The Fall of the Mortgage Industry - Research Paper Example

The Fall of the Mortgage Industry Introduction The impact of the mortgage financial crisis which started in the United States in 2006 is still being felt all over the world until today. Both borrowers and financial institutions feel the blow of the burst of the bubble economy. There are lessons to be learned in this crisis to avoid occurrence in the future. This study focuses on reasons for failures of the financing institutions, the delinquencies of subprime mortgage borrowers and the lack of government control that contributed to the fall of the mortgage industry. It has been reported that one of the reasons for the financial crisis is the leniency of financial institutions to borrowers of subprime mortgages. This study shows how the sub-prime mortgages shaped the financial crisis in the economy. Discussion of Sub-prime mortgages First let us have a definition of subprime mortgage and then have a review of how it operated. The term has been defined as real estate loans granted to someone who has no ability of getting a prime mortgage. It is further defined as someone whose ability to repay the loan is questionable In the event such person is granted a loan, the interest rate for such loan will be much higher than the normal rate. (Subprime Lending Resources). According to report of Subprime Lending Resources, a person is considered subprime borrower if falls under the following categories: He has a FICO score of 660 or less; he has late payments to any creditor within the last 12-24 months; he has a collection accounts; has any repossessions within the last 5-7 years, and has bankruptcy within the last 7 years. Start of the crisis Before 2007, it was easy to borrow money, and real estate in the US had its prime. People were as interested in real estate as return on investments was high at that time People will buy houses; make renovations then sell it at a handsome profit. The market condition created an artificial price that is not sustainable. Many people took advantage of this situation, used their existing properties as equity to purchase real estate as investment, and availed of the subprime lending facilities. Rates were attractive and everybody else wanted to own properties. It was easy to borrow and even marginal borrowers were granted housing loans. Several financial institutions were encouraged to go into subprime lending because of the big return on investments. Meantime as demand for subprime loans increased, the real estate prices started to fall as there was an oversupply of houses for sale. Houses were not selling anymore and borrowers begun to default on payment of loans. Even with lowered prices, houses cannot be sold, and foreclosure on properties started. A financial crisis has started. Before long, the sub-prime mortgage delinquencies have created an inter play of forces that have formed into a worldwide economic crisis. The impact of the mortgage crisis to players in the industry Each action has a cause and effect, and so does the interplay of sub-prime mortgages. The cause, impact and results of the action of each player in this crisis are described in the course of this study. A chart depicting courses of action is attached as Annex 1 (Control Credit Card, 2008) According to the study done by the Control Credit Card, the crisis started when subprime mortgage borrowers, the first player, begun to borrow loans beyond their means and loan rates have been reset. The impact of subprime borrowing is the increase in mortgage default payments and add=up of loan interests. The end result of a default is foreclosure, or a work out. Second player in this inter play is the housing market. Due to the liberal credit, housing developers constructed houses that created an oversupply. Meantime, the real estate prices have started to go down. There is also a significant decline in housing construction and a diminishing demand for real estate. Likewise, there is a slow demand for housing input. The depressing situation continued and was followed by an economic recession and a slowdown on GDP. There is no immediate relief seen under the circumstances but to wait till the economy stabilizes. Third player are the financial institutions who, from the start of the boom period, encouraged borrowers with attractive loan packages, and have adopted risk and debt tolerance polices. When the economy turned sour, these financial institutions suffered losses, bankruptcy and stock price reductions. Some financial institutions in order to avoid closures have adopted stringent policies of cost reduction, lay-offs, capital infusion, restructuring, imposition of credit reduction and adopted more strict lending policies. Fourth players are the economy and financial markets which seem to have encouraged the practice by introducing securitization and invited consumer spending thru borrowings. The credit rating guides were not followed as banks accept even marginal borrowers. As the economy declines, the demand for financing also follows, the stock market prices dips, and risks have increased. Recession has started as a result of economic decline. This has led to the adoption of policy measures on the side of financial markets such as litigation, self regulation, an improved debt rating method, and a better disclosure of information. The last players are the government and central bank sector who had established high interest rate policy and had limited control of non-bank lenders The FED, before the crisis, tolerated the sub-prime mortgage lending practices as it had reduced its interest rates and had extended loans to banks. After the crisis, the FED had adopted policies to correct the situation such as initiating a stimulus loan package, making new regulations and enforcement, to put downward pressure on inflation and to increase government deficit/debt. Impact of the mortgage crisis to the economy Reports have been gathered to show the impact of the mortgage crisis to the economy. The report of Control Credit Card Debt said that because of the credit problem the world financial market has imposed a control on credit availability making it harder now to obtain financing. On the part of borrowers, a big number had defaulted on mortgage payments, suffered mortgage foreclosure and had filed bankruptcy. Many subprime lenders, according to this report have closed their business, also filed bankruptcy or have been acquired by larger banking institutions. Scribd, reporting on the 2007 subprime mortgage financial crisis, said that the sharp rise in the foreclosure of mortgaged properties led to the bankruptcy of subprime mortgage lenders and have caused a chain effect. The bankruptcy caused the fall down of stock prices of large lenders in the subprime mortgage industry. Same report continued to say that this led to a world wide decline of stock market prices that caused further bankruptcy to several subprime mortgage lenders. This has caused “hedge funds” to be worthless and the curtailing of expected profit. Impact to government policies The causes of the crisis and policies that need to be addressed have been discussed by Chairman Ben S. Bernabe, FED Governor, in his speech at the London School of Economics in London, England on January 13, 2009. He stated that the mortgage crisis is only a part of a larger problem that has affected other forms of credit instruments, shook financial confidence of investors in worldwide scale. He said in this speech, that world market is easily interconnected thru IT technology thereby making any marketing transactions flexible and easier. Responding to this crisis, Chairman Bernabe said that the incoming government and FED have three sets of policy tools: “lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities.” It is expected that these policies will bring down the interest level and ease credit conditions in the market. He said that at present the federal fund rate is already close to its zero level. Before the crisis came to be widespread, a report said that losses could have been prevented if only the government acted on the matter early enough. Amadeo K. wrote about mortgage crisis and bank bail out, and had reported that FED intervention was already too late and the crisis had spread. Amadeo said that FED did not act on the situation at once, and when it did, credit was already too tight. FED loaned $75 billion to the ailing banks to get back to the lending business, but banks stopped lending activities, cut back on mortgages which caused more borrowers’ default and foreclosures. By August 2007 and over the next eight months, FED had reduced interest rates from 5.7% to 2% and has put billions of dollars in the banking system to bring it back to liquidity. This FED intervention did not bring in good results, because banks have lost their trust to each other. Banks do not want to lend to other banks for fear of receiving bad mortgage securities (MBS). MBS has been used by banks in securing loans. Banks are afraid to disclose true debt information on their books so as not to raise panic and lose the trust of their investors. When nothing seems to move, another bold move was done by the government in November 2007. (Amadeo). The government realized, according to this report, that it was no longer a bank liquidity problem but rather a credibility issue. A Treasury Guaranteed Fund of US$75 billion was used to purchase bad mortgages, but report said, the amount was no longer enough as panic had already been created in the market. Comment and discussion Everybody was unaware of the real situation until one day, news was flashed on television and printed on newspapers about the glut of debt crisis in the economy. Borrowers feel the pinch as they parted with their hard earned properties due to delinquent payments. Greed is the master of it all. It is a vicious cycle that no one could ever imagine will happen. The key players cannot keep the blame to him as it is an interconnecting action of several factors. The economy has a rise and fall and history repeats itself in a cycle. There was a recession before, and another one in front of our eyes. But there are lessons learned in this experience that economists and the government must consider so that a recurrence is avoided. w.c. 1844 Annex A. Impact of subprime mortgage crisis. List of References Amadeo, Kimberly. “Could the Mortgage Crisis and Bank Bailout Have Been Prevented?” About.com. U.S. Economy. Retrieved 29 May, 2009 Bernanke S. “The Crisis and the Policy Response” FRS Speech at the Stamp Lecture, London School of Economics, London, England. Board of Governors of the Federal State System. 13 Jan. 2009. Retrieved 29 May, 2009 http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm Control Credit Card. “The Subprime Mortgage Crisis”. Retrieved 20 May 2009 Source: Control Credit Card Debt Source: Control Credit Card Debt. (2006) List of References Bernanke, Ben S. (13 Jan. 2009) The crisis and the policy response.. Speech at the Stamp Lecture, London School of Economics, London, England Board of Governors Federal Reserve.. Retrieved May 29, 2009 from the Web site: http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm Control Credit Card Debt.(2008) The Subprime Mortgage Crisis. Retrieved May 29, 2009 from the Web site:http://www.controlcreditcarddebt.com/subprime-mortgage-crisis.html#top Scribd. (16 Oct. 2008). 2007 Subprime financial crisis. Retrieved May 29, 2009. from the Web site: http://www.scribd.com/doc/6920806/2007-Subprime-Mortgage-Financial-Crisis Subprime Lending Resources.(2008) Subprime Lending Crisis.. Retrieved May 29, 2009 from the Web site: http://www.subprimelendingcrisis.com/Subprime_Lending_Crisis.php Read More