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In the second half of the past decade, economies around the world were faced with an unexpected financial crisis that led to an exponential increase in the number of borrowing delinquencies, defaults, and eventual foreclosures. Subprime mortgages were one of the worst hit sectors and effects could be observed until 2006. This resulted in eventual financial meltdown and credit crunch in 2008, whose effects can still be felt today. On the one hand, borrowers were no longer in a position to repay their debts, and, on the other hand, all mortgage-backed securities lost value. As a result, there was an all-time high record of foreclosures of homes previously owned through mortgage payments. Between 2006 and 2008, there was a 75% increase in cases demanding foreclosure of homes, implying that more than 1% of homes across all sectors were facing foreclosure. The subprime mortgage market sector was severely encumbered and loaded with debt. Whereas other borrowers were observed to enter foreclosure at a 0.25% rate, subprime mortgage borrowers experienced the rate of 2.43%. By 2008, losses from foreclosures in this sector were estimated at a staggering $250 billion. Although there has been a remarkable turnaround in the economy, there are astounding issues that must be resolved if such a scenario is to be adequately averted in future (ElBoghdady & Trejos 1-3).
The subprime mortgage crisis describes the period between 2006-2009 when subprime borrowers faced multiple foreclosures and low property values due to the weakening global economy. Most subprime mortgage borrowers are classified as low and middle income earners. Therefore, these devastating effects had a profound effect on people who were struggling to own homes which they regarded as their hugest financial asset. In addition, this led to a decline in property values, as well as loss of government revenue.
In order to have a clear perspective on the subprime mortgage crisis, it is absolutely important to review the period preceding this crisis. In the mid-1990’s, mortgages were increasingly used, as securities and interest rates were increasingly lowered, more so with the advent of technology in 2001. In addition, the government encouraged mortgaging through offering incentives and introducing favorable policies. This led to a softened approach by banks to lending, the emergence of a group of unregulated and unscrupulous mortgage brokers, increased reliance on credit-rating firms and an overzealous attempt to earn the maximum profits with the booming economy. This led to a strain on the subprime mortgage sector resulting in a crisis that spilt over and spread to individual countries’ economies and eventually engulfed the international economy. This research paper will examine the effects of the subprime mortgage crisis on low and middle-income borrowers. An in-depth analysis shall be conducted as to the origin of the crisis, its implications to subprime mortgage home owners. It is also necessary to evaluate the mechanisms that have been put in place in order to avert a similar disaster in the future.
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1. Overview of the Subprime Mortgage Sector
Terms and rates which different lending facilities dictate differ due to characteristics possessed by different borrowers. Nonetheless, mortgage borrowers are classified either as prime or subprime on the basis of their capacity to repay amounts rendered and their credit risk ratings. Therefore, these two terms do not refer to the interest rates attached to mortgages, but they refer to credit worthiness of these borrowers. Borrowers below the credit score of 620 are classified as subprime; otherwise, the client is regarded as a prime borrower. Evidently, a lending facility assumes more risk when lending to subprime borrowers.
Whereas rates and terms may vary among subprime borrowers, which may be due to the credit history of an individual, income, and amount of down payment among other factors, subprime mortgage loans have a higher interest loading and more restrictive terms in comparison to prime mortgage loans. In the years preceding the recession, the subprime market experienced tremendous growth. For instance, in 1998, 2.4% of all outstanding mortgages taken out on homes were subprime. By 2006, the subprime mortgage market entailed approximately 14% of the outstanding mortgage loans. Notably, in the first quarter of 2006, 19% of the outstanding mortgage debt was attributed to the subprime market. At the end of 2007, subprime mortgage loans stood at a staggering $1.3 trillion, a considerably high amount in comparison to a meager $65 billion at the end of 1995, and $332 billion at the beginning of 2004. In years preceding the subprime mortgage crisis, the rate of home foreclosures on subprime borrowers was observed as always higher in comparison to prime borrowers. It was observed that 20% of all subprime mortgages taken out were not successfully repaid forcing a lending company to institute foreclosure in a period of less than 4 years. This rate was 10 times higher than that experienced with prime mortgage borrowers. However, delinquency and foreclosure rates accelerated in mid-2005 and skyrocketed by 2008 in the thick of the subprime mortgage crisis. At the beginning of 2008, there was an 11% delinquency rate, which was twice as much as that experienced in mid-2005. Sixty per cent of all foreclosures were attributed to subprime borrowers, a figure that ultimately climaxed in the third quarter of 2008 (Polakoff 2-4).
2. Impacts on Low and Middle-Income Borrowers
Low and middle-income borrowers were affected most by the subprime mortgage crisis. A study conducted in 2002 indicated that 10.9% of low and middle-income earners chose subprime mortgages as a means of owning homes. The subprime mortgage crisis slowed the global economy almost to a halt. This had several profound effects. First, low-income earners were not in a position to raise cash in order to pay their mortgages. Secondly, some properties such as homes depreciated rapidly. Therefore, homeowners could not sell or refinance, thus, forcing banks and other credit facilities to institute foreclosure in these delinquent cases. In March 2007, 490,000 homes were in advanced foreclosure or had been earmarked as seriously delinquent. The increase in interest rates towards the end of 2007 led to increased delinquency resulting in more losses in subprime mortgages. Despite the fact that delinquencies and foreclosure affected the entire economy, most of this burden was felt by low and middle-income earners. Individuals lost their most valuable asset, a home, and all accumulated equity. An individual was also bound to bear all administrative costs which were liable to accrue to as high as $7200. In addition, this dented individual credit worthiness and thus impaired any future chances of accessing loans, rental markets, and insurance. Moreover, social benefits are proportional to an individual’s satisfaction. Homeownership can be directly linked to personal satisfaction, community involvement, and self-esteem. It also provides collateral in case the owner is in need of financial aid. Once a person lost a home and became a renter, this was bound to impact negatively on the individual’s psychological well-being (Crandall 5).
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The subprime mortgage crisis has also had a deep impact not only on individual people. A study on residential property around Chicago reported that every foreclosure in any particular neighborhood lowered the value of surrounding property by approximately 1.44%. However, these rates were 60% higher in low and middle-income neighborhoods in comparison to high- income suburbs (Crandall 3). Finally, the subprime mortgage crisis resulted in the loss of direct revenue and the accumulation of direct costs. Increasing cases of foreclosure resulted in the erosion of property values; thus, there was loss of direct tax and a proportional demand for government services.
These effects were particularly magnified by the fact that most world economies were experiencing an economic meltdown. With an increasing delinquent subprime market, lending agencies were left with little option but to tighten their credit standards. This worsened the existing situation, making it unsalvageable.
The subprime mortgage crisis can be attributed to having occurred due two different forces. Whereas there was a distinct force that operated on the market, there was a proportional force that directly acted on the mortgage market and its underlying mechanics. In the mid-1990s, subprime mortgage loans were easily available at relatively low interest rates and flexible terms of payment. Credit risks were presumed due to the fact that properties experienced tremendous growth in value. Therefore, a subprime owner would opt to refinance instead of facing foreclosure. However, with the appearance of the financial crisis, this was no longer an option, as property prices fell drastically.
Although some individuals foresaw the possibility of a crash in the subprime market, most firms chose to pursue an aggressive policy and increased subprime loans even when there was a decline in prices in mid-2005. However, by 2007, it was clearly evident that there was no turnaround in home prices, and lending agencies introduced tighter credit evaluation measures. By the beginning of 2008, ripple effects could be felt in all sectors of the economy. There were several contributory factors that shall be discussed here.
This entails grouping large pools of financial assets into packages which are then presented in a secondary market for investors’ consideration. A typical subprime case entails grouping together mortgages and assigning them to an originator who may be a lender or a broker. These are then transferred to a special purpose vehicle (SPV) and then consequently issued to investors as debt securities. As a rule, the homeowner is oblivious of these transactions.
This practice encourages lending in the subprime market sector due to the fact that risk can be shifted from the lender to the SPV, who then transfers the risk to an investor. However, during the crisis, securitization hampered all efforts aimed at efficient screening of the credit worthiness of subprime mortgage applicants in favor of inserting sneaky predatory terms and excessive prepayment penalties in mortgage loan documents. Investors were highly protected from any risk of default, which ensured that they reaped the maximum profits. Although this allowed borrowers who would otherwise not have qualified if a proper and rigorous system was in place to access loans, in-built terms of payment as well as excessive supply of subprime mortgage loans at easy and flexible credit evaluation standards provided a suitable platform for a predictable exponential increase in foreclosures (Quamrul et al. 3-12).
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b) Credit-Rating Agencies
Three firms are charged with credit rating in the United States. They are Moody’s, Standard & Poor’s, and Fitch. Although these firms are private, they are subject to the government’s control. In most cases, subprime mortgage applicants were accorded an AAA rating. This is the highest credit rating possible which implied that they had the least risk and presented a sound investment opportunity. This led to a great number of conflicts. Firstly, firms that were bound by law to first acquire ratings for their clients paid large amounts of fees for securitization deals. Secondly, underwriters blatantly paid large amounts of fees to these companies in order to receive advice on how best they could structure subprime mortgages in order to achieve the highest credit rating possible. Obviously, products that received a high rating were in high demand by investors, giving the issuer (lending agency) an incentive to ensure that all products enlisted under the company received a high credit rating.
As the subprime mortgage crisis escalated and the investment risk increased in 2007, credit-rating agencies were reluctant to identify and downgrade these packages. Moreover, they had no financial incentive to re-rate subprime mortgages, since lending agencies are only liable for the initial credit-rating exercise. These conflicts as well as the delays in relating risk to actual market realities provided a fertile ground for an extensive subprime mortgage crisis in 2008.
c) Predatory Lending
The mortgage market practices before the appearance of the subprime mortgage crisis were highly dubious and biased in favor of investors, as well as lending agencies. Predatory lending is the practice of charging excessive fees, as well as inserting fraudulent and deceptive clauses in the lending contract that place the lender at a distinct advantage over the borrower. Whereas these practices may not be illegal, they are unethical and unprofessional. There were several malpractices that were in place before the subprime mortgage crisis (Wallison 1-2).
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The subprime mortgage market was marred with incidents which the investor and the lender stood to gain at the expense of the borrower. Although the increase in home prices before the 2008 recession contributed to these incidents, the depression starkly revealed these malpractices. For instance, lenders issued 2/28 loans. In these contracts, borrowers paid low fixed interest rates in the first two years (commonly referred to as teaser rates). However, once this period was over, interest rates were then re-adjusted continuously after every 6 months. Faced with a situation when borrowers could not repay their mortgages, they were forced to renegotiate with the lender who then offered them another teaser rate for additional two years. In the period before the crisis, lenders felt that borrowers were in a position to refinance their existing mortgages on the basis of their experience with the teaser rates. As a result, the majority of borrowers were refinanced, leading to increased debt that ultimately resulted in the subprime mortgage crisis.
These are malpractices that seek to extort excessive fees or charge high interest rates which are not proportional to the borrower’s credit risk. In 2007, prepayment penalties were thrice as likely to be instituted against subprime mortgage borrowers in comparison to prime mortgage borrowers, which greatly increased the cost of refinancing. This has been widely debated due to the fact that lenders are regarded as having issued loans that they felt would require the borrower to seek refinancing. Therefore, lenders used this technique to collect a large number of unethically collected fees. Although it is ethical and rational to charge higher fees for increased risk, it is evident that these fees were introduced to favor the lender at the expense of the borrower. How could the borrower be expected to refinance a loan at a higher cost when the original terms of contract had already rendered him/her delinquent?
Lending firms violated various statutes such as the Real Estate Settlement Procedures Act (RESPA) and the Truth in Lending Act (TILA).
Discrimination and Non-transparency
Lending agencies as well as brokers have been violating laws regarding full disclosure of mortgage prices and lending terms and conditions. Moreover, racial or ethnic-based discrimination, more so in areas that are considered to belong to specific ethnic communities, was observed.
d) Government Policies
One of the government’s core objectives is to encourage homeownership. Basically, banks and other lending institutions are charged with the responsibility of providing capital for investment. The Community Reinvestment Act (CRA), as well as Government Sponsored Enterprises, is one of the best policies that signify the government’s intent. However, it is apparent that the government was overzealous in its attempts to ensure that most citizens owned homes. It masked any malpractices detected in terms and conditions in loans issued to low and middle-income families.
4. Impacts and Responses
Since the beginning of the subprime mortgage crisis in 2007, various measures have been collectively instituted by both the government and lending facilities.
a) Introduction of Incentives that Encourage Renegotiation
At first, despite the fact that foreclosure is expensive to both the lender and the borrower, lending agencies were unwilling to renegotiate. The government introduced a number of incentives as well as mandatory measures that ensured that most adjustable-rate mortgages (ARMs) were converted to fixed rates, and repayment periods were extended. These were primarily introduced via the Federal Housing Authority and via the FHASecure plan.
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b) The Role of the United States Federal Reserve
The Federal Reserve chose to pursue changes on two fronts: The introduction of a sound monetary policy and measures that promote market liquidity. Ben Bernanke, the former Federal Reserve Chairman, stated the banks forthright intentions as “to support market liquidity and functioning and the pursuit of (our) macroeconomic objectives through monetary policy” (Bernanke 1). These measures were evidenced in:
a.) The Federal Reserve partnered with different central banks in pursuance of open market operations in an effort to uphold market liquidity.
b.) Measures have been taken in order to lower existing mortgage repayment rates such as the purchase of the Government Sponsored Enterprises’ (GSE) MBS program.
c.) The Federal Reserve Bank has successfully introduced lending facilities such as TAF (Term Auction Facility) and its predecessor (TALF) Term Asset-Backed Securities Loan Facility.
d.) The federal funds rate target was effectively lowered from a staggering 5.25% to an all-time low 2%, whereas the discount rate was lowered from 5.75% to 2.25%.
e.) In 2009, the government further purchased GSE’s mortgage-backed securities to the tune of $750 billion. This led to the expansion of the Federal bank’s balance sheet to $1.25 trillion. Further increases were made in the last quarter of 2009.
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c) Government-induced Stimulus Incentives
The most effective measure was the 2009 American Recovery and Reinvestment Act (commonly referred to as the Affordability and Stability Plan) which injected $787 billion into the economy in the form of tax reductions and spending stimulus. Specifically, $73 billion was allocated for the mortgage sector.
d) Mortgage Firms: Failure and Bailouts
As the economic recession took a strong foothold, major financial institutions collapsed. The government was forced to inject funds in its two major GSEs: Freddie Mac and Fannie Mae, which went into receivership. The aftermath of the global financial crisis left over 100 banks bankrupt and outstanding mortgages spiraling beyond the banks’ solvency statuses (PRMIA 3-6).
It is evident that the subprime mortgage crisis had greatly contributed to the start and acceleration of the global financial meltdown. Therefore, there is a need to take effective measures that will ensure that such a crisis does not re-occur or that adequate preventative measures shall be in place in case of such an event. Key among these is the need to overhaul securitization principles, as well as introduce proper regulatory measures in the credit-rating sector. The bridge between investor incentives and the borrower must be adequately addressed in order to encourage due diligence when conducting credit-risk evaluations. Moreover, such a system should encourage the introduction of structural mechanisms that spread the risk among the investor, the borrower, the lending facility and the broker. Finally, in the light of the recent subprime mortgage crisis, the government should stringently evaluate lending agencies and heavily punish all corporations that carry out predatory lending malpractices.