Thesis of US Subprime Mortgage Crises Background, Impact and Caution

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1 Thesis of US Subprime Mortgage Crises Background, Impact and Caution ZHAO Lingzhi Pingdingshan Institute of Technology,P.R.China, Abstract: In recent years, the crisis of subprime mortgages swept the main global financial market. The mortgage finance companies closed down one after another. The financial agencies such as banks suffered great loss. The fluidity of the international capital market was shocked greatly. Though it s negative effect on Chinese economy was comparatively less, we had the similar policies on interest rates and background of real estate as America. This essay emphasizes the caution of this crisis to our economy. Key words: Subprime mortgages; crisis; real estate 1 Introduction The subprime mortgage finance agencies went bankruptcy, the investment funds were forced to close down, the stock market vibrated severely. The Central Bank in America, Europe and Japan took active actions. Recently, the crisis of American subprime mortgages swept the world main financial market in America, EU, and Japan. The global capital markets had a certain degree of instability. 2 Summary of the crisis of subprime mortgages American mortgage loan market can be roughly divided into three levels: The first level is the prime loan market. It serves for the fine clients with a high credit degree of more tan 660 points and a stable income. These people mainly use the most traditional mortgage loans of 30 or 15 fixed-rates, and less use a more complex innovative mortgage tools. The second level is the "Alt-A" loan market, including both the mainstream class whose credit scores between 620 to 660, and a small number of those whose scores higher than 660 degrees. The third level is Sub-prime Market. It refers to those whose credit scores less than 620 points, proved to be income loss, indebted heavily. Its scale is roughly trillion US dollars and half of the people do not have a credence of a fixed income, the total amount of loans are trillion US dollars. In these three loan markets, the usurers of the prime market have a strong ability of repay the debts. They take a longer period of the fixed-rate loans. While the others have a weak ability, they prefer to choose more complex, risk-based pricing of mortgage loans tools. This crisis came into being since the spring of American subprime mortgages market usually choose the repayment of fixed interest rates combined with floating interest rates. That is, the house buyers should pay the loans on a fixed interest rates in the first several years after they bought the houses and then on a floating interest rates in the remained years. In the five years before 2007, the American subprime mortgages market developed rapidly due to the prosperity of the housing market and the low interest rates in those years. With the decline of the American housing market and the rising of the short-term interest rates, the rate of repayment were rising greatly and the burden of the repayment for the housing buyers were more heavy. Meanwhile, with the decline of the housing market, it made it difficult for the housing buyers to sell their houses or financing through housing mortgage. This situation directly made many borrowers of subprime mortgages couldn t repay the loans on time, thus further incur the crisis of subprime mortgages. These clients had to undertake heavy loan interest rates and became housing slaves. It put the repayment guarantee of the clients on the basis of the hypothesis that the price of the houses would be rising, not the basis of the ability of repayment of the clients by themselves. Its risk 433

2 was apparent. But the price of American purchase price continued to rise in recent years. The prosperity of the real estates made the loan agencies neglect the risks of the subprime mortgages and aimlessly pursue the high interest rates and continued the supply of the secondary mortgages. In April 2007, the second secondary mortgage loan companies The New Century Financial Company went bankruptcy. The crisis of American subprime mortgages began to surface. In the beginning of the August, AHMI and PMHC applied bankruptcy protection to the Federal Court. It is estimated t hat from November 2006 until now, there are altogether more than 80 secondary mortgage loan companies claimed shutdown among which 11 declared bankruptcy. 3 The source of the crisis of American subprime mortgages Since the 1980s, American financial industry took furious changes. The intensified competition in the same industry made many American banks loan business far beyond. And they began to take the consumption credit with high interest rates. The large number of derivative products available, the rapid development of financial technology made financial institutions a strong impression that all financial risks could be measured accurately and controllable. So many financial agencies became ambitious. Most of them get involved in secondary mortgage business with high interest rates to make up for the former negative properties assemble. They shared the enormous profits of the secondary mortgage but failed to properly measure the huge risks of the macroeconomy. The financial agencies began risky competitions which made the origin of the financial risks. Though the real intention to make the poor buy the houses of the American secondary mortgage was plumy, it still went too far. Statistically, in % secondary mortgage gave the borrowers who lacked the income credence. In 2006 this proportion has risen to 45%. Astonished, some loan agencies even introduced some loan methods without down payments and any documents. The usurers could buy houses without funds, only to claim their income with no certificate of repayment. The tender guarantee of the clients of secondary mortgage is not set on the basis of the clients own repayment abilities, but on the hypothesis of the rising housing price. Once the price dropped down and the interest rates risen, the burden of the clients will be heavier gradually. When this kind of burden reaches the utmost limit, numerous defaulters appeared, the crisis followed. The self-expansion of American credit agencies became the financial means for many secondary mortgagees. They took advantage of the characteristic of the low secondary credit requirement, getting loans again and again from different secondary mortgage loan agencies. For the continuous rising of American housing price, the secondary mortgagees always were in the cycling of getting high profits. This will further spur this kind of mortgagees to expand their scale of consumption loans. The foam of American real estate market upgraded in this mutual feedback. Otherwise, the 17 hike of the FRB broke this foam. This called for the rapid repayment of the mortgagees. There were so many clients of the secondary mortgage who couldn t pay for the mortgages. Among which the excessive speculators were hard to manage the situation. As the derivation of the secondary mortgage, the secondary debts couldn t be escaped. The chain reaction came one after another, so the crisis. 4 The influence of the crisis of American subprime mortgages to the economy The turbulent crisis of the secondary debts made American investors trapped, even those who entered the real estate market in 2005 and before. Concerned that the interest rates were 5% higher, increasing capital costs and the dropped-down American housing prices, the price of the real estates were still in the process of shrinking. The mortgage loan companies closed down, the financial agencies as banks, funds and insurance companies suffered great loss. The rate of unemployment was rising. The speed of economic development was slowed down. The crisis of American subprime mortgages swept the world main financial market in America, EU, and Japan. It has forced the world main Central Bank to provide fluidity of substantive money to the financial market to make the investors confidence stable. On 9th, 434

3 August, 2007, the Federal Reserve Bank of New York, under the U.S. Federal Reserve Board, raised temporary reserve of 24 billion US dollars. At the same day, European Central Bank raised a great number of low-interest loans of 94.8 billion euros (about130 billion dollars) emergently to the Euro zone financial system; the nest day, Japanese Central Bank took the similar action, raising 1 trillion yen (about 8.5 billion US dollars) to the financial system to help relieve the credit problem of shrinking. The total currency of all Central Bank rising from 9 to 23 in August was 500 billion US dollars. Thus formed the biggest united global action after the September eleventh hijackers Though all Central Banks took actions, the crisis of secondary mortgage was unavoidably hit the stock markets. on 15th August, the largest mortgage loan company the National Financial Company s stock price began to drop greatly. The Standard Poor's 500 index, the Dow Jones Industrial index, the Nikkei, the Hang Seng Index, and other global several Stock Exchange index also dropped sharply in several days. It s reasonable that the proportion of American 8 trillion US dollars of the total mortgage loans and 1.89 trillion US dollars of secondary mortgage loans is not large. The rising of the default rate couldn t bring great turmoil to the economy. But the question is American financial agencies sold secondary housing mortgage loans to the international investors as bonds. Many big banks, funds and insurance companies in America and Europe bought the secondary debts. Once American secondary mortgage loan markets had some changes, they unavoidably affect the international investment markets. Up to now, the crisis of American subprime mortgages was still in its development. In the future trend, it aroused great attention from the American and European Central Bank since it happened in American and European financial markets. With all kinds of emergent measures of control applied, the crisis might be relieved and finally solved. The scope of the crisis was limited in the financial market and wouldn t affect the entity economy. The assessment of IMF also thought that the crisis was controllable. 5 The Caution of the crisis of American subprime mortgages to Chinese economy The crisis of American subprime mortgages of the real estate market sounded us the alarm. We had to alert the implicit crisis behind the current prosperity of the real estate. Before the outbreak of the crisis, American economy has been performed on the platform of high growth rate, low inflation rate and unemployment rate for more than 5 years. The topic about the hot American housing market was sustained for many years. The economic prospect of China and America has some similarities. Similar to the prospect of American housing market, China cut interest 8 times since 1996 to 2002( 1-year survival benchmark lending rate of RMB from 10.98% and 12.06% in May 1996 to 1.98 % and 5.31% in February 2002). It greatly pulled the domestic demand and promote the economic growth, especially the governmental policy of encouraging housing mortgage accelerate the development pace of the real estate. According to the Central Bank s statistic, in 1997, the scale of the China's balance of individual commercial housing loans was only 19 billion Yuan, it had increased to billion Yuan to the end of 2002, it reached 2.27 trillion Yuan by the end of 2006, which increased more than 100 times in a decade. Banking industry bore the brunt of the crisis of American subprime mortgages. It should be given special attention to the hidden risk behind the housing mortgage loan from China's commercial banks. In the period of the overall rising of the real estate market, the housing mortgage loan is fine assets to the commercial banks with high profits, low rate of defaults. Once there was a default, the banks could get compensation through auction of the mortgage real estates. Currently, the housing mortgage loan occupies a large proportion in the assets of China s commercial banks and the major source of the loan revenues. In fact, the origin of this crisis was that American housing financial agencies loosened the loan conditions in the period of market prosperity. They introduced some loan products which requested no condition at first but so many in the following time. China s commercial banks should give full attention to the lesson of the crisis of American subprime mortgages. They firstly must guarantee the implement of the policy about the down payment, increase the ratio of the down payment to put an end to the Zero 435

4 down payment. Secondly, they should adopt strict credit examination before the loaning to prevent the false mortgage. The greatest caution of the crisis of American subprime mortgages is that we must alert the shock of the macro regulation policy for the economic cycle to a certain market. The fundamental reason of this crisis was the FRB s hike which led to the slash of the housing markets. The current China is exposed to the inflation. If the Central Bank raises the interest rates of RMB loans considerably to contain the pressure of inflation, it must look out two affects. One is the affect of loans string to the real estate enterprises which may cause the rupture of the developers investment. The other is the affect of the raising repayment pressure on the mortgagees which may cause the rate of default rising. These two affects will eventually converge to the commercial bank system and make the ratio of non-performing loan of commercial banks rise and decline in the value of real estate collateral; finally it will affect the profitability of the commercial banks and even survivability. Though in China, the main housing mortgages are prime loans without the same loans as American secondary mortgages and Zero down payment, (On the contrary, the proportion of the down payment has raised to 30% and more possibility of further raising.) the risk of default is rather low. But according to the overseas research report, the rise of the default about the housing mortgage loans will release after 3-5 years after the loan grant. Most of our present balance of housing mortgages are the newly debts in the recent two years, the rate of default is low which will increase with the time passing by. Moreover, to curb the liquidity of the excess market and to prevent economic developing from the rapid change to overheating, the Central Bank recently took measures of tightening credit and hike the interest and deposit reserve ratio. The hike of the interest gives more burdens to the loan tellers which bring about hidden trouble for the rise of the default rate. Moreover, China's current securitization of mortgage loans is still at a starting stage with small size and low liquidity. The risk of mortgage loans mainly concentrated in the banking system. If the default rate increased, the impact on banking system can not be underestimated This crisis gave enlightenment to China s macro-control which has three main aspects. 1. It is necessary to make the property price the monitoring subject of the Central Bank's monetary policy. Once asset prices finally influenced aggregate demand or supply through the wealth effect, or other channels, it will have an impact on the inflation rate. Even if the Central Bank who implemented the inflation target system needs to set fluctuations of asset price as an important reference to formulate monetary policy.2. When we conduct macro-control, we must consider the downsides of it. For example, when FRB continued its hike, it might not give sufficient attention to the burden of the housing market. 3. The government should not give support to the crisis easily. The crisis is a kind of punishment to the blind investment and aimlessly multiple actions. If the government gives support to these actions, it will lead to the result of moral risks. China is currently experiencing the period of rapid bubbled expansion of asset prices. Since 1998, the domestic commercial banks began to adjust their structure of the credit properties. The housing mortgage, with its low risk rates, got the attention of the commercial banks. The large number of housing mortgage loans is put in, which is the major reason why the domestic real estate prices soaring in recent years. The growth of credit in the property market will undoubtedly increase the effective demand of the housing market. While under regulatory pressure, the domestic commercial banks require the clients to pay a certain percentage of down payments which seem to weaken the loss of borrowers default to a certain extent. However, China s housing mortgage loans undoubtedly features more and more characteristics of American measured by the ratio of housing revenue. The economic discipline tells us that there is shadow of recession hidden behind any of prosperity. Once the asset price appeared the signs of frustrated fluctuations and interest rates unexpectedly rose, the debt burden of the borrowers will surpass the critical point; their probability of moral risks will also be greater. At this time, the crisis of mortgage may arise at any time. 6 Conclusion In light of the hidden risks in our housing mortgage loans, we should take necessary measures to 436

5 prevent the similar crisis of secondary mortgage loans as America. One measure is that Chinese banks should investigate carefully of the lending, strictly examine the repayment abilities and credit condition of the loan tellers. In particular, we should beware of the speculative fever which some people make use of the mortgage to invest in stocks and housing. They should determine rational housing prices and reasonable proportion and deadline of mortgage and down payment to prevent the rise of the default. On the other hand, the banking system should actively develop mortgage securitization to find ways to resolve the problems of the low negotiability of current mortgage bond issue, they should disperse mortgage risks maximum, and try to reduce the loss of the real estate bubble burst to the minimum. References [1]Gao Shanwen, How great the effect of the crisis of American secondary mortgage debt to China. [J] EMC Corporation, 7(2007) [2]Geng Qun, Disturbance of the secondary prime loans. [J]New fortune magazine,8(2007) [3]Shang Yaohua, Wan Weiwu, Housing mortgage loans: Risk Behind the receipts. CSSCI,3(2007) [4]Huang Wenjing, Gao Chao, Thinking China's housing mortgage loan securitization. [J],Cooperative economy, science and technology, 4(2007) [5]Deng Xuezhong, International Comparison Of Commercial Banks Subordinated Debt structural design. [J] Modern Economic Management; 3(2007) [6] Huang Xiaobiao, Research on China's Development of housing mortgage loan securitization. [D];South China Normal University;(2003) [7]Zhang Zhaojie, practice on Subordinated Debt as a regulator capital and that of foreign commercial banks.[j] International Finance Research; 10(2004) [8] Sun Zhixian, Analysis on transmission mechanism of China s monetary policy. [D]; University of International Business and Economics;(2005) 437