Credit Crunch in the United States - Essay Example

Introduction The subprime mortgage crisis is an ongoing economic problem manifesting itself through liquidity issues in the global banking system owing to foreclosures which accelerated in the United States in late 2006 and triggered a global financial crisis during 2007 and 2008. Also know as the "credit crunch", this financial contagion has now almost affected every market which is economically integrated and interdependent with the rest of the world. The crisis began with the bursting of the housing bubble which then by chain reaction affected every other industry due to this strong interdependence among countries and economies. This all lies in the fundamental of economics that teaches us that diversification is king and solution for reducing financial risk. It has now come back to haunt us. What can we learn from this That Harry Markowitz, father of financial risk management, and Thomas Friedman, father of globalization should maybe start writing about the correlation of such economics! Unfortunately, it is not that simple. But before we unleash an economic debate on this painful economic downturn we should intellectually dissect the individuals and the players responsible for the causes and facts that have resulted in the inevitable financial depression in the real estate industry. "It started with the real, it will end will real estate." "Sub-Prime lending typically has been characterized as lending at relatively costly interest rates and fees to credit impaired or otherwise high risk borrowers." (Lax, Manti, Raca, & Zorn, 2004). Subprime loans are among the newly popular mortgage products, such as interest-only loans, for people with strained budgets, including first-time buyers. Homeowners increasingly use them to refinance and consolidate household debts when their credit scores fall in the wake of bankruptcy, high medical bills, or other setbacks. (Blanton, 2005). It is generally believed that the subprime borrowers emerge due to lack of the good credit history on their back and since there number grew historically therefore banks and financial institutions by spotting the opportunity started lending to them at higher interest rates due to the perceived risks involved in these subprime loans. Not only these subprime borrowers pay higher interest rates but they also pay higher upfront fees also at the time of booking their loans. Due to this profitable alterative, financial institutions take the risk and lend to those customers who would otherwise can not qualify for obtaining loans from the banking channels in the ordinary course of the business. In nutshell, we can say that subprime lending is lending to those who do not deserve it. US Housing Bubble Most of the subprime lending is made into the mortgages market of the Banks. Studies suggest that So-called subprime loans have helped boost US homeownership to a record 69 percent of households. They are being tapped by borrowers in all income ranges, who struggle with poor credit ratings stemming from modest incomes or excessive credit card or other debts. In Massachusetts, subprime loans, fueled by refinancing, have grown from 1.6 percent of mortgages in 2000 to 12.3 percent today. (Blanton, 2005). Apart from that, the surge in the mortgage market was a result of generous monetary policy stance adapted by FED in order to ease the recession caused by the dot com bubble. Due to this reason, the interest rates were lowered by FED. This reduction in interest rates also induced financial institutions to lower the interest rates on the mortgages also. With the lowering interest rates, the demand for the homes increased which ultimately raised the prices for the new homes. In order to capture this rise in the property market, many financial institutions started easing off their standards to bring in more and more customers. This loosening in the standards allowed those borrowers to obtain mortgage loans who were otherwise not eligible to obtain the loans. Once these loans were obtained and subsequently securitized by the issuing financial institutions, the fixed period of low interest rates on the mortgages ended and virtually all mortgage loans were repriced using the flexible pricing systems thus effectively raising the monthly interest payment bills for the consumers. This lead to then to the defaults on the subprime mortgage loans. Further the innovation into the financial industry in US also fuelled this growth as many innovative means of financing the mortgages were devised. There were new types of loans offered to the borrowers such as interest only loans which give borrower an option to pay interest on their loans only; thereby Principal remain unchanged and at the end of loan term payments increase substantially. Traditionally these loans are cheaper in nature as the normal mortgage loans require some portion of principal and mark-up to be paid in the monthly installment of the mortgage. These loans became popular mainly due to the fact that they required lower loan payments therefore buyers can afford the larger homes as their monthly mortgage bills become lower as compared to other standardized mortgage loans. These loans however can be dangerous especially when markets are lower and down. Since the interest rates are fixed for very short period of time i.e. 1 to 5 years therefore as the re-pricing of these loans approach, any increase in the interest rates will suddenly increase the interest repayments. However, the issue in US became more problematic when the mortgages were obtained on the expectation of gain in the equity of the borrowers into homes. Minimum payment options increased principal balance. In anticipation of the increase in equity, buyers paid low interest payments which subsequently contributed towards the increase in their principal payments when loans were about to mature or when the refinance option was to be availed. This significantly reduced the spread between the equity gain and the principal outstanding in the loan thus effectively reduced the perceived benefits for the buyers to refinance at the later stages of the finance. Thus the current state of the real estate market is a result of inappropriate lending practices and fraud which has and continues to force many homeowners to simply walk away from the "American Dream". There are many players involved in this whole process and the current crisis in the economy due to subprime mortgage market is the result of the combined greed of lenders and appraisers to take advantage out of the potentially unaware customer. Banks and Securitization Securitization is the process of securitizing an interest in the pool of mortgages. Securitization of the pools of assets is done mainly through the issuance of bonds called Mortgage backed securities. Instead of paying the regular coupon and principle payments, these securities pay out the cash flows generated from these pools of assets. It is the process by which mortgage loans are sold to the investors. Through securitization, the mortgage loans are converted into mortgaged backed securities. Typical processes through which the mortgages are re-packaged into different securities involve the use of various structuring of the securities. The basic pass through nature of the various securities involve that the interest payments on the underlying mortgages are used to pay the coupon payments on those bonds whereas principal payments are passed through to pay the principal on those bonds. In its essence it is the separation of credit risk of group of assets from the bankruptcy and the credit risk of the owner through issuance and sell of securities backed by the cash flows from these assets. (Hunton & Williams LLP, 2005). Securitization with respect to mortgages mainly takes place through two type of securitization. It is mainly done through true sale and or synthetic securitization of the mortgage assets. In plain true sale securitization, the asset originator i.e. the financial institution which is carrying these assets as mortgages in its balance sheet, sell them to the Special Purpose Vehicle entity which takes the legal ownership title of the assets. The said SPV collateralized the purchased portfolio of assets and than refinance it through the issuance of the multiple classes of mortgaged backed securities in different and customized tranches suiting the various players in the capital markets according to their risk appetite. (Jobst, 2006). This packaging and re-packaging of the mortgages take place in various ways and with the help of various security structures. The most widely used method is the issuance of the mortgaged back bonds called Collateralized Mortgage Obligation Bonds or CMO bonds. CMO bonds are now widely considered as the single most widely used method of repacking the mortgages. A CMO is largely dependent on the cash flows generated by the pools of the mortgages and the payment to the investors is made on the sequential basis. Further a traditional CMO is broken into various tranches like Class A which has the preferential rights and need to be paid first whereas Class B and all subsequent classes receive only coupons till the senior tranches are paid. The Class Z is the zero coupon bond which do not receive any coupon payments and are paid in lump sum at its expiry. This class of bonds are also known as accrual bonds as they provide liquidity to the senior bonds. (Kothari,2007). The next most important way of re-packaging the mortgage backed securitization is the issuance of the PO and IO stripes. These are basically issued to protect the investors from the prepayment risks. These securities are linked with the interest rates and their value fluctuates according to the changes in the interest rates in the market. Another method of repacking the mortgages is to issue to the floaters and inverse floaters. These kinds of securities also suit a particular class of investors and provide a good hedge against the interest rate risks as these bonds vary according to the changes in the interest rates. Further Mortgage backed securities also use overcollateralization and excess spreads to provide buffers to their investors. The MBS are also further restructured to allocate timing of the payments as the MBS can be structured in such a way to include multiple classes of the bonds. Banks also use a reverse process of resecuritization where pools of MBS and bonds are collateralized and backed up seprate classes of bonds. Effects of Housing Bubbles and Securitization With the advent of innovation into the financial industry, Financial Derivatives provided a very efficient and effective tool to the financial managers to effectively manage these kinds of risks. However, financial derivatives itself are considered as detrimental if their use is made in more superficial way. Banks, in order to recoup the lost liquidity drained into the subprime mortgage loans have securitized them against the payments and real estate properties offered as securities in those mortgage loans. The process of securitization works in double way. Banks rely on the cash flows generated through the repayment of these subprime mortgage loans to pay off their obligations on those securitized instruments issued by the financial institutions. The problem arises when the subprime borrowers started to default on their obligations hence creating a mismatching in the liquidity positions of the financial institutions. Since most of the financials institutions have already securitized their mortgage portfolio therefore, in order to avoid being defaulted on their payments to the bond holders of those securitized loans, they divert their normal cash resources to the payments to be made to those bond holders. Since the normal and routine liquid resources of the financial institutions go to the repayments of those bonds therefore they find themselves short of liquidity hence a credit crunch in the economy emerges as a result of this. Though financial institutions have the legal rights of the properties mortgaged against those subprime loans however under distress conditions, these mortgages may not fetch the desired level of price so the recoupment of those loans do not seem to be working under these conditions also secondly financial institutions are in the business of lending and it is not their job to sell off the recouped homes therefore a double edged sword like problem emerge for the financial institutions for their subprime mortgage portfolio. The credit crunch caused by these subprime borrowers also leads to the crowding out effect also as more and more funds are being diverted in paying off the liabilities of the financial institutions therefore the availability of the credit to the private sector shrinks thus halting the progress of the economy since most of the companies rely on bank credit at least for their short term working capital needs as well as making long term investments through a combination of borrowings either through banking channels or secondary markets. Effects in Real Estate The worst hit sector after the banking sector throughout this crisis would be real estate sector. It is believed that facing the situation this sector would require a lot of debt through the whole process of creating the value again. This sector is heavily leveraged in nature thus cooling down of the construction activities as well as stagnation into the prices of the mortgages would force this sector to obtain more debt which in this current situation can be a very costly alternative. Thus the overall cost of doing the business is certain to increase with these crises. This is also because of the prevalent paranoia into the financial institutions as most of them are in real shock as to what went wrong during this whole episode of subprime mortgage crisis. This element would further limit the capability of the sector to innovate and come out of these crises successfully. As discussed above that the subprime crisis have created strong liquidity crunch therefore the same crunch would be felt by the real estate sector also and companies in this sector has to look for different real estate sector competing more on different elements rather than the very product they sell. Thus the impact on the real estate sector would be of multitude nature as the firms working in this sector would not only feel resources being drained out of them but also the very basis of the competition would change. Conclusion Subprime crisis are threatening the whole economy of the world as most sophisticated economies of the world are feeling the heat. Backed by increasing greed of financial institutions, artificial bubbles created in order to bring in more liquidity into the market triggered the crisis which is now engulfing many economies. However, many still believe that considering the overall share of the subprime mortgages into the US GDP, impact would not be as hard as it is expected. However what is needed is to place an effective mechanism for the management of risks so that the same can be avoided in future. Bibliography 1. Blanton, B. K. (2005, August 3). Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate. Retrieved Jun 16, 2008, from boston.com: http://boston.com/business/personalfinance/articles/2005/08/03/dark_side_of_subprime_loans/ 2. Lax, H., Manti, M., Raca, P., & Zorn, P. (2004). Subprime Lending: An investigation of Economic Efficiency. Housing Policy Debates , 15 (3), 533-571. 3. Hunton & Williams LLP. (2005). Securitization: An Introduction. Retrieved June 16 2008.Available: http://www.hg.org/articles/article_1122.html. 4. Kothari, Vinod. (2007). Residential mortgage-backed securitization. Retrieved June 16 2008 from Available: http://www.vinodkothari.com/secrmbs.htm.. 5. Jobst,Andreas A. (2006). Asset securitization as a risk management and funding tool:What small firms need to know. Managerial Finance. 32 (9), pp:731-760. Read More