A Brief Review of the US Financial Crisis Origin

Transcription

1 American Journal of Scientific Research ISSN Issue 74, 2012, pp EuroJournals Publishing, Inc A Brief Review of the US Financial Crisis Origin Francisco Jareño Departamento de Análisis Económicoy Finanzas Universidad de Castilla- La Mancha Facultad de CC Económicasy Empresariales Plaza de la Universidad, 1, 02071, Albacete, Spain francisco.jareno@uclm.es Tel: ; Fax: Marta Tolentino Departamento de Análisis Económicoy Finanzas Universidad de Castilla- La Mancha Facultad de Derecho y Ciencias Sociales Ronda de Toledo, s/n, 13071, Ciudad Real, Spain marta.tolentino@uclm.es Tel: ; Fax: Abstract This paper revises the origin of the financial crisis and the subsequent securitization process. Also, this research points out the importance of the last financial crisis to explain the current global economic crisis, and the main consequences and implications. Keywords: Economic crisis, Financial Crisis, Securitization process. 1. Introduction This paper briefly reviews the origin of the financial crisis in 2008 (Baily et al., 2008 and Bernanke, 2008) and the subsequent securitization process, because this explanation allows us to understand the current situation of the economy all over the world (United States. Congress Senate Committee on Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations, 2011, and United States. Financial Crisis Inquiry Commission, 2011). Thus, this research revises the origin of the financial crisis, analyzing US mortgage market, distinguishing between prime and subprime mortgages and evaluating the deregulation of financial institutions. Next section analyzes deeply the securitization process and, finally, this research identifies the main implications and consequences of this financial crisis and the most important conclusions. 2. The Origin of the Financial Crisis 2.1. US Mortgage Market Some decades ago, US authorities were concerned with the access to the homeownership by US families, so United States was a country with one of the highest increase in the percentage of homeownerships. According to Figure 1, the US homeownership rate increased from about 43% in 1940 to 65% approximately in 2005.

2 A Brief Review of the US Financial Crisis Origin 52 Figure 1: US homeownership rates Source: US Census Bureau data Thus, firstly, a good definition of mortgage is necessary. According to Fabozzi (2004), a mortgage is a loan secured by the collateral of specified real state property, which obliges the borrower to make a predetermined series of payments and gives the lender the right of foreclosure on the loan if the borrower defaults. Different protagonists began to act in the mortgage market: borrowers or debtors, Government Sponsored Enterprises (GSEs), lenders (financial institutions) or mortgages originators and, finally, mortgages insurers. In this context, some measures adopted by the US government encouraged people to purchase homes, such as the creation of Government Sponsored Enterprises (GSE): Federal National Mortgage Association (Fannie Mae), Federal Home Loan Corporation (Freddie Mac) and Government National Mortgage Association (Ginnie Mae). These agencies were aimed at reducing the cost of home mortgages for marginalized people (from the social and economic point of view). GSEs encouraged homeownership by providing a secondary market for (higher risk home loans) mortgages and also purchased loans from lenders and securitized them. So the existence of this secondary market encouraged lenders to create more loans, since they could easily sell them to the GSEs and use the profits to increase their lending. Mortgages originators were, on one hand, financial institutions very similar to banks (S&Ls, Savings and Loans companies), savings banks and cooperative banks in Spain, and, on the other hand, intermediaries specialized in mortgage market mortgage brokers- (without deposits and funded directly in capital markets). So, sources of revenue were: by charging an origination fee and by selling the mortgage at a higher price. Additionally, mortgages originators could (1) hold the mortgage in their portfolio, (2) sell the mortgage to an investor (to hold or to place it in a pool of mortgages to be used as collateral for the issue of a security), or (3) use the mortgage itself as collateral. Thus, when mortgage was used as collateral, the loan was said to be securitized Prime vs. Subprime Mortgages As far as government agencies are concerned, they focused on conforming mortgages, characterized by the following standards, such as mortgage size (loans with a balance below $), mortgage amount (80% of the appraisal value (maximum): Loan-to-Value (LTV) ratio), repayment ability (35-40% of the gross monthly income: Payment-to-Income (PTI) ratio), and information about the financial ability of borrowers (credit score, that is, credit evaluation of the applicant). On the other hand, non-conforming home loans dissatisfied some standards and they were focused on some ethnic minorities (Afro- or Latin- American people), traditionally excluded from mortgage credits. In the 80 s, US authorities eliminated maximum interest rates to avoid possible discriminatory treatment, so they created the precedent of the well-known subprime mortgages.

3 53 Francisco Jareño and Marta Tolentino With regards to mortgages insurers, when Loan-to-Value was over 80% (of the home s fair market value), an insurance was needed. This was a guarantee in case of insolvency, so lenders demanded these insurances, but borrowers suffered higher interest rates/costs (although this interest rate decreased with the outstanding balance). Federal Housing Administration (FHA) and Veterans Administration (VA) public institutions- insured mortgages and loans made by private lenders (full faith and credit). First, public agencies focused on borrowers with low incomes, but later, private insurers played a key role in the explosion of subprime mortgages, taking into account the importance of the Loan-to- Value in order to estimate the probability of default (ability to pay back the borrowed funds). As far as prime vs. subprime mortgages are concerned, on one hand, in prime mortgages or high-quality loans, the borrower paid interest and repaid principal in equal installments. Thus, at the end of the term the loan had been fully amortized, and the real estate property was the collateral. On the other hand, subprime mortgages or low-quality loans were mortgages with a higher risk. The contract rate was reset periodically in accordance with some reference rate plus a spread (Gramlich, 2007). Thus, the main characteristics of both sorts of mortgages are collected in table 1: Table 1: Prime vs. subprime mortgages Prime mortgages Subprime mortgages Maturity or term of the mortgage 30-year 30-year Interest lower fixed rates than subprime loans higher adjustable rates: +3%/5% than prime loans ARM- Loan-to-Value about 80% about 80% Penalty less likely to have a prepayment penalty more likely to have a prepayment penalty Approval more difficult, depending on the creditworthiness of the borrower less difficult, focused on borrowers with low creditworthiness Deception less likely to charge unreasonable fees more likely to charge unreasonable fees Source: Compiled by authors These subprime mortgages had two relevant sorts of risks: (1) low interest teaser rates during 2-3 years, that could lead to a payment shock when higher interest rates took effect later on (financial institutions promoted interest-only mortgages, negatively amortizing loans in which many borrowers increased rather than paid down their debt and authorized loans with multiple layers of risk), and (2) the evolution of interest rates (LIBOR), that increased dramatically US Mortgage Delinquency Rates. Figure 2: Reference rate (LIBOR) in mortgage market LIBOR (%) Positive effect Negative effect January 95 January 96 January 97 January 98 January Source: Compiled by authors from Navarro (2008) 99 January 00 January 01 January 02 January 03 January 04 January 05 January 06 January 07Febuary June

4 A Brief Review of the US Financial Crisis Origin 54 Figure 2 shows that a decrease in the reference rate in mortgage market (LIBOR) has a positive effect in the Economy between 2001 and Nevertheless, an increase in the LIBOR rate has a negative effect between 2004 and This phenomenon shows an increase in US mortgage delinquency rates in the last period, as we can see in Figure 3. Figure 3: US mortgage delinquency rates (90+ days past due or in foreclosure, share of outstandings) Source: Commented by authors from First American Loan Performance Financial experts affirm that the Financial Crisis was a consequence of different events: (1) a very relaxed monetary policy since 2001, with very low short-term interest rates in ARM (a trap for a lot of borrowers), (2) the appreciation of house-price and the revaluation expectations (cause of the subprime mortgages boom), and (3) the fact that Federal Reserve created conditions in which a housing bubble could burst. (4) Nevertheless, the evolution of the house-price in US seemed to have played an important role in this financial crisis, and it stopped a possible refinancing of the debt. 1 Figure 4: US house price trends (% increase/decrease year on year) Source: Center for Responsible Lending/OFHEO/NAR 2.3. Deregulation of Financial Institutions Regarding deregulation of financial institutions, US authorities incorporated changes in processes of evaluation of the borrowers creditworthiness: (1) high adjustable interest rate mortgages, in accordance with a riskier borrower, and (2) drop in the rejection rate of mortgages, and (3) automatic 1 Figure 4 shows the evolution of the US house price and the dramatic decrease suffered from 2005.

5 55 Francisco Jareño and Marta Tolentino processes of creditworthiness evaluation (based on credit scoring). But these authorities had no experience about subprime mortgages in this context (high interest rates, financial turbulences, drop in the house-price ), and, also, mortgages originators did not have deposits, and they were funded directly in capital markets, without supervision of the Federal Reserve. Thus, a new securitization process began. 3. The Securitization Process This section focuses on the securitization process (Firla-Cuchra and Jenkinson, 2005) and its consequences and implications on the global economy. As far as securitization process is concerned, GSEs developed the mortgage market, trading with Mortgage Backed Securities (MBS). GSEs sold MBSs and obtained funds to finance new mortgages. Thus, they created a secondary mortgage market, that is, the segment of the mortgage market where mortgages were resold, not where mortgages were originated. Mortgages in this secondary market were often grouped together and sold as collateralized debt obligations (CDOs), collateralized mortgage obligations, mortgage-backed securities (MBSs), or other types of securities. Thus, the securitization process (in Figure 5) was defined as a financial transaction in which assets such as mortgage loans are pooled, and securities representing interests in the pool are issued. Making home loans sales more efficient and profitable was the main objective of this process.for studying the superiority of comprehensive income to net income for firm performance, we test the following hypotheses: Figure 5: An example of the complexity of this securitization process Source: Christopher L. Peterson, Foreclosure, Subprime Mortgage Lending, and the Mortgage Electronic Registration System, U. Cin. L. Rev. 1359, 1367, Summer, In a securitization, a financial institution bundles a large number of home loans into a loan pool, and calculates the amount of mortgage payments that will be paid into that pool by the borrowers.

6 A Brief Review of the US Financial Crisis Origin 56 Then, the securitizer forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage revenue stream to support the creation of bonds that make payments to investors over time. Those bonds were called Mortgage Backed Securities (MBS) and were typically sold in a public offering to investors. Investors typically made a payment up front, and then hold onto the MBS securities which repaid the principal plus interest over time (Mason and Rosner, 2007). Collateralized debt obligations (CDOs) were another type of structured finance product whose securities received credit ratings and were sold to investors. CDOs were a more complex financial product that involved the re-securitization of existing income-producing assets (e.g. MBS securities from multiple mortgage pools). These CDOs were often called cash CDOs, because they received cash revenues from the underlying MBS bonds and other assets. The CDO arranger calculated the revenue stream coming into the pool of assets, designed a waterfall to divide those incoming revenues among a hierarchy of tranches, and used each tranche to issue securities that could then be marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all of its underlying assets had BBB ratings. Credit Default Swap (CDS) was an insurance contract. The buyer of the swap made periodic payments to the seller of the swap in return for protection against a possible credit event affecting the value of a specified asset. The seller agreed to buy the specified asset from the buyer at par in the event of a credit default. Thus, the asset was typically some type of security, such as a corporate bond, CDO, or MBS. Neither the buyer nor the seller typically owned the security and, finally, CDSs were derivatives. Various credit events might trigger the buyer s protection: missed payments to owners of the security, a downgrading of the security s credit rating, a downgrading of the seller s own credit rating. When the protection was triggered, the seller compensated the buyer. To compensate for a decline in the security s market value, the seller may deliver collateral to the buyer in the amount of the decline. Then, the seller may also close out the swap by paying full par value to buy the reduced-value security from the buyer. Parties and counterparties could disagree as to the amount of the decline in the value of the security and the compensation that was due. 4. Implications and Consequences Nevertheless, this securitization process had disastrous implications and consequences. As a result of innovations in securitization, risks related to the inability of homeowners to meet mortgage payments had been distributed broadly, with a series of consequential impacts (Credit risk, Asset price risk, Liquidity risk, Counterparty risk, and Systemic risk). The general public was not given adequate warning of the emerging dangers in the mortgage market. We could not expect policymakers to second guess markets or to know when assets were overvalued, but we could and should expect policymakers to warn of the growing riskiness of certain assets that might generate large rewards but that could also lead to large losses. Thus, households should have been warned that continuing large increases in house prices were not a sure thing. On the other hand, Credit Rating Agencies failed to accurately assess the risk of the securitized assets they graded, so they faced a conflict of interest in their fee structure. A big part of the credit ratings problem was that the system got so opaque that rating agencies became the de facto arbiters of risk, as everyone even regulators came to utterly rely on their opinion of risk assessment. Thus, there should be reforms in the credit ratings structure and perhaps less reliance on agency ratings. Besides, Federal and state regulators believed that less regulation was better and that the market would take care of any problems. The push to deregulate of the past thirty years had led to a lack of discrimination in policy. Thus, Economies needed to eliminate bad regulation that suppresses competition and inhibits innovation, but these Economies needed to improve regulation where it could make markets work better and avoid crises. Finally, the infrastructure of the financial system needed to be revised. While complex derivatives like CDS had grown exponentially, no one knew how exposed any institution was to these

7 57 Francisco Jareño and Marta Tolentino products because each CDS transaction was done Over the Counter (OTC) rather than on an exchange. This lack of transparency further exacerbated the problem of asymmetric information and magnified the potential for systemic risk. 5. Summary and Concluding Remarks To sum up, the origin of the financial crisis was in the US mortgage market and characterized by special features of the US mortgage market (creation of subprime market), lack of supervision to mortgage brokers, expansive monetary policy and the bubble in the house-price, particular characteristics of subprime mortgages (mainly ARM) and, finally, the complexity of the securitization process (securities difficult to value). References [1] Baily, M.N., Litan, R.E. and Johnson, M.S. (2008): The Origins of the Financial Crisis. Initiative on Business and Public Policy at Brookings. Fixing Finance Series Paper 3. November [2] Bernanke, B.S. (2008): Financial Markets, the Economic Outlook and Monetary Policy. Conference at the Women in Housing and Finance and Excheque Club Joint Luncheon, Washington D.C. Board of Governors of the Federal Reserve System. January 10. [3] Fabozzi, F.J. (2004): Bond Markets, Analysis and Strategies. Pearson Prentice Hall. Upper Saddle River, New Jersey. [4] Firla-Cuchra, M. and Jenkinson, T (2005): Why Are Securitisation Issues Tranched? Oxford University Press Working Paper March [5] Gramlich, E.M. (2007): Subprime Mortgages. America s Latest Boom and Bust. The Urban Institute Press. Washington D.C. [6] Mason, J.R. and Rosner, J. (2007): How Resilient Are Mortgage Backed Securities to collateralized Debt Obligation Market Disruptions. Paper presented to the Hudson Institute, Washington D.C. February 15. [7] Navarro, E. (2008): Reflections about the crisis in the subprime market (in Spanish). Working paper. [8] United States. Congress. Senate. Committee on Homeland Security and Governmental Affairs. Permanent Subcommittee on Investigations (2011): Wall Street and the financial crisis: anatomy of a financial collapse: majority and minority staff report. Editorial: Washington, D.C.: Permanent Subcommittee on Investigations. [9] United States. Financial Crisis Inquiry Commission (2011): The financial crisis inquiry report: final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Editorial: New York, NY: Public Affairs.