The subprime mortgage crisis is the event, which has started in 2007 in the USA, with a powerful unfavorable influence on the mortgage industry, and has led to the wave of foreclosures, the collapse of the significant number of lending institutions, and the further global financial crisis.
Many experts and economists have researched the origins of the subprime crisis. The combination of many reasons has led to the crisis, and they are the following:
Housing bubble. The crisis has begun with the bursting of the housing “bubble”. The bubble was caused by historically low mortgage interest rates and the government incentives for affordable housing (Bianco, 2008, pp. 3-4). As a result, the rise of risky subprime lending was very impressive. The mortgage loans were given almost to everybody; however, most of the borrowers couldn’t afford to service their debts.
Securitization. One of the most significant causes of the subprime crisis was securitization – the process of financing and acquiring assets or financial instruments by the issue of the securities. Three main stages of securitization are the selection of the suitable assets (mortgage loans), the classification of them into the pools, the issue of the securities backed by the respective assets. Then these securities are offered as the collateral for a third-party investment. That’s how most of the loans has been converted into mortgage-backed securities and high-risk derivatives before the start of the subprime crisis (Bianco, 2008, pp. 8-9).
The emergence of a new type of lenders. In addition to the traditional lenders such as commercial and investment banks, on the wave of mass mortgage lending the new type of specialized lenders has emerged. Among them were insurance companies, hedge funds, and building societies. Their activity was unregulated and they have substantially fueled the subprime crisis (Bianco, 2008, p. 7).
Mortgage brokers and underwriters. The brokers were blamed for seeking the profits from the mortgage loan boom without sufficient determination, whether borrowers could repay the loans (Bianco, 2008, p. 8).
Credit rating agencies. Rating agencies such as Fitch Ratings, Moody’s, and Standard & Poor’s were blamed for overrating risky mortgage-backed securities, placing an AAA rating on them, therefore claiming, that these securities were as safe as the government ones (Bianco, 2008, p. 9).
The government regulatory policies. Some economists have assumed that the government and federal policies contributed to the development of the crisis. Among others, the Community Reinvestment Act and the Glass-Steagall Act were criticized for forcing commercial and investment banks to lend to uncreditworthy customers. Moreover, the changed reserve requirements of the banks have raised their liquidity substantially, so they were able to offer more loans. Therefore, the demand for affordable mortgage loans has skyrocketed and that’s how the housing bubble began to grow (Bianco, 2008, pp. 11-12).
Economists assure that there was no way to avoid the subprime crisis. The experts, who tried to warn about the possible economic downturn, were ignored or sidelined because too many financial institutions have rushed for easy revenues and too many people have rushed for affordable real estate property (Denning, 2011).
Thus, the subprime crisis has caused a further financial crisis with a very unfavorable impact on the economy and severe consequences, which can be summarized as follows:
Tough economic downturn. The economic turmoil has resulted in the decrease of GDP growth rate, the rise of the unemployment rate, and the high inflation rate. It is astonishing, how fast and easy the financial crisis has affected the real economy.
The foreclosure mess. The economic meltdown was accompanied by the avalanche of foreclosures. Therefore, unable to repay their mortgages, many people have lost their houses.
The bankruptcy of financial institutions. With the rise of the foreclosures number, the mortgage lenders found themselves in a situation when their assets were worthless. The damage was huge and many mortgage giants went bankrupt, were taken over by other, more successful, ones or by the government.
The decrease of population’s revenues. The net income of American households has decreased significantly. Things have gotten harder, especially for the middle class.
Other consequences were much more difficult access to loans, the change of investor and lender preferences from structured finance to simpler cash securities, the increased number of borrowers’ claims against lenders, the dramatic fall of housing prices, and the devaluation of housing-related securities (Whalen, 2008, pp. 9-10).
Under unfavorable conditions of the severe mortgage and financial crisis, the most difficult challenge for any government is the development of prudent and efficient steps to tackle it. Generally suggested in such a situation is a wide range of actions, concerning the foreclosure mess, among them is ensuring a fair foreclosure process, encouraging the negotiations between lenders and borrowers, facilitating creditors to seek the alternatives to foreclosure, helping borrowers to gain access to short-term financial resources to restructure their loans (Mallach, 2008, pp. 8-13).
Moreover, some steps are suggested to forestall future abuses in the mortgage lending market, such as to improve the regulation of the mortgage brokerage activities (through the efficient licensure process, the requirements for regular and detailed reporting, the rigid penalties for violations and fraud); to prohibit abusive and unsuitable lending practices; to establish effective long-term policies to create the sound system of affordable housing (Mallach, 2008, pp. 18-22).
Regarding the macroeconomic level, government should take the following steps to improve economic situation and alleviate the consequences of the crisis: to lower short-term and longer-term interest rates in order to stimulate investment demand and business activity; to reduce tax rates in order to diminish the pressure on the enterprises, create the new working places and facilitate economic and business activity; to increase government investments into the economy (for example, into infrastructure, personnel retraining programs), in order to stimulate the demand and create new working places, when companies decreases their investments and consumers stop buying; to support the liquidity of the banking system through the recapitalization and the refinancing, the redemption of “bad” loans and government take-overs of bankrupt banks; to increase government expenses on social security of the population (unemployment benefits, medical insurance, building of the dwelling for homeless people); to organize voluntary works; to control consumer prices; to invest in innovative projects (How To Solve The Global Financial Crisis: A 20 Point Plan, 2012).
If one looks attentively at the financial crisis of 2007-2009, one will see, that its fundamentals were established in 1998 when investment banks were allowed to engage in highly risky business (Denning, 2011). The availability of high-risk mortgages to potential homebuyers with below-average credit histories has given a start to the growth of the housing bubble (Duca, 2013, para. 1).
The crisis has strongly affected the mortgage market. Then it has advanced very fast to the financial markets. And finally, the real economy has suffered from the crisis. Everyone was blamed for the crisis: greedy lenders, the government, which was conniving at the situation, biased rating agencies, and short-sighted borrowers. The consequences of the crisis in the U.S. economy are worth the blame for.
In 2008, the U.S. GDP growth rate was the lowest since 2001. The unemployment rate has risen above 10% in 2009 in comparison with about 5% in the previous years. According to the approximate estimates, there were about 2.25 million foreclosures each year from 2010 to 2012. The net income of American households has decreased by 15% in 2008 and about 2.5 million Americans have filed for bankruptcy in 2008-2009 (Begany, 2010).
In 2007-2009 the U.S. government had to spend almost $10 trillion (so-called bailout expenses) to save the economy. In April 2007, the large investment trust New Century Financial has filed a petition for bankruptcy. It was the first case of bankruptcy. The crisis has made its way to the credit markets in 2008. In September 2008, the large mortgage lenders Fannie Mae and Freddie Mac were taken over by the government. Then Bank of America has bought the investment bank Merrill Lynch for $50 billion to prevent its bankruptcy (in addition to the mortgage lender Countrywide Financial, purchased earlier that year for almost $4 billion). And finally, the most celebrated case has occurred on September 15, 2008 – the large investment bank Lehman Brothers went bankrupt. Moreover, the government has spent 150 billion dollars to save insurance holding AIG and 17.4 billion dollars from the Troubled Asset Relief Program for General Motors and Chrysler (Timeline: Key events in the financial crisis, 2013).
The U.S. government has also taken the other necessary steps to alleviate the consequences of the financial crisis: the Federal Reserve has reduced short-term interest rates to almost 0 percent; the Congress has significantly increased the maximum size of mortgages, insured by the Federal Housing Administration and has passed temporary tax credits for the homebuyers to stimulate the demand and ease the fall of housing prices (Duca, 2013, para. 9-10). Moreover, in 2009 the government has passed the crisis management program called “The American Recovery and Reinvestment Act”. According to the Act, the taxes for businesses and individuals were reduced, about 200 billion dollars were spent to modernize the infrastructure and social expenses were increased (The American Recovery and Reinvestment Act, 2013). These and other important steps have allowed stabilizing housing markets and the economy as a whole by 2012.
The financial crisis of 2007-2009 has taught us important lessons. First of all, government regulation should be balanced. The financial markets and their participants should be sufficiently regulated to suppress the speculations. Secondly, the strategic national policy must take into consideration the influence of global markets and the competition. Thirdly, it is a very dangerous practice to allow the volumes of the financial markets to be much greater, than the volumes of the real economy, and stimulate the investments in unsecured derivatives instead of the producing of real products and services. And the final lesson is that the price for the wrong economic policies as well as for the wrong foreign policies can be almost unbearable (Lessons from the Financial Crisis, 2011, pp. 34-35).
References
Begany, T. (2010). 5 Consequences Of The Mortgage Crisis. Web.
Bianco K.M. (2008). The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown. Web.
Denning, S. (2011). Lest We Forget: Why We Had A Financial Crisis. Web.
Duca, J.V. (2013). Subprime Mortgage Crisis. Web.
How To Solve The Global Financial Crisis: A 20 Point Plan. (2012). Web.
Lessons from the Financial Crisis. (2011). CEO Magazine, Special Edition, 34-35. Web.
Mallach, A. (2008). Tackling the Mortgage Crisis: 10 Action Steps for State Government. Web.
The American Recovery and Reinvestment Act of 2009: Information Center. (2013). Web.
Timeline: Key events in the financial crisis. (2013). Web.
Whalen, R.C. (2008). The Subprime Crisis: Cause, Effect and Consequences. Web.