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| “ | During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.28 | ” |
Boom and bust in the housing market
Low interest rates and large inflows of foreign funds created easy credit conditions for many years leading up to the crisis.29 Subprime lending and borrowing was a major contributor to an increase in home ownership rates and the demand for housing. The U.S. home ownership rate increased from 64% in 1994 (about where it was since 1980) to a peak in 2004 with an all-time high of 69.2%.30
This demand helped fuel housing price increases and consumer spending.31 Between 1997 and 2006, American home prices increased by 124%.32 For the two decades until 2001, the national median home price went up and down, but it remained between 2.9 and 3.1 times the median household income. By 2004, however, the ratio of home prices to income hit 4.0, and by 2006 the ratio was 4.6.33 Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130% during 2007, versus 100% earlier in the decade.34 A culture of consumerism is a factor "in an economy based on immediate gratification".35 Americans spent $800 billion per year more than they earned. Household debt grew from $680 billion in 1974 to $14 trillion in 2008, with the total doubling since 2001. During 2008, the average U.S. household owned 13 credit cards, and 40 percent of them carried a balance, up from 6 percent in 1970.36
Overbuilding during the boom period eventually led to a surplus inventory of homes, causing home prices to decline, beginning in the summer of 2006. Easy credit, combined with the assumption that housing prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages they could not afford after the initial incentive period. Once housing prices started depreciating moderately in many parts of the U.S., refinancing became more difficult. Some homeowners were unable to re-finance and began to default on loans as their loans reset to higher interest rates and payment amounts.
An estimated 8.8 million homeowners — nearly 10.8% of total homeowners — had zero or negative equity as of March 2008, meaning their homes are worth less than their mortgage. This provided an incentive to "walk away" from the home, despite the credit rating impact.37 In the U.S., home mortgages are non-recourse loans, meaning the creditor cannot seize other property or income to cover a default. The U.S. is virtually unique in such arrangements. By November 2008, 12 million homeowners had negative equity. As more homeowners stop paying their mortgages, foreclosures and the supply of homes increase. This places downward pressure on housing prices, which places more homeowners upside down, continuing the cycle. The declining mortgage payments also reduce the value of mortgage-backed securities, eating away at the financial health of banks. This vicious cycle is at the heart of the crisis.38
Increasing foreclosure rates increased the supply of housing inventory available. Sales volume (units) of new homes dropped by 26.4% in 2007 versus the prior year. By January 2008, the inventory of unsold new homes stood at 9.8 months based on December 2007 sales volume, the highest level since 1981.39 Further, a record of nearly four million unsold existing homes were for sale,40 including nearly 2.9 million that were vacant.41
This excess supply of home inventory placed significant downward pressure on prices. As prices declined, more homeowners were at risk of default and foreclosure. According to the S&P/Case-Shiller price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their Q2 2006 peak34 and by May 2008 they had fallen 18.4%.42 The price decline in December 2007 versus the year-ago period was 10.4% and for May 2008 it was 15.8%.43 Housing prices are expected to continue declining until this inventory of surplus homes (excess supply) is reduced to more typical levels.
Speculation
Speculation in real estate was a contributing factor. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, nearly 40% of home purchases (record levels) were not primary residences. NAR's chief economist at the time, David Lereah, stated that the fall in investment buying was expected in 2006. "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market."44
While homes had not traditionally been treated as investments like stocks, this behavior changed during the housing boom. For example, one company estimated that as many as 85% of condominium properties purchased in Miami were for investment purposes. Media widely reported the behavior of purchasing condominiums prior to completion, then "flipping" (selling) them for a profit without ever living in the home.45 Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.46
Keynesian economist Hyman Minsky described three types of speculative borrowing that can contribute to the accumulation of debt that eventually leads to a collapse of asset values:4748 the "hedge borrower" who borrows with the intent of making debt payments from cash flows from other investments; the "speculative borrower" who borrows based on the belief that they can service interest on the loan but who must continually roll over the principal into new investments; and the "Ponzi borrower" (named for Charles Ponzi), who relies on the appreciation of the value of their assets (e.g. real estate) to refinance or pay-off their debt but cannot repay the original loan.
The role of speculative borrowing has been cited as a contributing factor to the subprime mortgage crisis.49
High-risk mortgage loans and lending practices
A variety of factors have caused lenders to offer an increasing array of higher-risk loans to higher-risk borrowers,50 including illegal immigrants.51 The share of subprime mortgages to total originations was 5% ($35 billion) in 1994,52 9% in 1996,53 13% ($160 billion) in 1999,52 and 20% ($600 billion) in 2006.535455 A study by the Federal Reserve indicated that the average difference in mortgage interest rates between subprime and prime mortgages (the "subprime markup" or "risk premium") declined from 2.8 percentage points (280 basis points) in 2001, to 1.3 percentage points in 2007. In other words, the risk premium required by lenders to offer a subprime loan declined. This occurred even though subprime borrower credit ratings and loan characteristics declined overall during the 2001–2006 period, which should have had the opposite effect. The combination is common to classic boom and bust credit cycles.56
In addition to considering higher-risk borrowers, lenders have offered increasingly high-risk loan options and incentives. These high risk loans included the "No Income, No Job and no Assets" loans, sometimes referred to as Ninja loans. In 2005 the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever.57
Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Further, an estimated one-third of ARM originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment.58
Mortgage underwriting practices have also been criticized, including automated loan approvals that critics argued were not subjected to appropriate review and documentation.59 In 2007, 40% of all subprime loans were generated by automated underwriting.6061 The chairman of the Mortgage Bankers Association claimed mortgage brokers profited from a home loan boom but did not do enough to examine whether borrowers could repay.62 Mortgage fraud has also increased.63
Securitization practices
Securitization is structured finance process in which assets, receivables or financial instruments are acquired, pooled together as collateral for the third party investments (Investment banks).64 There are many parties involved. Due to the securitization, investor appetite for mortgage-backed securities (MBS), and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Asset securitization began with the structured financing of mortgage pools in the 1970s.65 In 1995 the Community Reinvestment Act (CRA) was revised to allow for the securitization of CRA loans into the secondary market for mortgages.
The traditional mortgage model involved a bank originating a loan to the borrower/homeowner and retaining credit (default) risk. With the advent of securitization, the traditional model has given way to the "originate to distribute" model, in which the credit risk is transferred (distributed) to investors through MBS. The securitized share of subprime mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to 75% in 2006.56 Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.3 trillion. The debt associated with the origination of such securities was sometimes placed by major banks into off-balance sheet entities called structured investment vehicles or special purpose entities. Moving the debt "off the books" enabled large financial institutions to circumvent capital reserve requirements, thereby assuming additional risk and increasing profits during the boom period. Such off-balance sheet financing is sometimes referred to as the shadow banking system and is thinly regulated.66 Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — was to blame for the current global credit crisis.67
However, instead of distributing mortgage-backed securities to investors, many financial institutions retained significant amounts. The credit risk remained concentrated within the banks instead of fully distributed to investors outside the banking sector. Some argue this was not a flaw in the securitization concept itself, but in its implementation.22
Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.6869
Under the CRA guidelines, a bank gets credit originating loans or buying on a whole loan basis, but not holding the loans. So, this gave the banks the incentive to originate loans and securitize them, passing the risk on others. Since the banks no longer carried the loan risk, they had every incentive to lower their underwriting standards to increase loan volume. The mortgage securitization freed up cash for banks and thrifts, this allowed them to make even more loans. In 1997, Bear Sterns bundled the first CRA loans into MBS. 70
Inaccurate credit ratings
Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. Higher ratings were believed justified by various credit enhancements including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Internal rating agency emails from before the time the credit markets deteriorated, released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce widespread negative results.71 For example, one 2006 email between colleagues at Standard & Poor's states "Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."72
High ratings encouraged the flow of investor funds into these securities, helping finance the housing boom. The reliance on ratings by these agencies and the intertwined nature of how ratings justified investment led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities and furthered by SEC removal of regulatory barriers and reduced disclosure requirements in the wake of the Enron scandal.73 Critics claim that conflicts of interest were involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.74 On 11 June 2008 the U.S. Securities and Exchange Commission proposed far-reaching rules designed to address perceived conflicts of interest between rating agencies and issuers of structured securities.75
Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressured MBS and stock prices lower.76
Government policies
Both government action and inaction have contributed to the crisis. Several critics have commented that the current regulatory framework is outdated. President George W. Bush stated in September 2008: "Once this crisis is resolved, there will be time to update our financial regulatory structures. Our 21st century global economy remains regulated largely by outdated 20th century laws."77 The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis.7879
Increasing home ownership was a goal of both Clinton and Bush administrations.808182 There is evidence that the government influenced participants in the mortgage industry, including Fannie Mae and Freddie Mac (the GSE), to lower lending standards.838485 The U.S. Department of Housing and Urban Development's mortgage policies fueled the trend towards issuing risky loans.8687
In 1995, the GSE began receiving government incentive payments for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities.88 Subprime mortgage loan originations surged by 25% per year between 1994 and 2003, resulting in a nearly ten-fold increase in the volume of these loans in just nine years.89 These securities were very attractive to Wall Street, and while Fannie and Freddie targeted the lowest-risk loans, they still fueled the subprime market as a result.90 In 1996 the Housing and Urban Development (HUD) agency directed the GSE to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005.91 By 2008, the GSE owned or guaranteed nearly $5 trillion in mortgages and mortgage-backed securities, close to half the outstanding balance of U.S. mortgages. The GSE were highly leveraged, having borrowed large sums to purchase mortgages. When concerns arose regarding the ability of the GSE to make good on their guarantee obligations in September 2008, the U.S. government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers expense.9293
Liberal economist Robert Kuttner has criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree.9495 A taxpayer-funded government bailout related to mortgages during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans.96
Additionally, there is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers979899100 and defenders claiming a thirty year history of lending without increased risk.101102103104 Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages.105106
Policies of central banks
Central banks are primarily concerned with managing monetary policy, they are less concerned with avoiding asset bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst to minimize collateral impact on the economy, rather than trying to avoid the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to properly deflate it are a matter of debate among economists.107108
Federal Reserve actions raised concerns among some market observers that it could create a moral hazard. Some industry officials said that Federal Reserve Bank of New York involvement in the rescue of Long-Term Capital Management in 1998 would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf.109
A contributing factor to the rise in home prices was the lowering of interest rates earlier in the decade by the Federal Reserve, to diminish the blow of the collapse of the dot-com bubble and combat the risk of deflation.107 From 2000 to 2003, the Federal Reserve lowered the federal funds rate target from 6.5% to 1.0%.110 The central bank believed that interest rates could be lowered safely primarily because the rate of inflation was low and disregarded other important factors. The Federal Reserve's inflation figures, however, were flawed. Richard W. Fisher, President and CEO of the Federal Reserve Bank of Dallas, stated that the Federal Reserve's interest rate policy during this time period was misguided by this erroneously low inflation data, thus contributing to the housing bubble.111
Financial institution debt levels and incentives
Many financial institutions borrowed enormous sums of money during 2004–2007 and made investments in mortgage-backed securities (MBS), essentially betting on the continued appreciation of home values and sustained mortgage payments. Borrowing at a lower interest rate to invest at a higher interest rate is using financial leverage. This is analogous to an individual taking out a second mortgage on their home to invest in the stock market. This strategy magnified profits during the housing boom period, but drove large losses after the bust. Financial institutions and individual investors holding MBS also suffered significant losses as a result of widespread and increasing mortgage payment defaults or MBS devaluation beginning in 2007 onward.23
A SEC regulatory ruling in 2004 greatly contributed to US investment banks' ability to take on additional debt, which was then used to purchase MBS. The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during September 2008, creating instability in the global financial system. The remaining two converted to commercial bank models, subjecting themselves to much tighter regulation.112
In 2006, Wall Street executives took home bonuses totaling $23.9 billion, according to the New York State Comptroller's Office. "Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm. The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those [investments] worked."33
Credit default swaps
Credit defaults swaps (CDS) are insurance contracts, typically used to protect bondholders or MBS investors from the risk of default. As the financial health of banks and other institutions deteriorated due to losses related to mortgages, the likelihood that those providing the insurance would have to pay their counterparties increased. This created uncertainty across the system, as investors wondered which companies would be forced to pay to cover defaults.
CDS may be used to insure a particular financial exposure or may be used speculatively. Trading of CDS increased 100-fold from 1998 to 2008, with debt covered by CDS contracts ranging from U.S. $33 to $47 trillion as of November 2008.113 CDS are lightly regulated. During 2008, there was no central clearinghouse to honor CDS in the event a key player in the industry was unable to perform its obligations. Required corporate disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as AIG, MBIA, and Ambac faced ratings downgrades due to their potential exposure due to widespread debt defaults. These institutions were forced to obtain additional funds (capital) to offset this exposure. In the case of AIG, its nearly $440 billion of CDS linked to MBS resulted in a U.S. government bailout.114
In theory, because credit default swaps are two-party contracts, there is no net loss of wealth. For every company that takes a loss, there will be a corresponding gain elsewhere. The question is which companies will be on the hook to make payments and take losses, and will they have the funds to cover such losses. When investment bank Lehman Brothers went bankrupt in September 2008, it created a great deal of uncertainty regarding which financial institutions would be required to pay off CDS contracts on its $600 billion in outstanding debts.115116 Significant losses at investment bank Merrill Lynch were also attributed in part to CDS and especially the drop in value of its unhedged mortgage portfolio in the form of Collateralized Debt Obligations after American International Group ceased offering CDS on Merril's CDOs. Trading partner's loss of confidence in Merril Lynch's solvency and ability to refinance short-term debt ultimately led to its sale to Bank of America.117118
Impact
Financial sector downturn
Financial institutions from around the world have recognized subprime-related losses and write-downs exceeding U.S. $501 billion as of August 2008.119 Profits at the 8,533 U.S. banks insured by the FDIC declined from $35.2 billion to $646 million (89%) during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift quarterly performance since 1990. For all of 2007, these banks earned approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits declined from $35.6 billion to $19.3 billion during the first quarter of 2008 versus the prior year, a decline of 46%.120121
The financial sector began to feel the consequences of this crisis in February 2007 with the $10.5 billion writedown of HSBC, which was the first major CDO or MBO related loss to be reported.122 During 2007, at least 100 mortgage companies either shut down, suspended operations or were sold.123 Top management has not escaped unscathed, as the CEOs of Merrill Lynch and Citigroup were forced to resign within a week of each other.124 Various institutions followed up with merger deals.125
Market weaknesses, 2007
On July 19, 2007, the Dow Jones Industrial Average hit a record high, closing above 14,000 for the first time.126
On August 15, 2007, the Dow dropped below 13,000 and the S&P 500 crossed into negative territory for that year. Similar drops occurred in virtually every market in the world, with Brazil and Korea being hard-hit. Through 2008, large daily drops became common, with, for example, the KOSPI dropping about 7% in one day,127dead link although 2007's largest daily drop by the S&P 500 in the U.S. was in February, a result of the subprime crisis.
Mortgage lenders128dead link129 and home builders130131dead link fared terribly, but losses cut across sectors, with some of the worst-hit industries, such as metals & mining companies, having only the vaguest connection with lending or mortgages.132
Stock indices worldwide trended downward for several months since the first panic in July–August 2007.
Market downturns and impacts, 2008
The crisis caused panic in financial markets and encouraged investors to take their money out of risky mortgage bonds and shaky equities and put it into commodities as "stores of value".133 Financial speculation in commodity futures following the collapse of the financial derivatives markets has contributed to the world food price crisis and oil price increases due to a "commodities super-cycle."134135 Financial speculators seeking quick returns have removed trillions of dollars from equities and mortgage bonds, some of which has been invested into food and raw materials.136
Beginning in mid-2008, all three major stock indices in the United States (the Dow Jones Industrial Average, NASDAQ, and the S&P 500) entered a bear market. On 15 September 2008, a slew of financial concerns caused the indices to drop by their sharpest amounts since the 2001 terrorist attacks. That day, the most noteworthy trigger was the declared bankruptcy of investment bank Lehman Brothers. Additionally, Merrill Lynch was joined with Bank of America in a forced merger worth $50 billion. Finally, concerns over insurer American International Group's ability to stay capitalized caused that stock to drop over 60% that day. Poor economic data on manufacturing contributed to the day's panic, but were eclipsed by the severe developments of the financial crisis. All of these events culminated into a stock selloff that was experienced worldwide. Overall, the Dow Jones Industrial plunged 504 points (4.4%) while the S&P 500 fell 59 points (4.7%). Asian and European markets rendered similarly sharp drops.
The much anticipated passage of the $700 billion bailout plan was struck down by the House of Representatives in a 228–205 vote on September 29. In the context of recent history, the result was catastrophic for stocks. The Dow Jones Industrial Average suffered a severe 777 point loss (7.0%), its worst point loss on record up to that date. The NASDAQ tumbled 9.1% and the S&P 500 fell 8.8%, both of which were the worst losses those indices experienced since the 1987 stock market crash.
Despite congressional passage of historic bailout legislation, which was signed by President Bush on Saturday, Oct. 4, Dow Jones Index tumbled further when markets resumed trading on Oct. 6. The Dow fell below 10,000 points for the first time in almost four years, losing 800 points before recovering to settle at -369.88 for the day.137 Stocks also continued to tumble to record lows ending one of the worst weeks in the Stock Market since September 11, 2001."138
It is also estimated that even with the passing of the so-called bailout package, many banks within the United States will tumble and therefore cease operating. It is estimated that over 100 banks in the United States will close their doors because of the financial crisis. This will have a severe impact on the economy and consumers. It is expected that it will take years for the United States to recover from the crisis .139
Indirect economic effects
The subprime crisis had a series of other economic effects. Housing price declines left consumers with less wealth, which placed downward pressure on consumption.140 Certain minority groups received a higher proportion of subprime loans and experienced a disproportional level of foreclosures.141142 Home related crimes including arson increased.143 Job losses in the financial sector were significant, with over 65,400 jobs lost in the United States as of September 2008.144
Many renters became innocent victims, often evicted from their homes without notice due to foreclosure of their landlord's property.145 In October 2008, Tom Dart, the elected Sheriff of Cook County, Illinois, criticized mortgage companies for their actions, and announced that he was suspending all foreclosure evictions.146
The sudden lack of credit also caused a slump in car sales. Ford sales in October 2008 were down 33.8% from a year ago, General Motors sales were down 15.6%, and Toyota sales had declined 32.3%. One in five car dealerships are expected to close in Fall of 2008.147
Responses
Various actions have been taken since the crisis became apparent in August 2007. In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis.
Legislative and regulatory responses
The Federal Reserve
The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy."15
- Between 18 September 2007 and 30 April 2008, the target for the Federal funds rate was lowered from 5.25% to 2% and the discount rate was lowered from 5.75% to 2.25%, through six separate actions.148149
- The Fed and other central banks have conducted open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities. Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans.150
- The Fed is using the Term Auction Facility (TAF) to provide short-term loans (liquidity) to banks. The Fed increased the monthly amount of these auctions to $100 billion during March 2008, up from $60 billion in prior months.
- In July 2008, the Fed finalized new rules that apply to mortgage lenders.151
- In October 2008, the Fed expanded the collateral it will loan against to include commercial paper, to help address continued liquidity concerns.152
Regulation
Regulators and legislators are considering action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.153 Regulations or guidelines can also influence the nature, transparency and regulatory reporting required for the complex legal entities and securities involved in these transactions. Congress also is conducting hearings to help identify solutions and apply pressure to the various parties involved.154
- A sweeping proposal was presented 31 March 2008 regarding the regulatory powers of the U.S. Federal Reserve, expanding its jurisdiction over other types of financial institutions and authority to intervene in market crises.155
- In response to a concern that lending was not properly regulated, the House and Senate are both considering bills to regulate lending practices.156
- In the wake of a subprime mortgage crisis and questions about Countrywide’s VIP program, ethics experts and key senators recommend that members of Congress should be required to disclose information about their mortgages.157
- Non-depository banks (e.g., investment banks and mortgage companies) are not subject to the same capital reserve requirements as depository banks. Many of the investment banks had limited capital reserves to address declines in mortgage backed securities or support their side of credit default derivative insurance contracts. Nobel prize winner Joseph Stiglitz recommends that regulations be established to limit the extent of leverage permitted and not allow companies to become "too big to fail."158
- UK regulators announced a temporary ban on short-selling of financial stocks on September 18, 2008.159
- The Australian federal government has announced an investment of AU$4 billion in non-bank lender mortgage backed securities in an attempt to maintain competition in the mortgage market.160
Economic Stimulus Act of 2008
President Bush also signed into law on 13 February 2008 an economic stimulus package of $168 billion, mainly in the form of income tax rebates, to help stimulate economic growth.161 The economic stimulus package included the mailing of rebate checks to taxpayers. Such mailings started the week of 28 April 2008. These mailings, however, coincided with unexpected all-time jumps in food and gasoline prices. This coincidence prompted some to question whether the stimulus package would have the desired effect or whether consumers would just use it to make up for the gap generated by the higher food and fuel prices. Some Congressmen even contemplated legislation for a second round of stimulus rebate checks to ensure the initial intention of the stimulus package had the expected effect. The Treasury Secretary strongly opposed such initiative.
Housing and Economic Recovery Act of 2008
The Housing and Economic Recovery Act of 2008 included six separate major acts designed to restore confidence in the domestic mortgage industry.162 The Act included:
- Providing insurance for $300 billion in mortgages estimated to assist 400,000 homeowners.
- Establishing a new regulator to ensure the safe and sound operation of the GSEs (Fannie Mae and Freddie Mac) and Federal Home Loan banks.
- Raising the dollar limit of the mortgages the government sponsored enterprises (GSEs) can purchase.
- Providing loans for the refinancing of mortgages to owner-occupants at risk of foreclosure. The original lender or investor reduces the amount of the original mortgage (typically taking a significant loss) and the homeowner shares any future appreciation with the Federal Housing Administration. The new loans must be 30-year fixed loans.
- Enhancements to mortgage disclosures.
- Community assistance to help local governments buy and renovate foreclosed properties.
Government bailouts
- Northern Rock had difficulty finding finance to keep the business going and was nationalized on 17 February 2008. As of October 8th, 2008, UK taxpayer liability for the bank had climbed to £87Bn ($150Bn) according to Robert Chote, director of the Institute for Fiscal Studies.163
- Bear Stearns was acquired in March 2008 by J.P. Morgan Chase for $1.2 billion.164 In order for the deal to go through, the Fed issued a nonrecourse loan of $29 billion to Bear Stearns.165
- In September 2008, the Treasury Department confirmed that both Fannie Mae and Freddie Mac would be placed into conservatorship166 with the government taking over management of the pair. The two GSEs have outstanding more than US$ 5 trillion in mortgage backed securities (MBS) and debt.167
- Merrill Lynch was acquired by Bank of America in September 2008 for $50 billion.168
- Scottish banking group HBOS agreed on 17 September 2008 to be acquired by UK rival Lloyds TSB in an emergency takeover after its share price experienced significant falls amid fears over its exposure to toxic debt. The deal was encouraged by the UK government, who agreed to waive competition rules to allow the takeover to go ahead.169
- Lehman Brothers declared bankruptcy on 15 September 2008, facing a refusal by the federal government to bail it out.170 Treasury Secretary Hank Paulson cited moral hazard as a reason for not bailing out Lehman Brothers.171
- In September 2008, The Federal Reserve provided an emergency loan of $85 billion to AIG,172 which will be repaid by selling off assets of the company.173 This intervention gave the US government a 79.9% equity stake at AIG.173 Just over three weeks later the Fed reported that AIG had drawn down $70.3 billion of that $85 billion facility174 and AIG announced that it may tap an additional $37.8 billion in secured funding from the Federal Reserve.175
- In September 2008, Washington Mutual declared bankruptcy.176 The United States Office of Thrift Supervision (OTS) announced that it was seizing WaMu and would sell most of its functional assets to J.P. Morgan Chase.177
- On 29 September 2008, British bank Bradford & Bingley was nationalised by the UK government. The government will take control of the bank's £50bn mortgages and loans, while its savings operations and branches are to be sold to Spain's Santander.178
- In October 2008, The Australian government announced that AU$4 billion was to be raised to fund non-bank lenders that are unable to obtain funding to finance new loans. After industry feedback this was increased to AU$8 billion.179
Emerging plan to bail out financial institutions
On 19 September 2008, the U.S. government announced a plan to purchase large amounts of illiquid, risky mortgage backed securities from financial institutions,180 which is estimated to involve at minimum, $700 billion of additional commitments.181 This plan also included a ban on short-selling of financial stocks.182 The mortgage market is estimated at $12 trillion183 with approximately 9.2% of loans either seriously delinquent or in foreclosure through August 2008.19 On 29 September 2008 the House of Representatives rejected a revised version of the plan.184 On 1 October 2008 the U.S. Senate approved an amended version of the plan,185 which was approved by the House on October 3 and immediately signed into law by President Bush.
Lending industry action
Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., refinancing, loan modification or loss mitigation). Homeowners have also been encouraged to contact their lenders to discuss alternatives.186
Corporations, trade groups, and consumer advocates have begun to cite statistics on the numbers and types of homeowners assisted by loan modification programs. There is some dispute regarding the appropriate measures, sources of data, and adequacy of progress. A report issued in January 2008 showed that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 new foreclosures. Consumer groups claimed the modifications affected less than 1% of the 3 million subprime loans with adjustable rates that were outstanding in the third quarter.187
The State Foreclosure Prevention Working Group, a coalition formed by 11 state attorney generals and bank regulators, reported in April 2008 that the increasing pace of foreclosures exceeds the ability of loan servicers to keep up. Seventy percent of subprime mortgage holders are not getting the help required. Nearly two-thirds of loan workouts require more than six weeks to complete under the current "case-by-case" method of review. The group has recommended applying a more systematic method of loan modification that can automatically be applied to a large number of struggling homeowners and slowing down the pace of foreclosures.188
In response to a legal settlement with several states announced 5 October 2008, Bank of America has announced a more aggressive program to systematically help an estimated 400,000 homeowners stay in their homes. This includes limiting payments to a specific level of income and writing down the values of mortgages.189
In Australia several lenders have amended their policy for low doc, no doc and no deposit loans that are considered to be riskier than standard home loans. Overall these changes have been relatively minor with the exception of the non conforming lenders that lend to credit impaired and subprime borrowers. It is unknown if this trend will continue or if Australian lenders will be forced to withdraw from riskier loan products.190
Hope Now Alliance
President George W. Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding ARMs.191192 A refinancing facility called FHA-Secure was also created.193 This action is part of an ongoing collaborative effort between the US Government and private industry to help some sub-prime borrowers called the Hope Now Alliance.194
The Hope Now Alliance released a report in February 2008 indicating it helped 545,000 subprime borrowers with shaky credit in the second half of 2007, or 7.7% of 7.1 million subprime loans outstanding in September 2007. A spokesperson acknowledged that much more must be done.195 During February 2008, a program called "Project Lifeline" was announced. Six of the largest U.S. lenders, in partnership with the Hope Now Alliance, agreed to defer foreclosure actions for 30 days for homeowners 90 or more days delinquent on payments. The intent of the program was to encourage more loan adjustments, to avoid foreclosures.196
Bank capital replenishment from private sources
Major financial institutions obtained over $260 billion in new capital (i.e., cash investments) as of May 2008.197 Such capital is used to help banks maintain required capital ratios (an important measure of financial health), which have declined significantly due to subprime loan or CDO losses. This capital was raised by issuing such instruments as bonds or preferred stock to investors in exchange for cash. Such capital raising has been advocated by the leaders of the U.S. Federal Reserve and the Treasury Department.198 Well-funded banks are in a better position to loan at favorable interest rates, which offsets the liquidity and uncertainty aspects of the crisis.
The ability of some banks and securities firms to place such large volumes of debt with investors is an indication to some analysts that these firms will survive the credit crisis.199 In response to the crisis, the last independent investment banks, Goldman Sachs and Morgan Stanley, elected to become bank holding companies in order to gain access to additional liquidity.200
Banks have obtained some of this capital from sovereign wealth funds, which are entities that control the surplus savings of developing countries. An estimated U.S. $69 billion has been invested by these entities in large financial institutions over the past year. On 15 January 2008, sovereign wealth funds provided a total of $21 billion to two major U.S. financial institutions. Sovereign wealth funds are estimated to control nearly $2.9 trillion. Much of this wealth is oil and gas related. As they represent the surplus funds of governments, these entities carry at least the perception that their investments have underlying political motives.201
Certain major banks have also reduced their dividend payouts202 to increase liquidity and further dividend reductions are expected by some analysts in 2008.203 Of the 3,776 U.S. FDIC insured institutions that paid common stock dividends in the first quarter of 2007, almost half (48%) paid lower dividends in the first quarter of 2008, including 666 institutions that paid no dividends. Insured institutions paid $14.0 billion in total dividends in the first quarter, down $12.2 billion (46.5%) from a year earlier.204
Litigation
Litigation related to the subprime crisis is underway. A study released in February 2008 indicated that 278 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis. The number of filings in state courts was not quantified but is also believed to be significant. The study found that 43% of the cases were class actions brought by borrowers, such as those that contended they were victims of discriminatory lending practices. Other cases include securities lawsuits filed by investors, commercial contract disputes, employment class actions, and bankruptcy-related cases. Defendants included mortgage bankers, brokers, lenders, appraisers, title companies, home builders, servicers, issuers, underwriters, bond insurers, money managers, public accounting firms, and company boards and officers.205
Former Bear Stearns managers were named in civil lawsuits brought in 2007 by investors, including Barclays Bank PLC, who claimed they had been misled. Barclays claimed that Bear Stearns knew that certain assets in the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth much less than their professed values. The suit claimed that Bear Stearns managers devised "a plan to make more money for themselves and further to use the Enhanced Fund as a repository for risky, poor-quality investments." The lawsuit said Bear Stearns told Barclays that the enhanced fund was up almost 6% through June 2007 — when "in reality, the portfolio's asset values were plummeting."206
In 2006, the OFHEO announced a suit against Franklin Raines, former chairman and chief executive officer of Fannie Mae, which was eventually settled.207