Concept of Subprime Loans, History, Risks, and the Crisis

Bernanke described economics as, “a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong. About the future, not so much” (2013). To further contemplate on this view, in the first blog, I shall briefly describe the subprime mortgage market concepts, history, risks and the crisis.

The subprime mortgages, also called non-traditional mortgages (NTMs) are the loans that are offered to borrowers that have higher credit-risk characteristics (Utt, 2008, p. 2; Gorton, 2008, p.7)

Figure 1, describes the relationships of all the key players involved in subprime mortgage loan crisis. Banks or mortgage lending institutions (lenders) through a mortgage broker (originator) would make the loans to the borrowers (homeowners) and after servicing the loans for a year or less, sell them off to big Wall Street investment banks.  The investment banks in turn securitized, with appropriate credit ratings assigned from the credit agencies, packaged them into various financial products, such as; mortgage backed securities (MBS), collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs), and credit default swaps (CDS) etc. and then sold them to investors (Demyanyk & Hemert, 2011; Gilbert, 2011; Lewis, 2010; Muolo & Padilla, 2008). According to Congressional research service report in 2005, $507 billion in subprime mortgage loans were pooled and sold as mortgage backed securities (MBS) to private investors, as compared with only $18.5 billion in 1995, (Getter, Jickling, Labonte & Murphy, 2007, p. CRS-3).  

Figure 1: Key Players, Key Influencers, and Governing Agencies involved in Subprime Mortgage Crisis (Depicted by Author)             

            

The Financial Crisis Inquiry Commission (FCIC) was set up by the US Congress (US Congress, 2009) to examine the cause of the economic and financial crisis in the United States. Table 1, shows the breakdown of NTMs held by Government-supported enterprises (GSEs) and the private investment banks (Angelides, et al., 2011, p. 456, Table 1).

Table 1: Government-sponsored enterprises (GSEs) and the Investment banks holdings of NTMs (Subprime and Alt-A Loans)

According to the annual report of the council of economic advisors (Lazear, 2008, p.291, Table B-56), presented by President Bush, record levels of 1.283 million homes were sold in 2005. The housing prices appreciated rapidly from 2001, reaching 13% in 2006 (Getter, et al. 2007, p. CRS-1), as shown in Figure 2 (Angelides et al., 2011, p. 457), and then the housing bubble burst.

Figure 2: The Great Housing Bubble 2007 (Angelides et al., 2011, p. 457)                      

 What went wrong? Subprime borrowers are riskier than prime borrowers (Gorton, 2008, p.6). A whopping $7 trillion in home equity was lost (Bernanke, 2012, p. 3).

  

 Figure 3: Mortgages with negative Equity (Bernanke, 2012, p. 5)

                               

As shown in Figure 3, there were 12 million homeowners that had a negative home equity in their homes (Bernanke, 2012, p.4) and the delinquency rates were rising as shown in Figure 4 (Bernanke, 2012, p. 6).

                              Figure 4: Prime Mortgage Delinquency Rate (Bernanke, 2012, p. 6)                                 

Apart from the homeowners being the biggest losers, many firms at Wall Street, either suffered huge losses, or got merged with other companies or went bankrupt, such as; Goldman Sachs, JP Morgan, Bear Sterns, Wachovia, Washington Mutual, Lehman Brothers to name a few (Angelides, et al., 2011) . To prevent the crisis from worsening, the US Government rescued AIG with a bailout of $180 billion and GSEs with additional $151 dollars in government support (Angelides, et al., 2011).

Reference

Angelides, P., Thomas, B. Hon., Born, B., Georgiou, B., Graham, B., Senator, Hennessey, K. & ...Wallison, P. J. (2011). The Financial Crisis Inquiry Report. Retrieved July 6, 2013, from http://cybercemetery.unt.edu/archive/fcic/20110310173545/http://c0182732.cdn1.cloudfiles.rackspacecloud.com/fcic_final_report_full.pdf

Bernanke, B. (2012). Housing-White-Paper-20120104. Retrieved July 2, 2013, from http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf

Bernanke, B. S. (2013). At the Baccalaureate Ceremony at Princeton University, Princeton, New Jersey. Retrieved July 4, 2013, from http://www.federalreserve.gov/newsevents/speech/bernanke20130602a.htm

Demyanyk, Y., & Van Hemert, O. (2011). Understanding the Subprime Mortgage Crisis. Review of Financial Studies, 24(6), 1848-1880. Retrieved from http://search.ebscohost.com.proxy1.ncu.edu/login.aspx?direct=true&db=bth&AN=61047576&site=eds-live

Getter, D., Jickling, M., Labonte, M., & Murphy, E. (2007). CRS Report for Congress: Financial Crisis? The Liquidity Crunch of August 2007. Retrieved July 5, 2013, from http://assets.opencrs.com/rpts/RL34182_20070921.pdf

Gilbert, J. (2011). Moral Duties in Business and their Societal Impacts: The Case of the Subprime Lending Mess. Business & Society Review (00453609), 116(1), 87-107. doi:10.1111/j.1467-8594.2011.00378.x

Gorton, G. B. (2008). The Panic of 2007. Retrieved July 4, 2013, from http://nber.org/papers/w14358.pdf

Lewis, M. (2010). The Big Short: Inside the Doomsday Machine. New York: W. W. Norton.

Muolo, P., & Padilla, M. (2008). Chain of Blame [electronic resource] : How Wall Street Caused the Mortgage and Credit Crisis / Paul Muolo, Mathew Padilla Hoboken, N.J. : John Wiley & Sons, c2008. Retrieved from http://search.ebscohost.com.proxy1.ncu.edu/login.aspx?direct=true&db=cat01034a&AN=nu.10249111&site=eds-live; http://site.ebrary.com.proxy1.ncu.edu/lib/ncent/Doc?id=10249111

US Congress. (2009). Fraud Enforcement and Recovery Act of 2009 or FERA. Retrieved July 7, 2013, from http://www.gpo.gov/fdsys/pkg/PLAW-111publ21/pdf/PLAW-111publ21.pdf

Utt, R. (2008). The Subprime Mortgage Market Collapse: A Primer on the Causes and Possible Solutions. Retrieved July 2, 2013, from http://www.heritage.org/research/reports/2008/04/the-subprime-mortgage-market-collapse-a-primer-on-the-causes-and-possible-solutions?ac=1