Usually, those qualify for the most ideal mortgages who have good credit scores and minimal

debt. A subprime mortgage is a type of loan granted to individuals with poor credit histories (typically below 600), who would not be able to qualify for conventional mortgages. Subprime mortgages charge interest rates that are above the typical interest rate because of the risk that is involved on the part of the lender.

 ARMs can be misleading to subprime borrowers because they initially pay a lower interest rate. After the given period of time, their mortgages are set to a much higher rate. Therefore, their mortgage payments increase dramatically.

 The following exhibit depicts that in 2002, subprime loans had a delinquency rate of 5.62 times higher (14.28 versus 2.54) than that of the prime rates. Therefore, the inclination of subprime borrowers to repay is much lower than that of the borrowers of prime loans.

 The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an all-time high of 69.2% in 2004. Between 1997 and 2006, the price of the typical American house increased by 124%

 The percentage of new lower-quality subprime mortgages rose from the historical 8% or lower range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S. As part of the housing and credit booms, the amount of financial agreements called mortgage-backed securities (MBS), which derive their value from mortgage payments and housing prices, greatly increased. Such financial innovation enabled institutions and investors around the world to invest in the U.S. housing market. As housing prices declined, major global financial institutions that had borrowed and invested heavily in MBS reported significant losses.

 Policymakers did not recognize the increasingly important role played by financial institutions such as investment banks and hedge funds, also known as the shadow banking system. Shadow banks were able to mask their leverage levels from investors and regulators through the use of complex, off-balance sheet derivatives and securitizations.

 Subprime loans were once predominantly guaranteed by the Federal Housing Association (FHA) but because of lack in flexibility with changing market conditions and high processing costs, FHA was made to reduce the limits in the guaranteed portion of subprime loans.

Effects on global stock markets due to the crisis have been dramatic. Between 1 January and 11 October 2008, owners of stocks in U.S. corporations had suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. Losses in other countries have averaged about 40%

Family wants to buy a house

Asks for money from comme rcial banks

T Bills AAA Ratin g

Investor Federal Reserve Interest Rate lowered to 1% !

Alan Greenspan, The Then Chairperson of Federal Reserve

 Since, investors were getting a return of only 1 %, they lost interest. But, the U.S Banks were able to borrow money at 1% . There was abundance of credit. Banks sought to leverage.

 Subprime borrowers typically have weakened credit histories and reduced repayment capacity. Subprime loans have a higher risk of default than loans to prime borrowers If a borrower is delinquent in making timely mortgage payments to the loan servicer (a bank or other financial firm), the lender may take possession of the property, in a process called foreclosure.

 Between 1997 and 2006, the price of the typical American house increased. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages had a lower than then prevailing market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.

 Housing prices were relatively stable during the 1990s, but they began to rise toward the end of the decade. Between January 2002 and mid-year 2006, housing prices increased The boom had turned to a bust, and the housing price declines continued throughout 2007 and 2008.

 Subprime mortgages were low until 2004, when they spiked and remained there through the 2005-2006 peak of the United States housing bubble. A proximate event to this increase was the April 2004 decision by the U.S. Securities and Exchange Commission (SEC) to relax the net capital rule, which encouraged the largest five investment banks to dramatically increase their financial leverage and aggressively expand their issuance of mortgage-backed securities. Subprime mortgage payment delinquency rates remained in the 1015% range from 1998 to 2006,then began to increase rapidly, rising to 25% by early 2008.

subprime lending volume was relatively modest in 1995 and 2000, but surged in 2005 and 2006, before easing in 2007 and completely dropping off in 2008.

 The 2004 rule change is seen as an important cause of the crisis since it permitted certain large investment banks i.e., Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley to increase dramatically their leverage(i.e., the ratio of their debt or assets to their equity )

 The leverage ratios of loans and other investments to capital assets for various financial institutions are shown here. When Bear Stearns was acquired by JP Morgan Chase its leverage ratio was 33 to Ratios (June 2008) was not particularly Leverage 1. Note, this unusual for the GSEs and large investment67.9 banks. Freddie Mac
Fannie Mae Brokers/hedge Funds Savings institutions Commercial banks Credit unions 0 9.4 9.8 9.1 20 40 60 80 21.5 31.6

 A credit rating generates demand for securities. The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of Moody's total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices.

 Rating agencies lowered the credit ratings in mortgage backed securities from 2007 to 2008, another indicator that their initial ratings were not accurate. During the month of July in 2008, Standard & Poor's had downgraded 902 tranches of U.S. residential mortgage backed securities and CDOs of asset-backed securities (ABS) that had been originally rated "triple-A" out of a total of 4,083 tranches originally rated "triple-A"

 Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with nontraditional mortgages that offered low introductory rates and minimal initial costs such as "no down payment". Contrary to appreciation of properties, when the housing bubble burst, prices dropped drastically. Many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.

 During the investment banking crisis in 2008, critics were quick to blame the Securities and Exchange Commission (SEC) for its 2004 decision that, they claimed, allowed greater leverage. This leverage enabled investment banks to substantially increase the level of debt they were taking on, fuelling the growth in mortgage-backed securities supporting subprime mortgages. The GlassSteagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. In 1999, President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which effectively repealed the Glass-Steagall Act.

Beginning in the mid-1990s, government regulations began to erode the conventional lending standards. Fannie Mae and Freddie Mac hold a huge share of American mortgages. Beginning in 1995, HUD regulations required Fannie Mae and Freddie Mac to increase their holdings of loans to low and moderate income borrowers. HUD regulations imposed in 1999 required Fannie and Freddie to accept more loans with little or no down payment. 1995 regulations stemming from an extension of the Community Reinvestment Act required banks to extend loans in proportion to the share of minority population in their market area. Conventional lending standards were reduced to meet these goals.

The Feds manipulation of interest rates during 20022006 Fed's prolonged Low-Interest Rate Policy of 20022004 increased demand for, and price of, housing. The low short-term interest rates made adjustable rate loans with low down payments highly attractive. As the Fed pushed short-term interest rates upward in 2005-2006, adjustable rates were soon reset, monthly payment on these loans increased, housing prices began to fall, and defaults soared.

 The Fed kept short-term interest rates at 2% or less throughout 2002-2004. Due to rising inflation in 2005, the Fed pushed interest rates upward. Interest rates on adjustable rate mortgages rose and the default rate began to Federal Funds Rate and 1-Year T-Bill Rate increase rapidly.
8% 7% 6% 5% 4% 3% 2% 1% 0%

19 95 19 95 19 96 19 96 19 97 19 97 19 98 19 99 19 99 20 00 20 00 20 01 20 02 20 02 20 03 20 03 20 04 20 04 20 05 20 06 20 06 20 07 20 07 20 08
Federal Funds
Source: www.federalreserve.gov and www.economagic.com

1 year T-bill

 In the years leading up to the crisis, significant amounts of foreign money flowed into the U.S. from fast-growing economies in Asia and oil-producing countries. This inflow of funds combined with low U.S. interest rates from 20022004 contributed to easy credit conditions, which fuelled both housing and credit bubbles. Loans of various types (e.g., mortgage, credit card, and auto) were easy to obtain and consumers assumed an unprecedented debt load.

 Borrowers Mortgage brokers Lender/originators Servicers SPEs Underwriters Rating agencies Credit enhancement provider Investors

Transfer for assets from the originators to the issuing vehicles.

SPV issues debt securities(asset backed)to investors

ASSET ORIGINATOR

ISSUING AGENT(SPV)

CAPITAL MARKET INVESTORS

UNDERLYING ASSETS

Assets immune from bankruptcy Originator retains no legal interest in assets

Typically structured into various classes/tranches, rated by one or more rating agencies

ISSUE ASSETBACKED SECURITIES

MORTGAGE BROKER
CASH

LENDER
TRANSFE R ASSETS

BORROWER
TRANSFER ASSETS

CASH

SERVICER
MONTHLY PAYMENT

MONTHLY PAYMENT

SPVs
SECURITI ES
MONTHLY PAYMENT

UNDERWRITER RATING AGENCY

CREDIT ENHANCEMENT PROVIDER

INVESTORS

CASH

FIXED MORTGAGE SECURITIES

ADJUSTABLE MORTGAGE SECURITIES

ALTERNATE MORTGAGE SECURITIES

HYBRID

PIGGYBACK

ALT-A

ASSET BACKED SECURITIES

SECURITIZATION

MORTGAGE BACKED SECURITIES

COLLATERALIZED DEBT OBLIGATION

1970
THRIFTS

2008

THRIFTS

COMMERCI AL BANKS COMMERCIA L BANKS

5% 14% 10% 57% 14% INSURANCE COMPANIES &PENSIONS OTHERS 17% 6% 20% 9% GSEs INSURANCE COMPANIE S& PENSIONS OTHERS

44%

4% AGENCY AND MBS

GSEs

ABS ISSUES

MBS
MBS ISSUANCE( $ MILLIONS) 1400000 1200000 1000000 800000 600000 400000 200000 0

1999 2000 2001 2002 2003 2004 2005 2006 2007 YEAR

GOVERNMENT SPONSORED ENTERPRISES

1938-The Federal National Mortgage Association

1968-Fannie Mac spins off Ginnie Mac 1970-Federal Home Mortgage Corporation

Timeline

1970 Ginnie Mac created first MBS Private companies begin mortgage asset securitization.

1974 Equal Credit Opportunity Act

1977 Community Reinvestment Act

Late 1970s Securitization is invented

1981 David Maxwell becomes CEO of Fannie , he greatly increases the use of mortgage Securities

Timeline

1980s CMO is introduced Tax reforms Guardian savings and Loan issues first subprime -backed mortgage security. RTC used structured finance 1990s The first mortgage bubble-many founder subprime lenders go bankrupt. J.P Morgan introduces Credit Default Swaps 1998 Housing bubble Initiated 1999 Fannie Mac eases the credit requirements Glass Steagall Act was repealed.
2000-2001 FFR lowered 11 times from 6.5% to 1.75%. 2004 Annual home price by 69.2% . 2003-2007 U.S mortgage increased 292% from $332 billion to $1.3 trillion. 2005 Booming housing market halts abruptly. 2007 steepest decline in home sales since 1989

Timeline

2008 CDO tranches failure. Financial crisis escalated with collapse of major lenders and investors.