The U.S. Sub-Prime Lending Crisis

Introduction

The first eight years of the new millennium marked a repeat of financial cycles that occurred in the Great Depression of the 1930’s. But this time, the problems expanded to global proportions that made this the most unprecedented and severe financial crisis the United States has experienced throughout history. What were thought of as mere local sub-prime lending problems eventually revealed connected financial troubles arising from responses to world crises and series of poor financial decisions both from the private sector and the government.
This decade started out with mixed trends in the economy. Signals of growth were seen but the general financial atmosphere was looming because of lackluster investments and housing demand; weak consumer spending, rising interest rates, falling house prices, rising unemployment, relentless spurt in oil prices and a lot of other reasons. These caused major rise in default installment payments, significantly from the risky sub-prime loans. Prices of securitized mortgage debt fell resulting to volumes of mortgage foreclosures (Demyank & Hemert 2008). Despite government take-over of Fannie Mae and Freddie Mac to back securities of home mortgages and other sub-prime loans, banks that carried huge investments in sub-prime lending continued to incur heavy losses. Large banking institutions such as Lehman Brothers, Washington Mutual and Wachovia collapsed along with AIG, the country’s biggest insurance company. Many other Wall Street torch bearers followed suit and triggered a global panic in banking and stock market investments (Demyank & Hemert 2008). What could have gone wrong? What were the missing parts in the financial system of the supposed to be strongest economy in the world, that caused these massive failures and that a government bailout of $700 billion could not even resolve?
This report aims to disentangle the mysteries behind the current financial crisis through an in-depth analysis of the historical causation of various financial crises from the Great Depression of 1930’s, through international large scale recessions, the 2007 crisis until the present. The report unravels the significance of how the sub-prime lending programs were implemented in different times to affect the present economic situation.

The Great Depression
The U.S. economy was booming in the 1920’s. Americans were generally optimistic about the economy especially with Herbert Hoover elected President in 1928 most people believed that national prosperity would continue. In his acceptance speech for the Republican-party nomination, Hoover said, “We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poorhouse is vanishing from among us” (Schultz, 1999, p. 1). The stock market was very active and people were enthusiastic to buy shares of stocks especially with just 10% option down payment. People thought that it was the easy way to get rich. Banks gave out loans at very low interests and most people loaned money not to buy houses or cars but to invest in stocks. Because the companies were making a lot of money in the stock market, they funneled their profits back to business. Production was increased; new equipment and facilities were procured, structures were put up and additional employees were hired. These gave the companies an aura of financial soundness and even more encouraged people to buy more stocks.
What people did not realize was that the stock market was out of proportion to the actual situation of the economy. Supply was so much over with very little demand. People realized that their optimisms were just boarded on speculations; stock market eventually tumbled. They called it “Black Tuesday, October 29, 1929” (Schultz, 1999, p. 2) when the stock market went into a deep crash. People lost much in their investments that they hurried to get out to minimize their losses. This triggered a domino effect. People lost trust in the economy; they also rushed to pull out their money from the banks resulting in massive bank runs. What happened to the stock market was propagated into the entire banking system. Banks did not have cash and had to foreclose mortgages, ending up with bulk of property without cash. Many banks did not survive. The government was not prepared with contingency measures to stop the shock. They were not able to prevent the collapse of the financial system.
The economy fell into shambles resulting in company mergers, closures and massive unemployment. The U.S. felt the recession but the government did not make any major move assuming that the economy would correct itself. But the situation got worse and extended for a long period and into global proportions. International trades have been deeply affected. Cities around the world were hit hard especially those that were dependent on major industries particularly farming, logging and mining sectors. Construction virtually halted in many countries. Great Depression continued until the beginning of the World War in 1939 (Schultz, 1999). It was only then that the government made a strong move. They poured massive amounts of money into the economy that stimulated prices to go up. With victory at hand, people increased their patriotism and renewed their trust. Eventually, the market was finally corrected and the economy revived.

Post War Bank-Centered Financial Crises
The Great Depression and recent economic crisis were distinct experiences. The only common denominator could be that the epicenter was the United States (Boeri & Guiso, 2007). During the depression, the Federal Reserve System did not have sufficient policies and regulations to cushion the crash in the stock market and the banking system. In contrast, in the recent crisis, the Fed has been active in performing its role in supplying liquidity to the market and showed good economic activities until 2006. Financial leaders throughout the world vouched never to let the Great Depression happen again. The United States instituted reforms to include the enactment of deposit insurance, so that for about half a century, the banking system has been quiet and smooth until the U.S. Savings and Loans Crisis in 1984 (Hubbard, 1991).
Around the globe, there were a number of financial crises that occurred in the late 20th century. Five of these large scale post-war bank centered financial crises were documented and studied by Carmen Reinhart and Kenneth Rogoff in 2008 through trends in asset prices, real economic growth, and public debt. The study compared the 2007 U.S. financial crisis performance and the crises in Spain in 1977, Norway in 1987, Finland in 1991, Sweden in 1991 and Japan in 1992. These five most catastrophic cases all exhibited a steep rise in housing prices during the four years preceding their crisis; steep rise in equity prices, large increase in account deficit and a decline in per-capita growth in gross domestic product. All had an aftermath drop in growth over five percent and these trends extended for at least two years. The results revealed that U.S. Savings and Loans crisis in 1984 and the sup-prime lending crisis in 2007, despite similarities with the other crises, did not suffer much because of new unregulated or lightly regulated financial entities and technological progress introduced to enhance the stability of the financial conditions. (Reinhart & Rogoff, 2008) It is also worthy to note that the U.S. banking system stood as an intermediary for oil-exporter surpluses and emerging market borrowers. The so-called “petro-dollar recycling” (Reinhart & Rogoff, 2008) by emerging markets was again flowing in the United States and trillions of dollars were pumped into the sub-prime mortgage markets. (Reinhart & Rogoff, 2008)

The Current Sub-prime Mortgage Crisis
It has been a long standing goal for the United States government to provide home ownership for low income and minority households. Sub-prime mortgages were found to be the innovation that would meet this goal. The 2001 Interagency Expanded Guidance for Sub-prime Lending Programs defines the sub-prime borrower as “one who generally displays a range of credit risk characteristics including one or more of the following: Two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months; Judgment, foreclosure, repossession, or charge-off in the prior 24 months; Bankruptcy in the last 5 years; Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 660 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood; and/or, Debt service-to-income ratio of 50 percent or greater; or, otherwise limited ability to cover family living expenses after deducting total debt-service requirements from monthly income” (Ascraft & Schuermann 2008).
Because loans made by sub-prime borrowers are considered very risky, the mortgage conditions had to be specially packaged. Securitization of these loans was also packaged in tranches. The packaging of financing and refinancing of sub-prime mortgages was so complicated that even institutions who ventured in it could not explain it fully, that was why it has come to be known as the “shadow banking system” (Gorton, 2008). To make this innovation work, house prices were supposed to rise. Sub-prime loans depended on the appreciation of housing prices because of refinancing. When prices are high, there will be investors who will agree to refinance the mortgage. When house prices reduce, the borrower is left with increased default or face mortgage foreclosure. Indeed, prices did rise for the succeeding six years after implementation of the strategy in 1998 but started to slump in the aftermath of 2006.
The Federal National Mortgage Association or commonly known as Fannie Mae and the Federal Home Loan Mortgage Corporation or commonly, Freddie Mac, are government sponsored enterprises created during the Great Depression to make sure that sufficient funds were made available to lending institutions. In 1968 these were re-chartered by the U.S. Congress. These two are the biggest mortgage buyers were the government’s strongest partners in making available housing to low and middle-income families. They played a vital role in the implementation of sub-prime lending programs. By buying mortgages, they provided lenders with fresh money to make new loans. They provide guarantee to mortgage backed securities that they issue and set the guidelines for the loans that they will accept. These guidelines differ and were regulated by the Fed. Like other banks that poured big investments in sub-prime lending, Fannie Mae and Freddie Mac both suffered significantly in the aftermath of the crisis (Whalen, 2008). They were eventually held in conservatorship by the Federal Housing Finance Agency (FHFA) as part of the major move of the U.S. government to solve the crisis in the financial system (Labaton & Andrews, 2008).

Causes of Sub-prime Lending Crises
There are three factors that were seen to clearly contribute to the current sub-prime lending crises: 1. low financial literacy of US households; 2. financial innovation that has resulted in the massive securitization of illiquid assets, and 3. low interest rate policy of the Fed from 2001 to 2004 (Boeri & Guiso, 2007). Like what has happened in the Great Depression of 1930, people went out to invest in stocks more than they could afford because it was vastly promoted that they could easily get rich by investing in the stock market. The current sub-prime lending crisis is caused by low literacy and inexperience of borrowers. Banks and other lenders who were out to attract clients lure borrowers through easy payment terms, low down payments or long term installments, packaging loans to become seemingly affordable but in reality were not. Most sub-prime borrowers had very little knowledge of computing interests or compounding interests and rely much on the sincerity of their lenders, simply eager to get own a house or property. In the end, they find themselves unable to sustain payments of their loans and end up with defaults or at worse, foreclosure.
The Federal Reserve System has installed numerous innovations to securitize lending, particularly the sub-prime loans. Securitization is a process liquidifying or making an illiquid credit liquid and repackaging these for refinancing by intermediaries (Ascraft & Schuermann 2008). These loans are refinanced into longer terms and therefore higher returns. The Fed regulations instituted complicated securitization of sub-prime loans but made it easy for delinquent loans to be cleared. Unlike standard lending procedures that required strict documentary requirements, sub-prime loans were allowed lean documentation. Securitization made it difficulty for intermediaries to monitor the behavior of the original borrowers and this opens doors to poor quality of borrowers and therefore caused vulnerability of loans for default.
The monetary policy of low interest rates was seen as the most significant contributing factor that caused the crisis. “Keynes theory” (Boeri & Guiso, 2007) states that a government can use to stimulate economic activity during a period of economic low through interest rates, taxation or public projects. In response to the September 11, 2001 recession, the Federal Reserve injected an enormous amount of liquidity into the monetary system. Short term interest rates were reduced to 1%, the lowest in 50 years (Boeri & Guiso, 2007). This was sustained for a long time causing investors and lenders to look for other sources where they can make more profit. So financial intermediaries ventured on investments with more risks in exchange for bigger gains. The government succeeded in attracting investors in the sub-prime lending program. Banks, investors of varying experiences and expertise poured their investments in the program while borrowers of all types piled to avail of housing loans, an opportunity they thought before was beyond their means. At that time house prices soared which encouraged additional extension of credits.

Conclusion
In the Great Depression, financial leaders vouched never to make the same mistakes. The Fed at that time was unable to make a move because they assumed that the financial market will correct itself. The Fed from then on instituted reforms to correct these mistakes and perform an active role in the management and control of the system. Despite all efforts and modern economic technological interventions, when the system becomes too complicated to control, something is bound to go wrong. The sub-prime lending crisis that was caused by poor literacy of borrowers and lenders, suspiciously vague regulations and securitization, lack of information and the Keynesian strategy implemented by the Federal Reserve System of low interest, were aggravated by panic from mistrust in the government that failed to establish its sincerity to serve its people.

Works Cited
Ascraft, Adam B. & Til Schuermann. Understanding the Securitization of Subprime Mortgage Credit. Federal Reserve Bank of New York Staff Reports, New York U.S.A. March 2008.
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Demyanyk, Yuliya. & Otto Van Hemert. Understanding the Subprime Mortgage Crisis. Banking Supervision and Regulation, Federal Reserve Bank of St. Louis, MO 63166, U.S.A. August 19, 2008.
Gorton, Gary B.The Sub-prime Panic. Working Paper 14398. National Bureau of Economic Research. Massachusetts Avenue, Cambridge, Massachusetts. U.S.A. 2008. Retrieved 18 November 2008 from http://www.nber.org/papers/w14398
Hubbard, R. Glenn. Financial Markets and Financial Crises. National Bureau of Economic Research. University of Chicago Press. ISBN 0226355888. 1991.
Labaton, Stephen & Edmund L. Andrews. In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans. The New York Times. September 2008. Retrieved 18 November 2008 from <http://www.nytimes.com/2008/09/08/business/08fannie.html>
Reinhart, Carmen M. & Kenneth S. Rogoff. Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison. Littauer Center, Harvard University, Cambridge MA 02138-3001. 2008.
Schultz, Stanley K. Crashing Hopes: The Great Depression. 1999. Retrieved 18 November 2008 from <http://us.history.wisc.edu/hist102/lectures/lecture18.html>
Whalen, R. Christopher. The Subprime Crisis – Cause, Effect and Consequences. Policy Brief. Network Financial Institute, Indiana State University, U.S.A. March 2008.