Subprime Mortgage Crisis

In September 2009, 14.4% of all outstanding U.S. mortgages were delinquent or in foreclosure. Write a page or two that generally presents and explains the following familiar elements of the crisis: TARP funds, Adjustable Rate Mortgages, Subprime Mortgages, Investment banks, Collateralized debt obligation (CDO) and Credit Default Swaps (CDS).

According to the Mortgage Bankers Association, 1.35 million homes went into foreclosure in 2007. Meanwhile, the number of U.S. homeowners behind on their payments has hit a 21-year high, sending a huge ripple effect through the economy. The US sub-prime mortgage crisis spawned severe financial market dislocations. These dislocations, including the widely reported credit-crunch, have intensified what might have only been a mild economic slowdown. The US economy is now in a recession. Economic growth will continue to be disappointing and unemployment will continue to rise.

The subprime mortgage crisis is the ongoing real estate and financial crisis, which is triggered by a tremendous rise in mortgage delinquencies and foreclosures in the United States, which has consequently affected major financial institutions and financial markets all around the globe. More than 80% of the mortgages issued in the US to subprime borrowers were adjustable-rate mortgages. Adjustable-rate mortgage is a mortgage loan where the interest rate is adjusted periodically based on a number of different reasons. Consequently, payments made by the barrower may change over time with changing interest rates. The adjustable-rate mortgage is different from graduated payment mortgage, because graduated mortgages allow barrowers a changing payment amount but a fixed interest rate. Many US mortgages are subprime, which means that little or no down payments are made. In addition, many mortgages were issued to households with low incomes and assets who had troubled credit histories. When housing prices suddenly declined, mortgage delinquencies soared and securities held by financial firms lost most of their value. The result was a loss of capital in many investment banks and US government sponsored enterprises, which tightened credit around the world.

Essentially, people with poor credit got in on the action when mortgage lenders created non-traditional mortgages such as interest only loans, payment-option, ARM’s and mortgages with extended amortization periods. Eventually, interest rates climbed back up and many subprime borrowers defaulted when their mortgages were reset to much higher monthly payments. This left mortgage lenders with property that was worth less than the loan value due to a weakening housing market. Defaults increased; the problem snowballed, and several lenders went bankrupt.

Interestingly, hedge funds and investors also suffered, because lenders sold mortgages that they originated into a secondary market. Essentially, the mortgages were bundled together and sold to investors as collateralized debt obligations (CDOs) and other mortgage-backed securities (MBSs). Collateralized debt obligations are a type of structured asset-backed security whose value and payments are derived from a portfolio of fixed-income underlying assets. Many analysts had warned that CDOs and other ABS’s and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. When the higher risk underlying mortgages started to default, investors were left with properties that were quickly losing value. After the meltdown, central banks released liquidity into the market place, which allowed struggling lenders and hedge funds to continue operations and make the necessary payments on their obligations. Therefore, banks were required to write-down billions of dollars because they had worthless subprime mortgage securities. This led to depleted capital in most investment banks, and a loss of confidence in bank’s lending and their ability to pay back their debts. It is in this way that the subprime mortgage crisis was born.

Sources:

CBS News. "U.S. Facing Mortgage Crisis - CBS News Video." Breaking News Headlines: Business, Entertainment & World News - CBS News. Web. 8 July 2010.

Wiki Dot. "The Subprime Mortgage Crisis - Investment Banking Industry." The Investment Banking Industry - Investment Banking Industry. Web. 8 July 2010