Analysis of Mortgage Crisis - Research Paper Example

Mortgage Crisis Introduction The recent financial turmoil on account of mortgage crisis/sub prime lending crisis has appealed the attention of economists as well as non-economists (general public) across the globe. The US originated crisis started late in the 20th century became acute in 2007 and trembled the entire global financial system. The US sub prime lending market crisis continues to rattle the global financial markets like a distant tornado. The epicenter of this tremor was the US, but its ripples were felt all over the world. More than two million homes financed by sub prime lenders were expected to face foreclosure in the period of crisis and nearly 17% of sub prime mortgages issued so far were projected to fail (Center for Responsible Lending). The Problem The roots of the current US sub prime lending crisis can be traced back to the spiraling housing prices in the first half of this decade. Extremely low lending and borrowing rates increased the demand and supply of existing and new houses. Several institutions started offering sub prime mortgages, to borrowers who had unfavorable credit history, at lower than normal repayment interest levels with little or no down payments. Many investment banks and hedge fund owners began to bet on this new aspect of the US economy. This had allowed investors to avail themselves of loans at low interest rates and invest them in higher yielding avenues. But soon with the US Central Bank (Federal Reserve) initiating a series of interest rate hikes leading to the increase of cost of borrowing to 5.25%, which is the maximum since the last half a decade, and a simultaneous decrease in housing prices, the sub prime mortgages were reset at high rates leaving the borrowers to foreclose their accounts and miss payments. As an outcome, financial institutions and banks with mortgage securities incurred huge losses and had to trade their assets leading to sub prime lending crisis. Even though "Countrywide Financial", the biggest mortgage lender in the US, managed to withstand this crisis owing to the diversification in writing of the loans, other big players like New Century Financial, DR Horton, Weyerhaeuser and American Home Mortgage are all reeling under its impact. What is mortgage crisis Normally, when banks lend money to people, they are bifurcated into prime and sub prime debtors. Prime debtors are the ones who are considered creditworthy. Sub prime debtors are the ones with impaired or no credit history. Sub prime lending can be defined simply as lending that involves higher credit risk. While prime loans are typically made to borrowers who have a strong credit history and can demonstrate a capacity to repay their loans, sub prime loans are typically made to borrowers who are perceived as deficient on either or both of these grounds. Since this involves risk of non-payment by the client, it is usually offered at a higher interest rate. The sub prime mortgage financial crisis refers to the sharp rise in foreclosures in the sub prime mortgage market that started in the US in 2006 and became a global financial crisis in July 2007. The sub prime lending storm did not break out overnight. The clouds had been gathering strength for the past few years. Low interest rates and ample liquidity led to unbridled credit expansion, asset growth and an increase in demand for collateralized debt. Who are Responsible It is quite interesting to ask who are all responsible for the worst crisis that had shocked the global financial wellness and prosperity. The major players involved in the market are sub prime lenders, home buyers, rating agency, and the Federal Reserve. When the Federal Reserve flooded the markets with capital liquidity, the lenders found themselves with ample capital to lend. Lenders were willing to undertake additional risk to increase their investment returns. This increase in the risk appetite led the lenders to offer home loans to borrowers with poor or no credit history by requiring higher than normal repayment levels. Lenient lending norms of banks/financial institutions that lent the loans to sub prime debtors was one of the major reasons for the crisis. Homebuyers or borrowers also share some responsibility for the problems that sub prime crisis has caused. Sub prime loans certainly increased the opportunities for home ownership, adding nine million US households to the list of homeowners in less than a decade. But what the homebuyers failed to understand is whether they have the ability to repay the loan when the interest rates rise and/or the value of the house falls. Many borrowers bought a home they could not afford and hoped that prices would continue rising and they could resell their homes for a profit. Unfortunately, prices went in the wrong direction forcing the borrowers to default. The credit rating agencies play a very important role in debt markets, as regulators require banks, insurance companies and pension managers to purchase only high-quality debts. Major credit rating agencies like Moody's and Standard and Poor's (S&P) assigned generous ratings like AAA and AA. Problems also stemmed from the Fed's decision to keep interest rates low between 2002 and 2005 that resulted in the housing bubble. Solution The US Fed rate cut is seen as a timely effort by many to steer the US economy clear of the mess created by the sub prime crisis. But experts believe that it is not going to be a lasting solution for the country's crisis and global trauma amidst the concerns of a rise in inflation and capital outflows. Some experts however feel that the Fed move will have a significant impact on the global economy. In a world of large current account imbalances, changes in relative interest rates that might once have had only a muted impact internationally could lead to sharp changes in capital flows or exchange rates. Given that, there are growing fears that the US rate cut might precipitate a sharp change in both capital flows and exchange rates. Work Cited Center for Responsible Lending. A Resource for Predatory Lending Opponents. (2006)10 December, 2008 http://www.responsiblelending.org/research/index.jspissue=Issue_mortgage&pubtype=&page=2 Sufi Amir, Atif R. Mian (2008)The Consequences of Mortgage Credit Expansion: Evidence from the Mortgage Default Crisis. Social Science Research network. 10 December, 2008 Hemert Otto Van, Yuliya Demyanyk (2008). Understanding the Subprime Mortgage Crisis: Social Science Research network. 10 December, 2008,http://papers.ssrn.com/sol3/papers.cfmabstract_id=1020396 David Thornton. Sub prime mortgage crisis: Who's responsible for the mortgage mess. Helium.com. 10 December, 2008 US Sub prime Mortgage Crisis: Economy Watch. 10 December, 2008 Read More