Subprime mortgage crisis

Dissertation. Housing Market and Sub-prime Crisis: Insight into its Operations, Causes and Effects

Abstract

Subprime mortgage crisis has caused the economies of the US and UK to slowdown and enter recession by the beginning of 2009. This study investigates the causes and effects of the subprime mortgage crisis and explores securitisation operations and their role in the economic catastrophe. Economic boom in the 2000’s created a housing bubble and property prices were rising faster than before. The preconditions of this property bubble were created by loose monetary policy of the US government in early 2000’s when the economy nearly entered recession after the stock market crash. Nonetheless, the regression analysis undertaken in this study does not prove that this cut in interest rates affected current economic slow down in the US and UK. Low interest rates affected mortgage rates and the attraction of subprime borrowers in the housing market. The subprime mortgages were risky but a local housing market crash would not have caused global economic recession if investment banks had not sold billions of dollars worth CDOs containing subprime mortgages to institutional investors. Thus, oversecuritisation is argued to be a stronger cause of the crisis than monetary policy of the Federal Reserve System or housing market crash. The study further compared the effects of the subprime mortgage crisis on the US and UK economies.

1. INTRODUCTION

Financial system in the US and the economies of a number of states in different parts of the world were shaken by the subprime mortgage crisis. It broke out in 2007 and by the second half of 2008 it caused credit crunches and economic declines in the European countries. The causes of the crisis center at lending to subprime borrowers and injecting a great amount of securities that were backed by these mortgages into financial system. Preconditions and changes in macroeconomic indicators prior to the crisis are analysed in the research project.

Economic prosperity and growth created opportunities for more people to be able to afford a house. Residential property market had been flourishing until 2006, prices of real estates kept increasing and mortgage rates kept falling down. A new layer of customers appeared – subprime borrowers. They had poor credit history, low paying or odd jobs, recent filings for bankruptcy and other features that had not let them take a mortgage loan in the past. Lending institutions observed that the price of residential property had been going up and households could easily refinance their loans. And the more loans are made, the more money is earned by the lender. In order to attract new customers to make more loans, lending institutions introduced more and more attractive conditions such as little or no downpayment. Buying a home became so easy that people who previously could not qualify for a loan were able to afford buying a house on new conditions. Initial deposit did not have to be large and banks attracted them by offering low interest rates for the first two or three years. After that, the property acquired would be refinanced on new conditions and clients would make new adjusted monthly payments (Franzini, 2007).

This was creating a moral hazard because lending institutions knew that this scheme of refinancing subprime mortgages will only last as long as house price go up. The borrowers who bought into the deals could be expected to meet the initial obligations on the loans since monthly payments were affordable. However, after refinancing and an increase in mortgage rates that were adjustable, the risk of default becomes high. In order to minimise the risk associated with subprime mortgages, lending institutions decided to spread it among thousands of institutional investors. So, investment banks and securitisation process were used to finance the subprime mortgages (Bible, 2009; Trimbath, 2009).

Securitisation implies that several assets are pooled together and sold as one new security. Subprime mortgages were pooled to form mortgage backed securities that were ranked from low to high risk. However, the level of risk was a matter of assumption since both high-risk and low-risk securities used subprime mortgage as underlying assets. Lower probability of simultaneous default by all subprime borrowers allowed investment banks to issue collateralised debt obligations with up to AAA rating. However, this research argues that high ratings were obtained because large credit rating firms such as Moody’s and Standard and Poor’s were paid by the issuers of the securities. The conflict of interest resulted in the failure of corporate governance in rating agencies (Strier, 2008).

Financial crisis affected most of the population in the US and UK. First of all, millions of homeowners risk to lose their property in the near future because credit conditions are tight, it is impossible to refinance a home, unemployment is growing as more people lose jobs and business confidence remains low. Secondly, pension funds and hedge funds that bought collateralised debt obligations containing subprime mortgages as underlying assets suffered losses when the default rates increased. Therefore, even more people risk to lose their savings for retirement. Thirdly, the subprime mortgage caused economic recessions in a number of countries including the US and UK. Decline in gross domestic product decreases national income in general and individual income of many households in particular.

1.1. Aims and Objectives

This project has an aim to disclose the mechanism through which the US mortgage market and housing market crash caused economic slowdown and quantitatively estimate the effects. The objectives are the following:

• to investigate the sub-prime lending operations and legislations that stimulated the expansion of sub-prime lending;
• to assess the major causes of the financial crisis;
• to review underlying economic theories that explain the crisis;
• to assess the role of financial institutions in the sub-prime crisis;
• to evaluate the effects of the crisis and future consequences.

Methodology of the research project comprises regression analysis that will show the impact of the crisis on gross domestic product in two countries: the US and UK. Important economic indicators such as interest rates, unemployment, house prices, share price indexes and balance of trade will be used to quantitatively measure the effect of the subprime crisis. The data will consist of quarterly observations covering the period of eighteen years from 1991 to 2009. A comparison between the two countries will be made in order to find which one suffered the most. Although, the subprime mortgage crisis originated in the United States, the hypothesis is made that other countries such as the UK suffered even worse repercussions than national economy of the US. The inquiry will start from reviewing the literature on real estate market, lending and subprime mortgage issues that will further lead into the quantitative research.