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The Subprime Mortgage Crisis
 

The Subprime Mortgage Crisis

TestFunda ,  18-Nov-08

The Stakeholders: Subprime borrowers, Investment Banks, privately-owned investment funds, corporations, pension funds, mutual funds, banks and individual investors, and many others

Background:

·         The fall of housing rates in the US escalated into a major financial crisis, with borrowers choosing to default on home loans.

·         This led to the collapse of banks, financial institutions, and insurance companies.

·         Finally, the federal government had to step in with a rescue plan to save the collapsing financial institutions and bail out the economy.

·         As expected, the economic situation in the US had far reaching affects across the globe.

Key points:

·         Subprime borrowers are people who have a history of defaulting on credit, which makes lending money to them very risky.

·         To cover the risk, lenders usually charge them higher interest rates. Many borrowers are unable to pay monthly installments at these rates. So, they choose to take interest-only loans.

·         Interest-only loans are unlike conventional loans in the sense that the entire monthly payment is used to pay interest. So, the monthly payment is much lower. Another enticing feature is that the initial interest rates are low. But, they reset to very high values after a certain period.

·         However, these loans are risky to lenders because of the possibility that borrowers would default when the interest rates were reset. But, the rise of the housing market made lenders complacent. They assumed that borrowers would opt to resell houses at higher prices rather than default.

·         To finance loans, lenders packaged them into mortgage-backed securities, called Collateralized Debt Obligations (CDOs) and resold them.

·         The risk was now transferred to the buyers of CDOs. But, with a lot of money available, the housing market thrived and no one paid much attention to the risks.

·         The inevitable bust came in 2006 with a decline in housing prices. The subprime borrowers could no longer sell their houses at high rates. So, they were forced to default on the repayment of the loans.

·          Other than the lenders, privately-owned investment funds, corporations, pension funds, mutual funds, banks and individual investors had bought CDOs. People felt obliged to invest as the stock market was rising. But, as borrowers continued to default, the stock market suffered a decline.

·          Apparently all kinds of debts, such as the loans house owners took on their houses, were also bundled into CDOs. As housing prices fell, defaults crept up on all kinds of loans.

·         Banks found that the CDOs they owned had no buyers. Consequently, they had less money to lend. Banks that did have funds were reluctant to bailout banks that might default. This deepened the crisis. Banks now lent so little that the housing market continued its downward slide.

The U.S. Government’s Reaction to the Crisis

·         The U.S. government proposed the Emergency Economic Stabilization Act of 2008, which authorizes the Treasury to use $700 billion of tax money to purchase mortgage-backed securities from banks.

·         The initial bill was rejected by the House of Representatives, but the amended version was passed on October 1, 2008. President Bush signed it into a law.

Merits of the Plan

·         The bailout plan is necessary to restore confidence in the US credit system and prevent the continuing failure of financial institutions.

·         It is a necessary step to prevent an economic depression.

·         Buying troubled assets will create liquidity and reduce any speculation investors have about the soundness of financial institutions.

·         The government will actively try to resell the troubled mortgages to investors. The prompt approval of the bailout plan by the Congress could raise the prices of these mortgages.

·         As the new owner of the mortgage-backed securities, the government would be required to play an active role in preventing home foreclosures.

·         The government would have equity stakes in some companies that seek aid. If the rescue plan works and the private firms do well again, taxpayers would earn their share of the profits.

Demerits of the Plan

·         The enormous cost of the plan is a deterrent.

·         In spite of the astronomical amount asked for in the rescue plan, it still falls well short of $ 2 trillion, which is what some experts believe bad loans amount to.

·         The Treasury has the authority to buy not just worthless mortgage paper but other assets as it sees fit. There is no real accountability.

·         Tax payer’s money will be used to buy mortgage backed securities, which are ultimately backed by American homeowners.

·         The success of the plan would eventually depend on whether the government is able to sell the securities at a profit. Meanwhile, hyperinflation and a collapse of the dollar remain possibilities.

·         Tax payers are being asked to bear the brunt of the unwise decisions of investors. Investors who took risks to earn profits must also bear the losses.

·         Private capital markets have helped America make a lot of money in the past. According to some economists, the bailout plan to deal with a short-run disruption will weaken those markets and is a desperately short-sighted move.

·         How the treasury is willing to spend this enormous sum, but could not find enough money to deal with other problems like improving the nation’s health insurance or improving infrastructure is a question that will be repeatedly asked.

More Links

·         Meltdown in the US: Emerging Lessons from the Crisis

·         The US Financial Situation: Anatomy of a Crisis

Group Discussion Topics

1.       Was it right to let Lehman Brothers go bankrupt?

For

·         Lehman brothers paid for the risky decisions it took. In the past, it had registered heavy profits because of the same decisions.

·          Bailing out one firm would have started a bailout trend. It would involve using taxpayer’s money to rescue firms that had taken risky decisions to earn profits.

·         Assured of government support, other banks would be encouraged to continue taking risks.

·         Financial institutions do fail from time to time. The assets of the institution are sold to new owners, who bring in new capital and business goes on as usual. The failure does not impair a financial system severely.

·         The Federal Reserve removed a lot of restrictions on the collateral that investment banks could pledge to borrow from the Fed, but excluded Lehman Brothers from the program because it was deemed too troubled to be rescued by the government.

Against

·         If the government had expressed interest in helping Lehman overcome it losses on mortgage holdings, other financial firms would not have shied away from acquiring the old firm.

·         Lehman’s proposal to convert itself into a commercial bank was rejected by the government. But just a week after the bank collapsed, Goldman Sachs and Morgan Stanley were allowed to make this transition.

·         Treasury Secretary Henry Paulson has gone on record saying that he never considered using taxpayer’s money to bailout Lehman. But his rescue plan to tide over the subprime mortgage crisis proposes using $700 billion of taxpayer’s money to bailout other banks and financial institutions.

·         Nearly 1,000 workers were laid off in the days leading to the bank filing for bankruptcy. Later, they were also intimated that their promised severance payments and health benefits would cease with immediate effect.


2.       Will the crisis in the US have a negative impact on India?

For

·         A decline in the inflow of capital and reduced access to credit in international markets is likely.

·         Exports of goods and services from India to the US could slow down.

·         The crisis will depress Indian stock markets.

Against

·         Indian banks had very limited exposure to instruments like CDOs.

·         As a matter of policy, India has exercised caution in dealing with complex derivative products.

·         Trade is unlikely to be affected too much because of the declining importance of the US as a trading partner.

·         New lending laws being worked out in the US will stress on cost reduction by banks. This would mean that more work would be outsourced to India. This would work to the advantage of BPOs. In this case, the impact would be positive.

·         The Indian economy is based on the domestic market unlike the Chinese economy, which is export oriented.

·         NRI investments are unlikely to dry up because of the emotional attachment they have with their country of origin and because the interest rates here are very high.

3.       Is such a crisis likely in India?

For

·         House prices in Indian cities compare favorably with that in Europe and the US. But the per capita income does not. This indicates the presence of a bubble.

·         Starting in May this year, house prices have started declining in some major Indian cities.

·         Interest rates are shooting up phenomenally. This could lead to instances of default.

Against

·         In India, the economically weaker sections of the society take loans from local lenders with whom they have long standing relations. These lenders charge exorbitant interests, but the arrangement seems to work better for the borrowers since the loans are very short term. It makes better sense than to take long term loans from banks at lower interest rates.

·         The high incidents of default on loans have ensured that most banks no longer lend money to this economic section. So, the chances of indiscriminate lending and high rate of default, the main cause of a subprime mortgage crisis, are remote.

·         The RBI has advised lenders to set up counseling centers to advice borrowers if they are taking on loans beyond their means.

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