CHAPTER S Page No

I INTRODUCTION 5

 Background of the Study 7

 Statement of the Problem 12

 Objectives of the Study 13

 Hypotheses of the Study 14

 Significance of the Study 15

 Scope and Limitations of the Study 19

 Definition of Terms 20

II REVIEW OF RELATED LITERATURE 51

III THEORETICAL FRAMEWORK 52

IV METHODOLOGY 106

 Research Design
 Sources of Data
 Method of Data Collection/Data Collection Procedure
 Analytical Procedures/Methods of Analysis

V RESULTS AND DISCUSSION 108

VI SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS 115

 Summary 115

 Conclusions & Recommendations 117

BIBLIOGRAPHY 118

APPENDIXES

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 Declaration

I Matthew Bhasker Singh Roll no M.Phil/1456/MBA/008D, student of M.Phil of

“The Global Open University Nagaland”, hereby declare that the Research report
on “Subprime crises a five factor Model”, is an original and authenticated work
done by me. I further declare that it has not been submitted elsewhere by any other
person in any of the University for the Award of any degree or diploma.

Date (Matthew B Singh)

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 The purpose of the research is to unearth the contributing factor of the subprime crises. The

result has shown significant reasons which have contributed to set the ball of subprime crises

rolling. It has been found that five main factors have synergized the crises. These factors are:

 Decrease in prime lending rate

 Securitization

 Adjustable rate Mortgage

 Increase in interest rate of prime borrowers

 Mortgage backed securities

In the first stage when the housing loan was magnified due to low prime rate and easy loan

at a subprime rate to the people with default credit history. These loans were advanced the loan

created in the assets side of the balance sheet were converted into marketable securities known as

Mortgage backed securities through the mechanism of securitization. The fund acquired by

selling Mortgage backed securities was again extended as loan and again these loans were

securitized and, hence a single loan was multiplied several times along with the exposure of risk.

These loans were extended with an Adjustable rate mortgage condition which means that

the loan rates were subjected to changes as per market conditions. As some defaults started

pouring in the biggest mistake that the American bank did was that they increased the interest

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rate of prime rate borrowers. As the interest rate of prime rate borrowers increased, they being

from service class with a calculated income could not maintain pace with increased interest rate

and, they too started to default. This default due to increase interest rate took the face of

uncontrollable reaction and the entire housing loan market crashed.

Because the loan was magnified many times through the means of securitization due to rise

in the market of housing loans the bankers faced heavy liquidity crises to repay the deposit and

thus many banks went bankrupt. In order to provide with liquidity the banks started selling their

securities which increased the supply of shares in the market. When the supply went so high and

was not justified by the demand the stock exchange also crashed.

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 Subprime crises consist of two words Sub and Prime. Prime here means standard and

subprime means below standard. Prime rate is the rate on which the banks give loan to its

permanent customers at a lower interest rate as compared with the other borrowers. Subprime

loan is loan which is subprime or below standard. Therefore subprime loan is situation where the

banks have extended loans to people with default credit history at a higher rate.

Subprime started in US where the private banks were in kingdom and enjoying their reign.

These banks started extending loans to people with bad credit history at a higher interest rate.

They thought that the loan will be secured with the mortgage of the property purchased by the

borrower. This was the point where the banks did a mistake, Because of rise in demand of the

real estate the price of real estate were already inflated therefore the collateral security of the

property was not enough to cover the loan 100%. When these subprime loans stated mounting up

some defaults form few borrowers started pouring in the bank in order to recover these losses

raised the interest rate of prime borrowers, The prime borrowers who were service class people

could not maintain pace with rising interest rate and they too started defaulting. Bankers when

saw that the rate of default started increasing they started seizing the house of the borrowers and

selling them in the real estate market this shifted the entire paradigm of the market. The prices of

the real estate which were too high due to increase in demand crashed down due to excess supply

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of real estate property, the banks could not realized the amount of loan due to fall in property

prices and the loan could not be recovered. The bank suffered with serious credit crunch to repay

the money to the borrowers; Due to inability of the banks to repay the money to the borrowers

they went bankrupt.

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The problems we are witnessing today developed over a long period of time. For more than a

decade, a massive amount of money flowed into the United States from investors abroad. This

large influx of money to U.S. banks and financial institutions — along with low interest rates —

made it easier for Americans to get credit. Easy credit — combined with the faulty assumption

that home values would continue to rise — led to excesses and bad decisions. Many mortgage

lenders approved loans for borrowers without carefully examining their ability to pay. Many

borrowers took out loans larger than they could afford, assuming that they could sell or refinance

their homes at a higher price later on. Both individuals and financial institutions increased their

debt levels relative to historical norms during the past decade significantly.

Optimism about housing values also led to a boom in home construction. Eventually the number

of new houses exceeded the number of people willing to buy them. And with supply exceeding

demand, housing prices fell. And this created a problem: Borrowers with adjustable rate

mortgages (i.e., those with initially low rates that later rise) who had been planning to sell or

refinance their homes before the adjustments occurred were unable to refinance. As a result,

many mortgage holders began to default as the adjustments began.

These widespread defaults (and related foreclosures) had effects far beyond the housing market.

Home loans are often packaged together, and converted into financial products called "mortgage-

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backed securities". These securities were sold to investors around the world. Many investors

assumed these securities were trustworthy, and asked few questions about their actual value.

Credit rating agencies gave them high-grade, safe ratings. Two of the leading sellers of

mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were

chartered by Congress, many believed they were guaranteed by the federal government. This

allowed them to borrow enormous sums of money, fuel the market for questionable investments,

and put the financial system at risk.

The decline in the housing market set off a domino effect across the U.S. economy. When home

values declined and adjustable rate mortgage payment amounts increased, borrowers defaulted

on their mortgages. Investors globally holding mortgage-backed securities (including many of

the banks that originated them and traded them among themselves) began to incur serious losses.

Before long, these securities became so unreliable that they were not being bought or sold.

Investment banks such as Bear Stearns and Lehman Brothers found themselves saddled with

large amounts of assets they could not sell. They ran out of the money needed to meet their

immediate obligations. And they faced imminent collapse. Other banks found themselves in

severe financial trouble. These banks began holding on to their money, and lending dried up, and

the gears of the American financial system began grinding to a halt.

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Stages of the crisis

The crisis has gone through stages. First, during late 2007, over 100 mortgage lending

companies went bankrupt as subprime mortgage-backed securities could no longer be sold to

investors to acquire funds. Second, starting in Q4 2007 and in each quarter since then, financial

institutions have recognized massive losses as they adjust the value of their mortgage backed

securities to a fraction of their purchased prices. These losses as the housing market continued to

deteriorate meant that the banks have a weaker capital base from which to lend. Third, during Q1

2008, investment bank Bear Stearns was hastily merged with bank JP Morgan with $30 billion in

government guarantees, after it was unable to continue borrowing to finance its operations.

Fourth, during September 2008, the system approached meltdown. In early September Fannie

Mae and Freddie Mac, representing $5 trillion in mortgage obligations, were nationalized by the

U.S. government as mortgage losses increased. Next, investment bank Lehman Brothers filed for

bankruptcy. In addition, two large U.S. banks (Washington Mutual and Wachovia) became

insolvent and were sold to stronger banks. The world's largest insurer, AIG, was 80%

nationalized by the U.S. government, due to concerns regarding its ability to honor its

obligations via a form of financial insurance called credit default swaps. These sequential and

significant institutional failures, particularly the Lehman bankruptcy, involved further seizing of

credit markets and more serious global impact. The interconnected nature of Lehman was such

that its failure triggered system-wide (systemic) concerns regarding the ability of major

institutions to honor their obligations to counterparties. The interest rates banks charged to each

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other (see the TED spread) increased to record levels and various methods of obtaining short-

term funding became less available to non-financial corporations. It was this "credit freeze" that

some described as a near-complete seizing of the credit markets in September that drove the

massive bailout procedures implemented by worldwide governments in Q4 2008. Prior to that

point, each major U.S. institutional intervention had been ad-hoc; critics argued this damaged

investor and consumer confidence in the U.S. government's ability to deal effectively and

proactively with the crisis. Further, the judgment and credibility of senior U.S. financial

leadership was called into question.[4]

Since the near-meltdown, the crisis has shifted into what some consider to be a deep

recession and others consider to be a "reset" of economic activity at a lower level, now that

enormous lending capacity has been removed from the system. Unsustainable U.S. borrowing

and consumption were significant drivers of global economic growth in the years leading up to

the crisis. Record rates of housing foreclosures are expected to continue in the U.S. during the

2009-2011, continuing to inflict losses on financial institutions. Dramatically reduced wealth due

to both housing prices and stock market declines are unlikely to enable U.S. consumption to

return to pre-crisis levels.

Thomas Friedman summarized how the crisis has moved through stages:

When these reckless mortgages eventually blew up, it led to a credit crisis. Banks stopped lending.

That soon morphed into an equity crisis, as worried investors liquidated stock portfolios. The equity crisis

made people feel poor and metastasized into a consumption crisis, which is why purchases of cars,

appliances, electronics, homes and clothing have just fallen off a cliff. This, in turn, has sparked more

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company defaults, exacerbated the credit crisis and metastasized into an unemployment crisis, as

companies rush to shed workers.

Alan Greenspan has stated that until the record level of housing inventory currently on the

market declines to more typical historical levels, there will be downward pressure on home

prices. As long as the uncertainty remains regarding housing prices, mortgage-backed securities

will continue to decline in value, placing the health of banks at risk

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Research Gaps:-

The research conducted till date has explained the conceptual frame work of subprime crises and

the factors which contributed to it. This research is different because it doesn’t blame subprime

loans for the crises but other important factors in lieu of which the crises would have not come

into picture.

The questions, which the study hopes to answer.

1: Is the subprime loan the only cause for the crises,

2: How did if effect the global economy,

3: What could have been done to stop the crises?

4: What can be done to reverse the crises?

Objective:

The Importance of study is to find other related factors that have caused the recession in the

global market. The main factor that has been known for the crises is the subprime loan (Below

standard loan) which was advanced by the US Banks. However the study shows that the

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subprime cause was not the only factor that caused this entire phenomenon. The study has

focused upon the other contributing factors which have magnified this entire process.

The Importance of study is to find other related factors that have caused the recession in the

global market. The main factor that has been known for the crises is the subprime loan (Below

standard loan) which was advanced by the US Banks. However the study shows that the

subprime cause was not the only factor that caused this entire phenomenon. The study has

focused upon the other contributing factors which have magnified this entire process.

History is the knowledge that teaches us. The present crises will become history tomorrow.

But the real history must be known. If we miss out, or the entire reasons are not taken into

consideration may be we may miss out with the root cause of the recession.

The objective of the study is to go deep down and to highlight the entire process which has

caused the crises.

The importance of study is for the following outfits:-

1: Banks and Financial Institutions,

2: Stock Exchanges, Brokers

3: Companies,

5: Government.

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 H0= If the securization has magnified the crises to the maximum level which was beyond
control then subprime rate mortgage is not the primary cause of the crises.

H1= If the securization has not magnified the crises to the maximum level which was

beyond control then subprime rate mortgage is the primary cause of the crises.

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 A key factor in evaluating the report is understanding which problem it seeks to correct. The

subprime mortgage crisis requires responses to three problems: the thousands of individuals who

may lose their homes due to unaffordable mortgage payments; the stresses in the overall

financial system caused by huge losses on investments backed by these mortgages; and the credit

practices surrounding the granting of mortgages, their packaging into structured investments, and

the evaluation of those financial instruments. The report focuses exclusively upon the third area.

Improved Credit Ratings

The report calls for credit rating agencies to improve the way in which they "grade"

securities. Currently, both traditional securities and structured credit products are graded the

same way. Structured credit products are sophisticated and often highly complex packages that

include such ingredients as tranches (pieces) of mortgages representing a specific level of

repayment risk. They are designed to meet specific investor needs.

When credit rating agencies gave structured credit products ratings that appeared to be the

same as those given to traditional securities, investors assumed that they had received the same

level of scrutiny and carried an equivalent risk level. In fact, the analysis was often based on

models with faulty assumptions (such as continuously rising housing prices) and greatly

underestimated the actual risk. Since the model and assumptions used to evaluate structured

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credit products were not disclosed, investors were unable to evaluate properly either the

securities or the ratings given to them.

In response, the working group recommends that credit rating agencies make their processes

more transparent. This includes publishing sufficient information about the assumptions

underlying their credit rating models and methodologies and clearly differentiating the ratings

given to complex products from those given to traditional instruments. In addition, the report

encourages formal and periodic reviews of those assumptions. Investors would be told to what

extent the agencies had examined the actual assets that were securitized to create the structured

credit products. In the case of mortgage-related securities, this would indicate whether the actual

mortgages were credit-worthy and properly originated.

Many of these improvements are already being implemented by the credit rating agencies

themselves. However, to ensure that these reforms continue, the agencies would set up a private-

sector group with representatives from issuers, investors, and underwriters to monitor the

situation and develop recommendations for additional actions to improve transparency, the actual

ratings, and the way that ratings are used.

Improving Mortgage Origination

One factor in the current upheaval is that mortgages were made to homebuyers who normally

would not qualify for them and were presented as being of much higher quality than they

actually were. While much attention has focused on underwriting problems in the subprime

market, the fact is that credit standards were relaxed for most classes of loans with the result that

home purchasers found themselves in mortgages that were inappropriate for their financial

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circumstances, and underwriters of mortgage-backed securities purchased mortgages that were

far riskier than they seemed.

To answer this problem, the report recommends better underwriting standards by originators

of mortgages. A key recommendation is better oversight of mortgage brokers by states and

federal regulators, including state licensing of mortgage brokers who are currently unsupervised.

This is an important step that would address a consistent weakness in mortgage originations.

Licensing requirements that are properly enforced would help to improve the quality of the

mortgages that those brokers create.

In addition, the report recommends that oversight of all mortgage originators should be more

consistent, meet certain minimum standards, and include effective enforcement mechanisms.

This would improve existing regulation rather than add a new layer that would only complicate

matters further.

Improved Risk Management and Regulation

The report also addresses poor risk management practices within financial institutions that

both purchased and originated sophisticated mortgage-related investments. One of the more

disturbing revelations of the subprime crisis is that major financial institutions are unable to

estimate their actual exposure to losses resulting from these types of securities accurately. The

causes of this range from improper understanding of the actual risk associated with individual

investments to the inability to aggregate the holdings of various investments properly across all

of a firm's business lines. As a result, financial institutions have found themselves far more

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exposed to risk and potential liquidity problems than expected, especially as credit conditions

have deteriorated.

Improved firm risk management will be supplemented by regulatory improvements designed

to encourage firms to improve both capital and liquidity cushions and enhanced guidance for the

risk associated with firms that distribute sophisticated financial products to investors or other

sellers. Equally important are recommendations for improved disclosure of off-balance sheet

obligations, including the actual value of complex or illiquid investments.

Significant number should also result in an international effort to improve capital standards

and regulation. Such improvements would enable investors to do a better job of evaluating the

financial institution's true condition and give regulators a better understanding of the risk that a

particular institution could pose to the financial system.

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 If properly implemented, the recommendations is for the Working Group of Financial

Markets should go a long way toward preventing financial crises like the current subprime

mortgage problems. However, since the report is nothing more than a series of general guidelines

and statements, how its recommendations are implemented will be extremely important.

Implementation needs to be both consistent among the various state and federal regulators and

balanced. While most of the report's recommendations can be put into effect under existing laws,

it will be important to watch carefully for congressional attempts to use them to justify harsh new

laws that could end up crippling credit markets. The key is to learn from recent events and to use

those lessons to ensure that the current crisis is not repeated.

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Mortgage Backed Securities

Mortgage Backed Securities can be referred to as asset backed securities, where the flow of

funds is supported by the regular payments towards the principal amount and payments of

interests for a number of mortgage loans.

Advantages of Mortgage Backed Securities:

The need of mortgage backed securities has been felt in the past few years by the mortgage

originators to refill their investments. The mortgage backed securities aid in the development

of new instruments to collect funds from the market, as the mortgage backed securities are

usually very economic and more effective than the other financing instruments offered by the

banks and the other forms of financing issued by the central government. The mortgage

backed securities mainly aid the companies dealing in these securities, to posses a better

alternative than the assets owned by them. The financing companies will now be relieved of

the costs of maintenance of the assets and other costs related to assets, which will reduce their

overheads immensely and increase the profit ratio.

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Special Feature of Mortgage Backed Securities:

The commercial mortgage-backed securities are bought in exchange of offices, manufacturing

units, land, multi-story buildings, and hotels, which means that they are gained against the

personal or commercial holdings. The loans provided in lieu of the above mentioned

collaterals can be extended beyond 5 years at fixed interest rates and may not provide the

facility of paying off the loans before the specified tenure. These loans are also stretched over

shorter periods like a maximum of 3 years with the facility of payment before time and are

mostly accompanied by adjustable interest rates.

Exceptions to Mortgage Backed Securities:

The mortgage-backed securities can, however, prove problematic in case of the home

mortgage lenders of the United States of America, as home loan applicants there are provided

with the facility to make the loan payment before time to cover up a part of the next month's

interest amount. Such activities have a deep impact on the loan amount and the

inconsistencies in payment make it difficult to have an idea about the exact amount of funds

to be obtained at every month from the mortgage-backed securities.

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Kinds of Mortgage Backed Securities:

The mortgage backed securities can be divided into various kinds, but the most prominent

mortgage backed securities are:

 Commercial mortgage backed securities

 Collateralized mortgage obligation

 Stripped mortgage backed securities

 Residential mortgage backed securities

The residential mortgage backed securities (RMBS) are special bonds found in the security

market in the US and are the kind of securities which are supported by private property

especially the house of the mortgagor, this private property here serves as the collateral. The

stripped mortgage backed securities (SBMS) can be further classified into two kinds- the

interest only stripped mortgage backed securities and the principal only stripped mortgage

backed securities. The interest only stripped mortgage backed securities are supported by the

interest payments towards the collateral of the mortgagor, whereas the amount that is paid

towards the principal amount of the collateral of the mortgagor supports the principal only

stripped mortgage backed securities. The commercial mortgage backed securities are

supported by the properties used for business purposes.

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Asset-backed security

An asset-backed security is a security whose value and income payments are derived from

and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is

typically a group of small and illiquid assets that are unable to be sold individually. Pooling

the assets into financial instruments allows them to be sold to general investors, a process

called securitization, and allows the risk of investing in the underlying assets to be diversified

because each security will represent a fraction of the total value of the diverse pool of

underlying assets. The pools of underlying assets can include common payments from credit

cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty

payments and movie revenues.

Often a separate institution, called a special purpose vehicle, is created to handle the

securitization of asset backed securities. The special purpose vehicle, which creates and sells

the securities, uses the proceeds of the sale to pay back the bank that created, or originated,

the underlying assets. The special purpose vehicle is responsible for "bundling" the

underlying assets into a specified pool that will fit the risk preferences and other needs of

investors who might want to buy the securities, for managing credit risk—often by

transferring it to an insurance company after paying a premium—and for distributing

payments from the securities. As long as the credit risk of the underlying assets is transferred

to another institution, the originating bank removes the value of the underlying assets from its

balance sheet and receives cash in return as the asset backed securities are sold, a transaction

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which can improve its credit rating and reduce the amount of capital that it needs. In this case,

a credit rating of the asset backed securities would be based only on the assets and liabilities

of the special purpose vehicle, and this rating could be higher than if the originating bank

issued the securities because the risk of the asset backed securities would no longer be

associated with other risks that the originating bank might bear. A higher credit rating could

allow the special purpose vehicle and, by extension, the originating institution to pay a lower

interest rate (that is, charge a higher price) on the asset-backed securities than if the

originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from their

balance sheet by having another institution assume the credit risk, so that they (the banks)

receive cash in return. This allows banks to invest more of their capital in new loans or other

assets and possibly have a lower capital requirement.

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Types

Home equity loans

Securities collateralized by home equity loans (HELs) are currently the largest asset class

within the ABS market. Investors typically refer to HELs as any nonagency loans that do not

fit into either the jumbo or alt-A loan categories. While early HELs were mostly second lien

subprime mortgages, first-lien loans now make up the majority of issuance. Subprime

mortgage borrowers have a less than perfect credit history and are required to pay interest

rates higher than what would be available to a typical agency borrower. In addition to first

and second-lien loans, other HE loans can consist of high loan to value (LTV) loans, re-

performing loans, scratch and dent loans, or open-ended home equity lines of credit

(HELOC),which homeowners use as a method to consolidate debt.

Auto loans

The second largest subsector in the ABS market is auto loans. Auto finance companies issue

securities backed by underlying pools of auto-related loans. Auto ABS are classified into

three categories: prime, nonprime, and subprime:

 Prime auto ABS are collaterized by loans made to borrowers with strong credit

histories.

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  Nonprime auto ABS consist of loans made to lesser credit quality consumers, which

may have higher cumulative losses.

 Subprime borrowers will typically have lower incomes, tainted credited histories, or

both.

Owner trusts are the most common structure used when issuing auto loans and allow investors

to receive interest and principal on sequential basis. Deals can also be structured to pay on a

pro-rata or combination of the two.

Credit card receivables

Securities backed by credit card receivables have been benchmark for the ABS market since

they were first introduced in 1987. Credit card holders may borrow funds on a revolving basis

up to an assigned credit limit. The borrowers then pay principal and interest as desired, along

with the required minimum monthly payments. Because principal repayment is not scheduled,

credit card debt does not have an actual maturity date and is considered a non amortizing

loan.

ABS backed by credit card receivables are issued out of trusts that have evolved over time

from discrete trusts to various types of master trusts of which the most common is the de-

linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are

trenched into senior/subordinated bonds. A master trust has the advantage of offering multiple

deals out of the same trust as the number of receivables grows, each of which is entitled to a

pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the

senior and subordinate series within a trust and issue them at different points in time. The

latter two structures allow investors to benefit from a larger pool of loans made over time

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rather than one static pool.

Student loans

ABS collateralized by student loans (“SLABS”) comprise one of the four (along with home

equity loans, auto loans and credit card receivables) core asset classes financed through asset-

backed securitizations and are a benchmark subsector for most floating rate indices. Federal

Family Education Loan Program (FFELP) loans are the most common form of student loans

and are guaranteed by the U.S. Department of Education ("DOE") at rates ranging from 95%-

98% (if the student loan is serviced by a servicer designated as an "exceptional performer" by

the DOE the reimbursement rate was up to 100%). As a result, performance (other than high

cohort default rates in the late 1980's) has historically been very good and investors rate of

return has been excellent. The College Cost Reduction and Access Act became effective on

October 1, 2007 and significantly changed the economics for FFELP loans; lender special

allowance payments were reduced, the exceptional performer designation was revoked, lender

insurance rates were reduced, and the lender paid origination fees were doubled.

A second, and faster growing, portion of the student loan market consists of non-FFELP or

private student loans. Though borrowing limits on certain types of FFELP loans were slightly

increased by the student loan bill referenced above, essentially static borrowing limits for

FFELP loans and increasing tuition are driving students to search for alternative lenders.

Students utlilize private loans to bridge the gap between amounts that can be borrowed

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through federal programs and the remaining costs of education.

The United States Congress created the Student Loan Marketing Association (Sallie Mae) as a

government sponsored enterprise to purchase student loans in the secondary market and to

securitize pools of student loans. Since its first issuance in 1995, Sallie Mae is now the major

issuer of SLABS and its issues are viewed as the benchmark issues.

Stranded cost utilities

Rate reduction bonds (RRBs) came about as the result of the Energy Policy Act of 1992,

which was designed to increase competition in the US electricity market. To avoid any

disruptions while moving from a non-competitive to a competitive market, regulators have

allowed utilities to recover certain "transition costs" over a period of time. These costs are

considered nonbypassable and are added to all customer bills. Since consumers usually pay

utility bills before any other, chargeoffs have historically been low. RRBs offerings are

typically large enough to create reasonable liquidity in the aftermarket, and average life

extension is limited by a "true up" mechanism.

Others

There are many other cash-flow-producing assets, including manufactured housing loans,

equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, and

royalties. Intangibles are another emerging asset class.

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Trading asset-backed securities

"In the United States, the process for issuing asset-backed securities in the primary market is

similar to that of issuing other securities, such as corporate bonds, and is governed by the

Securities Act of 1933, and the Securities Exchange Act of 1934, as amended. Publicly issued

asset-backed securities have to satisfy standard SEC registration and disclosure requirements,

and have to file periodic financial statements."

"The Process of trading asset-backed securities in the secondary market is similar to that of

trading corporate bonds, and also to some extent, mortgage-backed securities. Most of the

trading is done in over-the-counter markets, with telephone quotes on a security basis. There

appear to be no publicly available measures of trading volume, or of number of dealers

trading in these securities."

"A survey by the Bond Market Association shows that at the end of 2004, in the United States

and Europe there were 74 electronic trading platforms for trading fixed-income securities and

derivatives, with 5 platforms for asset-backed securities in the United States, and 8 in

Europe."

"Discussions with market participants show that compared to Treasury securities and

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mortgage-backed securities, many asset-backed securities are not liquid, and their prices are

not transparent. This is partly because asset-backed securities are not as standardized as

Treasury securities, or even mortgage-backed securities, and investors have to evaluate the

different structures, maturity profiles, credit enhancements, and other features of an asset-

backed security before trading it."

The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap

rate. For example, the price of a credit card-backed, AAA rated security with a two-year

maturity by a benchmark issuer might be quoted at 5 basis points (or less) to the two-year

swap rate."

"Indeed, market participants sometimes view the highest-rated credit card and automobile

securities as having default risk close to that of the highest-rated mortgage-backed securities,

which are reportedly viewed as substitute for the default risk-free Treasury securities."

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Adjustable Rate Mortgage

ARM. A mortgage with an interest rate that may change, usually in response to changes in the

Treasury Bill rate or the prime rate. The purpose of the interest rate adjustment is primarily to

bring the interest rate on the mortgage in line with market rates. The mortgage holder is protected

by a maximum interest rate (called a ceiling), which might be reset annually. ARMs usually start

with better rates than fixed rate mortgages, in order to compensate the borrower for the additional

risk that future interest rate fluctuations will create.

Characteristics

Index

Rates for some common indexes used for Adjustable Rate Mortgages (1996-2006)

All adjustable rate mortgages have an adjusting interest rate tied to an index.[1]

In Western Europe, the index may be the ECB Refi rate (where the mortgage is called a

tracker mortgage), TIBOR or Euro Interbank Offered Rate (EURIBOR).

Six common indices in the United States are:

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  11th District Cost of Funds Index (COFI)

 London Interbank Offered Rate (LIBOR)

 12-month Treasury Average Index (MTA)

 Constant Maturity Treasury (CMT)

 National Average Contract Mortgage Rate

 Bank Bill Swap Rate (BBSW)

In some countries, banks may publish a prime lending rate which is used as the index. The

index may be applied in one of three ways: directly, on a rate plus margin basis, or based on

index movement.

A directly applied index means that the interest rate changes exactly with the index. In other

words, the interest rate on the note exactly equals the index. Of the above indices, only the

contract rate index is applied directly.

To apply an index on a rate plus margin basis means that the interest rate will equal the

underlying index plus a margin. The margin is specified in the note and remains fixed over

the life of the loan. For example, a mortgage interest rate may be specified in the note as

being LIBOR plus 2%, 2% being the margin and LIBOR being the index.

The final way to apply an index is on a movement basis. In this scheme, the mortgage is

originated at an agreed upon rate, then adjusted based on the movement of the index. Unlike

direct or index plus margin, the initial rate is not explicitly tied to any index; the adjustments

are tied to an index.

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Basic features of ARMs

The most important basic features of ARMs are:

1. Initial interest rate. This is the beginning interest rate on an ARM.

2. The adjustment period. This is the length of time that the interest rate or loan period on an

ARM is scheduled to remain unchanged. The rate is reset at the end of this period, and the

monthly loan payment is recalculated.

3. The index rate. Most lenders tie ARM interest rates changes to changes in an index rate.

Lenders base ARM rates on a variety of indices, the most common being rates on one-,

three-, or five-year Treasury securities. Another common index is the national or regional

average cost of funds to savings and loan associations.

4. The margin. This is the percentage points that lenders add to the index rate to determine the

ARM's interest rate.

5. Interest rate caps. These are the limits on how much the interest rate or the monthly

payment can be changed at the end of each adjustment period or over the life of the loan.

6. Initial discounts. These are interest rate concessions, often used as promotional aids, offered

the first year or more of a loan. They reduce the interest rate below the prevailing rate (the

index plus the margin).

7. Negative amortization. This means the mortgage balance is increasing. This occurs whenever

the monthly mortgage payments are not large enough to pay all the interest due on the

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 mortgage. This may be caused by the payment cap contained in the ARM when are high

enough that the principal plus interest payment is greater than the payment cap.

8. Conversion. The agreement with the lender may have a clause that allows the buyer to

convert the ARM to a fixed-rate mortgage at designated times.

9. Prepayment. Some agreements may require the buyer to pay special fees or penalties if the

ARM is paid off early. Prepayment terms are sometimes negotiable.

It should be obvious that the choice of a home mortgage loan is complicated and time

consuming. As a help to the buyer, the Federal Reserve Board and the Federal Home Loan

Bank Board have prepared a mortgage checklist.

Limitations on charges (caps)

Any mortgage where payments made by the borrower may increase over time brings with it

the risk of financial hardship to the borrower. To limit this risk, limitations on charges—

known as caps in the industry—are a common feature of adjustable rate mortgages. Caps

typically apply to three characteristics of the mortgage:

 frequency of the interest rate change

 periodic change in interest rate

 total change in interest rate over the life of the loan, sometimes called life cap

For example, a given ARM might have the following types of caps:

Interest rate adjustment caps:

 interest adjustments made every 6 months, typically 1% per adjustment, 2% total per year

34 | P a g e
  interest adjustments made only once a year, typically 2% maximum

 interest rate may adjust no more than 1% in a year

Mortgage payment adjustment caps:

 maximum mortgage payment adjustments, usually 7.5% annually on pay-option/negative

amortization loans

Life of loan interest rate adjustment caps:

 total interest rate adjustment limited to 5% or 6% for the life of the loan.

Caps on the periodic change in interest rate may be broken up into one limit on the first

periodic change and a separate limit on subsequent periodic change, for example 5% on the

initial adjustment and 2% on subsequent adjustments.

Although uncommon, a cap may limit the maximum monthly payment in absolute terms

(for example, $1000 a month), rather than in relative terms.

ARMs that allow negative amortization will typically have payment adjustments that

occur less frequently than the interest rate adjustment. For example, the interest rate may be

adjusted every month, but the payment amount only once every 12 months.

Cap structure is sometimes expressed as initial adjustment cap / subsequent adjustment

cap / life cap, for example 2/2/5 for a loan with a 2% cap on the initial adjustment, a 2% cap

on subsequent adjustments, and a 5% cap on total interest rate adjustments. When only two

values are given, this indicates that the initial change cap and periodic cap are the same. For

35 | P a g e
 example, a 2/2/5 cap structure may sometimes be written simply 2/5.

Securitization of Debt

Securitization Defined

Securitization of debt, or asset securitization as is more often referred to, is a process by

which identified pools of receivables, which are usually illiquid on their own, are transformed

into marketable securities through suitable repackaging of cashflows that they generate.

Securitization, in effect, is a credit arbitrage transaction that permits for more efficient

management of risks by isolating a specific pool of assets from the originator's balance sheet.

Further, unlike the case of conventional debt financing, where the interest and principal

obligations of a borrowing entity are serviced out of its own general cash flows, debt servicing

with assetbacked securities (ABS) is from the cash flows originating from its underlying assets.

What can be Securitized?

In concept, all assets generating stable and predictable cash flows can be taken up for

securitization. In practice however, much of the securitised paper issued have underlying

periodic cashflows secured through contracts defining cash flow volumes, yield and timing. In

36 | P a g e
this respect, securitization of auto loans, credit card receivables, computer leases, unsecured

consumer loans, residential and commercial mortgages, franchise/royalty payments, and other

receivables relating to telecom, trade, toll road and future export have gained prominence.

Typically, asset portfolios that are relatively homogeneous with regard to credit, maturity and

interest rate risk could be pooled together to create a securitization structure. However, to make

reasonable estimates of the credit quality and payment speed of the securitised paper, it would be

essential to analyse the historical data on portfolio performance over some reasonable length of

time.

Why Securitize?

Securitization effort will call for considerable investments in time and resources. Hence, on a

comparative cost scale it can even be somewhat more expensive than other types of debt

financing that may be available to a borrower, at least in the initial stages. However, it has been

demonstrated that a continuing securitization program rather than a single deal often goes to

reduce the costs, as economies of scale and expertise pick up over a period of time. Bearing this

in mind, many securitization programs are run with a long-term strategic perspective. Growing

importance of securitization is perhaps best illustrated by the volume through-put in the non-

OECD world over the past few years. Criteria that constitute the general motivation behind most

securitization efforts are examined. From the viewpoint of an originator of such paper, the

following are typically the main persuasions to securitize.

Funding alternative

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 Being distinct and different from the originator's own obligations, a well structured ABS

stands on its own credit rating and thus generates genuine incremental funding. This is so as the

originator's existing creditors may invest in the ABS in addition to providing lines of credit to the

originator. Further, there may also be other investors in the ABS who do not have a lending

relationship with the originator. It is also possible to achieve a superior credit rating for the ABS

than the originator's own through appropriate structuring and credit enhancement.This could

mean accessing an investor base focusing on high grades, which otherwise may not be possible

for an originator. Also, where the originator is not permitted to issue capital market instruments

on his own ABS could help overcome such constraints.

Balance sheet management

Fundamental benefit of a true sale, i.e., freeing up the capital of the originator would apply in

the case of all securitization transactions. In response, the balance sheet gets compressed and

becomes more robust. Its

ratios improve. Alternately, reduction in leverage post-securitised sale can be restored by

adding on new assets to the balance sheet. Thus the asset through-put of the originator's balance

sheet increases. Securitization can also generate matched funding for balance sheet assets.

Further, it may also enable the disposal of non-core assets through suitable structuring.

Re-allocation of risks
Securitization transfers much of the credit risk in the portfolio to the ABS investors and helps

to quantify the residual credit risk that the originator is exposed to. This is very useful, as the

originator can then take larger

38 | P a g e
 exposure to individual obligors as well as provide a higher degree of comfort to his creditors.

Securitization also transfers the originator's market risks, i.e., liquidity, interest rate and

prepayment risks, to ABS investors and reduces risk capital requirement. This can lead to more

competitive pricing of the underlying asset products.

Operating process efficiency

The extent of portfolio analysis and information demanded by securitization programs often

lead to serious re-examination and consequent reengineering of operating processes within the

originator organisation. Further, specialist handling of various functional components, such as

origination, funding, risk management and administration, often achieved through outsourcing,

promotes efficiency across operating processes.

Securitization improves operating leverage

The originator usually assumes the function of the servicer, the issuing and paying agent, and

sometimes that of the credit enhancer. Fees accrue on account of all of these. Excess servicing,

i.e., the difference between the asset yield and the cost of funds, is also normally extracted by the

originator. These income streams can push up the operating leverage of the originator generating

income from a larger asset base than what may be otherwise possible for a given capital

structure. Apart from the incentives that it offers to originators, ABS confer several benefits to its

investors as well. These include:

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Low event risk
The pool of assets representing the obligations of a number of entities is usually more

resilient to event risks than the obligations of a single borrower – i.e. the risk that the credit

rating of the security will deteriorate due to circumstances usually beyond the obligor's control is

much higher in the latter case. The diversity that the securitization pool represents makes the

ABS largely immune to event risks.

Higher yields for lower/similar risk

ABS usually offer higher yields over securities of comparable credit and maturities. The

yield spread typically represents the premium paid to compensate for prepayment risk,

amortizing cashflows and the uniqueness of the instrument. In some cases, ABS also provide an

opportunity to invest into a pool of otherwise illiquid and inaccessible assets.

Structured issuances

Through appropriate structuring, an ABS can be tailored to meet investor standards on credit

quality, yield and maturity. Working with a pool of receivables gives the originator the needed

flexibility to be able to offer investors a menu of options around which issuances could be made.

Secondary Market Liquidity

Investment decisions of institutional investors accord a sizeable weightage to instrument

liquidity. ABS does fit the requirement in this regard. While the ideal scenario would be to have

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an active secondary market trading in ABS, institutional investors are often willing to settle for

credible liquidity backstops provided by well-rated institutions.

Parties in a Securitization Transaction

Securitization programs usually involve several participants, each carrying out a specialist

function, such as, creating and analyzing the asset pool, administration, credit rating, accounting,

legal negotiation, etc. These include:

• The Originator – also interchangeably referred to as the Seller – is the entity whose

receivable portfolio forms the basis for ABS issuance,

• Special Purpose Vehicle (SPV), which as the issuer of the ABS ensures adequate

distancing of the instrument from the originator,

• The Servicer, who bears all administrative responsibilities relating to the securitization

transaction,

• The Trustee or the Investor Representative, who act in a fiduciary capacity safeguarding

the interests of investors in the ABS, The Credit Rating Agency, which provides an objective

estimate of the credit risk in the securitization transaction by assigning a well-defined

creditrating,

41 | P a g e
• The Regulators, whose principal concerns relate to capital adequacy, liquidity, and credit

quality of the ABS, and balance sheet treatment of thetransaction,

• Service providers such as Credit Enhancers and Liquidity Providers, and,

• Specialist functionaries such as legal and tax counsels, accounting firms,

pool auditors, et al. However, more important than all the aforementioned are the investors in

the securitised paper. Investors are the ultimate judges of any securitization effort.

Originators should therefore interact actively with the investor community to get to know

investor preferences and concerns for effective structuring and distribution of ABS. Such

knowledge would also make the origination process more efficient. Further, it shall always

be remembered that investors have their constraints in the form of legal restrictions,

complexity of credit analysis, house name limits, long response time for in-house approvals,

etc., all of which can block a deal, and more so in the case of ABS, which, on account

of their uniqueness and complexity, present a host of issues which are not normally

encountered, say in a straightforward bond investment.

42 | P a g e
Securitization Process

Essential features of a securitization transaction comprise the following:

1. Creation of asset pool and its sale

The originator/seller (of assets) creates a pool of assets and executes a legal true sale of the

same to a special purpose vehicle (SPV). An SPV in such cases is either a trust or a company, as

may be appropriate under applicable law, setup to carry out a restricted set of activities,

management of which would usually rest with an independent board of directors.

2. Issuance of the securitised paper

This activity is usually performed by the SPV. Design of the instrument however would be

based on the nature of interest that investors would have on the asset pool. In the case of pass-

through issuances, the investors will

have a direct ownership interest in the underlying assets, while pay-throughs are debt issued

by the SPV secured by the assets and their cash flows.

43 | P a g e
 3. Credit Risk

It must be made abundantly clear at the very outset that the accretions on the asset-backed

security, i.e., interest, amortisation and redemption payments, are entirely dependent on the

performance of the pooled assets, and will have nothing to do with the credit of the originator.

By the same argument, such cash flows would also be not influenced by events affecting the

condition of the originator, including insolvency.

4. Pool Selection

The process of selecting assets to build a securitization pool would take into careful

consideration, loan characteristics that are important from a cash flow, legal, and credit points of

view, such as type of asset, minimum and maximum loan size, vintage, rate, maturity and

concentration limits (geographic, single-borrower, etc.). 'Cherry-picking' to include only the

highest quality assets in the pool should be consciously avoided. Ideal selection would be a

random choice among assets conforming only to cash flow or legal criteria. Often, substitution of

eligible assets in the place of original assets that mature/prepay in order to maintain the level of

asset cover would also be required.

5. Administration

Formal delineation of duties and responsibilities relating to administration of securitised assets,

including payment servicing and managing relationship with the final obligors must be spelt out

44 | P a g e
clearly through a contractual agreement with the entity who would perform those functions. In

addition, the following features are often included as part of a securitization transaction:

• Credit enhancement to support timely payments of interest and principal and to handle

delinquencies,

• Independent credit rating of the securitised paper from a well known credit rating agency, and,

• Providing liquidity support to investors, such as appointment of market makers.

Documentation

In documentation lies the heart of all securitization. An appropriate set of documentation,

perfected against the applicable legal framework, is fundamental to structuring transactions.

While the specifics may vary from one jurisdiction to another, there is a generic body of

documentation that is normally applicable in most cases. Legal opinions constitute the very

foundations. These must provide clear affirmation on all things fundamental, such as the legality

of the transaction, the bankruptcy remoteness of the issuer from the originator, the issuer's

authority to enter into such transactions, the legal true sale of receivables to the issuer, the

creation of security over the receivable pool, etc.

Other documentation relate to receivables, security, administration and operational aspects.

Receivable documentation should first establish the existence and nature of underlying

obligations, such as payment schedules, the conditions under which the obligors may either

45 | P a g e
renege or repudiate payments, and terms of sale of such receivables. It must also confirm that the

receivables have been originated in compliance with the applicable statutes. When receivables

are sold, documentation specifying the items sold, the mechanics of sale and the representations

and warranties made by the seller on their characteristics would be drawn up. Further, the claims

of investors in ABS over such flows need to be established clearly through the security

documentation. Service documentation specifying the duties and responsibilities of the servicer

or servicing agent would also be a key one. In practice, originators often double up as servicers.

Related documentation in addition to the above would typically comprise those relating to credit

enhancement, liquidity and market-making, listing agreements with stock exchanges, as well as

transaction prospectus or information memoranda, as may be appropriate.

Structuring Considerations

These are fundamental to every securitization deal, as they determine the specifics relating to

the ABS instrument, the issuer, the relevant tax and accounting treatment, and other key factors.

Every ABS issuance may have to be structured differently in order to take the best advantage of

the various environmental factors. First of the structuring decisions would concern the manner in

which the pool of assets will be sold/transferred. This would be followed by the design of the

ABS instrument, as either a pass through or a pay through security. Pass-throughs represent

direct ownership interests in theunderlying assets, which are typically held in trust for the

investors, so that payments on the assets are passed through to the investors directly from the

assets (after payment of all fees and expenses, including excess servicing). Pay throughs, on the

other hand, are general obligations or preferred stock of the issuer (SPV), substantially all the

46 | P a g e
assets of which consist of a pool of receivables and the related credit enhancement or other

structural support.

As the assets are owned by this entity rather than the investors, who as a matter of law receive

payments on a separate security backed by the general credit of the entity rather than an interest

in the assets, payments on these assets are said to be paid rather than passed through to the

investors. Tax and accounting treatments constitute other important dimensions of structuring.

Typical tax issues that need to be addressed relate to transfer charges (stamp duty), capital gains

taxation as applicable to the originator on sale of assets, taxation of the issuer, and withholding

tax or taxes deducted at source as applicable to the issuer and the investors. Accounting

treatment of securitization could fall into one of the following three categories, viz., full

derecognition, partial derecognition where only transferred assets receive derecognition, and full

on-balance sheet recognition. Specialist opinion must be obtained on both tax and accounting

aspects. These would be environment specific. Credit enhancement of the ABS would also be an

important structuring consideration, as it strives to strike a balance between the investor and the

issuer needs on the credit quality of the instrument. Typical forms of credit enhancement include:

Spread Account or Reserve Account, Over collateralization, Letters of credit, Insurance company

guarantees, Senior/ Subordinated structure, etc. Other structuring issues that need to be addressed

relate to extraction of excess servicing, identification of payment and loss priorities, etc.

47 | P a g e
Capital adequacy ratio

Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio

(CRAR) is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure

that it can absorb a reasonable amount of loss and are complying with their statutory Capital

requirements.

Capital adequacy ratios ("CAR") are a measure of the amount of a bank's capital expressed as

a percentage of its risk weighted credit exposures.

Capital adequacy ratio is defined as

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 where Risk can either be weighted assets ( ) or the respective national regulator's minimum

total capital requirement. If using risk weighted assets,

≥ 10%.

The percent threshold (10% in this case, a common requirement for regulators conforming to

the Basel Accords) is set by the national banking regulator.

Two types of capital are measured: tier one capital (T1 above), which can absorb losses

without a bank being required to cease trading, and tier two capital (T2 above), which can absorb

losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

Use

Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of

meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most

simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's

depositors or other lenders. Banking regulators in most countries define and monitor CAR to

protect depositors, thereby maintaining confidence in the banking system.

CAR is similar to leverage; in the most basic formulation, it is comparable to the inverse of

debt-to-equity leverage formulations (although CAR uses equity over assets instead of debt-to-

equity; since assets are by definition equal to debt plus equity, a transformation is required).

Unlike traditional leverage, however, CAR recognizes that assets can have different levels of

risk. Capital adequacy ratio is the ratio which determines the capacity of the bank in terms of

49 | P a g e
meeting the time liabilities and other risk such as credit risk, operational risk, etc. In the most

simple formulation, a bank's capital is the "cushion" for potential losses, which protect the bank's

depositors or other lenders. Banking regulators in most countries define and monitor CAR to

protect depositors, thereby maintaining confidence in the banking system.

Risk weighting

Since different types of assets have different risk profiles, CAR primarily adjusts for assets

that are less risky by allowing banks to "discount" lower-risk assets. The specifics of CAR

calculation vary from country to country, but general approaches tend to be similar for countries

that apply the Basel Accords. In the most basic application, government debt is allowed a 0%

"risk weighting" - that is, they are subtracted from total assets for purposes of calculating the

CAR.

50 | P a g e
BACKGROUND

This article has been written in form of literature review from various sources including, wall

street journal, financial management Taxman, Wikipedia free encyclopedia, ICFAI journal on

finance, Guest lectures, personal interrogation and internet search.

This article exists in modified from the original templates. In the past research the main area

covered are phenomena and the explanation of the entire crises. This research focus on the micro

elements of the crises and what aggravated it rather than the only conceptual frame work.

LITERATURE

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1 Greg Ip, Mark Whitehouse, and Aaron Lucchetti, “U.S. Mortgage Crisis Rivals S&L
Meltdown,” Wall Street
Journal, December 10, 2007, p. A1.
2 ABC News, “Who Qualifies for Bush's Mortgage Bailout Plan?” December 7, 2007,
http://abcnews.go.com/GMA/Consumer/story?id=3968737&page=1.
3 Jane Sasseen, “Does the housing plan go far enough,” Business Week, Dec 11, 2007,
http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db2007126_445035.htm.
4 Errol Louis, “The Guilty Parties,” New York Daily News, December 11, 2007,
http://www.nydailynews.com/opinions/2007/12/09/2007-12-09_the_guilty_parties.html.
5 Organization for Economic Cooperation and Development, “Standardized Unemployment Rate
(SUR): October2007,”
FINDINGS
The finding shows that the factors responsible for the crises were
 Decrease in prime lending rate

 Securitization

 Adjustable rate Mortgage

 Increase in interest rate of prime borrowers

 Mortgage backed securities

The immediate cause or trigger of the crisis was the bursting of the United States housing

bubble which peaked in approximately 2005–2006. High default rates on "subprime" and

adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase in loan

incentives such as easy initial terms and a long-term trend of rising housing prices had

encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly

refinance at more favorable terms. However, once interest rates began to rise and housing prices

started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more

difficult. Defaults and foreclosure activity increased dramatically as easy initial terms expired,

home prices failed to go up as anticipated, and ARM interest rates reset higher. Falling prices

52 | P a g e
also resulted in homes worth less than the mortgage loan, providing a financial incentive to enter

foreclosure. The ongoing foreclosure epidemic that began in late 2006 in the U.S. continues to be

a key factor in the global economic crisis, because it drains wealth from consumers and erodes

the financial strength of banking institutions.

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.

While the housing and credit bubbles built, a series of factors caused the financial system to

become increasingly fragile. Policymakers did not recognize the increasingly important role

played by financial institutions such as investment banks and hedge funds, also known as the

shadow banking system. Some experts believe these institutions had become as important as

commercial (depository) banks in providing credit to the U.S. economy, but they were not

53 | P a g e
subject to the same regulations. These institutions as well as certain regulated banks had also

assumed significant debt burdens while providing the loans described above and did not have a

financial cushion sufficient to absorb large loan defaults or MBS losses. These losses impacted

the ability of financial institutions to lend, slowing economic activity. Concerns regarding the

stability of key financial institutions drove central banks to take action to provide funds to

encourage lending and to restore faith in the commercial paper markets, which are integral to

funding business operations. Governments also bailed out key financial institutions, assuming

significant additional financial commitments.

The risks to the broader economy created by the housing market downturn and subsequent

financial market crisis were primary factors in several decisions by central banks around the

world to cut interest rates and governments to implement economic stimulus packages. Effects

on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October

2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their

holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have

averaged about 40%. Losses in the stock markets and housing value declines place further

downward pressure on consumer spending, a key economic engine. Leaders of the larger

developed and emerging nations met in November 2008 and March 2009 to formulate strategies

for addressing the crisis. As of April 2009, many of the root causes of the crisis had yet to be

addressed. A variety of solutions have been proposed by government officials, central bankers,

economists, and business executives.

54 | P a g e
 Mortgage market

Number of U.S. residential properties subject to foreclosure actions by quarter (2007-2009).

Subprime borrowers typically have weakened credit histories and reduced repayment capacity.

Subprime loans have a higher risk of default than loans to prime borrowers. If a borrower is

delinquent in making timely mortgage payments to the loan servicer (a bank or other financial

firm), the lender may take possession of the property, in a process called foreclosure.

The value of USA subprime mortgages was estimated at $1.3 trillion as of March 2007, with

over 7.5 million first-lien subprime mortgages outstanding. Between 2004-2006 the share of

subprime mortgages relative to total originations ranged from 18%-21%, versus less than 10% in

2001-2003 and during 2007. In the third quarter of 2007, subprime ARMs making up only 6.8%

55 | P a g e
of USA mortgages outstanding also accounted for 43% of the foreclosures which began during

that quarter. By October 2007, approximately 16% of subprime adjustable rate mortgages

(ARM) were either 90-days delinquent or the lender had begun foreclosure proceedings, roughly

triple the rate of 2005. By January 2008, the delinquency rate had risen to 21% and by May 2008

it was 25%.

The value of all outstanding residential mortgages, owed by USA households to purchase

residences housing at most four families, was US$9.9 trillion as of year-end 2006, and US$10.6

trillion as of midyear 2008. During 2007, lenders had begun foreclosure proceedings on nearly

1.3 million properties, a 79% increase over 2006. This increased to 2.3 million in 2008, an 81%

increase vs. 2007. By August 2008, 9.2% of all U.S. mortgages outstanding were either

delinquent or in foreclosure. By September 2009, this had risen to 14.4%. Between August 2007

and October 2008, 936,439 USA residences completed foreclosure. Foreclosures are

concentrated in particular states both in terms of the number and rate of foreclosure filings. Ten

states accounted for 74% of the foreclosure filings during 2008; the top two (California and

Florida) represented 41%. Nine states were above the national foreclosure rate average of 1.84%

of households.

56 | P a g e
 Causes

The crisis can be attributed to a number of factors pervasive in both housing and credit

markets, factors which emerged over a number of years. Causes proposed include the inability of

homeowners to make their mortgage payments, due primarily to adjustable rate mortgages

resetting, borrowers overextending, predatory lending, speculation and overbuilding during the

boom period, risky mortgage products, high personal and corporate debt levels, financial

products that distributed and perhaps concealed the risk of mortgage default, monetary policy,

international trade imbalances, and government regulation (or the lack thereof) Three important

catalysts of the subprime crisis were the influx of moneys from the private sector, the banks

entering into the mortgage bond market and the predatory lending practices of mortgage brokers,

specifically the adjustable rate mortgage, 2-28 loan. On Wall Street and in the financial industry,

moral hazard lay at the core of many of the causes.

57 | P a g e
 In its "Declaration of the Summit on Financial Markets and the World Economy," dated 15

November 2008, leaders of the Group of 20 cited the following causes:

During a period of strong global growth, growing capital flows, and prolonged stability

earlier this decade, market participants sought higher yields without an adequate appreciation of

the risks and failed to exercise proper due diligence. At the same time, weak underwriting

standards, unsound risk management practices, increasingly complex and opaque financial

products, and consequent excessive leverage combined to create vulnerabilities in the system.

Policy-makers, regulators and supervisors, in some advanced countries, did not adequately

appreciate and address the risks building up in financial markets, keep pace with financial

innovation, or take into account the systemic ramifications of domestic regulatory actions.

Boom and bust in the housing market

Main articles: United States housing bubble and United States housing market correction

Existing homes sales, inventory, and months supply, by quarter.

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 Vicious Cycles in the Housing & Financial Markets

Low interest rates and large inflows of foreign funds created easy credit conditions for a

number of years prior to the crisis, fueling a housing market boom and encouraging debt-

financed consumption. The USA home ownership rate increased from 64% in 1994 (about where

it had been since 1980) to an all-time high of 69.2% in 2004. Subprime lending was a major

contributor to this increase in home ownership rates and in the overall demand for housing,

which drove prices higher.

Between 1997 and 2006, the price of the typical American house increased by 124%. During

the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times

median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble

resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing

consumer spending by taking out second mortgages secured by the price appreciation. USA

household debt as a percentage of annual disposable personal income was 127% at the end of

2007, versus 77% in 1990.

While housing prices were increasing, consumers were saving less and both borrowing and

spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable

personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008,

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134% of disposable personal income. During 2008, the typical USA household owned 13 credit

cards, with 40% of households carrying a balance, up from 6% in 1970. Free cash used by

consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in

2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. U.S. home

mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73%

during 2008, reaching $10.5 trillion.

This credit and house price explosion led to a building boom and eventually to a surplus of

unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. Easy

credit, and a belief that house prices would continue to appreciate, had encouraged many

subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers

with a below market interest rate for some predetermined period, followed by market interest

rates for the remainder of the mortgage's term. Borrowers who could not make the higher

payments once the initial grace period ended would try to refinance their mortgages. Refinancing

became more difficult, once house prices began to decline in many parts of the USA. Borrowers

who found themselves unable to escape higher monthly payments by refinancing began to

default.

As more borrowers stop paying their mortgage payments (this is an on-going crisis),

foreclosures and the supply of homes for sale increases. This places downward pressure on

housing prices, which further lowers homeowners' equity. The decline in mortgage payments

also reduces the value of mortgage-backed securities, which erodes the net worth and financial

health of banks. This vicious cycle is at the heart of the crisis.

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 By September 2008, average U.S. housing prices had declined by over 20% from their mid-

2006 peak. This major and unexpected decline in house prices means that many borrowers have

zero or negative equity in their homes, meaning their homes were worth less than their

mortgages. As of March 2008, an estimated 8.8 million borrowers — 10.8% of all homeowners

— had negative equity in their homes, a number that is believed to have risen to 12 million by

November 2008. Borrowers in this situation have an incentive to default on their mortgages as a

mortgage is typically nonrecourse debt secured against the property. Economist Stan Leibowitz

argued in the Wall Street Journal that although only 12% of homes had negative equity, they

comprised 47% of foreclosures during the second half of 2008. He concluded that the extent of

equity in the home was the key factor in foreclosure, rather than the type of loan, credit

worthiness of the borrower, or ability to pay.

Increasing foreclosure rates increases the inventory of houses offered for sale. The number of

new homes sold in 2007 was 26.4% less than in the preceding year. By January 2008, the

inventory of unsold new homes was 9.8 times the December 2007 sales volume, the highest

value of this ratio since 1981. Furthermore, nearly four million existing homes were for sale, of

which almost 2.9 million were vacant. This overhang of unsold homes lowered house prices. As

prices declined, more homeowners were at risk of default or foreclosure. House prices are

expected to continue declining until this inventory of unsold homes (an instance of excess

supply) declines to normal levels.

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 Speculation

Speculative borrowing in residential real estate has been cited as a contributing factor to the

subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for

investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes.

During 2005, these figures were 28% and 12%, respectively. In other words, a record level of

nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's

chief economist at the time, stated that the 2006 decline in investment buying was expected:

"Speculators left the market in 2006, which caused investment sales to fall much faster than the

primary market.

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 Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the

historical appreciation at roughly the rate of inflation. While homes had not traditionally been

treated as investments subject to speculation, this behavior changed during the housing boom.

Media widely reported condominiums being purchased while under construction, then being

"flipped" (sold) for a profit without the seller ever having lived in them. [63] Some mortgage

companies identified risks inherent in this activity as early as 2005, after identifying investors

assuming highly leveraged positions in multiple properties.

Nicole Gelinas of the Manhattan Institute described the negative consequences of not

adjusting tax and mortgage policies to the shifting treatment of a home from conservative

inflation hedge to speculative investment. Economist Robert Shiller argued that speculative

bubbles are fueled by "contagious optimism, seemingly impervious to facts, that often takes hold

when prices are rising. Bubbles are primarily social phenomena; until we understand and address

the psychology that fuels them, they're going to keep forming. Keynesian economist Hyman

Minsky described how speculative borrowing contributed to rising debt and an eventual collapse

of asset values.

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 High-risk mortgage loans and lending/borrowing practices

In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered

more and more loans to higher-risk borrowers, including illegal immigrants. Subprime

mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion

(13%) in 1999, and $600 billion (20%) in 2006. A study by the Federal Reserve found that the

average difference between subprime and prime mortgage interest rates (the "subprime markup")

declined significantly between 2001 and 2007. The combination of declining risk premia and

credit standards is common to boom and bust credit cycles.

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 In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan

options and borrowing incentives. In 2005, the median down payment for first-time home buyers

was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China

has down payment requirements that exceed 20%, with higher amounts for non-primary

residences.

Growth in mortgage loan fraud based upon US Department of the Treasury Suspicious

Activity Report Analysis.

The mortgage qualification guidelines began to change. At first, the stated income, verified

assets (SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to

"state" it and show that they had money in the bank. Then, the no income, verified assets (NIVA)

loans came out. The lender no longer required proof of employment. Borrowers just needed to

show proof of money in their bank accounts. The qualification guidelines kept getting looser in

order to produce more mortgages and more securities. This lead to the creation of NINA. NINA

is an abbreviation of No Income No Assets (sometimes referred to as Ninja loans). Basically,

NINA loans are official loan products and let you borrow money without having to prove or even

state any owned assets. All that was required for a mortgage was a credit score.

Another example is the interest-only adjustable-rate mortgage (ARM), which allows the

homeowner to pay just the interest (not principal) during an initial period. Still another is a

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"payment option" loan, in which the homeowner can pay a variable amount, but any interest not

paid is added to the principal. An estimated one-third of ARMs originated between 2004 and

2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as

much as doubling the monthly payment.

The proportion of subprime ARM loans made to people with credit scores high enough to

qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by

2006. However, there are many factors other than credit score that affect lending. In addition,

mortgage brokers in some cases received incentives from lenders to offer subprime ARM's even

to those with credit ratings that merited a conforming (i.e., non-subprime) loan.

Mortgage underwriting standards declined precipitously during the boom period. The use of

automated loan approvals allowed loans to be made without appropriate review and

documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The

chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting

from the home loan boom, did not do enough to examine whether borrowers could repay.

Mortgage fraud by lenders and borrowers increased enormously. In 2004, the Federal Bureau of

Investigation warned of an "epidemic" in mortgage fraud, an important credit risk of nonprime

mortgage lending, which, they said, could lead to "a problem that could have as much impact as

the S&L crisis".

So why did lending standards decline? In a Peabody Award winning program, NPR

correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide

fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early

in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet

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the supply of relatively safe, income generating investments had not grown as fast. Investment

banks on Wall Street answered this demand with financial innovation such as the mortgage-

backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe

ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the

mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage

supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers,

to the giant investment banks behind them. By approximately 2003, the supply of mortgages

originated at traditional lending standards had been exhausted. However, continued strong

demand for MBS and CDO began to drive down lending standards, as long as mortgages could

still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable.

NPR described it this way:

The problem was that even though housing prices were going through the roof, people

weren't making any more money. From 2000 to 2007, the median household income stayed flat.

And so the more prices rose, the more tenuous the whole thing became. No matter how lax

lending standards got, no matter how many exotic mortgage products were created to shoehorn

people into homes they couldn't possibly afford, no matter what the mortgage machine tried, the

people just couldn't swing it. By late 2006, the average home cost nearly four times what the

average family made. Historically it was between two and three times. And mortgage lenders

noticed something that they'd almost never seen before. People would close on a house, sign all

the mortgage papers, and then default on their very first payment. No loss of a job, no medical

emergency, they were underwater before they even started. And although no one could really

hear it, that was probably the moment when one of the biggest speculative bubbles in American

history popped.

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Securitization practices

Borrowing under a securitization structure.

Further information: Securitization and Mortgage-backed security

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 The traditional mortgage model involved a bank originating a loan to the

borrower/homeowner and retaining the credit (default) risk. With the advent of securitization, the

traditional model has given way to the "originate to distribute" model, in which banks essentially

sell the mortgages and distribute credit risk to investors through mortgage-backed securities.

Securitization meant that those issuing mortgages were no longer required to hold them to

maturity. By selling the mortgages to investors, the originating banks replenished their funds,

enabling them to issue more loans and generating transaction fees. This may have created moral

hazard and increased focus on processing mortgage transactions rather than ensuring their credit

quality.

Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities

issued almost tripled between 1996 and 2007, to $7.3 trillion. The securitized share of subprime

mortgages (i.e., those passed to third-party investors via MBS) increased from 54% in 2001, to

75% in 2006. American homeowners, consumers, and corporations owed roughly $25 trillion

during 2008. American banks retained about $8 trillion of that total directly as traditional

mortgage loans. Bondholders and other traditional lenders provided another $7 trillion. The

remaining $10 trillion came from the securitization markets. The securitization markets started to

close down in the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of

the private credit markets thus became unavailable as a source of funds. In February 2009, Ben

Bernanke stated that securitization markets remained effectively shut, with the exception of

conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.

A more direct connection between securitization and the subprime crisis relates to a

fundamental fault in the way that underwriters, rating agencies and investors modeled the

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correlation of risks among loans in securitization pools. Correlation modeling—determining how

the default risk of one loan in a pool is statistically related to the default risk for other loans—

was based on a "Gaussian copula" technique developed by statistician David X. Li. This

technique, widely adopted as a means of evaluating the risk associated with securitization

transactions, used what turned out to be an overly simplistic approach to correlation.

Unfortunately, the flaws in this technique did not become apparent to market participants until

after many hundreds of billions of dollars of ABS and CDOs backed by subprime loans had been

rated and sold. By the time investors stopped buying subprime-backed securities—which halted

the ability of mortgage originators to extend subprime loans—the effects of the crisis were

already beginning to emerge.

Nobel laureate Dr. A. Michael Spence wrote: "Financial innovation, intended to redistribute

and reduce risk, appears mainly to have hidden it from view. An important challenge going

forward is to better understand these dynamics as the analytical underpinning of an early warning

system with respect to financial instability.

Inaccurate credit ratings

Main article: Credit rating agencies and the subprime crisis

MBS credit rating downgrades, by quarter.

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 Credit rating agencies are now under scrutiny for having given investment-grade ratings to

MBSs based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold

to investors, thereby financing the housing boom. These ratings were believed justified because

of risk reducing practices, such as credit default insurance and equity investors willing to bear

the first losses. However, there are also indications that some involved in rating subprime-related

securities knew at the time that the rating process was faulty.

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by

investment banks and other firms that organize and sell structured securities to investors. On 11

June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between

rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved

measures to strengthen oversight of credit rating agencies, following a ten-month investigation

that found "significant weaknesses in ratings practices," including conflicts of interest.

Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in

mortgage backed securities. Financial institutions felt they had to lower the value of their MBS

and acquire additional capital so as to maintain capital ratios. If this involved the sale of new

shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered

the stock prices of many financial firms.

Government policies

Main article: Government policies and the subprime mortgage crisis

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 U.S. Subprime lending expanded dramatically 2004-2006

Both government failed regulation and deregulation contributed to the crisis. In testimony

before Congress both the Securities and Exchange Commission (SEC) and Alan Greenspan

conceded failure in allowing the self-regulation of investment banks.

Increasing home ownership has been the goal of several presidents including Roosevelt,

Reagan, Clinton and G.W.Bush. In 1982, Congress passed the Alternative Mortgage

Transactions Parity Act (AMTPA), which allowed non-federally chartered housing creditors to

write adjustable-rate mortgages. Among the new mortgage loan types created and gaining in

popularity in the early 1980s were adjustable-rate, option adjustable-rate, balloon-payment and

interest-only mortgages. These new loan types are credited with replacing the long standing

practice of banks making conventional fixed-rate, amortizing mortgages. Among the criticisms

of banking industry deregulation that contributed to the savings and loan crisis was that Congress

failed to enact regulations that would have prevented exploitations by these loan types.

Subsequent widespread abuses of predatory lending occurred with the use of adjustable-rate

mortgages. Approximately 80% of subprime mortgages are adjustable-rate mortgages.

In 1995, the GSEs like Fannie Mae began receiving government tax incentives for

purchasing mortgage backed securities which included loans to low income borrowers. Thus

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began the involvement of the Fannie Mae and Freddie Mac with the subprime market. In 1996,

HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they

purchase be issued to borrowers whose household income was below the median in their area.

This target was increased to 50% in 2000 and 52% in 2005. From 2002 to 2006, as the U.S.

subprime market grew 292% over previous years, Fannie Mae and Freddie Mac combined

purchases of subprime securities rose from $38 billion to around $175 billion per year before

dropping to $90 billion per year, which included $350 billion of Alt-A securities. Fannie Mae

had stopped buying Alt-A products in the early 1990s because of the high risk of default. By

2008, the Fannie Mae and Freddie Mac owned, either directly or through mortgage pools they

sponsored, $5.1 trillion in residential mortgages, about half the total U.S. mortgage market. The

GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere

US$114 billion. When concerns arose in September 2008 regarding the ability of the GSE to

make good on their guarantees, the Federal government was forced to place the companies into a

conservatorship, effectively nationalizing them at the taxpayers' expense.

The Glass-Steagall Act was enacted after the Great Depression. It separated commercial

banks and investment banks, in part to avoid potential conflicts of interest between the lending

activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the

repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the

banking and financial services industries...spearheaded in Congress by Senator Phil Gramm." He

believes it contributed to this crisis because the risk-taking culture of investment banking

dominated the more conservative commercial banking culture, leading to increased levels of

risk-taking and leverage during the boom period. The Federal government bailout of thrifts

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during the savings and loan crisis of the late 1980s may have encouraged other lenders to make

risky loans, and thus given rise to moral hazard.

Conservatives and Libertarians have also debated the possible effects of the Community

Reinvestment Act (CRA), with detractors claiming that the Act encouraged lending to

uncreditworthy borrowers, and defenders claiming a thirty year history of lending without

increased risk. Detractors also claim that amendments to the CRA in the mid-1990s, raised the

amount of mortgages issued to otherwise unqualified low-income borrowers, and allowed the

securitization of CRA-regulated mortgages, even though a fair number of them were subprime.

Both Federal Reserve Governor Randall Kroszner and FDIC Chairman Sheila Bair have

stated their belief that the CRA was not to blame for the crisis.

Policies of central banks

Federal Funds Rate and Various Mortgage Rates

Central banks manage monetary policy and may target the rate of inflation. They have some

authority over commercial banks and possibly other financial institutions. They are less

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concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble.

Central banks have generally chosen to react after such bubbles burst so as to minimize collateral

damage to the economy, rather than trying to prevent or stop the bubble itself. This is because

identifying an asset bubble and determining the proper monetary policy to deflate it are matters

of debate among economists.

Some market observers have been concerned that Federal Reserve actions could give rise to

moral hazard. A Government Accountability Office critic said that the Federal Reserve Bank of

New York's rescue of Long-Term Capital Management in 1998 would encourage large financial

institutions to believe that the Federal Reserve would intervene on their behalf if risky loans

went sour because they were “too big to fail.”

A contributing factor to the rise in house prices was the Federal Reserve's lowering of

interest rates early in the decade. From 2000 to 2003, the Federal Reserve lowered the federal

funds rate target from 6.5% to 1.0%. This was done to soften the effects of the collapse of the

dot-com bubble and of the September 2001 terrorist attacks, and to combat the perceived risk of

deflation. The Fed believed that interest rates could be lowered safely primarily because the rate

of inflation was low; it disregarded other important factors. Richard W. Fisher, President and

CEO of the Federal Reserve Bank of Dallas, said that the Fed's interest rate policy during the

early 2000s was misguided, because measured inflation in those years was below true inflation,

which led to a monetary policy that contributed to the housing bubble. According to Ben

Bernanke, now chairman of the Federal Reserve, it was capital or savings pushing into the

United States, due to a world wide "saving glut", which kept long term interest rates low

independently of Central Bank action.

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 The Fed then raised the Fed funds rate significantly between July 2004 and July 2006. This

contributed to an increase in 1-year and 5-year ARM rates, making ARM interest rate resets

more expensive for homeowners. This may have also contributed to the deflating of the housing

bubble, as asset prices generally move inversely to interest rates and it became riskier to

speculate in housing.

Financial institution debt levels and incentives

Leverage Ratios of Investment Banks Increased Significantly 2003–2007

Many financial institutions, investment banks in particular, issued large amounts of debt

during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS), essentially

betting that house prices would continue to rise, and that households would continue to make

their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a

higher interest rate is a form of financial leverage. This is analogous to an individual taking out a

second mortgage on his residence to invest in the stock market. This strategy proved profitable

during the housing boom, but resulted in large losses when house prices began to decline and

mortgages began to default. Beginning in 2007, financial institutions and individual investors

holding MBS also suffered significant losses from mortgage payment defaults and the resulting

decline in the value of MBS.

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 A 2004 U.S. Securities and Exchange Commission (SEC) decision related to the net capital

rule allowed USA investment banks to issue substantially more debt, which was then used to

purchase MBS. Over 2004-07, the top five US investment banks each significantly increased

their financial leverage (see diagram), which increased their vulnerability to the declining value

of MBSs. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, about

30% of USA nominal GDP for 2007. Further, the percentage of subprime mortgages originated

to total originations increased from below 10% in 2001-2003 to between 18-20% from 2004-

2006, due in-part to financing from investment banks.

During 2008, three of the largest U.S. investment banks either went bankrupt (Lehman

Brothers) or were sold at fire sale prices to other banks (Bear Stearns and Merrill Lynch). These

failures augmented the instability in the global financial system. The remaining two investment

banks, Morgan Stanley and Goldman Sachs, opted to become commercial banks, thereby

subjecting themselves to more stringent regulation.

In the years leading up to the crisis, the top four U.S. depository banks moved an estimated

$5.2 trillion in assets and liabilities off-balance sheet into special purpose vehicles or other

entities in the shadow banking system. This enabled them to essentially bypass existing

regulations regarding minimum capital ratios, thereby increasing leverage and profits during the

boom but increasing losses during the crisis. New accounting guidance will require them to put

some of these assets back onto their books during 2009, which will significantly reduce their

capital ratios. One news agency estimated this amount to be between $500 billion and $1 trillion.

This effect was considered as part of the stress tests performed by the government during 2009.

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 Martin Wolf wrote in June 2009: "...an enormous part of what banks did in the early part of

this decade – the off-balance-sheet vehicles, the derivatives and the 'shadow banking system'

itself – was to find a way round regulation.

The New York State Comptroller's Office has said that in 2006, Wall Street executives took

home bonuses totaling $23.9 billion. "Wall Street traders were thinking of the bonus at the end of

the year, not the long-term health of their firm. The whole system—from mortgage brokers to

Wall Street risk managers—seemed tilted toward taking short-term risks while ignoring long-

term obligations. The most damning evidence is that most of the people at the top of the banks

didn't really understand how those [investments] worked.

Investment banker incentive compensation was focused on fees generated from assembling

financial products, rather than the performance of those products and profits generated over time.

Their bonuses were heavily skewed towards cash rather than stock and not subject to "claw-

back" (recovery of the bonus from the employee by the firm) in the event the MBS or CDO

created did not perform. In addition, the increased risk (in the form of financial leverage) taken

by the major investment banks was not adequately factored into the compensation of senior

executives.

Credit default swaps

Credit default swaps (CDS) are financial instruments used as a hedge and protection for

debtholders, in particular MBS investors, from the risk of default. As the net worth of banks and

other financial institutions deteriorated because of losses related to subprime mortgages, the

likelihood increased that those providing the insurance would have to pay their counterparties.

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This created uncertainty across the system, as investors wondered which companies would be

required to pay to cover mortgage defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks

(specifically, to insure creditors against default) or to profit from speculation. The volume of

CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by

CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly

regulated. As of 2008, there was no central clearing house to honor CDS in the event a party to a

CDS proved unable to perform his obligations under the CDS contract. Required disclosure of

CDS-related obligations has been criticized as inadequate. Insurance companies such as

American International Group (AIG), MBIA, and Ambac faced ratings downgrades because

widespread mortgage defaults increased their potential exposure to CDS losses. These firms had

to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440

billion of MBS resulted in its seeking and obtaining a Federal government bailout.

Like all swaps and other pure wagers, what one party loses under a CDS, the other party

gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can

perform]. Hence the question is which side of the CDS will have to pay and will it be able to do

so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much

uncertainty as to which financial firms would be required to honor the CDS contracts on its $600

billion of bonds outstanding.[142][143] Merrill Lynch's large losses in 2008 were attributed in part to

the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG

ceased offering CDS on Merrill's CDOs. The loss of confidence of trading partners in Merrill

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Lynch's solvency and its ability to refinance its short-term debt led to its acquisition by the Bank

of America.

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic

meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure

of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit

markets froze.

Investment in U.S. by foreigners of their proceeds from America's net imports

U.S. Current Account or Trade Deficit

In 2005, Ben Bernanke addressed the implications of the USA's high and rising current

account (trade) deficit, resulting from USA imports exceeding its exports. Between 1996 and

2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP.

Financing these deficits required the USA to borrow large sums from abroad, much of it from

countries running trade surpluses, mainly the emerging economies in Asia and oil-exporting

nations. The balance of payments identity requires that a country (such as the USA) running a

current account deficit also have a capital account (investment) surplus of the same amount.

Hence large and growing amounts of foreign funds (capital) flowed into the USA to finance its

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imports. Foreign investors had these funds to lend, either because they had very high personal

savings rates (as high as 40% in China), or because of high oil prices. Bernanke referred to this

as a "saving glut" that may have pushed capital into the USA, a view differing from that of other

economists, who view such capital as having been pulled into the USA by its high consumption

levels. In other words, a nation cannot consume more than its income unless it sells assets to

foreigners, or foreigners are willing to lend to it.

Regardless of the push or pull view, a "flood" of funds (capital or liquidity) reached the USA

financial markets. Foreign governments supplied funds by purchasing USA Treasury bonds and

thus avoided much of the direct impact of the crisis. USA households, on the other hand, used

funds borrowed from foreigners to finance consumption or to bid up the prices of housing and

financial assets. Financial institutions invested foreign funds in mortgage-backed securities. USA

housing and financial assets dramatically declined in value after the housing bubble burst.[148][149]

Boom and collapse of the shadow banking system

In a June 2008 speech, U.S. Treasury Secretary Timothy Geithner, then President of the NY

Federal Reserve Bank, placed significant blame for the freezing of credit markets on a "run" on

the entities in the "parallel" banking system, also called the shadow banking system. These

entities became critical to the credit markets underpinning the financial system, but were not

subject to the same regulatory controls. Further, these entities were vulnerable because they

borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets. This

meant that disruptions in credit markets would make them subject to rapid deleveraging, selling

their long-term assets at depressed prices. He described the significance of these entities: "In

early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in

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auction-rate preferred securities, tender option bonds and variable rate demand notes, had a

combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to

$2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance

sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets

of the top five bank holding companies in the United States at that point were just over $6

trillion, and total assets of the entire banking system were about $10 trillion." He stated that the

"combined effect of these factors was a financial system vulnerable to self-reinforcing asset price

and credit cycles."

Nobel laureate Paul Krugman described the run on the shadow banking system as the "core

of what happened" to cause the crisis. "As the shadow banking system expanded to rival or even

surpass conventional banking in importance, politicians and government officials should have

realized that they were re-creating the kind of financial vulnerability that made the Great

Depression possible—and they should have responded by extending regulations and the financial

safety net to cover these new institutions. Influential figures should have proclaimed a simple

rule: anything that does what a bank does, anything that has to be rescued in crises the way banks

are, should be regulated like a bank." He referred to this lack of controls as "malign neglect.

The securitization markets supported by the shadow banking system started to close down in

the spring of 2007 and nearly shut-down in the fall of 2008. More than a third of the private

credit markets thus became unavailable as a source of funds. According to the Brookings

Institution, the traditional banking system does not have the capital to close this gap as of June

2009: "It would take a number of years of strong profits to generate sufficient capital to support

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that additional lending volume." The authors also indicate that some forms of securitization are

"likely to vanish forever, having been an artifact of excessively loose credit conditions.

Impacts

Main article: Financial crisis of 2007–2009

Impact in the U.S.

Impacts from the Crisis on Key Wealth Measures

Between June 2007 and November 2008, Americans lost more than a quarter of their net

worth. By early November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent

from its 2007 high. Housing prices had dropped 20% from their 2006 peak, with futures markets

signaling a 30-35% potential drop. Total home equity in the United States, which was valued at

$13 trillion at its peak in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in

late 2008. Total retirement assets, Americans' second-largest household asset, dropped by 22

percent, from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings

and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets lost

$1.3 trillion. Taken together, these losses total a staggering $8.3 trillion. [151] Members of USA

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minority groups received a disproportionate number of subprime mortgages, and so have

experienced a disproportionate level of the resulting foreclosures.

Financial market impacts, 2007

Further information: List of write-down due to subprime crisis

FDIC Graph - U.S. Bank & Thrift Profitability By Quarter

The crisis began to affect the financial sector in February 2007, when HSBC, the world's

largest (2008) bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first

major subprime related loss to be reported.[155] During 2007, at least 100 mortgage companies

either shut down, suspended operations or were sold. Top management has not escaped

unscathed, as the CEOs of Merrill Lynch and Citigroup resigned within a week of each other in

late 2007.] As the crisis deepened, more and more financial firms either merged, or announced

that they were negotiating seeking merger partners.

During 2007, the crisis caused panic in financial markets and encouraged investors to take

their money out of risky mortgage bonds and shaky equities and put it into commodities as

"stores of value". Financial speculation in commodity futures following the collapse of the

financial derivatives markets has contributed to the world food price crisis and oil price increases

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due to a "commodities super-cycle." Financial speculators seeking quick returns have removed

trillions of dollars from equities and mortgage bonds, some of which has been invested into food

and raw materials.

Mortgage defaults and provisions for future defaults caused profits at the 8533 USA

depository institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 billion to

$646 million in the same quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and

thrift quarterly performance since 1990. In all of 2007, insured depository institutions earned

approximately $100 billion, down 31% from a record profit of $145 billion in 2006. Profits

declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008 Q1, a decline of 46%.

Financial market impacts, 2008

The TED spread – an indicator of credit risk – increased dramatically during September

2008.Further information: Indirect economic effects of the subprime mortgage crisis.

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 As of August 2008, financial firms around the globe have written down their holdings of

subprime related securities by US$501 billion. The IMF estimates that financial institutions

around the globe will eventually have to write off $1.5 trillion of their holdings of subprime

MBSs. About $750 billion in such losses had been recognized as of November 2008. These

losses have wiped out much of the capital of the world banking system. Banks headquartered in

nations that have signed the Basel Accords must have so many cents of capital for every dollar of

credit extended to consumers and businesses. Thus the massive reduction in bank capital just

described has reduced the credit available to businesses and households.

When Lehman Brothers and other important financial institutions failed in September 2008,

the crisis hit a key point. During a two day period in September 2008, $150 billion were

withdrawn from USA money funds. The average two day outflow had been $5 billion. In effect,

the money market was subject to a bank run. The money market had been a key source of credit

for banks (CDs) and nonfinancial firms (commercial paper). The TED spread (see graph above),

a measure of the risk of interbank lending, quadrupled shortly after the Lehman failure. This

credit freeze brought the global financial system to the brink of collapse. The response of the

USA Federal Reserve, the European Central Bank, and other central banks was immediate and

dramatic. During the last quarter of 2008, these central banks purchased US$2.5 trillion of

government debt and troubled private assets from banks. This was the largest liquidity injection

into the credit market, and the largest monetary policy action, in world history. The governments

of European nations and the USA also raised the capital of their national banking systems by

$1.5 trillion, by purchasing newly issued preferred stock in their major banks.

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 However, some economists state that Third-World economies, such as the Brazilian and

Chinese ones, will not suffer as much as those from more developed countries.

The International Monetary Fund estimated that large U.S. and European banks lost more

than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009. These

losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1

trillion and European bank losses will reach $1.6 trillion. The IMF estimated that U.S. banks

were about 60 percent through their losses, but British and eurozone banks only 40 percent.[169]

Responses

Further information: Subprime mortgage crisis solutions debate

Various actions have been taken since the crisis became apparent in August 2007. In

September 2008, major instability in world financial markets increased awareness and attention

to the crisis. Various agencies and regulators, as well as political officials, began to take

additional, more comprehensive steps to handle the crisis.

To date, various government agencies have committed or spent trillions of dollars in loans,

asset purchases, guarantees, and direct spending. For a summary of U.S. government financial

commitments and investments related to the crisis, see CNN - Bailout Scorecard.

Federal Reserve and central banks

Main article: Federal Reserve responses to the subprime crisis

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 The central bank of the USA, the Federal Reserve, in partnership with central banks around

the world, has taken several steps to address the crisis. Federal Reserve Chairman Ben Bernanke

stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to

support market liquidity and functioning and the pursuit of our macroeconomic objectives

through monetary policy." The Fed has:

 Lowered the target for the Federal funds rate from 5.25% to 2%, and the discount rate

from 5.75% to 2.25%. This took place in six steps occurring between 18 September 2007

and 30 April 2008;[170][171] In December 2008, the Fed further lowered the federal funds

rate target to a range of 0-0.25% (25 basis points).

 Undertaken, along with other central banks, open market operations to ensure member

banks remain liquid. These are effectively short-term loans to member banks

collateralized by government securities. Central banks have also lowered the interest rates

(called the discount rate in the USA) they charge member banks for short-term loans;

 Created a variety of lending facilities to enable the Fed to lend directly to banks and non-

bank institutions, against specific types of collateral of varying credit quality. These

include the Term Auction Facility (TAF) and Term Asset-Backed Securities Loan

Facility (TALF).

 In November 2008, the Fed announced a $600 billion program to purchase the MBS of

the GSE, to help lower mortgage rates.

 In March 2009, the FOMC decided to increase the size of the Federal Reserve’s balance

sheet further by purchasing up to an additional $750 billion of agency (GSE) mortgage-

backed securities, bringing its total purchases of these securities to up to $1.25 trillion

this year, and to increase its purchases of agency debt this year by up to $100 billion to a

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 total of up to $200 billion. Moreover, to help improve conditions in private credit

markets, the Committee decided to purchase up to $300 billion of longer-term Treasury

securities during 2009.

According to Ben Bernanke, expansion of the Fed balance sheet means the Fed is

electronically creating money, necessary "...because our economy is very weak and inflation is

very low. When the economy begins to recover, that will be the time that we need to unwind

those programs, raise interest rates, reduce the money supply, and make sure that we have a

recovery that does not involve inflation.

Economic stimulus

Main article: Economic Stimulus Act of 2008

Main article: American Recovery and Reinvestment Act of 2009

On 13 February 2008, President Bush signed into law a $168 billion economic stimulus

package, mainly taking the form of income tax rebate checks mailed directly to taxpayers.

Checks were mailed starting the week of 28 April 2008. However, this rebate coincided with an

unexpected jump in gasoline and food prices. This coincidence led some to wonder whether the

stimulus package would have the intended effect, or whether consumers would simply spend

their rebates to cover higher food and fuel prices.

On 17 February 2009, U.S. President Barack Obama signed the American Recovery and

Reinvestment Act of 2009, an $787 billion stimulus package with a broad spectrum of spending

and tax cuts. Over $75 billion of which was specifically allocated to programs which help

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struggling homeowners. This program is referred to as the Homeowner Affordability and

Stability Plan.

Bank solvency and capital replenishment

Main article: Emergency Economic Stabilization Act of 2008

Common Equity to Total Assets Ratios for Major USA Banks

Losses on mortgage-backed securities and other assets purchased with borrowed money have

dramatically reduced the capital base of financial institutions, rendering many either insolvent or

less capable of lending. Governments have provided funds to banks. Some banks have taken

significant steps to acquire additional capital from private sources.

The U.S. government passed the Emergency Economic Stabilization Act of 2008 (EESA or

TARP) during October 2008. This law included $700 billion in funding for the "Troubled Assets

Relief Program" (TARP), which was used to lend funds to banks in exchange for dividend-

paying preferred stock.

Another method of recapitalizing banks is for government and private investors to provide

cash in exchange for mortgage-related assets (i.e., "toxic" or "legacy" assets), improving the

quality of bank capital while reducing uncertainty regarding the financial position of banks. U.S.

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Treasury Secretary Timothy Geithner announced a plan during March 2009 to purchase "legacy"

or "toxic" assets from banks. The Public-Private Partnership Investment Program involves

government loans and guarantees to encourage private investors to provide funds to purchase

toxic assets from banks.

For a summary of U.S. government financial commitments and investments related to the

crisis, see CNN - Bailout Scorecard.

Bailouts and failures of financial firms

Further information: List of bankrupt or acquired banks during the financial crisis of 2007–

2008, Federal takeover of Fannie Mae and Freddie Mac, Government intervention during the

subprime mortgage crisis, and Bailout

People queuing outside a Northern Rock bank branch in Birmingham, United Kingdom on

September 15, 2007, to withdraw their savings because of the subprime crisis.

Several major financial institutions either failed, were bailed-out by governments, or merged

(voluntarily or otherwise) during the crisis. While the specific circumstances varied, in general

the decline in the value of mortgage-backed securities held by these companies resulted in either

their insolvency, the equivalent of bank runs as investors pulled funds from them, or inability to

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secure new funding in the credit markets. These firms had typically borrowed and invested large

sums of money relative to their cash or equity capital, meaning they were highly leveraged and

vulnerable to unanticipated credit market disruptions.

The five largest U.S. investment banks, with combined liabilities or debts of $4 trillion, either

went bankrupt (Lehman Brothers), were taken over by other companies (Bear Stearns and

Merrill Lynch), or were bailed-out by the U.S. government (Goldman Sachs and Morgan

Stanley) during 2008. Government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac

either directly owed or guaranteed nearly $5 trillion in mortgage obligations, with a similarly

weak capital base, when they were placed into receivership in September 2008. For scale, this $9

trillion in obligations concentrated in seven highly leveraged institutions can be compared to the

$14 trillion size of the U.S. economy (GDP) or to the total national debt of $10 trillion in

September 2008.

Major depository banks around the world had also used financial innovations such as

structured investment vehicles to circumvent capital ratio regulations. Notable global failures

included Northern Rock, which was nationalized at an estimated cost of £87 billion ($150

billion). In the U.S., Washington Mutual (WaMu) was seized in September 2008 by the USA

Office of Thrift Supervision (OTS). Dozens of U.S. banks received funds as part of the TARP or

$700 billion bailout.

As a result of the financial crisis in 2008, twenty five U.S. banks became insolvent and were

taken over by the FDIC.. As of August 14, 2009, an additional 77 banks became insolvent. This

seven month tally surpasses the 50 banks that were seized in all of 1993, but is still much smaller

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than the number of failed banking institutions in 1992, 1991, and 1990. The United States has

lost over 6 million jobs since the recession began in December 2007.

The FDIC deposit insurance fund, supported by fees on insured banks, fell to $13 billion in

the first quarter of 2009. That is the lowest total since September, 1993.

Homeowner assistance

Both lenders and borrowers may benefit from avoiding foreclosure, which is a costly and

lengthy process. Some lenders have offered troubled borrowers more favorable mortgage terms

(i.e., refinancing, loan modification or loss mitigation). Borrowers have also been encouraged to

contact their lenders to discuss alternatives.

The Economist described the issue this way: "No part of the financial crisis has received so

much attention, with so little to show for it, as the tidal wave of home foreclosures sweeping

over America. Government programmes have been ineffectual, and private efforts not much

better." Up to 9 million homes may enter foreclosure over the 2009-2011 period, versus one

million in a typical year. At roughly U.S. $50,000 per foreclosure according to a 2006 study by

the Chicago Federal Reserve Bank, 9 million foreclosures represents $450 billion in losses.

A variety of voluntary private and government-administered or supported programs were

implemented during 2007-2009 to assist homeowners with case-by-case mortgage assistance, to

mitigate the foreclosure crisis engulfing the U.S. One example is the Hope Now Alliance, an

ongoing collaborative effort between the US Government and private industry to help certain

subprime borrowers. In February 2008, the Alliance reported that during the second half of 2007,

it had helped 545,000 subprime borrowers with shaky credit, or 7.7% of 7.1 million subprime

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loans outstanding as of September 2007. A spokesperson for the Alliance acknowledged that

much more must be done.

During late 2008, major banks and both Fannie Mae and Freddie Mac established

moratoriums (delays) on foreclosures, to give homeowners time to work towards refinancing.

Critics have argued that the case-by-case loan modification method is ineffective, with too few

homeowners assisted relative to the number of foreclosures and with nearly 40% of those

assisted homeowners again becoming delinquent within 8 months. In December 2008, the U.S.

FDIC reported that more than half of mortgages modified during the first half of 2008 were

delinquent again, in many cases because payments were not reduced or mortgage debt was not

forgiven. This is further evidence that case-by-case loan modification is not effective as a policy

tool.

In February 2009, economists Nouriel Roubini and Mark Zandi recommended an "across the

board" (systemic) reduction of mortgage principal balances by as much as 20-30%. Lowering the

mortgage balance would help lower monthly payments and also address an estimated 20 million

homeowners that may have a financial incentive to enter voluntary foreclosure because they are

"underwater" (i.e., the mortgage balance is larger than the home value).

A study by the Federal Reserve Bank of Boston indicated that banks were reluctant to modify

loans. Only 3% of seriously delinquent homeowners had their mortgage payments reduced

during 2008. In addition, investors who hold MBS and have a say in mortgage modifications

have not been a significant impediment; the study found no difference in the rate of assistance

whether the loans were controlled by the bank or by investors. Commenting on the study,

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economists Dean Baker and Paul Willen both advocated providing funds directly to homeowners

instead of banks.

The L.A. Times reported the results of a study that found homeowners with high credit

scores at the time of entering the mortgage are 50% more likely to "strategically default" --

abruptly and intentionally pull the plug and abandon the mortgage—compared with lower-

scoring borrowers. Such strategic defaults were heavily concentrated in markets with the highest

price declines. An estimated 588,000 strategic defaults occurred nationwide during 2008, more

than double the total in 2007. They represented 18% of all serious delinquencies that extended

for more than 60 days in the fourth quarter of 2008.

Homeowners Affordability and Stability Plan

Main article: Homeowners Affordability and Stability Plan

On 18 February 2009, U.S. President Barack Obama announced a $73 billion program to

help up to nine million homeowners avoid foreclosure, which was supplemented by $200 billion

in additional funding for Fannie Mae and Freddie Mac to purchase and more easily refinance

mortgages. The plan is funded mostly from the EESA's $700 billion financial bailout fund. It

uses cost sharing and incentives to encourage lenders to reduce homeowner's monthly payments

to 31 percent of their monthly income. Under the program, a lender would be responsible for

reducing monthly payments to no more than 38 percent of a borrower’s income, with

government sharing the cost to further cut the rate to 31 percent. The plan also involves forgiving

a portion of the borrower’s mortgage balance. Companies that service mortgages will get

incentives to modify loans and to help the homeowner stay current.

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 Regulatory proposals and long-term solutions

Further information: Subprime mortgage crisis solutions debate and Regulatory responses to

the subprime crisis

President Barack Obama and key advisers introduced a series of regulatory proposals in June

2009. The proposals address consumer protection, executive pay, bank financial cushions or

capital requirements, expanded regulation of the shadow banking system and derivatives, and

enhanced authority for the Federal Reserve to safely wind-down systemically important

institutions, among others.

A variety of regulatory changes have been proposed by economists, politicians, journalists,

and business leaders to minimize the impact of the current crisis and prevent recurrence.

However, as of June 2009, many of the proposed solutions have not yet been implemented.

These include:

 Ben Bernanke: Establish resolution procedures for closing troubled financial institutions

in the shadow banking system, such as investment banks and hedge funds.

 Joseph Stiglitz: Restrict the leverage that financial institutions can assume. Require

executive compensation to be more related to long-term performance. Re-instate the

separation of commercial (depository) and investment banking established by the Glass-

Steagall Act in 1933 and repealed in 1999 by the Gramm-Leach-Bliley Act.

 Simon Johnson: Break-up institutions that are "too big to fail" to limit systemic risk.

 Paul Krugman: Regulate institutions that "act like banks " similarly to banks.

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 Alan Greenspan: Banks should have a stronger capital cushion, with graduated regulatory

capital requirements (i.e., capital ratios that increase with bank size), to "discourage them

from becoming too big and to offset their competitive advantage.

 Warren Buffett: Require minimum down payments for home mortgages of at least 10%

and income verification.

 Eric Dinallo: Ensure any financial institution has the necessary capital to support its

financial commitments. Regulate credit derivatives and ensure they are traded on well-

capitalized exchanges to limit counterparty risk.

 Raghuram Rajan: Require financial institutions to maintain sufficient "contingent capital"

(i.e., pay insurance premiums to the government during boom periods, in exchange for

payments during a downturn.)

 A. Michael Spence and Gordon Brown: Establish an early-warning system to help detect

systemic risk.

 Niall Ferguson and Jeffrey Sachs: Impose haircuts on bondholders and counterparties

prior to using taxpayer money in bailouts.

 Nouriel Roubini: Nationalize insolvent banks. Reduce debt levels across the financial

system through debt for equity swaps. Reduce mortgage balances to assist homeowners,

giving the lender a share in any future home appreciation.

 Paul McCulley advocated "counter-cyclical regulatory policy to help modulate human

nature." He cited the work of economist Hyman Minsky, who believed that human

behavior is pro-cyclical, meaning it amplifies the extent of booms and busts. In other

words, humans are momentum investors rather than value investors. Counter-cyclical

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 policies would include increasing capital requirements during boom periods and reducing

them during busts.

U.S. Treasury Secretary Timothy Geithner testified before Congress on October 29, 2009.

His testimony included five elements he stated as critical to effective reform: 1) Expand the

FDIC bank resolution mechanism to include non-bank financial institutions; 2) Ensure that a

firm is allowed to fail in an orderly way and not be "rescued"; 3) Ensure taxpayers are not on the

hook for any losses, by applying losses to the firm's investors and creating a monetary pool

funded by the largest financial institutions; 4) Apply appropriate checks and balances to the

FDIC and Federal Reserve in this resolution process; 5) Require stronger capital and liquidity

positions for financial firms and related regulatory authority.

Other responses

Significant law enforcement action and litigation is resulting from the crisis. The U.S.

Federal Bureau of Investigation was looking into the possibility of fraud by mortgage financing

companies Fannie Mae and Freddie Mac, Lehman Brothers, and insurer American International

Group, among others. New York Attorney General Andrew Cuomo is suing Long Island based

Amerimod, one of the nation's largest loan modification corporations for fraud, and has issued 14

subpoenas to other similar companies. The FBI also assigned more agents to mortgage-related

crimes and its caseload has dramatically increased. The FBI began a probe of Countrywide in

March 2008 for possible fraudulent lending practices and securities fraud.

Over 250 civil lawsuits were filed in federal courts during 2007 related to the subprime crisis.

The number of filings in state courts was not quantified but is also believed to be significant.

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Implications

Estimates of impact have continued to climb. During April 2008, International Monetary

Fund (IMF) estimated that global losses for financial institutions would approach $1 trillion. [238]

One year later, the IMF estimated cumulative losses of banks and other financial institutions

globally would exceed $4 trillion.

This is equal to U.S. $20,000 for each of 200,000,000 people.Francis Fukuyama has argued

that the crisis represents the end of Reaganism in the financial sector, which was characterized

by lighter regulation, pared-back government, and lower taxes. Significant financial sector

regulatory changes are expected as a result of the crisis.

Fareed Zakaria believes that the crisis may force Americans and their government to live

within their means. Further, some of the best minds may be redeployed from financial

engineering to more valuable business activities, or to science and technology.

Roger Altman wrote that "the crash of 2008 has inflicted profound damage on [the U.S.]

financial system, its economy, and its standing in the world; the crisis is an important

geopolitical setback...the crisis has coincided with historical forces that were already shifting the

world's focus away from the United States. Over the medium term, the United States will have to

operate from a smaller global platform -- while others, especially China, will have a chance to

rise faster.

GE CEO Jeffrey Immelt has argued that U.S. trade deficits and budget deficits are

unsustainable. America must regain its competitiveness through innovative products, training of

production workers, and business leadership. He advocates specific national goals related to

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energy security or independence, specific technologies, expansion of the manufacturing job base,

and net exporter status. "The world has been reset. Now we must lead an aggressive American

renewal to win in the future." Of critical importance, he said, is the need to focus on technology

and manufacturing. “Many bought into the idea that America could go from a technology-based,

export-oriented powerhouse to a services-led, consumption-based economy — and somehow still

expect to prosper,” Jeff said. “That idea was flat wrong.

Economist Paul Krugman wrote in 2009: "The prosperity of a few years ago, such as it was

— profits were terrific, wages not so much — depended on a huge bubble in housing, which

replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the

spending that sustained the economy in the pre-crisis years isn’t coming back either. Niall

Ferguson stated that excluding the effect of home equity extraction, the U.S. economy grew at a

1% rate during the Bush years. Microsoft CEO Steve Ballmer has argued that this is an economic

reset at a lower level, rather than a recession, meaning that no quick recovery to pre-recession

levels can be expected.

The U.S. Federal government's efforts to support the global financial system have resulted in

significant new financial commitments, totaling $7 trillion by November, 2008. These

commitments can be characterized as investments, loans, and loan guarantees, rather than direct

expenditures. In many cases, the government purchased financial assets such as commercial

paper, mortgage-backed securities, or other types of asset-backed paper, to enhance liquidity in

frozen markets. As the crisis has progressed, the Fed has expanded the collateral against which it

is willing to lend to include higher-risk assets.

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 The Economist wrote: "Having spent a fortune bailing out their banks, Western governments

will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of

countries (like Britain and America) that have trade as well as budget deficits, those higher taxes

will be needed to meet the claims of foreign creditors. Given the political implications of such

austerity, the temptation will be to default by stealth, by letting their currencies depreciate.

Investors are increasingly alive to this danger...

The crisis has cast doubt on the legacy of Alan Greenspan, the Chairman of the Federal

Reserve System from 1986 to January 2006. Senator Chris Dodd claimed that Greenspan created

the "perfect storm". When asked to comment on the crisis, Greenspan spoke as follows:

The current credit crisis will come to an end when the overhang of inventories of newly built

homes is largely liquidated, and home price deflation comes to an end. That will stabilize the

now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most

importantly for those held as collateral for residential mortgage-backed securities. Very large

losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted

adjustment, the U.S. economy, and the world economy more generally, will be able to get back

to business.

Derivatives and deception

A well-regulated stock exchange is a phenomenal source of information for all market

participants. It generates second-by-second data concerning the volume and price of trades, and

its settlement system registers the identity of buyers and sellers. The analytic feats of the

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financial economists were themselves based on such data. Yet the advent of structured finance

generated a gigantic volume of direct trades between institutions whose details were only known

to the participants. These ‘over-the-counter’ transactions exceeded stock-exchange transactions

by the turn of the millennium, and led the exchanges to skimp on procedure in order to remain

competitive. Here we have both the cause of the credit crunch and the ultimate irony of the

Western crusade to marketize the globe. A great wave of securitization aimed to turn even the

most unpromising cash prospect, or intimate personal ambition, into a tradeable. It succeeded in

submerging the world’s main capital markets in a deluge of non-performing and unpriced

securities. The fog of grey capital descended on the financial districts, shrouding the great banks

and clouding the view of investors and regulators alike.

In order to grasp today’s capitalism we need financial analysis, but the phenomenon of

financialization sucks oxygen from the atmosphere. It privatizes information that should be

public, just as it commercializes everyday life and promotes a pattern of ‘uncreative destruction’

in which enterprises and work teams are continually broken up and re-assembled to take

advantage of transient arbitrage gains. In addition to helping financial institutions game their

own customers, the techniques of financialization allow big capital—large corporations and

wealthy individuals—to escape tax and skim the holdings of small shareholders. Note that most

pension funds and charitable endowments, but not us mutual funds, are limited by fiduciary rules

from much exposure to hedge funds or exotic derivatives. A further corollary of proliferating

financialization is that the regulations governing credit creation were first loosened and then

almost entirely ignored. Reckless credit expansion has long been the primrose path to financial

crisis and collapse.

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 The post-1972 take-off of financialization coincided with advances in computing capacity

and the discovery of new mathematical techniques for valuing options and constructing

derivatives. To begin with, these techniques were used mainly to reduce uncertainty and hedge

currency risk. But before long it became clear that derivative swaps could be used to bamboozle

tax authorities and shareholders. Financial engineering could convert one type of income stream

into another, or an asset into income or the other way round—reducing or avoiding tax.

Derivatives could also be used to refine the techniques of fund management and strategies for

merger and acquisition. The more responsible pension funds avoid hyper-trading programmes

and stick with long-term investment strategies. But they do use derivates to hedge their positions.

While several financial products serve no useful purpose, we should not expect a generalized

rejection of all options and derivatives. Instead it will be necessary to distinguish, as the irs

already tries to do, between derivative contracts that really do seek to hedge risks and those

whose only rationale is to cheat the tax authority and confuse the unwitting shareholder. There

are already calls for proper regulation and registration of these instruments and of the ‘shadow

banking system’ as a whole. More and better regulation is indeed needed, but will regulation be

enough? It is worth recalling that financialization was born in a quite heavily regulated world,

with some of its techniques designed to frustrate and defeat the regulators, just as others aimed at

releasing ‘value’.

Lessons of the 1930s

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 The 1920s share bubble, and the bank runs of 1929 and after, prompted a wave of regulation,

including the passage of Glass–Steagall in 1933—repealed by Clinton in 1999. For a long period,

roughly 1929 to 1972, the scope for financialization was limited, first because of the sharp

financial contraction of the Great Depression and then because of the extensive coordination of

the Bretton Woods system and postwar economy more generally.

The centrality of banks, and the role of property bonds in the current crisis, bear an eerie

resemblance to the onset of the Great Crash. Joseph Schumpeter stressed how the tumbling of

property prices in Florida precipitated the collapse of a speculative bubble centred on property

bonds. For Schumpeter the stock-market falls were secondary to the impact on the banks, which

in turn reflected the bursting of a credit bubble. He pointed out that the 1929 crash exhibited the

classic features of the onset of a ‘Juglar cycle’. Named for the economic historian Clément

Juglar, this cycle began with a devastating financial crisis and credit famine, which then took its

dreadful toll on industry and agriculture. Schumpeter was already aware of the particular role of

housing investment in economic turbulence: ‘Nothing is so likely to produce cumulative

depressive processes as such commitments made by a vast number of households to an overhead

financed to a considerable extent by commercial banks.’

This time around, speculative financial instruments based on property mortgages have also

collapsed—with Florida again an epicentre. Despite many unknowns it is reasonable to suppose

that usgdp will stagnate rather than suffer anything like the crushing decline of the 1930s.

Nevertheless, the loss in potential output could be large: Greenlaw and his colleagues estimate a

conservative 1–1.5 per cent of gdp, as we have seen. So far both politicians and regulators have

sought to tackle the crisis by prompting the banks to come up with their own solutions, rather

104 | P a g e
than by devising new instruments of regulation. The Brown government havered for six months

before taking Northern Rock into public ownership. In the United States neither the Fed nor the

Treasury have shown a clear determination to expose losses and recapitalize the affected

institutions. Even Herbert Hoover established the Reconstruction Finance Corporation, a public

agency designed to resuscitate threatened assets, which eventually made a huge contribution to

reviving the us economy.

The New Deal response to the crisis also comprised, in addition to Glass–Steagall, the setting

up of the Home-Owners Loan Corporation (holc) in 1933, the introduction of the Securities and

Exchange Commission in 1934, the passage of the Social Security Act in 1935, and the

establishment of a Federal National Mortgage Association, now more familiarly known as

Fannie Mae, in 1938. While the holc was supposed to head off mounting foreclosures, Fannie

Mae was designed to secure and subsidize prime residential mortgages. The holc bought

mortgages in default from the banks and offered the borrowers lower repayment terms. Within

two years the holc had received 1.9 million applications from distressed homeowners and

successfully re-negotiated one million mortgages. It closed in 1951 after the last 1936 mortgage

was paid off.

While the holc was dealing with subprime borrowers, Fannie Mae made it easier and cheaper

for prime borrowers to get a mortgage, using its Federal guarantee and tax-free status to organize

a secondary mortgage market that underwrote any residential mortgage up to a certain value. The

guarantee and tax exemption enabled Fannie Mae to borrow at cheap rates which were passed on

to the individual borrowers. This partial decommodification of the residential mortgage market

105 | P a g e
subsequently proved a great success. In 1968 Fannie Mae was semi-privatized and allowed to

raise capital from investors, but kept its Federal guarantee and remained exempt from taxation.

These subsidies enabled it to finance the process whereby, over the subsequent forty years, over

50 million householders acquired ownership of their homes. However the semi-privatization can

now be seen as a huge mistake, since it allowed the two government-sponsored enterprises to

take on inordinate amounts of debt in a bid to promote securitization and boost earnings. The

more general problem here—also seen in the privatization of so many British building societies

—is the hostility to even partially decommodified social forms and an infatuation with the

corporate model.

Research Methodology

Research Design:

106 | P a g e
Descriptive Research
This Research is a descriptive research since the analysis is based on the statistics which is utmost

essential for proving the study. The statistical tools used are Average, diagrams, Graphs and tables.

Exploratory Research
The research is also exploratory since the Exploratory research often relies on secondary research

such as reviewing available literature and/or data, or qualitative approaches such as informal

discussions with consumers, employees, management or competitors, and more formal approaches

through in-depth interviews, focus groups, projective methods.

Quantitative Research
The research is also quantitative because it has tried to establish relationship between subprime

loans and recession since in quantitative research your aim is to determine the relationship between one

thing (an independent variable) and another (a dependent or outcome variable) in a population.

Source of data

In the research both the data are used Viz Primary Data, Secondary Data.

Sources of primary Data

1: Interview with bankers, Academicians, Stock exchange Brokers.

Sources of Secondary Data

1 Book

2 Journals

3 Internets

107 | P a g e
Method of Data Collection/Data Collection Procedure

The sampling techniques used in the research are:-

Judgmental sampling:
The sample based on who they think would be appropriate for the study. This is used primarily when

there is a limited number of people that have expertise in the area being researched.

Convenience Sampling

The members of the population are chosen based on their relative ease of access. To sample

friends, co-workers, or shoppers at a single mall, are all examples of convenience sampling.

Snowball sampling

The first respondent refers a friend. The friend also refers a friend, etc.

108 | P a g e
 The following data shows how the prime rate has decreased over the years which have

induce high borrowings. The following data is published by wall street journal of the past three

decades.

Home ownership became attainable even for low income earners financial institutions offered

low income earners adjustable rate mortgages with extremely low interest rates, which reset to

higher rates after an initial ‘honeymoon period.’ Provided house prices kept rising, borrowers

could refinance their loans or sell their properties to pay off their mortgages.

109 | P a g e
Data Source Wall Street Journal http://mortgage-x.com/general/indexes/prime.asp

Date of Date of Date of Rate

Rate Rate
Rate Rate Rate (%)
(%) (%)
Change Change Change
2-Jan-81 20.5 8-Nov-84 11.75 16-Oct-98 8
9-Jan-81 20 28-Nov-84 11.25 18-Nov-98 7.75
3-Feb-81 19.5 19-Dec-84 10.75 1-Jul-99 8
23-Feb-81 19 15-Jan-85 10.5 25-Aug-99 8.25
10-Mar-81 18 20-May-85 10 17-Nov-99 8.5
17-Mar-81 17.5 18-Jun-85 9.5 3-Feb-00 8.75
2-Apr-81 17 7-Mar-86 9 22-Mar-00 9
24-Apr-81 17.5 21-Apr-86 8.5 17-May-00 9.5
30-Apr-81 18 11-Jul-86 8 4-Jan-01 9
4-May-81 19 26-Aug-86 7.5 1-Feb-01 8.5
11-May-81 19.5 1-Apr-87 7.75 21-Mar-01 8
19-May-81 20 1-May-87 8 19-Apr-01 7.5
22-May-81 20.5 15-May-87 8.25 16-May-01 7
3-Jun-81 20 4-Sep-87 8.75 28-Jun-01 6.75
8-Jul-81 20.5 7-Oct-87 9.25 22-Aug-01 6.5
15-Sep-81 19.5 22-Oct-87 9 18-Sep-01 6
5-Oct-81 19 5-Nov-87 8.75 3-Oct-01 5.5
13-Oct-81 18 2-Feb-88 8.5 7-Nov-01 5
3-Nov-81 17.5 11-May-88 9 12-Dec-01 4.75
9-Nov-81 17 14-Jul-88 9.5 7-Nov-02 4.25
16-Nov-81 16.5 11-Aug-88 10 27-Jun-03 4
24-Nov-81 16 28-Nov-88 10.5 1-Jul-04 4.25
3-Dec-81 15.75 10-Feb-89 11 11-Aug-04 4.5
8-Feb-82 16.5 24-Feb-89 11.5 22-Sep-04 4.75
18-Feb-82 17 5-Jun-89 11 10-Nov-04 5
23-Feb-82 16.5 31-Jul-89 10.5 14-Dec-04 5.25
20-Jul-82 16 8-Jan-90 10 2-Feb-05 5.5
29-Jul-82 15.5 2-Jan-91 9.5 22-Mar-05 5.75
2-Aug-82 15 4-Feb-91 9 3-May-05 6
16-Aug-82 14.5 1-May-91 8.5 30-Jun-05 6.25
18-Aug-82 14 13-Sep-91 8 9-Aug-05 6.5
3-Sep-82 13.5 6-Nov-91 7.5 21-Sep-05 6.75
7-Oct-82 13 23-Dec-91 6.5 1-Nov-05 7
13-Oct-82 12 2-Jul-92 6 13-Dec-05 7.25
22-Nov-82 11.5 24-Mar-94 6.25 31-Jan-06 7.5
11-Jan-83 11 19-Apr-94 6.75 28-Mar-06 7.75

110 | P a g e
 21-Feb-83 10.5 18-May-94 7.25 10-May-06 8
8-Aug-83 11 16-Aug-94 7.75 29-Jun-06 8.25
19-Mar-84 11.5 15-Nov-94 8.5 18-Sep-07 7.75
5-Apr-84 12 1-Feb-95 9 31-Oct-07 7.5
8-May-84 12.5 7-Jul-95 8.75 11-Dec-07 7.25
26-Jun-84 13 20-Dec-95 8.5 22-Jan-08 6.5
27-Sep-84 12.75 31-Jan-96 8.25 30-Jan-08 6
16-Oct-84 12.5 27-Mar-97 8.5 18-Mar-08 5.25
24-Oct-84 12 30-Sep-98 8.25 30-Apr-08 5
8.90555
8-Oct-08 4.5
Average 15.98889 Average 6
29-Oct-08 4
Average 6.60638

Average Prime Rate

18
16
14
12
10 Average Prime Rate

8
6
4
2
0
1 2 3

Three averages have been calculated of consecutive periods and the trend has shown a

significant decrease in the prime rate which has increased the price of houses. The rise in

demand of the loan was replenished by the way of securitization. The following trend shows the

rising demand of the house and the rise in the price of the house property.

Data Source: www.virginiaforeclosureprevention.com/

111 | P a g e
 Example: Prince William Market Area
$500,000 1,500
25 months
Median Existing Home Price

$400,000 1,200

Existing Home Sales

(12-month rolling average)
$300,000 900
Home Sales
$200,000 600
Home Prices
$100,000 300
14 months

$0 0
D 99

D 00

D -01

D -02

D 03

D 04

D 05

D 06

D -07

D -08

09
Ju 8

Ju 9

Ju 0

Ju 1

Ju 2

Ju 3

Ju 4

Ju 5

Ju 6

Ju 7

Ju 8
-9

-9

-0

-0

-0

-0

-0

-0

-0

-0

-0
n-

n-

n-

n-

n-

n-

n-
n

n
n

n
ec

ec

ec

ec

ec

ec

ec

ec

ec

ec

ec
D

The following trend shows increase in home sales and home prices. Many borrowers had no

hope of repaying the loan, and knew this For many borrowers, the honeymoon rates were such

that repayments were cheaper than rent; They knew that at the end of the honeymoon period they

would not be able to keep up; But if house prices at least stayed where they were, they would be

able to sell the property, or refinance with another sub-prime lender and start again.

Data Source: Vinod Kothari’s Financial services website

Table 1 U.S. Annual Issuance of ABS by Collateral, 1985-1999, (Mil.$)

                 

112 | P a g e
 Credit Manufacture Equipment Student
  Total Auto cards d housing leasing loans Others  
1985 1,135 797 - - - - 338  
1986 10,041 9,661 - - 380 - -  
1987 9,855 6,522 2,410 184 - - 739  
1988 16,079 5,897 7,420 848 64 - 1,851  
1989 21,785 7,823 11,326 1,970 - - 666  
12,62
1990 37,187 3 22,466 1,048 118 - 932  
15,04
1991 40,299 6 20,833 1,316 385 - 2,720  
19,77
1992 45,156 1 15,762 2,661 1,295 - 5,668  
25,26
1993 54,994 8 19,597 2,459 3,668 597 3,406  
13,20
1994 64,727 4 31,943 4,342 2,755 2,352 10,132  
23,47
1995 90,302 1 46,975 5,739 2,657 3,345 8,116  
39,22
1996 131,890 0 54,850 8,060 9,340 11,000 9,420  
45,68
1997 150,100 0 47,610 9,310 7,760 16,970 22,770  
45,89
1998 149,000 0 46,480 14,870 9,570 15,760 16,430  
73,14
1999 185,787 7 50,427 21,667 11,253 12,267 17,027  

Innovative securitised debt products such as residential mortgage backed securities (RMBS)

added fuel to the fire. Securitisation involves bundling various assets with a series of predictable

cash flows (such as a mortgage) into a single fixed interest security.

Banks packaged subprime mortgages with prime loans to form asset-backed securities called

‘collateralised debt obligations’ (CDOs):Ratings agencies such as Moody’s and S&P gave these

assets AAA and A+ ratings, signalling their safety to investors. Nearly 80% of these bundled

securities were deemed by ratings agencies to be investment grade. Debt instruments were also

created exclusively from subprime loans.

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For many lenders, securitisation had become a major source of funding: When investors no

longer wanted to purchase securitized debt instruments, many of these lenders were left with

large paper losses on illiquid and unmarketable assets; This resulted in substantial losses for Wall

Street firms…

This resulted in substantial losses for Wall Street firms…

Banks Firm Loss
Citigroup $US 39.2 bn
UBS $US 37.9 bn
Merrill Lynch $US 29.1 bn
HSBC $US 17.2 bn
Morgan Stanley $US 11.7 bn
JP Morgan $US 5 5 bn

114 | P a g e
SUMMARY

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Securitization is the "financial innovation" that allows banks to make loans and then sell them to

someone else. This is critically important to banks because they need to retain a certain amount

of capital on their books if they want to make more loans. With securitization, banks could

originate the loans and then sell them -- thus freeing up the capital to originate and sell even

more loans.

Unfortunately, that little game of financial musical chairs is through for now. Nobody wants to

buy the bundles of loans -- whether backed by credit card receivables, mortgages, auto loans, or

leveraged buyout loans. This is forcing banks to make loans and then keep them on their books.

And it just so happens that many of the loans are going bad and the write-downs are cutting into

banks' capital.

So what? Banks are simply going to stop making loans until they can either raise much more

capital or the market for asset-backed securities revives. Until then, any company that depends

on borrowing for its growth is going to find itself seeking alternative forms of financing. And if

those are not available, they'll simply have to cut back -- on growth plans and workers.

The way to replenish bank capital coffers is to create a wider net interest margin. That is to lower

the rates that banks pay depositors while raising the rates they charge borrowers. The wider that

margin is, the more rapidly banks can pour profits into their capital accounts. Unfortunately,

there is very little room for dropping deposit rates and given higher energy and labor costs,

businesses probably can't afford to borrow at higher rates.

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 Despite the comparison to previous crises, the current one is the first one that's magnified by

securitization. Investors bought bundles of mortgages which were so complex that nobody could

put a price on them. Investors relied on ratings agencies to AAA-rate them. But the investment

banks paid the ratings agencies that gave the highest rating.

Nobody seems to know what these mortgage bundles are worth, who owns them, how much

has been borrowed using the bundles as collateral, how deeply their value has declined, and how

much bank capital the resulting write-downs will cost.

And this is just the beginning of securitization's problems -- there are hundreds of billions of

securities backed by credit card receivables, auto loans, and leveraged buyout loans whose

problems have yet to surface. Moreover, as I posted here, securitization's fallout could damage

other investors such as life insurance companies.When this is all over, the government will need

to step in and decide whether securitization should continue. If so, there'll need to be a huge leap

in transparency. And that leap may be too much to achieve.

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Subprime crisis happens because everyone predicts the property value will appreciate over time.

The economy now is no longer as simple as in 30 years ago where we can predict the future with

certain of accuracy.

While the subprime crisis demands careful attention, it appears unlikely to have major economic

impacts beyond the housing sector. Home prices are only falling slightly overall and are even

rising in many markets. About 87 percent of residential mortgages are not subprime loans,

according to the Mortgage Bankers Association’s delinquency studies.19 The subprime crisis has

a long way to go to reach the level of the S&L debacle or the foreclosure level of the Great

Depression. It is not a major crisis, and, thus is no reason for drastic action—which itself could

have unintended negative consequences including reduced homeownership, less liquidity in the

housing market, and a reduced level of economic freedom and prosperity for all Americans.

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1 Greg Ip, Mark Whitehouse, and Aaron Lucchetti, “U.S. Mortgage Crisis Rivals S&L

Meltdown,” Wall Street

Journal, December 10, 2007, p. A1.

2 ABC News, “Who Qualifies for Bush's Mortgage Bailout Plan?” December 7, 2007,

http://abcnews.go.com/GMA/Consumer/story?id=3968737&page=1.

3 Jane Sasseen, “Does the housing plan go far enough,” Business Week, Dec 11, 2007,

http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db2007126_445035.htm.

4 Errol Louis, “The Guilty Parties,” New York Daily News, December 11, 2007,

http://www.nydailynews.com/opinions/2007/12/09/2007-12-09_the_guilty_parties.html.

5 Organization for Economic Cooperation and Development, “Standardized Unemployment Rate

(SUR): October

2007,” http://stats.oecd.org/WBOS/Default.aspx?

QueryName=251&QueryType=View&Lang=en.

6 Joint Economic Committee, “The Subprime Lending Crisis: The Economic Impact on Wealth,

Property Values and

Tax Revenues, and How We Got Here,”October 25, 2007,

http://jec.senate.gov/Documents/Releases/10.25.07subprimereportrelease.pdf.

7 Ibid., and Global Insight, “The Mortgage Crisis: Economic and Fiscal Implications for Metro

Areas,” United States

Conference of Mayors, November 26, 2007. Note that the Conference of Mayors estimate deals

only with

119 | P a g e
metropolitan areas (which contain about 80 percent of America’s population) and thus do not

jibe entirely with those

of the Joint Economic Committee.

http://usmayors.org/uscm/news/press_releases/documents/mortgagereport_112707.pdf

8 For 1.2 million number see, e.g. First American Core Logic, “Home Mortgage Estate

Foreclosures, 2006” in Real

Estate Statistics, 2006. As this paper is being written in late 2007, of course, its not possible to

know the exact total

of foreclosures during 2007. Through the third quarter of 2007, however, the FDIC and First

American both

reported that overall foreclosures were up about 20 percent year over year.

9 Anthony Downs, “Credit Crisis: The sky is not falling,” The Brookings Institution, 2007,

http://www.brookings.edu/papers/2007/10_mortgage_industry_downs.aspx.

10 Laurie Goodman, “Total Subprime Losses as High as $480 billion,” Research Note, UBS AG,

November 14,

2007. Jan Hatzius, Research Note, Goldman Sachs, November 18, 2007. Morgan Stanley, “The

Subprime Crisis,”

(Accessed December 12, 2007).

11 Dr. George Freidman, “Subprime Geopolitics,” Stratfor Geopolitics, 2007,

http://www.stratfor.com/products/premium/read_article.php?id=293933.

12 Office of Management and Budget. “Gross Domestic Product and Deflators Used in

Historical Tables, (2005)”

http://www.whitehouse.gov/omb/budget/fy2005/hist.html

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13 Official numbers are not yet available for 2007. A review of a variety of estimates—all of

which come in between

1.4 and 1.5 percent is found in Bloomberg News, “Foreclosures rise 68 Percent in one Year,”

December 20, 2007

(As of this writing statistics are only available through November).

14 For 2006 foreclosure statistics, see: Realtytrac.com “2005 Foreclosure Report,”

http://www.realtytrac.com/news/press/pressRelease.asp?PressReleaseID=86.

15 For overall numbers see U.S. Census Bureau, “Historical Census of Housing Tables,” 2000,

http://www.census.gov/hhes/www/housing/census/historic/owner.html.A more detailed table is

found in: Arthur B.

Gallion. The Urban Pattern, Van Nostrand: 1963, p. 173.

16 Conference of Mayors.

17 U.S. Census Population Clock, December 12, 2007, http://www.census.gov/.

18 U.S. Census Bureau. “Historical Census of Housing Tables,” 2000,

http://www.census.gov/hhes/www/housing/census/historic/owner.html.

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