the high cost and associated risk of subprime lending. More often than not, written into the loan agreement are mandatory prepayment penalty clauses. As with prime loans, escrow of taxes and insurance are not required for subprime loans. While the development of the subprime market has made homeownership available to those that otherwise would not qualify, borrowers that may qualify for prime loans are often steered into subprime loans. This type of behaviour can sometimes lead to unscrupulous lending practices. For many years, the mortgage industry classified borrowers as either “A” paper or “B” paper. This classification actually did separate lending into credit challenged or not. Prime lending was more reserved for banking which provided short term, revolving construction or equity loans. These loans were usually tied to the prime interest rate plus points (Ornstein etal p5). B” paper represents a loan, usually credit challenged, that did not meet investor, Fannie Mae or Freddie Mac’s standard lending guidelines. Due to this, lending institutions began to develop loans to accommodate this sector of home buyers. As property values had steadily increased, it was believed the equity would provide a built in insurance policy in the case of default. Subprime lending was once seen as a second chance for borrowers to live the “American Dream” of homeownership. The majority of borrowers were placed on loans called a 2/28 or 3/27, arm loans. The design of the loan program allowed an affordable start rate (still higher than market) for the first two (2/28) or three (3/27) years, and the loan would adjust annually for the remainder of the term. These adjustable-rate mortgages (ARMs) have been defined by Federal agencies as having one or more of the following features: • Low initial introductory rate for a short period, which then adjusts to a variable rate several points above the prime rate for the loan’s term • No limits — or very high limits — on how much the monthly payments or interest rate can increase when the loan resets • Little or no documentation of borrower’s income required • Substantial prepayment penalties or prepayment penalties after the introductory period • Other features that would result in frequent refinancing to secure an affordable monthly payment (http://www.pathtoinvesting.org/investinggoals/homeownership/understanding-subprime-crisis/understanding-subprime-crisis.htm) Initially, the loans required a down payment; however, as property values increased, coupled with decreasing interest rates and ever changing leniency in mortgage guidelines the criteria for these loans changed. 100% financing along with higher debt allowances caused an even higher risk scenario. These high priced loans were meant to be short term to allow the borrower time to repair their credit to the point where they are able to qualify for or refinance into a lower risk, lower rate loan from a major bank or savings and loan institution. However, this was not always the case. A considerable percentage of the borrowers would not make any changes. The problem arose when the term ended and their loan would “adjust” to a rate sometimes 5% higher than the current rate. Needless to say, borrowers would fall into what is called “payment shock”; sometimes the loans were usually refinanced before they became delinquent. This would sometimes be repeated, as the loan would once again fall into “B” paper status. While many lenders would argue that the borrowers new of the terms and conditions of the loan agreement before signing on the dotted line, more borrowers often unsophisticated, have a different story. Purpose of the study The purpose of the study is to analyze the credit crunch with reference to price. Research Questions What has caused Price of the commodity to decrease in relation to the US Subprime crisis? How intense is the credit crunch with reference to price both in US and UK Significance The study will help economist to have a clearer understanding of the cre4dit crunch and its effects. Once the economists get picture in front of them they will be able to do something about it. Apart from this study will also help a lot of economists to generate solution to the credit crunch. Chapter 2 Literature Review Lending and Credit Crunch The credit crisis, which started with high priced ARM loans for house buyers with weak credit during a period of fast growth in the US, has blown up into what is arguably the most disruptive event for global finance of the decade. Between 2000 and 2006, the number of home foreclosures continued to rise in America as the cost of housing increased and the demand for housing declined; overbuilding continued and housing prices fell. These economic downturns became a big problem for people who have mortgages, especially if they have to move or trying to sell because their payments increased or loss of income, etc. If they sell their house, they wont make enough money to pay off the mortgage ( Hallock 2004 p 7). This now creates a huge financial problem for many homeowners. Many studies as well as data analysis state that there is a strong association among the rise in foreclosures and the lending market of subprime mortgage. In what way the subprime crisis will be successful in developing to near-nationwide misfortune lies mainly in an agreement made among mortgage lenders and Wall Street. The arrangement was thought to be equally helpful for several reasons. The mortgage lenders first would give a loan to a family which earned a decent income however not to those families who were extremely wealthy. They would then convenience those to get a high priced loan for a property they could not manage to pay for. As per history mortgage lenders in the past would not put their signature on a loan like the one above mentioned as they knew this would mean that they would not get their money back. These mortgage loans were securitized in a meaning sets of them were categorized collectively as the fundamental assurance for securities that are then traded via firms that deal in investment these are known as CDO’s ( CDO stands for collateralized debt obligation). These CDO’s might be utilized to convert mortgage-backed securities (MBS) into investment-grade bonds. The mortgage-backed securities had the least risk and thus it gained highest bond ratings that are AAA/Aaa, whilst the ones that had high risk got a BBB/Bbb rating of medium-quality, a little more than junk bonds. This meant that Wall Street can purchase this debt, and put up for sale it more than once so a group of different individuals on different levels were selling bad loans in order to make money . Ultimately, mortgage lenders were not even concerned if they were really going to get their lent money back since they knew them that they could fulfil their loss by selling the loan to Wall Street (Davenport 2003 p547). Some would say the elevated returns offered by MBS and CDO’s made some investment firms less cautious about the creditworthiness of the loans they bought. Many investors and analysts assumed that CDO’s were diversified and carried less risk, because CDO’s carry the same type of bonds, lenders and investors were not as protected against downturns as they thought they were (Adamson etal 2007 p14). Consequences of the Credit Crunch on Bond Insurers Over the past few months all financial institutions have encountered problems; in the past few weeks the latest group to be affected is the bond insurers. Bond insurance companies such as Ambac, MBIA, and ACA Capital are facing a severe test. These companies insure bonds that have been issued by other entities. The sector was created several decades ago in the US to insure bonds issued by US municipalities. Today the US is the focus as the biggest companies, like MBIA or Ambac, are owned. By Americans. Nevertheless, in the last few months of the 1990s bond insurers shifted their attention to London, and currently UK is considered the second biggest global market. Ambac, the chief UK operator, gained UK bonds of $5.3 billion of in 2007 only in 9 months (Zimmerman 2007 p 20). The most important reason for this amazing growth was the development of the private finance initiative (PFI). While private finance initiative projects began to issue bonds to finance themselves 10 years back, a number of investors were careful since it was difficult to estimate their long-term risks. Nevertheless, the companies of private finance initiative found out that if they enclosed the bonds with a guarantee for the bond insurer in a way that it guaranteed that these instruments had a AAA credit rating of top-notch; investors may be more eager to purchase the debt. However, the problem now is that some investors fear bond insurers insurance companies face losses on subprime business. That might potentially damage their credit ratings, which can, in turn, have an effect on the value of wrapped bonds. Implications of the Credit Crunch on Investment Banks Banks may face up to $300 billion of losses from the subprime credit crisis over the next 18 months. Thus the top US as well as European banks have confirmed losses on subprime associated debt be a total of $52 billion. As the UKs key banks come close to the end of their financial year- their share prices have greatly dropped it is fear that their US counterparts will face immense write-offs (Kellogg 2007 p 22). In the US, until now the largest write-offs have been generated from huge investment banks. The above mentioned investment banks were the experts at the centre of the complex market which made the CDO’s for asset-backed securities. Chapter 3 Methodology This is a secondary research study as all the information for this study will be obtained from periodicals, books and the inter net. Apart from this to give a clear understating of the issue a number of economical theories will be used is Marx’s Theory of Economic Crisis as it states the fact that Capital produces an massive excess of factories, services as well as products that it cannot give them profit nor can they operate them . Marx’s theory can give a good understanding of the current credit crisis and threatening recession. The other theory used to analyze the sub crime crisis is the Standard economic theory, which points out that just central banks can revive the flow of money that effect by a an intense market crisis Summary The entire study will be based on the analysis of change in the “price” of the commodity in relation to the US sub-prime crisis. It will use theories for analysis. Apart from this the study will also analyze credit crunch with reference to price. References Adamson, Joseph, and Todd J. Zywicki (2007), "Subprime mortgage lending." Regulation. 30.2 p14 Davenport, Tania (2003). "An American nightmare: predatory lending in the subprime home mortgage industry.” Suffolk University Law Review. Pp547–57 Hallock, Micah (2004), "Predatory lending: legislative and regulatory challenges. Bank Accounting & Finance Vol 17 P7. http://www.pathtoinvesting.org/investinggoals/homeownership/understanding-subprime-crisis/understanding-subprime-crisis.htm retrieved on 25 May 2008 Kellogg, Sarah (2008). "The subprime mortgage meltdown: an uncertain future." Washington Lawyer, p22. Ornstein, Stephen F.J., David A. Tallman, and John P. Holahan (2006), "Predatory lending and the secondary market.” Journal of Structured Finance. 12.3 p 5 Zimmerman, Thomas (2007); "The great subprime meltdown of 2007." Journal of Structured Finance vol 13.3 p14 -20. Gale. Eastern Michigan University. Read More