Demyanyk and Van Hemert (2008) argue that the most important cause of the subprime mortgage market crisis was that the quality of the loans worsened for six consecutive years before the crisis. This loss of quality was caused by bankers who put their worst subprime mortgages in their securitization portfolios (adverse selection of risk). (Calomiris, 2008) Together with an enormous rise in the number of subprime mortgages this led to the eventual collapse of the subprime mortgage market. They see the subsequent house price appreciation as the most important macroeconomic factor for this collapse. However, the Federal Reserve argues that “the decline in home values only revealed the problems with subprime mortgages; it did not cause the defaults” . On the other side again Mian and Sufi (2008) found that through the increase in supply of subprime loans new borrowers gained acces to the mortgage market which was a driving force for the house price appreciation, but it went together with a rise in the risk profile of borrowers. In the end this led to high default rates which led to a depressing house market (the ability of borrowers to refinance was reduces due to house price depreciation) and finally caused problems on the financial market. As Demyanyk and Van Hemert (2008) show, low house price appreciation and high mortgage rates increased the probability of delinquency but the negative trend in loan quality was not seen because “the housing boom allowed homeowners to refinance even the worst mortgages”1. The increase in riskiness should have been accompanied with an increase in the subprime mark-up. Instead, it declined.
Monetary policy has a an influence on the risk taking behaviour of banks and from 2001 to 2005 interest rates were very low (Jimenez, Ongena, Peydro, Saurina, 2007). Ioannidou, Ongena and Peydró (2008) find evidence that a decrease in the US federal funds rate prior to loan origination raises the probability of default on new individual bank loans and not on outstanding loans. They too find that initiating riskier loans becomes more likely when the federal funds rate is low, but spreads do not increase but even decrease (like Demyanyk et al. (2008) argued too). Simply said: banks do not seem to price the additional risk they take, although they softened their lending standards during the period of relaxed monetary conditions. When then, because of a change in monetary policy, interest rates rise (for example because of a monetary contraction) on these already riskier loans the risk increases substantially and so did hazard rates. (Jimenez et al. 2007)
Another big problem was the U.S. government's believe that everybody should have a house for themselves. It therefore subsidized homeownership in several ways like deductibility of mortgage interest and government funding subsidies via Federal Loan Home Bank Lending. These measures however increased the fragility in the real estate market. Also because of this U.S. government believe, GSE's purchased more subprime portfolios because the government encouraged them to do so and thus bid up the prices of these portfolios. This made it easier for people with a bad credit score to borrow at financial institutions. On top of that, the global savings glut, created by loose monetary policy and globalization, stimulated investors to take more risk. This led asset managers to invest knowingly in risky assets, because they were mainly compensated on the size rather than the value of their funds. They also reasoned that if they would not invest, other asset managers would. Sponsors of subprime securitization and rating agencies gave the demanding asset managers the opportunity to invest their money into risky assets because they provided them with investments that obviously understated risk. Firstly, rating agencies assumed an unrealistic view about the expected losses of subprime mortgages. Rating agencies did not have full information about what the risks were because subprime mortgages are quite recent financial innovation, which has only been around for about 20 years. During this time housing prices always increased and its core assumption was based on such a permanent appreciation of home prices. This market however had not been really tested because of the favorable housing market of the last 20 years (Calomiris, 2008). Secondly, rating agencies also understated the risk because (institutional) investors pressured rating agencies to get their desired ratings (and rating agencies were paid by financial institutions). Thirdly, the thread of anti-notching regulations leaded to further overpricing of subprime mortgages because conservative rating agencies had to accept the ratings of the more lenient rating agencies. Lastly, because of loosened standards for rating and the Basel II-requirements rating agencies received more regulatory power which changed their conservative behavior. All of them thought this would lead to “plausible deniability” (Calomiris, 2008).
Furthermore, Keys, Mukherjee, Seru and Vig (2008) find evidence that suggests that the securitization practices did adversely affect the screening incentives of lenders. One possible problem is that securitization creates a distance between a loan's originator and the final bearer of the loan's risk. This might have reduced the incentives of lenders to screen and monitor borrowers carefully (Peterson and Rajan, 2002). Guidelines established by GSEs cautioned against lending to risky borrowers and advised not to lend to borrowers with FICO scores below 620. This increased the likelihood of 620+ loans to be securitized. Especially since investors purchase securitized loans based on hard information (FICO score) and contractual terms, this might be a problem for the true creditworthiness of the 620+ borrowers since there is little soft information (income stability etc.). They even find that “loans made to borrowers with higher FICO scores perform worse around the credit threshold of 620” Another problem with securitization was that banks used it “in order to avoid certain governmental regulatory policies that tried to limit bank asset risk per unit of capital.”On the other hand Gorton (2008) argues that securitization was not the cause of the financial crisis. It was the form of design of the subprime mortgages that was the problem since it was highly sensitive to house prices, and passed on this sensitivity to other financial structures. Dell'Ariccia, Igan and Laeven (2008)
find evidence that suggests that market conditions and strategic interactions played an important role in decion making by subprime lenders which led to the deterioration of lending standards on this market, whereas in the prime lending market standards were mainly determined by underlying fundamentals. Which actually supports this idea of the design being the problem. However, we believe that securitization also is an important reason why the subprime lending crisis spread over the world, since because of securitization, a lot of risk was taken by investors in other countries.
The losses of this financial crisis are not quite clear because it was hard to estimate the losses of subprime mortgages in a declining housing market which the subprime mortgages market never experienced. What also makes it difficult is that some of these mortgages have been repackaged into complex obligations. (Calomiris, 2008). This uncertainty led to a reduced willingness of banks and borrowers to lend to each other, which resulted in an increase in quality. The reduced willingness was caused by asymmetric information about the true financial positions of the parties lending each other, causing a liquidity crisis (Calomiris, 2008). This financial crisis led to the unique event of governments having to invest billions of dollars/euro's in order to help banks to survive. To keep banks out of more trouble the TARP (Troubled asset relief program) has been introduced by the government: This program purchased for about 700 billion dollars troubled assets and equity from financial institutions. “These banks were helped to survive because of the relative favorable condition of banks balance sheets at the time of the shock and the major structural changes in the financial system. Many funds were almost unaffected by the subprime shock and had thus money to recapitalize banks. Banks were much better diversified than before.” This prevented the subprime turmoil from turning into a major recession.
If this essay isn't quite what you're looking for, why not order your own custom Economics essay, dissertation or piece of coursework that answers your exact question? There are UK writers just like me on hand, waiting to help you. Each of us is qualified to a high level in our area of expertise, and we can write you a fully researched, fully referenced complete original answer to your essay question. Just complete our simple order form and you could have your customised Economics work in your email box, in as little as 3 hours.
This Economics essay was submitted to us by a student in order to help you with your studies.
This page has approximately words.
If you use part of this page in your own work, you need to provide a citation, as follows:
Essay UK, Subprime mortgage market crisis. Available from: <http://buystrangestuff.com/free-essays/economics/subprime-mortgage-market-crisis.php> [22-03-18].
If you are the original author of this content and no longer wish to have it published on our website then please click on the link below to request removal: