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The Subprime mortgage crisis was a sharp rise in home foreclosures which started in the United States during the fall of 2006 and became a global financial crisis during 2007 and 2008. The crisis began with the bursting of the housing bubble in the U.S. and high default rates on "subprime", adjustable rate, " and other mortgage loans made to higher-risk borrowers with lower income or lesser credit history than "prime" borrowers. Many banks, mortgage lenders, real estate investment trusts (REIT), and hedge funds suffered significant losses as a result of mortgage payment defaults or mortgage asset devaluation. As of January 30, 2008 financial institutions worldwide had recognized subprime-related losses or write-downs exceeding U.S. $135 billion.[1] Meanwhile scores of mortgage lenders also filed for bankruptcy. All this has been accompanied by a credit crunch.The subprime crisis was caused by unbridled expansion of subprime mortgages between 1996 and 2006. The magazine ‘Inside B&C lending’, reported that total subprime loans had grown from $65 billion in 1995 to $332 billion in 2003.[2] This increased even more rapidly during 2005-2006.

By March 2007 the value of U.S. subprime mortgages was estimated at $1.3 trillion.[3]

Subprime lending (also known as B-paper, near-prime, or second chance lending) is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history or low income. Subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and adverse financial situations usually associated with subprime applicants. A subprime loan is offered at a rate higher than A-paper loans due to the increased risk. Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the credit status of the borrower (being less than ideal). Subprime mortgage lending is surrounded by controversy. Opponents have alleged that subprime lenders have engaged in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. [4] To reduce their risks, the originators of subprime loans often resort to large downpayments and pre-payment penalties to increase loan tenures. Another lesser used term predatory borrowing has also come into use. It refers to the large number of fraudulent misrepresentations in their loan applications by subprime borrowers who often hid information about their current liabilities and/or lied about their income levels.

Fannie Mae (Federal National Mortgage Association) has lending guidelines for what it considers to be "prime" borrowers on conforming loans. Their standard provides a good comparison between those who are "prime borrowers" and those who are "subprime borrowers." Prime borrowers have a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723), a debt-to-income ratio (DTI) no greater than 75% (meaning that no more than 75% of net income pays for housing and other debt), and a combined loan to value ratio of 90%, meaning that the borrower is paying a 10% downpayment. Any borrower seeking a loan with less than those criteria is a subprime borrower by Fannie Mae standards.

According to the U.S. Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment deliquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories."

1 interest-only mortgages, which allow borrowers to pay only interest for a period of time (typically 5–10 years);

2 "pick a payment" loans, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);

This last class of mortgages (which set teaser rates)has grown particularly popular among subprime lenders since the 1990s. Common lending vehicles within this group include the "2-28 loan", which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. Variations on the "2-28" include the "3-27" and the "5-25".

The share of subprime mortgages to total originations was 5% ($35 billion) in 1994 , 9% in 1996, 13% ($160 billion) in 1999[5]. In 2006 this share grew to 20%. Many factors have contributed to the growth of subprime lending. Most fundamentally, it became legal. The ability to charge high rates and fees to borrowers was not possible until the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was adopted in 1980. It preempted state interest rate caps. The Alternative Mortgage Transaction Parity Act (AMTPA) in 1982 permitted the use of variable interest rates and balloon payments. These laws opened the door for the development of a subprime market, but subprime lending would not become a viable large-scale lending alternative until the Tax Reform Act of 1986 (TRA). The TRA increased the demand for mortgage debt because it prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home. This made even high-cost mortgage debt cheaper than consumer debt for many homeowners.[6] To avoid damage to the economy following the collapse of the Internet bubble in 1999, the U.S. Federal Reserve lowered interest rates which, in turn, lowered mortgage rates. The rate for 30-year, fixed-rate mortgages in the U.S. declined from 8.25% in January, 2000, to a low of 5.25% in January, 2003. A resulting surge in investment in housing, , helped drive median housing prices in the U.S. from $170,000 in 2000 to $240,000 in 2005. The resulting "equity cushion" permitted homeowners to increase their borrowing and encouraged still more speculation.[7] Changes in and finally the repeal of the Glass Steagall act led to rapid development of securitization. Securitization of mortgages into collateralized debt obligations (CDOs) decoupled mortgage originators from the credit risks of the loans they were writing. This made the originators more aggressive and less circumspect while granting loans. Apart from financial institutions, builders like Beazer and KB homes themselves started mortgage lending businesses or aggressively arranged loans for prospective buyers.

A number of interlinked causes led to the present crisis in the subprime mortgage business.

1) Softening of the housing prices: The easy availability of cheap credit and increasing real estate prices had led to a housing boom. The assumption was that housing prices would keep on rising and homeowners would be able to pay of their debts by refinancing or selling their houses at higher prices. However, once there was an over supply of new houses, the prices started softening. According to the S&P/Case-Shiller housing price index, by November 2007, average U.S. housing prices had fallen approximately 8% from their 2006 peak. A decrease in prices meant that many of the borrowers could not refinance. This meant more people were unable or unwilling to pay their debts. This led to more foreclosures. [8]

Source: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_csmahp/0,0,

* The housing prices fell 13.88 percent from 1/1/2007 to 29/2/2008 (according to S&P Case Shiller Index). The prices have been decreasing consecutively since January 2007.

(source: http://www.realtytrac.com/ContentManagement/PressRelease.aspx?template=nonmemb_cm)

* The Month on Month foreclosure percentage has been positive except for four months (April, June, September 2007 and February 2008) during January 2007 to March 2008. The trend line seems to show volatility with a positive bias.

(source: http://www.realtytrac.com/ContentManagement/PressRelease.aspx?template=nonmemb_cm)

* Apart from April, June, September 2007 and February 2008, housing foreclosures have been increasing on a month on month basis since January 2007. In absolute number the foreclosures increased from 148425 in January 2007 to 234685 in March 2008, an increase of 58 percent. The trend line points towards a likely increase in the number of foreclosures in the future

2) Role of financial institutions: To increase their volumes and profits, originators pushed for subprime lending. They brought out a number of innovative schemes like interest only, teaser rates and adjustable rate mortgage schemes to lure customers with weak credit scores. This led to borrowing by financially weaker customers and speculators who hoped to gain from rapidly increasing house prices. However once the prices softened and adjustable interest rates increased, many of the low income borrowers and speculators defaulted.[9] Critics point out that banks deliberately gave loans they knew would not be paid back in the with a view to take possession of the borrowers property.

3) Role of securitization: The growth of securitization made banks more aggressive in their lending activities. Securitization helped banks to raise resources by selling their financial instuments to third party investors in form of MBS (Mortgage Backed Securities) or collateralized debt obligations (CDO). It also helped banks in reducing and dispersing the risks involved. As a result of the reduced risks, the banks became more lax in giving advances. On the other hand, people who bought MBS had no direct means to ascertain the risks involved. Most of the times they relied on ratings assigned by reputed rating agencies to various asset backed securities. In the simplest terms, what went wrong in the sub prime mortgage market is that the people responsible for making loans had too little financial interest in the performance of those loans

and the people with financial interest in the loans had too little involvement in the how the loans were made.[10]

4) Responsibility of mortgage brokers and mortgage underwriters: The mortgage brokers who sell the loans to people have also been criticised. Mortgage brokers earn commissions on selling loans and usually their appraisal is not linked to the performance of the loans they sell. It is alleged that mortgage brokers misguided people and in many cases did not explain the full terms and conditions of the loan.

Mortgage underwriters determine if a potential borrower has the capacity to pay back and also assess the value of the borrowers properties. While many mortgage underwriters were lenient in their assessments, some banks did away with manual underwriting altogether. A number of subprime loans were generated by automated underwritng that took a few minutes only thus considerably shortening the time for underwriting.

5) Role of credit rating agencies: Rating agencies rated the mortgage backed assets being sold by the financial institutions. It is being alleged that the methodology of rating agencies like Moody’s or Standard & Poors or Fitch allowed for the inclusion of loans of dubious quality into sub prime mortgage pools. This led gullible third party investors to invest in CDOs and MBS without realizing the risks involved. When the defaults increased and the crisis began these investors found out that the value of the financial assets held by them had considerably eroded.

6) Role of Federal Reserve Bank : To tide over the economic crisis caused by the bursting of the dotcom bubble, the Federal Reserve announced a series of rate cuts. It is alleged that these rate cuts replaced the dotcom bubble with the housing bubble.[11]

7) Role of the borrowers: Borrowers must also take a part of the blame for the current crisis. Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain ARMs (adjustable rate mortgages) they could not afford after the initial incentive period Misrepresentation of loan application data was another contributing factor. In a January 13, 2008 column in the New York Times, Tyler Cowen, economics professor at George Mason University wrote, "There has been plenty of talk about 'predatory lending,' but 'predatory borrowing' may have been the bigger problem. As much as 70 percent of recent early payment defaults had fraudulent misrepresentations on their original loan applications, according to one recent study done by BasePoint Analytics.

1) Impact on Banks: As borrowers started to default, the mortgage lenders were the first to be affected. Major banks and other financial institutions around the world have reported losses of approximately U.S. $170 billion as of February 2008. Profits of the 8,533 U.S. banks insured by the Federal Deposit Insurance Corporation (FDIC) declined from $35.2 billion to $5.8 billion (83.5 percent) during the fourth quarter of 2007 versus the prior year, due to soaring loan defaults and provisions for loan losses. It was the worst bank and thrift performance since the fourth quarter of 1991. For all of 2007, these banks earned $105.5 billion, down 27.4 percent from a record profit of $145.2 billion in 2006.[12] A number of mortgage lenders like New Century Financial Corporation, American Home Mortgage Investment Corporation and Ameriquest have filed for bankruptcy.

By February 7, 2008 Merril Lynch was leading the list of US banks suffering due to the subprime crisis. Its losses stood at $24.5 billion. Citigroup followed closely losing $19.6 billion on account of write downs and credit losses. Morgan Stanley had lost $9.4 billion and Bank of America $7.9 billion. They were followed by Wachovia ($4.7 billion), JPMorgan Chase($3.2billion) and Bear Stearns ($2.6billion).[13] In March 2008, Bear Sterns faced further difficulties and was on the verge of a dramatic collapse before it was finally bailed out by some extraordinary financial help by JPMorgan Chase and the Federal Reserve.

On April 21, 2008, Bank of America Corp., the second- largest U.S. bank, declared that its profit dropped for a third straight quarter as the company set aside $6.01 billion for bad loans. First-quarter net income declined 77 percent to $1.21 billion from $5.26 billion a year earlier. Results included $1.31 billion in trading losses and $2.72 billion in costs for uncollectible loans. Earnings per share shrank to 23 cents from $1.16, falling short of analysts' estimates and sending the bank's stock down as much as 2.6 percent in New York trading. The result rekindled fears that earnings of financial companies would be hit badly thus ending the short term relief that had been infused following Citibank’s results a week earlier.

Even government backed originators like Freddie Mac(FRE) and Fannie Mae(FNM),who gave only prime loans, were hurt by rising defaults. Top management has not escaped unscathed, as the CEO of Merrill Lynch Stanley O Neal and of Citigroup Charles Prince were forced to resign within a week of each other.

Apart from US banks, European and Asian banks also suffered huge losses. These included Swiss bank UBS ($18.4 billion), England’s HSBC ($10.7 billion), French Credit Agricole ($5 billion) and another French bank Societe General ($3.6 billion). Mizuho Financial of Japan sufferd a loss of $2.6 billion and Nomura of $1 billion.[14] Northern Rock a British mortgage lender experienced a bank run after its financial difficulties become public. ICICI, India’s largest private sector bank reported a loss of $264 Million from US linked Mortgage Backed Securities it held.[15] Earlier, speaking after the meeting of Group of Seven finance leaders held on Feb 11, 2008, Peer Steinbrück, German finance minister, had said that the G7 feared that write-offs of losses on securities linked to US sub-prime mortgages could reach $400 billion. This is significantly higher than the US Federal Reserves’ estimates of $150 billion for last year.

The following table shows a tentative list of banks losses till April 21, 2008 : MAIN SUB-PRIME LOSSES SO FAR

2) Impact on Stock Markets: Though the Subprime Mortgage Crisis started in the fall of 2006 and financial institutions like New Century Financial started suffering serious difficulties in early 2007, it took some time before casting its shadow on the stock markets in US and around the world. Infact on July, 2007 the Dow closed above 14,000 for the first time ever. However this milestone was soon followed by news of subprime losses and the Dow lost close to 1000 points in less than a week. By August 15, the Dow had dropped below 13,000 and the S&P 500 had crossed into negative territory year-to-date.The crash in US stocks led to a major correction in most markets worldwide. The stock markets made a smart recovery in October after the Fed cut the interest rates from 5.25 to 4.75 on 18^th September. On 9^th October the Dow made a new closing high at 14,164 points. However the markets tumbled once again on new disclosures of losses by banks and have not recovered yet. On 10^th March, 2008 the Dow closed at 11,740 its lowest closing in 18 months.

[1] http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

[2] The Evolution of the Subprime Mortgage Market Souphala Chomsisengphet and Anthony Pennington-Cross (FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JANUARY/FEBRUARY 2006)

[3] http://www.msnbc.msn com/id/17584725

[4] http://en.wikipedia.org/wiki/Subprime_mortgage_crisis

[5] http://www.bankrate.com/brm/news/mortgages/20040615a2.asp

[6] The Evolution of the Subprime Mortgage Market Souphala Chomsisengphet and Anthony Pennington-Cross (FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JANUARY/FEBRUARY 2006)

[7] http://www.businessweek.com/managing/content/dec2007/ca20071213_764745.htm?chan=search

[8] For all of 2007, nearly 1.3 million properties were subject to 2.2 million foreclosure filings, up 79% and 75% respectively versus 2006. Source : “U.S. FORECLOSURE ACTIVITY INCREASES 75 PERCENT IN 2007”, RealtyTrac, Jan. 29, 2008.

[9] According to a Mortgage Bankers Association report titled “AN EXAMINATION OF MORTGAGE FORECLOSURES,MODIFICATIONS, REPAYMENT PLANSAND OTHER LOSS MITIGATION ACTIVITIES IN THE THIRD QUARTER OF 2007” 18 percent of foreclosures in the 3^rd quarter of 2007 were of speculators who did not occupy the houses they had bought.

[10] Andrew Davidson in The Pipeline - Special Edition, August 2007

[11] F. William Engdahl in, “The Financial Tsunami: Sub-Prime Mortgage Debt is but the Tip of the Iceberg.” Source : Global Research, November 23, 2007

[12] http://biz.yahoo.com/ap/080226/banks_and_thrifts_profits_plunge.html?.v=3

[13] The Financial Times dated 7 Feb, 2008

[14] Ibid

[15] The India Express dated March5, 2008