Causes of the subprime crisis
The first cause of the subprime crisis is the mortgage lending process in the United States. In the U.S. the residential mortgage process is that a person who wants to purchase a house, with help from a real estate broker, selects a mortgage lender who gives the loan after checking his or her credit score, and then the property that he or she is going to purchase will serve as collateral for the loan. After the loan is disbursed, most mortgage lenders resell these loans to investors or Wall Street firms, often through multiple intermediaries. Wall Street firms in turn bundle thousands of mortgage loans from different lenders into mortgage-backed securities (MBS).These institutions then slice these mortgages into residential mortgages backed securities(RMBS), or in other words, securities that are backed by collateral; the collateral here being the mortgages held by subprime borrowers. These mortgage-backed securities are, in turn, often sliced and diced into different structures, for example, a Collateralized Debt Obligation (CDO). Thus CDOs are pools of bond securities that are grouped together to help diversify risk. The different tranches of these structures are assigned a risk rating by the rating agencies such as Moody’s, Standard & Poor’s, and Fitch based on various parameters. They are subsequently sold by Wall Street firms to institutional investors worldwide – mutual funds, banks, hedge funds, central banks and pension funds. The information provided above lists the agents involved the US housing mortgage market, and it will help to identify who were hit by the crisis. There are house purchasers, real estate agents, mortgage lenders, wall-street firms, rating agencies, and investors.
The second cause of the subprime crisis is mortgage securitization which creates multiple principal agent problems. Securitization is viewed as bank “disintermediation”, but the fact is that it replaces one middleman by several. In the traditional model, there is only one middleman between the lender and the borrower, the bank. However, mortgage securitization brings principal agent problems. One problem is between the depositors and the banks, and another is between the banks and the borrowers. In the process of mortgage securitization, the lender is supplanted by the mortgage broker, the loan originator, the servicer who collects payments, the investor, the arranger, rating agencies and mortgage bond issuers.
The third cause of the subprime crisis is subprime lending and housing bubble. Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. A housing bubble is characterized by rapid increases in the valuations of real property such as housing until unsustainable levels are reached relative to incomes, price-to-rent ratios, and other economic indicators of affordability. The housing bubble (See Figure 1) was largely fed by the lowering of interest rates to record low levels to diminish the blow of the massive collapse of the bubble. Encouraged by the low interest regime and high liquidity, thanks to inflows from Asia and other economies, US banks started lending liberally for housing. Their credit to sub prime mortgages bloomed because of the low interest regime and hefty promotional campaigns. The sub prime crisis is the result of
excessive amounts of loans made to people who could not afford them and excessive
amounts of money thrown into the mortgage arena by investors who were very eager for
high-yielding investments. It fed the real estate mania, the real estate bubble in many
parts of the country. The bubble prices in the US housing market were caused by:
• Lax lending standards.
• Low treasury rates on adjustable rate mortgages.
• Speculative behavior by consumers.
Interest paid on residential mortgages in the US is linked to US Federal Reserve Fed
Funds Rates. Between 2004 and 2006, because of incipient inflation in the US economy,
the Fed increased its Fed fund rate1 from 1% all that way to 5.25% and the discount rate2
from 2% to 6.25%. Because of this, holders of residential mortgages saw their payments
on their house loans rise. This rise in rates was a disaster in the making for banks that
gave loans to sub prime borrowers. Defaults on sub-prime mortgages turned out more
Reference
Bass, B. M. (1990). Handbook of Leadership: Theory, Research and Managerial Applications 3rd Edition. New York: The Free Press.
Pierce J., & Newstrom, J.W. (2011). Leaders & the Leadership Process: Readings, Self- Assessments and Applications (6th Edition). The United States:McGraw-Hill.
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scarlett13 (student)
