Subprime Mortgage Crisis - Assignment Example

Subprime Mortgage Crisis Which banks, financial s and specialised management funds played a major part in the crisis and which events were they specifically involved in? What was the role played by regulators? Due to massive scale default in mortgage repayments, many major US based banks sustained heavy financial losses and most famous banks like Morgan Stanley, Bear Stearns ,Merrill –Lynch , Fannie Mae , AIG , Freddie Mac, Citibank, Lehman Brothers and Merrill Lynch were in red. Morgan-Stanley and Goldman Sachs were transformed as holding companies, which perhaps acted as the end of investment banking in U.S.A. Bear Stearns The Bear Stearns was an aggressive investment bank in U.S before March 2007 and its hedge funds were trading at $ 133 before the ‘sub prime’ mortgage crisis. On 10 March 2008, it’s share was quoted around $62. The main reason for this down was due to rumours that Bear Sterns was facing liquidity issues and again this made the price to fall to $30 during the end of the second week. Big investment bank namely Bear Stearns had pumped over $ 3 million mainly to save one of its hedge funds that witnessed heavy losses on mortgage investments. On March 17, J.P.Morgan Chase extended an offer to purchase the majority stake in Bear Sterns for $2 per share as Federal Reserve was guaranteeing $30 billion’s of Bear Stearns of its assets. However, on May 30, 2008, the deal was completed at $10 per share. (Brownell 2008:25). Lehman Bros It is a 158 –year old company with 23,000 employees, which witnessed two world wars, the Great Depression and dot.com bubble. It is one of the Wall Street’s greatest investments banking house. Lehman Bros went for an IPO in 1994. Lehman steadily posted higher revenues. Lehman burnt its finger due to subprime mortgage crisis as it had to close its subsidiary namely BNC Mortgage during August 2007, which is the subprime mortgage arm of Lehman Bros. Year 2008 was not all good for Lehman as it posted unprecedented losses. During the second quarter of 2008, Lehman posted $ 2.8 billion losses and was compelled to dispose of its assets worth about $6 billion. During the third quarter of 2008, Lehman posted a whooping loss of $3.9 billion. On September 15, 2008, Lehman Bros made it public that it would file a Chapter 11 petition. (Drum 2008). Merrill Lynch Merrill Lynch was acquired by Bank of America through a $29 per share deal. Financial giant Merrill Lynch reported an $ 8 billion loss on mortgage securities. Citigroup It is a 196 year old bank. The ever increasing defaults in home loans compelled it to write off by $18 billion their subprime –mortgage investments. Citigroup net profit and EPS had dwindled to unprecedented low level in 2007. This is mainly due to loan defaults by major clients and general slow down in the housing market. To restructure its liquidity, Citigroup sold its $7.5 billion shares to Abu Dhabi Investment Authority in 2008. (Jerome 2007). GMAC General Motor’s insurance and finance business operations are carried through GMAC LLC. GMAC major profits and revenues were emanated from initiating, scrutinising and servicing residential mortgages, which include subprime loans. Year 2007 was a catastrophe year for real estate market in U.S.A as real estate value declined drastically with declined housing constructions, falling residential sales and increasing rate of foreclosures and defaults. Due to subprime crisis, GMAC profit was adversely affected. Due to this, Residential Capital LLC (ResCap), a subsidiary of GMAC in 2007 incurred a total pecuniary loss of $ 2.4 billion alone as equated to its net revenue of $ 2.3 billion in the year 2006. Due to subprime mortgage crisis, ResCap’s mortgage loans were significantly written down, which were held for sale portfolio. Any prolonging of these situations may continue to drastically affect GM’s results, its operations and financial conditions. (Form 10-k 2007). Others The majority of repackaged securities of subprime mortgage was bought out by “Fannie Mae and Freddie Mac,” a US administration patronised mortgage giants. Due to this liquidity crisis, the U.S government during September 2008 is forced to take over the mortgage institutions like Freddie Mac and Fanny Mac. To save another famous financial institution namely “AIG “, Federal Reserve of America organised an $85 billion bailout. Table 1- List of banks or financial institution that applied for bankruptcy in USA. Financial / Bank Name Year of Bankruptcy Filing Total assets Lehman Brothers Holding Inc 2008 $639,000,000,000 General Motors 2009 $91,047,000,000 CIT Group Inc 2009 $ 71,019,000,000 Chrysler LLC 2009 $39,300,000,000 Washington Mutual Inc 2008 $32,900,000,000 Indy Mac Bancorp Inc 2008 $32,734,000,000 General Growth Properties 2009 $29,560,000,000 Source-http://in.news.yahoo.com/137/20091102/748/tbs-factbox-largest-u-s-bankruptcies.html 2. Which financial contracts were involved in the contracts and what were their main characteristics? What is a subprime mortgage? Subprime mortgage is just opposite to regular residential mortgage. For a regular home mortgage, the borrower should have good credit worthiness. In the case of subprime mortgage, no such credit worthiness is taken into consideration by the lenders. In other words, whosoever entered into a mortgage bank and asks for a home loan, will be granted a loan. Lender will not see whether he is employed or not. They will not ask for any income proof. Further, subprime mortgage loans will have a lesser rate of interest at the beginning. Lender never cares whether a borrower has the capability to repay the monthly instalments. Thus, subprime mortgage can be described as a lower quality residential mortgage that is subordinated to prime mortgage. The US subprime mortgage bubble started in the year 2000 and blasted to full scale in July 2007. A global savings glut and securitisation of these subprime mortgages have added more fuel to the subprime mortgage fire. The majority of repackaged securities of subprime mortgage were bought out by “Fannie Mae and Freddie Mac,” a US administration patronised mortgage giants. (Brownell 2008:12). Main reasons for subprime mortgage crisis Majority of the subprime mortgages was securitised through a new kind of financial instrument namely “ Collateralised Debt Obligation “ ( CDO’s) and marketed in the global financial market as coupon bearing bonds. Major financial institutions around the world invested in CDO’s. Rating agencies have given high ratings for these instruments. Because of AAA ratings, major insurance companies, hedge and pension funds and much government owned institutions around the world made their investments in these bonds. The major portion of these bonds was sold to pension funds and European banks. (Brownell 2008:51). Some of the main reasons for subprime mortgage crisis: Securitisation of subprime mortgages as “ Collateralised Debt Obligation “ ( CDOs) The role of rating agencies in rating these CDO’s to higher grade. Prevalence of lower interest rates as low as 1% in 2003 The increase in interest rates in 2007 and fall in property values in USA in 2007 Large default on home loans had created acute credit crunch. Poor lending standards -A home buyer need not to pay even a single down payment from his pocket as the same has been lent by the lending bank in a disguised form. Many established financial firms have either merged with or applied for chapter11 petition. Further, there was a decline in business investment. It appears that the recession would continue all through 2009 and may recover at the fag end of 2010. (Brownell 2008:34). 3)Discuss whether the crisis could have been prevented or at least seen before it was triggered. The following are some of the supply-side intervention to correct the falling housing market. Introduction of insurance schemes to lenders. Offering tax sops to developers. Offering credit sops to developers. To concentrate on production of public housing. Some of the demand-side interventions would include the following. Offering tax sops to home owners. Offer of subsidisation to home owners and renters. ( Moroney & Krysik , p.91) For the wider financial system: It is recommended to shift away from the present disjointed regulatory setup. The new combined overture proposed in the Treasury plan offers a rational origin but many significant facts have to be determined. “Federal Reserve” should be vested with more authority to initiate its new responsibilities to effectively manage its role as the market –stability regulator. Federal Reserve should increase its supervision more tightly on financial institutions and banks. It is to be ensured that banks should maintain adequate capital, mainly to meet “off-balance sheet” perils, to offset dogmatic arbitrage. There is a need to introduce counter-cyclical requirements and larger emphasis is to be made on the “leverage ratio” to enhance the strength of the financial setup over the sequence. It is the right time to introduce more changes in regulations and laws pertaining to “corporate governance” to offer investors more sway on day-to-day management like empowering shareholders with the privilege to disapprove the remuneration packages as now applicable in Netherlands and UK. For instance, to assist the negotiation of pay structuring that intermingle incentives of management better with shareholders interests. When the risk is experienced by any given financial organisation, regulators should think of restructuring remuneration packages. It is recommended that a federal legislation should be enacted thereby establishing an analogous national responsibility of suitability in subprime mortgage lending. Hence, the proposed law should strictly prohibit any person including a mortgage broker or salesperson to entice incompetent applicants and to recommend only securities that are conforming to the requirements of the specific customer. Thus, an appropriate federal authority like Federal Trade commission should have authority to enforce the suitability and to minimise abuses and to initiate action against infringers. (Rubin 2007:248). As of today, about sixty percent of all subprime home loans are offered in the secondary market through securitisation. Unless some other regulations get rid of the holder –in-due course concept, especially for subprime loans, borrowers harmed by the predatory practices are restricted from availing relief against any securitised trust or investors.( Rubin 200 :250). For Financial Institutions Those financial institutions with huge investment banks divisions should be placed under the supervision of a sole watchdog, having adequate power to frame norms for leverage, capital, risk management and “liquidity holdings. “ For GSE’s and mortgage lenders: For high cost mortgaging, it is essential to implement the new Federal Reserve standards to make sure that underwriting standards for a non-prime mortgage are improved. It is time for relaxing the obstacles for the restructuring of mortgage on a voluntary basis. Bankruptcy laws should be amended thereby vesting powers to judges for reduction of mortgage principal for the owner inhabited homes to offer motivations for lenders to involve in reorganisation agreements. Further, it becomes necessary to alter property regulations that second –mortgage holders cannot wantonly impede the reorganisation agreements between borrowers and “first-mortgage holders. “ In most of the countries, securitisation of mortgages is being carried over the private sector. The same should be followed in the U.S.A. To develop competition and minimise moral peril, the GSE’s are privatised and they should be disintegrated from the probable lending units with the “federal government.” They should be in tune with the same set of supervision and regulations that is being applicable to private banking institutions, which include capital adequacy norms. Further, these companies should be alienated into small companies so that they are not too large to fail easily. Federal government should come forward to assist the private sector by resolving the agency issues that have impacted the securitisation of mortgages. If the SEC proposed reforms are put in place to enhance the credit rating process which includes a prohibition placed on companies to organise the analogous products that they rank and by revealing the information that being employed to finalise a rating. (OCED Economic Surveys 2008:96) . List of Reference “Form 10-k (2007). “General Motors Annual Report –for the year 2007. [online] available from [8 November 2009]. “Form10k.”.(2008). Bank of America Corporation financial. [online] available from . [8 November 2009]. Brownell, Charles. (2008), Subprime Meltdown From U.S Liquidity Crisis to Global Recession. New York: Solving Difficult Sudoku. Drum Kevin. (2008). The Collapse of Bear Stearns. [online] available from [8 November 2009]. Jerome R.Corsi (2007). Abu Dhabi bails out Citigroup. [online] available from [8 November 2009]. Moroney Robert & Krysik Judy. (1998). Social Policy and Social Work. Aldine Transaction. OECD (2008). Overcoming the Financial Crisis. OECD Economic Surveys: United States 2008. New York: OECD Publishing. Rubin, Julia Sass. (2007). Financing Low –Income Communities. New York: Russell Sage Foundation. Read More