LOVELY PROFESSIONAL

UNIVERSITY
DEPARTMENT OF MANAGEMENT

Seminar Report on Contemporary Issues

“MORTGAGE CRISIS”

Submitted to Lovely Professional University

In partial fulfilment of the requirements for the award of

Degree of
Master of Business Administration.

Submitted To: - Submitted by:-

Mrs. Deepika Dhall Mam Renika Kirti

Department of Management M.B.A 4th sem.
Lovely Professional University RT1801 B54
Phagwara (2010) Regd.No: 10800790
ACKNOWLEDGEMENT

A few typewritten words of thanks cannot really express the sincerity of my gratitude. But I
am still trying to put into words my gratefulness towards all who have helped and encouraged
me in carrying out this project. This project of mine bears the imprint of many people who
have an important impact on my thinking, behaviour, and acts during the course of study.

First of all I would like to take this opportunity to thank the LOVELY PROFESSIONAL
UNIVERSITY for having seminar report on contemporary issues of management as a part of
the MBA degree. The accomplishment of this project otherwise would have been painstaking
endeavour, for lack of staunch and sincere support of the management department of LIM.
The incessant and undeterred succours extended by the members of the department facilitated
the job to the great extent. If this goes unnoticed and unacknowledged it would be selfishness.

Many people have influenced the shape and content of this project, and many supported me
throughout. I express my sincere gratitude to Mrs. Deepika Dhall Mam, my guide who was
available for help whenever I required, her guidance, gentle persuasion and active support has
made it possible to complete this project. I also express my sincere gratitude I have
immensely benefited from my interactions with my family members and friends and I
acknowledge their contributions to my learning.

In the end, I can say only this much that “ALL ARE NOT MENTIONED BUT NONE IS
FORGOTTEN”

Sincerely
RENIKA KIRTI
Introduction
The mortgage crisis is an ongoing real estate crisis and financial crisis triggered by a dramatic
rise in mortgage delinquencies and foreclosures in the United States, with major adverse
consequences for banks and financial markets around the globe. The crisis, which has its roots in
the closing years of the 20th century, became apparent in 2007 and has exposed pervasive
weaknesses in financial industry regulation and the global financial system.

Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were
adjustable-rate mortgages. After U.S. house prices peaked in mid-2006 and began their steep
decline thereafter, refinancing became more difficult. As adjustable-rate mortgages began to
reset at higher rates, mortgage delinquencies soared. Securities backed with subprime mortgages,
widely held by financial firms, lost most of their value. The result has been a large decline in the
capital of many banks and U.S. government sponsored enterprises, tightening credit around the
world. The mortgage crisis is the crisis that brought the global financial system down. How did
it happen and how did we let it happen? This is the point. An individual gets a mortgage loan
from broker, then the broker sells the mortgage to the bank which its turns again sells the
mortgage but this time to an investment firm on wall street. Such firms collect thousands of
mortgages in a one big pile.
Review of literature

 Downturn In Real Estate Could Threaten US

Economy
Thursday November 23, 2006

According to the November 17 Commerce Department Real Estate Report, new home permits
were at 1.535 million, 28% below the October 2005 rate.

Real Estate is a Leading Indicator for the US Economy

New home permits are usually issued about six months before the new home is completed and
the mortgage closes. This means that permits are a leading indicator of new home closes. A
slump in permits means that new home closings will continue to be in a slump for the next nine
months. A decline in new home permits could threaten the economy because real estate
contributes 10% of the total US economy's output. If real estate declines, so do construction jobs,
thus potentially increasing unemployment. A decline in new home closings reduces the value of
everyone’s homes, which reduces home equity loans, which reduces consumer spending. This
will contribute to a downward spiral in the economy...hopefully not enough to trigger a
recession. The only good news about lower home prices is that it lessens the chances of inflation.

 The Fuel That Fed The Subprime Meltdown

by Ryan Barnes
Dozens of mortgage lenders declare bankruptcy in a matter of weeks. The market is filled with
concerns of a major global credit crunch, which could affect all classes of borrowers. Central
banks use emergency clauses to inject liquidity into scared financial markets. The real estate
markets plummet after years of record highs. Foreclosure rates double year-over-year during the
latter half of 2006 and in 2007. The reports sound intimidating, but what does all this mean?
We are currently knee-deep in a financial crisis that centers on the U.S. housing market, where
fallout from the frozen subprime mortgage market is spilling over into the credit markets, as well
as domestic and global stock markets. Read on to learn more about how the markets fell this far,
and what may lie ahead. Was this the case of one group or one company falling asleep at the
wheel? Is this the result of too little oversight, too much greed, or simply not enough
understanding? As is often the case when financial markets go awry, the answer is likely "all the
above" Remember, the market we are watching today is a byproduct of the market of six years
ago. Rewind back to late 2001, when fear of global terror attacks after Sept. 11 roiled an already-
struggling economy, one that was just beginning to come out of the recession induced by the
tech bubble of the late 1990s. In response, during 2001, the Federal Reserve began cutting rates
dramatically, and the fed funds rate arrived at 1% in 2003, which in central banking parlance is
essentially zero. The goal of a low federal funds rate is to expand the money supply and
encourage borrowing, which should spur spending and investing. The idea that spending was
"patriotic" was widely propagated and everyone - from the White House down to the local
parent-teacher association - encouraged us to buy, buy, buy. It worked, and the economy began
to steadily expand in 2002.

 How the mortgage crisis is affecting you; upheavals

in the housing market are affecting homeowners of
all income levels
Ebony, Nov, 2007 by Ivory Johnson

It now appears that Americans have spent considerable effort trying to keep up with the Joneses,
but failed to realize that the Joneses were trying to keep up with the Kennedys. This ongoing
pursuit of material goods has prompted many Americans to spend more than they can afford--in
effect using their homes as a cash machine--leading us to the current mortgage crisis that has the
potential to affect every household. Based on news reports, it would seem that all the housing
problems rest on the doorsteps of sub-prime mortgage holders. A sub-prime borrower is one who
has a poor payment history and a low credit score. Sub-prime loans make up 10 to 15 percent of
all mortgages, and 15 percent of all sub-prime loans are more than 60 days past due or in
foreclosure. Many sub-prime mortgages are interest only loans or adjustable-rate mortgages that
offer a low introductory rate but increase in as early as a year from inception. Consider a typical
$250,000, three-year adjustable-rate mortgage with a 2 percent rate-hike cap. If the monthly
payment is now $1,123, after the first adjustment, the monthly payment will be $1,419. After the
second adjustment, the monthly payment will be $1,748--a $625 per-month increase. That means
that the homeowner must come up with $7,500 more each year just to maintain the same
mortgage. An estimated $515 billion of adjustable-rate home loans will adjust this year, and
another $680 billion worth of mortgages will reset in 2008. Many people will not be able to
make these higher payments, and this fact has rattled the confidence in our financial markets. To
make matters worse, when home values appreciated, many homeowners borrowed money from
their homes through home-equity loans and credit lines. Consequently, some have no remaining
equity when it comes time to refinance their original mortgages. Home-equity extraction was
estimated to be $600-$800 billion in 2005. Of that, at least $150-$250 billion went toward
consumer spending, as people essentially used their homes as an ATM to buy big-screen
televisions, pay off other bills, and finance home improvements. With tighter lending standards
and failing home values, even the ability to refinance is becoming a daunting task.

Research methodology
For accomplishing the objectives of the study, both secondary and primary data will be analyzed.

1. Secondary Data:
The Secondary Data for some years is used for the purpose of this study. The data will be
collected from:.

(1) Internet.
(2) Publications of Journals.
(3) Existing literature and other scholarly works

Objectives of the study

 To study the impact of Mortgage crisis.
 To study the causes and their effect on the Banks and corporate.
 To study the reasons of the mortgage crisis.

Scope of this study:

 To see the impact of the mortgage crisis on the banking and corporate sector.
 To know the reasons why this happened and who is the responsible for these crisis.
 To know the effect of these crisis on economy of our country
Mortgage crisis
A mortgage is granted to borrowers whose credit history is not sufficient to get a conventional
mortgage. Often these borrowers have impaired or even no credit history. Mortgages often offer
interest-only loans.That's because an interest-only loan is easier to afford. The loan doesn't
require that any of the principle be paid for the first several years of the loan. Most borrowers
assume they will refinance before the principal needs to be repaid, and the monthly payment
increases. If they can't refinance, they often are forced to default because they can't make the
higher payment.

Background information about the current mortgage

crisis
In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S.
from fast-growing economies in Asia and oil-producing countries. This inflow of funds
combined with low U.S. interest rates from 2002-2004 contributed to easy credit conditions,
which fueled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit
card, and auto) were easy to obtain and consumers assumed an unprecedented debt load. As part
of the housing and credit booms, the amount of financial agreements called mortgage-backed
securities (MBS), which derive their value from mortgage payments and housing prices, greatly
increased. Such financial innovation enabled institutions and investors around the world to invest
in the U.S. housing market. As housing prices declined, major global financial institutions that
had borrowed and invested heavily in subprime MBS reported significant losses. Defaults and
losses on other loan types also increased significantly as the crisis expanded from the housing
market to other parts of the economy. Total losses are estimated in the trillions of U.S. dollars
globally. Many of the subprime loans given to borrowers during the later part of the housing
boom were adjustable-rate mortgages (ARMs). This type of mortgage can appear very attractive
since it can be offered with low initial "teaser" interest rates. However, the rates of ARM loans
reset at a given time (often within 2-5 years), and the borrower's monthly payments can rise
dramatically. Since the housing market was booming a couple of years ago, many people
assumed they could take on a low initial interest rate and just refinance before their ARM loan
reset to a higher interest rate. Unfortunately, dropping home property values made it impossible
for many people to refinance their loans. So, these subprime ARMs began resetting in the last
few years, leaving the borrowers with much higher mortgage payments.

As housing prices began to fall it became obvious that many homeowners with subprime
mortgage loans would be unable to make their mortgage payments after the loan interest rates
reset. Subprime ARMs comprise only 6.8% of the total outstanding home loans in the U.S., but
as of the 3rd quarter of 2007 they represented 43% of the loans involved in home foreclosures.†
That means that nearly half of the home foreclosures in the U.S. were subprime loans. Studies
today show that while consumers with subprime loans continues to generate the greatest number
of foreclosures, other borrower segments are definitely feeling the pinch.

Many near-prime or prime mortgage loans are also in trouble as the housing market continues to
decline and borrowers cannot extract equity from their homes. While the crisis centers on a
handful of states here in the U.S., it's having a national and even a global impact as foreign
investors withdraw their support for investment that might be tied to U.S. subprime mortgages.
Europe may also go through similar subprime mortgage pains because several European
countries began offering subprime mortgage loans within the last few years. While the global
story is still being written, here in the states some observers speculate that we will continue to
feel a drain on the U.S. economy until lending practices tighten and subprime ARMs become
less common.

mortgage financial crisis

The mortgage financial crisis, which has yet to be resolved, is the sharp rise in foreclosures in
the subprime mortgage market that began in the United States in 2006 and became a global
financial crisis in July 2007. Rising interest rates increased the monthly payments on newly-
popular adjustable rate mortgages and property values suffered declines from the demise of the
United States housing bubble, leaving home owners unable to meet financial commitments and
lenders without a means to recoup their losses. Many observers believe this has resulted in a
severe credit crunch, threatening the solvency of a number of marginal private banks and other
financial institutions.
The sharp rise in foreclosures after the housing bubble caused several major subprime mortgage
lenders, such as New Century Financial Corporation, to shut down or file for bankruptcy, with
some accused of actively encouraging fraudulent income inflation on loan applications. This led
to the collapse of stock prices for many in the subprime mortgage industry, and drops in stock
prices of some large lenders like Countrywide Financial.This has been associated with declines
in stock markets worldwide, several hedgefunds becoming worthless, coordinated national bank
interventions, contractions of retail profits, and bankruptcy of several mortgage lenders.
The effects of the meltdown spread beyond housing and disrupted global financial markets (see
financial contagion and systemic risk) as investors, largely deregulated foreign and domestic
hedge funds, were forced to re-evaluate the risks they were taking and consumers lost the ability
to finance further consumer spending, causing increased volatility in the fixed income, equity,
and derivative markets.
The impact on the economy of this American problem was also felt in Europe, where the
European Central Bank tried to control the crisis by injecting over 205 billion U.S. Dollars in the
European financial markets.
Mortgage crisis facts
The housing market crisis has been receiving media attention for sometime now. Individual
borrowers and investors are feeling the crunch, and so are U.S. and international markets. The
following facts offer insight into the breadth of the crisis:

 Nearly 25% of all mortgage loans made in 2005 were interest-only.

 From 2004 to 2006, more than 2,500 banks, thrifts, credit unions and mortgage
companies made a combined $1.5 trillion in high-interest-rate loans.
 In 2005, borrowers with FICO® scores above 620 got more than half – 55% – of all
subprime mortgages.
 Every three months, approximately 167,000 new families enter into foreclosure in the
United States.
 Roughly 50% of homeowners who enter into foreclosure never contact their lender, even
though their lender is the party most able to help them stay in their homes.
 In 2006, over 40,000 homeowners at risk called the (888-995-HOPE) hotline. Nearly half
of them have avoided foreclosure.

Causes and Risks of the Mortgage crisis

The reasons for this crisis are varied and complex. Understanding and managing the ripple effect
through the world-wide economy is a critical challenge for governments, businesses, and
investors. The risks related to the inability of homeowners to make their mortgage payments
have been distributed broadly, due to innovations in securitization, with a series of consequential
impacts. The crisis can be described as stemming from the inability of homeowners to make their
mortgage payments due to a variety of factors such as poor judgment by either the borrower or
the lender, mortgage incentives, and rising adjustable mortgage rates. Further, declining home
prices have made re-financing more difficult. Traditionally, the risk of default (called credit risk)
would be assumed by the bank originating the loan. However, due to innovations in
securitization, credit risk is now shared more broadly. This is because the rights to these
mortgage payments have been repackaged into a variety of complex investment securities,
generally categorized as mortgage-backed securities or collateralized debt obligations
(CDO). A CDO, essentially, is a repacking of existing debt, and in recent years MBS collateral
has made up a large proportion of issuance.
In exchange for purchasing the MBS, third-party investors receive a claim on the mortgage
assets, which become collateral in the event of default. Further, the MBS investor has the right to
cash flows related to the mortgage payments.
To manage their risk, mortgage originators (e.g., banks or mortgage lenders) may also create
separate legal entities, called special-purpose entities (SPE), to both assume the risk of default
and issue the MBS. These banks effectively sell the mortgage assets (i.e., banking receivables,
which are the rights to receive the mortgage payments) to these SPE. The SPE then sells the
MBS to the investors. The mortgage assets in the SPE become the collateral. Most CDOs require
that a number of tests be satisfied on a periodic basis, such as tests of interest cash flows,
collateral ratings, or market values. Because the ability of sub-prime and lower-quality (e.g., Alt-
A) mortgage homeowners to pay is now in question, the value of the mortgage asset may be
reduced suddenly. For deals with market value tests, if the valuation falls below certain levels,
the CDO may be required by its terms to sell collateral in a short period of time, often at a steep
loss, much like a stock brokerage account margin call. If the risk is not legally contained within
an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types
of assets, as well, to satisfy the terms of the deal. A related risk involves the commercial paper
market, a key source of funds (i.e. liquidity) for many companies. Companies and SPE called
special investment vehicles (SIV) often obtain short-term loans by issuing commercial paper,
pledging mortgage assets or CDO as collateral. Investors provide cash in exchange for the
commercial paper, receiving money-market interest rates. However, because of concerns
regarding the value of the mortgage asset collateral linked to subprime and Alt-A loans, the
ability of many companies to issue such paper has been significantly affected.The amount of
commercial paper issued as of October 18, 2007 dropped by 25%, to $888 billion, from the
August 8 level. In addition, the interest rate charged by investors to provide loans for
commercial paper has increased substantially above historical levels.

The impact on corporations and investors

Average investors and corporations face a variety of risks due to the inability of mortgage
holders to pay. These vary by legal entity. A variety of specific impacts by firm are specified
later in the article. Some general exposures by entity type include:
 Bank corporations: The earnings reported by major banks are adversely
affected by defaults on mortgages they issue and retain. Companies value their mortgage
assets (receivables) based on estimates of collections from homeowners. Companies
record expenses in the current period to adjust this valuation, increasing their bad debt
reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation
can lead to volatility in earnings and stock prices. The ability of lenders to predict future
collections is a complex task subject to a multitude of variables.
 Mortgage lenders and Real Estate Investment Trusts:
These entities face similar risks to banks. In addition, they have business models with
significant reliance on the ability to regularly secure new financing through CDO or
commercial paper issuance secured by mortgages. Investors have become reluctant to
fund such investments and are demanding higher interest rates. Such lenders are at
 increased risk of significant reductions in book value due to asset sales at unfavorable
prices and several have filed bankruptcy.
 Special purpose entities (SPE): Like corporations, SPE are required
to revalue their mortgage assets based on estimates of collection of mortgage payments.
If this valuation falls below a certain level, or if cash flow falls below contractual levels,
investors may have immediate rights to the mortgage asset collateral. This can also cause
the rapid sale of assets at unfavorable prices. Other SPE called special investment
vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized
assets such as CDO. These entities have been affected by mortgage asset devaluation.
Several major SIV are associated with large banks.
 Investors: The stocks or bonds of the entities above are affected by the lower
earnings and uncertainty regarding the valuation of mortgage assets and related payment
collection.

Strategies for managing the crisis:-

The many parties involved each have a role to play in managing through the current
circumstances to limit adverse impacts. Specific actions taken by these parties are identified later
in the article. Some of the major alternatives, by participant, include:
 Lenders and Homeowners: Both may benefit from avoiding foreclosure,
which is a costly and lengthy process. Some lenders have taken action to reach out to
homeowners to provide more favorable mortgage terms (i.e., loan modification or
refinancing). Homeowners have also been encouraged to contact their lenders to discuss
alternatives.

 Central banks have conducted open market operations to ensure member banks
have access to funds (i.e., liquidity). These are effectively short-term loans to member
banks collateralized by government securities. Central banks have also lowered the
interest rates charged to member banks (called the discount rate in the U.S.) for short-
term loans. Both measures effectively lubricate the financial system, in two key ways.
First, they help provide access to funds for those entities with illiquid mortgage-backed
assets. This helps lenders, SPE, and SIV avoid selling mortgage-backed assets at a steep
loss. Second, the available funds stimulate the commercial paper market and general
economic activity.

 Credit rating agencies: Credit rating agencies help evaluate and report on
the risk involved with various investment alternatives. The rating processes can be re-
 examined and improved to encourage greater transparency to the risks involved with
complex mortgage-backed securities and the entities that provide them. Rating agencies
have recently begun to aggressively downgrade large amounts of mortgage-backed debt.

 Regulators and legislators: Laws and regulations can be considered

regarding lending practices, bankruptcy protection, tax policies, affordable housing,
credit counseling, education, and the licensing and qualifications of lenders. Regulations
or guidelines can also influence the nature, transparency and regulatory reporting
required for the complex legal entities and securities involved in these transactions.
Congress also is conducting hearings help identify solutions and apply pressure to the
various parties involved.
 Media: The media can help educate the public and parties involved. It can also
ensure the top subject material experts are engaged and have a voice to ensure a reasoned
debate about the pros and cons of various solutions

The rise of mortgage companies

 Pools many loans

GSE’s required to buy low-income loans

Mortgage companies: Yield Spread Premiums

Some mortgage companies became abusive

and made more money by charging higher
fees or rates. This increased default rates, but
they weren’t going to hold the loan anyway.
 side effects ON INDIA
The last couple of months, capital markets around the globe have been going through somewhat
uncertain times on account of the sub-prime problems affecting the American banking industry.
It now appears to be spreading to the UK as well. It’s a problem much bigger than it looks as it is
more qualitative than quantitative. It is important to understand how the sub-prime problem is
causing a great concern to the global financial markets and the recent decision of the US Federal
Reserve to reduce the lending rates by 50 basis points had made it even more pronounced.
Perhaps this was a rather surprise move, and Wall Street has taken this as a pointer towards a
stock rally. Since last Tuesday, all stock markets worldwide have rallied on account of this
announcement by the Fed. A similar situation is prevailing in India as well, where, in just four
trading sessions, our benchmark index, the Sensex, has gone up about 1,000 points. One fails to
understand this euphoria in global equity markets and, more importantly, how this is benefiting
the Indian growth story for the stock market to rally the way it has. But, first, let us examine
how the sub-prime crisis is likely to affect the confidence of global markets in the months to
come. The last few years, global markets have been awash with excess liquidity — a classical
problem of plenty that created hyper-valuations for all asset classes and, more significantly, for
real-estate in the US.

The decline :-
• As interest rates started falling due to excess liquidity, house prices started rising rapidly,
creating a pool of wealth in the hands of Americans, which they unlocked by contracting
mortgage loans. It benefited them in two ways — they got huge liquidity at inflated
housing prices and at interest rates that were practically lowest in the last 20 years. This
became a virtuous cycle, resulting in a very high consumer spending and obviously
fuelling global growth.
 • As interest rates started rising in the US due to inflation concerns, this virtuous cycle came
to a standstill and the demand for houses started tapering. This resulted in lower prices for
houses and many were unable to cover the mortgage loans. It has now hit the entire
banking industry in the US and the virtuous cycle is becoming a vicious cycle.
• The excess liquidity is slowly evaporating and premium on risk is reappearing. It has
started causing problems for Americans in the form of job losses, less consumer spending
and the fears of a slowdown, if not recession. A similar situation may develop in the UK,
where housing prices during last five years have risen very rapidly, creating a wealth
effect just as in the US. But prices there have now started correcting. This has a contagion
effect and we may see a huge write-off by banks doing business in the US and the UK.

Implications for India

What does all this mean for the Indian capital market? To my mind, this will reduce the flow of
capital coming to the Indian stock market. India was always considered one of the robust
emerging markets, but definitely with certain political and economic risks. These risks, in recent
times, were not priced into equity valuations as the excess liquidity was chasing emerging
market exposures and India became the investor’s darling, after China. Now, with the sub-prime
crisis, excess liquidity will vanish and the market will correct for the price of risks. Now let’s
look at domestic fundamentals. Indian markets will see a correction on account of high oil prices,
high interest rates, slowing down of exports on account of the slowing down of the US economy
and rupee appreciation. This will definitely have an impact on the GDP growth rate.

• The stock market has, in the recent past, rallied largely on account of global cues and has
almost completely ignored the local issues. With liquidity drying up, the market will now
focus on local issues, including political uncertainties and corporate earnings. It is natural
to expect that, finally, fundamentals will rule over technicals, and the market will look at
ground realities.
• We saw that the July 2007 IIP numbers were much lower than expected. And we are
seeing a slowdown in the automobile sector, some slowing down is already being
witnessed in the real-estate segment and, with exports coming down, it will not be too
long before we see the same in textiles, jewellery and other areas as well.
• We are yet to hear the last word on the sub-prime issue. Uncertainty in the global markets
on this issue is similar to the case of Enron. Everyone knew there was a problem but
nobody knew where it was until Enron went belly-up.
• Perhaps a similar story will unfold in the next couple of months for these lenders who
have lent big money into the sub-prime markets and one or more banks will fold, just like
Enron did, resulting in a huge crisis of confidence.
 • It would be naive to wish away this major problem inflicting global markets and to
presume that the Indian market is decoupled. If the global super-tanker, the US, which has
a 25 per cent share of global GDP, slows down, it will definitely have an impact on the
Indian economy.
• The next couple of months are definitely going to be crucial and the best course of action
in these uncertain times should be ‘wait and watch’

Who Is To Blame For The mortgage Crisis

Anytime something bad happens, it doesn't take long before blame starts to be assigned. In the
instance of subprime mortgage woes, there is no single entity or individual to point the finger at.
Instead, this mess is a collective creation of the world's central banks, homeowners, lenders,
credit rating agencies and underwriters, and investors. The economy was at risk of a deep
recession after the dotcom bubble burst in early 2000; this situation was compounded by the
September 11 terrorist attacks that followed in 2001. In response, central banks around the world
tried to stimulate the economy. They created capital liquidity through a reduction in interest
rates. In turn, investors sought higher returns through riskier investments. Lenders took on
greater risks too, and approved subprime mortgage loans to borrowers with poor credit.
Consumer demand drove the housing bubble to all-time highs in the summer of 2005, which
ultimately collapsed in August of 2006. The end result of these key events was increased
foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding
further decreases in economic growth and consumer spending.
 Biggest Culprit: The Lenders
Most of the blame should be pointed at the mortgage originators (lenders) for creating
these problems. It was the lenders who ultimately lent funds to people with poor credit
and a high risk of default. When the central banks flooded the markets with capital
liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as
investors sought riskier opportunities to bolster their investment returns. At the same
time, lenders found themselves with ample capital to lend and, like investors, an
increased willingness to undertake additional risk to increase their investment returns.
In defense of the lenders, there was an increased demand for mortgages, and housing
prices were increasing because interest rates had dropped substantially. At the time,
lenders probably saw subprime mortgages as less of a risk than they really were: rates
were low, the economy was healthy and people were making their payments.
As  in Figure 1, it is given that mortgage originations grew from $173 billion in 2001 to a
 record level of $665 billion in 2005, which represented an increase of nearly 300%.
There is a clear relationship between the liquidity following September 11, 2001, and
subprime loan originations; lenders were clearly willing and able to provide borrowers
with the necessary funds to purchase a home.

Figure 1

Partner In Crime: Homebuyers

There is also mention the home buyers who plays very important role in this crisis. Many were
playing an extremely risky game by buying houses they could barely afford. They were able to
make these purchases with non-traditional mortgages (such as 2/28 and interest-only mortgages)
that offered low introductory rates and minimal initial costs such as "no down payment". Their
hope lay in price appreciation, which would have allowed them to refinance at lower rates and
take the equity out of the home for use in other spending. However, instead of continued
appreciation, the housing bubble burst, and prices dropped rapidly. As a result, when their
mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as
there was no equity being created as housing prices fell. They were, therefore, forced to reset
their mortgage at higher rates, which many could not afford. Many homeowners were simply
forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.

In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may
have given the impression that there was no risk to these mortgages and that the costs weren't
that high; however, at the end of the day, many borrowers simply assumed mortgages they
couldn't reasonably afford. Had they not made such an aggressive purchase and assumed a less
risky mortgage, the overall effects might have been manageable.
Exacerbating the situation, lenders and investors of securities backed by these defaulting
mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left
with property that was worth less than the amount originally loaned. In many cases, the losses
were large enough to result in bankruptcy.

Investment Banks Worsen the Situation

The increased use of the secondary mortgage market by lenders added to the number of
subprime loans lenders could originate. Instead of holding the originated mortgages on their
books, lenders were able to simply sell off the mortgages in the secondary market and collect the
originating fees. This freed up more capital for even more lending, which increased liquidity
even more. The snowball began to build momentum. (For a crash course on the secondary
mortgage market, check out Behind The Scenes Of Your Mortgage.)

A lot of the demand for these mortgages came from the creation of assets that pooled mortgages
together into a security, such as a collateralized debt obligation (CDO). In this process,
investment banks would buy the mortgages from lenders and securitize these mortgages into
bonds, which were sold to investors through CDOs.

The chart below demonstrates the incredible increase in global CDOs issues in 2006.

Figure 2
 Rating Agencies: Possible Conflict of Interest
A lot of criticism has been directed at the rating agencies and underwriters of the CDOs
and other mortgage-backed securities that included subprime loans in their mortgage
pools. Some argue that the rating agencies should have foreseen the high default rates for
subprime borrowers, and they should have given these CDOs much lower ratings than the
'AAA' rating given to the higher quality tranches. If the ratings had been more accurate,
fewer investors would have bought into these securities, and the losses may not have
been as bad. Moreover, some have pointed to the conflict of interest between rating
agencies, which receive fees from a security's creator, and their ability to give an
unbiased assessment of risk. The argument is that rating agencies were enticed to give
better ratings in order to continue receiving service fees, or they run the risk of the
underwriter going to a different rating agency (or the security not getting rated at all).
However, on the flip side, it's hard to sell a security if it is not rated. Regardless of the
criticism surrounding the relationship between underwriters and rating agencies, the fact
of the matter is that they were simply bringing bonds to market based on market demand.
 Fuel to the Fire: Investor Behavior
Just as the homeowners are to blame for their purchases gone wrong, much of the blame
also must be placed on those who invested in CDOs. Investors were the ones willing to
purchase these CDOs at ridiculously low premiums over Treasury bonds. These
enticingly low rates are what ultimately led to such huge demand for subprime loans.
Much of the blame here lies with investors because it is up to individuals to perform due
diligence on their investments and make appropriate expectations. Investors failed in this
by taking the 'AAA' CDO ratings at face value.
 Final Culprit: Hedge Funds
Another party that added to the mess was the hedge fund industry. It aggravated the
problem not only by pushing rates lower, but also by fueling the market volatility that
caused investor losses. The failures of a few investment managers also contributed to the
problem. To illustrate, there is a type of hedge fund strategy that can be best described as
"credit arbitrage". It involves purchasing subprime bonds on credit and hedging these
positions with credit default swaps. This amplified demand for CDOs; by using leverage,
a fund could purchase a lot more CDOs and bonds than it could with existing capital
alone, pushing subprime interest rates lower and further fueling the problem. Moreover,
because leverage was involved, this set the stage for a spike in volatility, which is exactly
what happened as soon as investors realized the true, lesser quality of subprime CDOs.
Because hedge funds use a significant amount of leverage, losses were amplified and
 many hedge funds shut down operations as they ran out of money in the face of margin
calls.

To Stop the Mortgage Crisis

The potential collapse of house prices, accompanied by widespread mortgage defaults, is
a major threat to the American economy. A voluntary loan-substitution program could
reduce the number of defaults and dampen the decline in house prices -- without violating
contracts, bailing out lenders or borrowers, or increasing government spending.
The unprecedented combination of rapid house-price increases, high loan-to-value (LTV)
ratios, and securitized mortgages has made the current housing-related risk greater than
anything we have seen since the 1930s. House prices exploded between 2000 and 2006,
rising some 60% more than the level of rents. The inevitable decline since mid-2006 has
reduced prices by 10%. Experts forecast an additional 15% to 20% decline to correct the
excessive rise. The real danger is that prices could fall substantially further if there are
widespread defaults and foreclosures.
Irresponsible lending created new mortgages with LTV ratios of nearly 100%. By the end
of 2006, the fall in prices caused 7% of mortgages to have LTV ratios above 100%. A
further 20% of mortgages had LTV ratios over 80% and will shift to negative equity as
prices decline. Most mortgages are no longer held by originating lenders, but are securitized and
sold to investors world-wide. More significant, mortgages are used to create complex,
assetbacked securities that are central to current credit-market problems. Investors no longer
own specific mortgages, but only have rights to certain conditional payment streams. So
generally, it is no longer possible to prevent foreclosures by negotiations between borrowers and
lenders. The 1.8 million mortgages now in default have created substantial personal hardship.
The 10% decline in house prices has cut household wealth by more than $2 trillion, reducing
consumer spending and increasing the risk of a deep recession. Defaults also damage the
capital of lending institutions, causing further declines in credit and economic activity. Rising
unemployment during a downturn will force more homeowners to default, driving house prices
lower. Since mortgages are generally "no recourse" loans, when there is a default the mortgage
lender can only collect the value of the property. The lender does not have the right to seize other
property (a car, a boat, money in the bank) or to put a lien on future wages. Thus, a homeowner
with a mortgage that exceeds the value of his house has a strong incentive to default, even if he
can afford to make the monthly payments. Optimists note that homeowners with negative equity
have generally been reluctant to default in past years. That was sensible when house prices were
rising. But with house prices falling, defaulting on the mortgage is the rational thing to do.
Limiting the number of such defaults, and preventing the overshooting of price declines, requires
a public policy to reduce the number of homeowners who will slide into negative equity. Since
house prices still have further to fall, this can only be done by a reduction in the value of
mortgages. None of the current mortgage-reduction proposals are satisfactory. Although bankers
sometimes have the incentive to reduce mortgage-loan balances voluntarily in order to avoid a
foreclosure, this is usually not possible because the syndication of mortgage loans means that
there is generally not a single lender who can agree to the mortgage write down. Proposals to
force creditors to accept write-downs of interest or principal violate their contractual rights,
reducing the future availability of mortgage credit and raising the relative interest rate on future
mortgages. Reviving the depression-era Home Owners' Loan Corporation would have the
government use taxpayer money to pay off existing loans and become the largest mortgage
lender in the country. This would require an enormous federal bureaucracy of appraisers and
loan agents. If the government is to reduce significantly the number of future defaults, something
fundamentally different is needed. Although there is no perfect plan, a program of federal
mortgage-paydown loans to individuals, secured by future income rather than by a formal
mortgage, could reduce the number of mortgages with high LTV ratios and cut future defaults.
Here's one way that such a program might work:
The federal government would lend each participant 20% of that individual's current mortgage,
with a 15-year payback period and an adjustable interest rate based on what the government pays
on two-year Treasury debt (now just 1.6%). The loan proceeds would immediately reduce the
borrower's primary mortgage, cutting interest and principal payments by 20%. Participation in
the program would be voluntary and participants could prepay the government loan at any time.
The legislation creating these loans would stipulate that the interest payments would be, like
mortgage interest, tax deductible. Individuals who accept the government loan would be
precluded from increasing the value of their existing mortgage debt. The legislation would also
provide that the government must be repaid before any creditor other than the mortgage lenders.
Although individuals who accept the loan would not be lowering their total debt, they would pay
less in total interest. In exchange for that reduction in interest, they would decrease the amount
of the debt that they can escape by defaulting on their mortgage. The debt to the government
would still have to be paid, even if they default on their mortgage. Participation will therefore
not be attractive to those whose mortgages that already exceed the value of their homes. But for
the vast majority of other homeowners, the loan substitution program would provide an attractive
opportunity. Although home owners may recognize that the national average level of house
prices has further to fall, they do not know what will happen to the price of their own home.
They will participate if they prefer the certainty of an immediate and permanent reduction in
their interest cost to the possible option of defaulting later if the price of their own home falls
substantially. The loan-substitution program would decrease the number of homeowners who
would come to have negative equity as house prices decline. That reduces the number of
homeowners who will have an incentive to default, thereby limiting the risk of a downward
spiral of house prices. Since individuals now have the right to prepay any part of their mortgage
debt, the 20% reduction in the mortgage balance would not violate mortgage creditors' rights.
Creditors should welcome the mortgage pay downs, because they make the remaining mortgage
debt more secure. The 20% repayments to creditors would also create a major source of funds
that should stimulate all forms of lending. The simplest way to administer the new loans would
be for the current mortgage servicer to collect on behalf of the government and remit those funds
to Washington. There would be no need for a new government bureaucracy, for new appraisals,
or for negotiations in bankruptcy. The program could be up and running within months after the
legislation is passed. The government would fund these loans by issuing new two-year debt and
rolling over the debt until the loans are fully repaid, thus eliminating any net cost to the
government. The government loans would not add to the budget deficit or to the net debt of the
nation. Gross government debt would rise by the amount of the new government lending, but
this
would be balanced by the asset value of those loans. The current possibility of widespread
defaults is a cloud over all mortgage-backed securities, and over credit markets generally. The
uncertainty about the future value of such asset-backed loans has been a primary reason credit
markets have become dysfunctional. And without a flow of credit, the economy cannot expand.
To lower the risk of a downward spiral of house prices and to revive the frozen credit markets,
the government must move quickly to reduce the potential number of mortgage defaults. A loan
substitution program may be the best way to achieve that.
References:-
http://www.stock-market-investors.com/stock-investment-risk/the-subprime-mortgage-crisis-
explained.html

http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

http://en.wikipedia.org/wiki/Causes_of_the_financial_crisis_of_2007%E2%80%932010

http://www.mortgagecrisisexplained.com/

http://www.americanchronicle.com/articles/view/35112

http://www.economicshelp.org/blog/economics/subprime-mortgage-crisis-explained/

http://www.valuesvoternews.com/2009/04/mortgage-crisis-explained-from-1913-to.html