Commentary - Subprime Mortgage Meltdown

By Scott Boyd - October 22 / 07

Much of the economic news regarding the U.S. has been centered around the subprime mortgage collapse and the effect this is having on not just the U.S. economy, but other countries as well. In the U.S., several high-profile lending institutions have failed and the Bank of England recently stepped in to prop up the Northern Rock Bank when the bank found itself with insufficient liquidity as investors started to withdraw savings en masse. Northern Rock was unable to borrow short-term funds as institutional lenders felt that the bank was overexposed in the subprime market, making them too great a risk in which to invest.

In this article, we will look at the rise of the subprime mortgage industry, how it has affected the U.S. economy, and finally, how the Federal Reserve has responded to the growing crisis. One thing you should note – the subprime fallout really came to prominence around the same time that Ben Bernanke replaced Alan Greenspan at the head of the Federal Reserve. His comments and actions as the subprime issue unfolded provided much insight into Bernanke’s approach and helped him emerge from Greenspan’s shadow early into his mandate.

What is a Subprime Mortgage?

The term “subprime” refers to the risk profile belonging to the borrower of funds and not the actual rate at which the loan is charged. The subprime mortgage predicament that has gripped the U.S. – which has now filtered through to other countries as well – stems from the fact that mortgages were being offered to individuals for amounts that they really could not afford. In some cases, mortgages were even being offered to individuals that, given their credit history, would not ordinarily qualify for a mortgage in the first place.

Several factors came together giving rise to the subprime mortgage crisis. To understand these factors, we need to consider the three main groups involved. Firstly, we will look at those that borrowed funds, the institutions that provided the mortgages, and other participants involved in the secondary mortgage market.

The Borrowers

Since the early 2000s, housing prices in the U.S. have increased dramatically. Homeowners came to expect yearly 10-20% gains and early on at least, this rapid appreciation showed no sign of ending. This had a dramatic effect on two groups of consumers in particular; those that did not yet own homes, and those that wanted to take advantage of the equity in their homes and use this to leverage a move to a larger, more expensive home. Also caught up in this “house rush” were the mortgage and lending institutions.

Around this time, the U.S. economy was recovering from a downturn that had been brought on by the economic fallout of the “dotcom” bust as well as the events of 9/11. The Federal Reserve was promoting an expansionary monetary policy through the lowering of the Discount Window rate in an effort to reduce interest rates in a bid to stimulate spending. The federal government directly encouraged consumer spending as a way to boost the economy and soon the notion that spending and “buying American” became analogous to being a good and patriotic citizen.^[1]

Clearly, this message came through loud and clear. In 2003, the Federal Funds rate reached a low of 1% making investment capital readily available for financial institutions. As a result, the rate on a 30-year fixed-rate mortgage hit lows not seen in over forty years, and suddenly, a group of people that normally could not afford to carry a mortgage, became potential customers. Add to this the heavy competition that mortgage lenders were facing and it is easy to understand how the housing bubble continued to be fueled at an accelerated pace – right up until late 2006 when the first cracks in the housing market began to show.^[2]

In order to get in on the rapidly-expanding housing market, many individuals entered into very high-ratio mortgages – these are mortgages that are nearly equal to the value of the home itself. The belief that house prices would continue to appreciate was still widely held and many homeowners felt that if they could just cover the minimum payments for the first few years, they would be able to either sell their house for a generous profit or could use the acquired equity in the house to refinance the mortgage.^[3]

However, as the housing boom began to unravel, the much depended-upon market value increase failed to sustain itself and many homeowners were left with mortgages that were impossible for them to manage. For thousands, the result was to add their home to the unprecedented number of foreclosures – for many others, it was cheaper to simply walk away from their homes.

The Lenders

As noted, the financial institutions were very eager to gain larger business share in the burgeoning housing market. During the early part of the boom, the economy was performing well, inflation was low, and banks and other lending institutions had easy access to relatively cheap investment capital.

As a result, some lenders offered incentives to gain mortgage business, including “teaser rates” consisting of very low interest rates for the first year or two, that would automatically revert to prevailing market rates after the introduction period. They also approved high-ratio mortgages making it unnecessary for borrowers to come up with sizable down payments. There were even many instances where lenders provided mortgages valued at more than 100% of the value of the home!^[4]

It is hard to imagine how so many risky mortgages could have been authorized by the lending firms but the pressure to get in on the market, coupled with the availability of inexpensive capital through the Federal Funds program, obviously proved too great an incentive. Like many homeowners, the lending firms expected property values to continue to set records so they had little concern over recouping their investment should a mortgage go into default.

When the inevitable happened and the mortgage rate incentives reverted to the true market price, many owners were unable to meet the new payment requirements. Additionally, homeowners with large-ratio mortgages were unable to refinance and obtain a lower rate and mortgage payment.

As the number of defaults continued to rise, many lenders and investors began to suffer high losses as defaulted mortgages often exceeded the value of the underlying properties. This situation grew worse as the house price decline deepened and even many conventional mortgages taken out at the height of the housing boom exceeded the property value as house prices continued to deteriorate. Lending firms were unable to recover their losses on defaulted mortgages and several high profile firms were forced into bankruptcy.

Secondary Mortgage Market

While it can be argued that buyers and the lending institutions brought this issue on themselves – buyers entered into mortgages that they could only afford when the rates were held below market, and lenders offered unnaturally low mortgages to buyers that did not qualify – one other factor that played a role in the subprime drama is the emergence of the secondary mortgage market.

Lenders were increasingly bundling original mortgages they offered into a larger security known as a collateralized debt obligation, or a CDO. This new security could then be re-sold on the secondary mortgage market to investors that only knew they were buying a collection of mortgages – they would have no idea as to the quality of each individual mortgage.

Because there was no way of knowing the exact composition of individual CDOs, investors relied on a risk assessment assigned to each CDO by various rating agencies. The rating agencies were expected to assign a risk rating for each CDO that reflected an unbiased risk assessment to be used by secondary mortgage market investors to determine the quality of a particular CDO offering. These investors included large institutional investors and many of the larger hedge funds.

Unfortunately, some questions have surfaced as to a possible conflict of interest with the manner in which the CDOs were rated. Firstly, the rating agencies were paid by the institution offering the CDO and it has been suggested that agencies that offered higher ratings received more repeat business. The allegation is that rating agencies felt pressured to provide higher ratings in order to receive additional rating fees.^[5]

Ultimately, whether or not blame lies with the rating agencies, the firms that offered the CDOs, or the CDO investors themselves, it is apparent that the true level of risk for the underlying mortgages and the CDOs created from these mortgages was either not understood, or not correctly assessed. As the full scale of the subprime failures became known, the repercussions were felt in many sectors of the economy.

How Do the Subprime Problems Affect the U.S. Economy?

Certainly, the high rate of foreclosures and the resulting decline in new housing starts in the U.S. has a direct, negative impact on the economy. The housing industry employs a great number of people both directly in construction trades, and indirectly through manufacturing and retail stores, and unemployment in these sectors has increased dramatically in the last six months. Also, several high-profile lending firms including New Century Financial and American Home Mortgage Investment have filed for Chapter 11 bankruptcy protection.

Many other financial institutions have also been affected by the subprime issue as they were heavily invested in subprime mortgages through the secondary mortgage market. In the Spring of 2007, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns lost an estimated $18 billion in combined market value in a single trading session.^[6] In essence, CDOs consisting of bundled subprime mortgages have moved from being merely illiquid, to essentially being unmarketable and many institutions were caught with considerable amounts of these now worthless CDOs in their holdings.

These losses and perhaps more importantly, the open questions around what could still happen, have resulted in a tightening of the investment supply capital. It is this issue that is being watched very carefully by the Federal Reserve and other central banks as the reduction in capital means less liquidity and a possible increase in borrowing costs.

How did the Federal Reserve Respond?

In a speech delivered to the Economic Club of New York on October 15, 2007, Chairman Bernanke outlined actions the Federal Reserve had implemented in response to the subprime mortgage crisis. Bernanke explained that banks were becoming “protective” of their liquid assets and as a result “both overnight and term interbank funding markets came under considerable pressure. Interbank lending rates rose notably, and the liquidity in these markets diminished”. ^[7]

From this statement, it is clear that the Board of Governors fears that a reduction in the money supply could lead to an interest rate increase as well as possible liquidity issues. Bernanke and the Board of Governors decided on a course of action to increase the supply of funds available for overnight lending in an attempt to bring the Federal Funds interest rate back to the target established by the Federal Open Market Committee.

The Federal Reserve’s “initial action was to increase liquidity in short-term money markets through larger open market operations – the standard means by which it seeks to ensure that the federal funds rate stays at or near the target rate set by the Federal Open Market Committee”.^[8] The results of this action “helped counter the resulting pressure on the funds rate early in the day; it also eased banks’ concerns about the availability of funding and thus assisted the functioning of the interbank market”.^[9]

At the time of this writing, the final chapter of the subprime meltdown is far from complete. The Federal Reserve continues to follow developments closely and seems determined to ensure that meeting liquidity and interest rate targets is the most effective means to counter the subprime fallout. In what may be the greatest financial crisis in the past twenty years, the Fed remains committed to its open market policies as the approach for protecting the U.S. economy in the face of severe market shocks.

Update – December 12 2007

Recent Bank Losses Linked to Subprime Mortgages

Evidence of the global nature of the subprime problems continued to surface as 2007 winds to a close. In Canada, two of the country’s major banks reported significant write downs based on subprime CDO exposures. The Royal Bank of Canada (RBC) announced nearly one billion in subprime-related losses, while the Canadian Imperial Bank of Commerce (CIBC) revealed on December 7 that it would take a $3 billion write down.^[10]

Rumors continue to swirl that more loss announcements are pending in the Canadian banking industry even as Swiss-based UBS highlights problems of its own with a $13 billion write down. In fact, UBS turned to the Government of Singapore Investment Corporation and a private investor from the Middle East in order to acquire the necessary funds to bring liquidity levels up to acceptable levels prior to the announcement.^[11]

Federal Reserve Actions

FOMC Federal Funds Rate Cut

The Federal Reserve has faced a formidable challenge as the credit crunch continues to grow. While all observers are in agreement that the U.S. financial system is in shock, overall however, the economy has remained reasonably healthy. Employment numbers have remained constant and prices have not fluctuated greatly. For these reasons, the Fed has been reluctant to lower interest rates for fears of flooding the system with money and risking an outbreak of inflation.

On December 11, 2007 however, the Federal Open Market Committee did lower the federal funds rate twenty-five basis points to 4 ¼ percent. While a rate cut was not unexpected, many analysts were looking for a half point cut and critics argued this was too little, too late and Bernanke was singled-out as “lacking a sense of urgency”.^[12]

The Fed’s rate cut was coordinated with similar cuts by the European Central Bank, the Bank of England, the Swiss National Bank, and the Bank of Canada.

“This will help to improve the distribution of liquidity in the system,” said Marvin Goodfriend a former Fed advisor. “The Fed is willing to be patient because it sees that the system is repairing itself,” he added.^[13]

Federal Reserve TAF Auctions

As the financial system struggles to maintain liquidity in an environment where the banks are hesitant to lend funds to each other over fears of the quality of the collateral being offered, the Fed has unveiled a series of auction loans to provide funds to struggling banks.

Billed as a "temporary Term Auction Facility” or TAF for short , the program consists of a funds auction where depository institutions can borrow short-term funds using a wide range of collateral including CDOs containing mortgage-backed securities. Interest rates will be determined by a bidding competition with insiders suggesting interest rates at least as high as the federal funds rate the banks charge each other for overnight loans using their reserve funds, but still lower than the discount rate the Fed usually charges for its loans.^[14] The first of these new auctions is scheduled for December 17 with settlement on December 20 – the auction will make $20 billion available on a 28-day term, maturing on January 17, 2008.

Depository institutions wishing to submit bids will do so through their local Reserve Bank. In order to qualify, institutions must be judged as financially sound by their local Reserve Bank and be eligible to borrow funds under the primary credit Discount Window program.^[15]

In addition to the TAF announcement, the Federal Reserve also released details on an agreement to establish temporary reciprocal currency arrangements (swap lines) with the European Central Bank (ECB) and the Swiss National Bank (SNB). These swap agreements will provide $20 billion to the ECB and $4 billion to the SNB respectively.

References

1. ↑ How Severe is the Subprime Mess? - MSNBC.com – March 13, 2007
2. ↑ How Severe is the Subprime Mess? - MSNBC.com – March 13, 2007
3. ↑ CBC News - August 31, 2007
4. ↑ CBC News - August 31, 2007
5. ↑ Who is to Blame for the Subprime Crisis? - Eric Petroff, Senior Consultant, Hammond Associates
6. ↑ CNN News
7. ↑ Federal Reserve Governor Ben Bernanke in a speech to the Economic Club of New York - October 15, 2007
8. ↑ Federal Reserve Governor Ben Bernanke in a speech to the Economic Club of New York - October 15, 2007
9. ↑ Federal Reserve Governor Ben Bernanke in a speech to the Economic Club of New York - October 15, 2007
10. ↑ Bloomberg.com - December 7, 2007
11. ↑ Financial Times Online - December 10, 2007
12. ↑ Reuters - December 12, 2007
13. ↑ Reuters - December 12, 2007
14. ↑ Business Week - December 12, 2007
15. ↑ Federal Reserve Press Release - December 12, 2007