The mortgage crisis, popularly known as the mortgage mess or mortgage meltdown, came to the publics attention when

a steep rise in home foreclosures in 2006 spiraled seemingly out of control in 2007, triggering a national financial crisis that went global within the year. Consumer spending is down, the housing market has plummeted, foreclosure numbers continue to rise and the stock market has been shaken. The subprime crisis and resulting foreclosure fallout has caused dissension among consumers, lenders and legislators and spawned furious debate over the causes and possible fixes of the mess.

Root Causes of the Mortgage Market Collapse There are a number of theories as to what led to the mortgage crisis. Many experts and economists believe it came about though the combination of a number of factors in which subprime lending played a major part.

Housing Bubble The current mortgage meltdown actually began with the bursting of the U.S. housing bubble that began in 2001 and reached its peak in 2005. A housing bubble is an economic bubble that occurs in local or global real estate markets. It is defined by rapid increases in the valuations of real property until unsustainable levels are reached in relation to incomes and other indicators of affordability. Following the rapid increases are decreases in home prices and mortgage debt that is higher than the value of the property.

Low mortgage interest rates Even though the U.S. savings rate was low during the housing bubble, an influx of saving entering the U.S. economy from countries such as Japan and China helped to keep mortgage interest rates low. Investors in these countries sought investments providing relatively low risk

and good returns. As Wall Street developed new ways to funnel savings from worldwide sources to the U.S. mortgage market (e.g., mortgage backed securities), U.S. mortgage interest rates were kept low. Mortgage interest rates in the U.S. peaked at 18 percent in 1982, as the Federal Reserve drove interest rates skyward in a successful attempt to squeeze inflation out of the economy. Mortgage interest rates generally fell over the next twenty years, with the rate on a 30-year fixed mortgage falling below 6 percent late in 2002. The rate stayed below 6 percent most of the time through 2005. Mortgage interest rates were falling despite the low savings rate in the U.S. because of an influx of saving entering the U.S. from other countries. Most of this saving came from countries with high savings rates such as Japan and the United Kingdom and from countries with rapidly growing economies such as China, Brazil, and the major oil exporting countries. The foreign investors grew bolder, investing in mortgage-backed securities issued by Wall Street firms. These mortgage-backed securities appeared to be low-risk because they had received favorable ratings issued by highly respected credit rating agencies such as Moodys and Standard & Poors. The low mortgage interest rates contributed to the housing bubble by keeping monthly mortgage payments affordable for more buyers even as home prices rose.

Subprime Lending Subprime borrowing was a major factor in the increase in home ownership rates and the demand for housing during the bubble years. The U.S. ownership rate increased from 64 percent in 1994 to an all-time high peak of 69.2 percent in 2004. The demand helped fuel the rise of housing prices and consumer spending, creating an unheard of increase in home values of 124 percent between 1997 and 2006. Some homeowners took advantage of the increased property values of their home to refinance their homes with lower interest rates and take out second mortgages against the added value to use for consumer spending. In turn, U.S. household debt as a percentage of income rose to 130 percent in 2007, 30 percent higher than the average amount earlier in the decade.

With the collapse of the housing bubble came high default rates on subprime, adjustable rate, Alt-A and other mortgage loans made to higher-risk borrowers with lower income or lesser credit history than prime borrowers. Alt-A is a classification of mortgages in which the risk profile falls between prime and subprime. The borrowers behind these mortgages typically will have clean credit histories, but the mortgage itself generally will have some issues that increase its risk profile. These issues include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower's income. The share of subprime mortgages to total originations increased from 9 percent in 1996 to 20 percent in 2006 according to Forbes. Subprime mortgages totaled $600 billion in 2006, accounting for approximately one-fifth of the U.S. home loan market. An estimated $1.3 trillion in subprime loans are outstanding. The number of subprime loans rose as rising real estate values led to lenders taking more risks. Some experts believe that Wall Street encouraged this type of behavior by bundling the loans into securities that were sold to pension funds and other institutional investors seeking higher returns.

Declining Risk Premiums A Federal Reserve study in 2007 reported that the average difference in mortgage interest rates between subprime and prime mortgages declined from 2.8 percentage points in 2001 to 1.3 percentage points in 2007. This means that the risk premium required by lenders to offer a subprime loan declined. This decline occurred even though subprime borrower and loan characteristics declined overall during the 2001-2006 period, which should have had the opposite effect. Instead, the decline of the risk premium led to lenders considering higher-risk borrowers for loans. New Kind of Lender Emerges Mortgage lender for fueling the mortgage crisis. These lenders were not regulated as are traditional banks. In the mid-1970s, traditional lenders carried approximately 60 percent of the mortgage market. Today, such lenders hold about 10 percent. During this time period, the

share held by commercial banks had grown from virtually zero to approximately 40 percent of the market.

Risky Mortgage Products and Lax Lending Standards Economists say have sounded an alarm. The large number of adjustable rate mortgages, interest-only mortgages and stated income loans are an example of this thinking. Stated income loans, also called no doc loans and, sarcastically, liar loans, are a subset of Alt-A loans. The borrower does not have to provide documentation to substantiate the income stated on the application to finance home purchases. Such loans should have raised concerns about the quality of the loans if interest rates increased or the borrower became unable to pay the mortgage. In many areas of the country, especially those areas with the highest appreciation during the bubble days, such non-standard loans went from being almost unheard of to prevalent. Eighty percent of all mortgages initiated in San Diego County in 2004 were adjustable-rate, and 47 percent were interest-only loans. In addition to increasingly higher-risk loan options like ARMs and interest-only loans, lenders increasingly offered incentives for buyers. An estimated one-third of ARMs originated between 2004 and 2006 had teaser rates below 4 percent. A teaser rate, which is a very low but temporary introductory rate, would increase significantly after the initial period, sometimes doubling the monthly payment. Programs such as seller-funded down payment assistance programs (DPA) also came into being during the boom years. DPAs are programs in which a seller gives money to a charitable organization that then gives the money to buyers. From 2000 to 2006, more than 650,000 buyers got their down payments via nonprofits. According to the Government Accountability Office (GAO), there are much higher default and foreclosure rates for these types of mortgages. A GAO study also determined that the sellers in DPA programs inflated home prices to recoup their contributions to the nonprofits.

Securitization Securitization is a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools and offered as collateral for third-party investment. Due to securitization, investor appetite for mortgage-backed securities (MBS) and the tendency of rating agencies to assign investment-grade ratings to MBS, loans with a high risk of default could be originated, packaged and the risk readily transferred to others. Asset securitization began with the structured financing of mortgage pools in the 1970s, according to the Office of the Comptroller of the Currencys Asset Securitization Comptrollers Handbook. The securitized share of subprime mortgages, those passed to third-party investors, increased from 54 percent in 2001, to 75 percent in 2006. In a speech given in London in October 2007, Alan Greenspan, while defending the U.S. subprime mortgage market, said that the securitization of home loans for people with poor creditnot the loans themselveswere to blame for the mortgage meltdown.

Credit Rating Agencies Credit rating agencies are now under scrutiny for giving investment-grade ratings to securitization transactions holding subprime mortgages. Higher ratings theoretically were due to the multiple, independent mortgages held in the mortgage-backed securities, according to the agencies. Critics claim that conflicts of interest were involved, as rating agencies are paid by those companies selling the MBS to investors, such as investment banks. As of November 2007, credit rating agencies had downgraded over $50 billion in highly rated collateralized debt obligations and more such downgrades are possible. Since certain types of institutional investors are allowed to only carry higher-quality assets, there is an increased risk of forced asset sales, which could cause further devaluation. Ratings agencies such as Standard & Poors Corp., Moodys Investors Service Inc. and Fitch Ratings have come under fire for being slow to lower their ratings on securities based on mortgage loans to U.S. borrowers with poor credit records.

Irrational Exuberance. Irrational exuberance played a key role in the housing bubble, as with all bubbles, when all parties involved in creating the housing bubble became convinced that home prices would continue to rise. What does irrational exuberance mean? Robert Shiller (2005), who wrote a book titled Irrational Exuberance, defines the term as a heightened state of speculative fervor. The term became famous when, in a speech given on December 5, 1996, Alan Greenspan hinted that stock prices might be unduly escalated due to irrational exuberance. The Dow Jones Industrial Average fell 2 percent at the opening of trading the next day. All the participants. All the participants who contributed to the housing bubble (government

regulators, mortgage lenders, investment bankers, credit rating agencies, foreign investors, insurance companies, and home buyers) acted on the assumption that home prices would continue to rise. For example, BusinessWeek (2005) quoted Frank Nothaft, chief economist of Freddie Mac, as saying, I dont foresee any national decline in home price values. Freddie Macs analysis of single family houses over the last half century hasnt shown a single year when the national average housing price has gone down. Since home prices had not fallen nationwide in any single year since the Great Depression, most people assumed that they would not fall. This almost universal assumption of rising home prices led the participants who contributed to the housing bubble to make the decisions that created the bubble. Government regulators felt no need to try to control rising home prices, which they did not recognize as a bubble. Mortgage lenders continued to make increasing numbers of subprime mortgages and adjustable rate mortgages. These mortgages would continue to have low default rates if home prices kept rising. Investment bankers continued to issue highly leveraged mortgage backed securities. These securities would continue to perform well if home prices kept rising. Credit rating agencies continued to give AAA ratings to securities backed by subprime, adjustable rate mortgages. These ratings, again, would prove to be accurate if home prices kept rising. Foreign investors continued to pour billions of dollars into highly rated mortgage-backed securities. These securities also would prove to be deserving of their high ratings if home prices kept rising. Insurance companies continued to sell credit

default swaps (a type of Insurance contract) to investors in mortgagebacked securities. The insurance companies would face little liability on these contracts if home prices kept rising. Home buyers continued to purchase homes (often for speculative purposes) even though the monthly payments would eventually prove unmanageable. They assumed that they would be able to flip the home for a profit or refinance the loan when the adjustable rate increased. This too would work if home prices kept rising.

US Mortgage Insurance Companies Looking at the problems at the epicentre of the crisis, the mortgage sector, one finds mortgage insurance companies in the United States having the most direct exposure of any insurance sector to mortgage credit risk and consequently being the institutions most rapidly hit in a significant manner. This outcome is not so surprising given that the crisis started in the United States residential mortgage market and that these entities core business consists of guaranteeing to other financial service companies that either individual loans or a portfolio of mortgages will retain their value. Moreover, they insure relatively highrisk (e.g. where the loan to-value ratios exceed a specific percentage, such as 80 per cent) or otherwise non-standard loans (e.g. the absolute amount of the loan exceeds specific limits). 2006, there have been sizable losses on the part of several of these entities, which have depleted substantial amounts of the capital buffers that many of them had been able to build up beforehand. Already inApril 2007, New Century Financial Corporation, a leading US subprime mortgage lender, filed for Chapter 11 bankruptcy protection. The largest independent US mortgage insurers (MGIC Investment, PMI Group, and Radian) have posted significant quarterly as well as full-year losses. Rating agencies predict a return to profitability to be an unlikely event before 2010. At least one of the ten largest US mortgage insurers by 2008 sales has entered run-off, continuing to pay claims and book profits or losses from previously sold policies, but not writing new policies. Reflecting these developments, share prices fell significantly both for independent mortgage insurance companies and for those insurance companies that have significant mortgage insurance subsidiaries. At the same time, prices for protection against default of these

companies rose significantly. In reaction, mortgage insurance companies implemented several rounds of underwriting changes that should result in more conservative credit portfolios going forward. But the legacy portfolios remain large and their performance will only stabilise, as US housing markets stabilise and foreclosure rates fall, which is unlikely as long as real activity growth is weak and unemployment rising. That said, home prices in the United States have shown signs of stabilising as judged by developments in the Federal Housing Finance Agency's seasonally adjusted purchase-only house price index and the Shiller-Case composite index of the top 20 metropolitan statistical areas in the country.

References JEFF HOLTA, Summary of the Primary Causes of the Housing Bubble and the Resulting Credit Crisis (2009), The Journal of Business Inquiry. Sebastian Schich , Insurance Companies and the Financial Crisis(2009), Financial Market Trends. Katalina M. Bianco, The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown (2008). William W. Lang, Federal Reserve Bank of PhiladelphiaThe Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance (2010), Atlantic Economic Journal.