wlmac economics

subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations

Partner In Crime: HomebuyersWhile we're on the topic of lenders, we should also mention the home buyers. Many were playing an extremely risky game by buying houses they could barely afford. They were able to make these purchases with non-traditional mortgages

However, instead of continued appreciation, the housing bubble burst, and prices dropped rapidly

As a result, when their mortgages reset, 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.

Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.

a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.The chart below demonstrates the incredible increase in global CDOs issues in 2006.

Investment Banks Worsen the SituationThe increased use of the secondary mortgage market by lenders added to the number of subprime loans lenders could originate. Instead of holding the originated mortgages on their books, lenders were able to simply sell off the mortgages in the secondary market and collect the originating fees. This freed up more capital for even more lending, which increased liquidity even more. The snowball began to build momentum.

Rating Agencies: Possible Conflict of InterestA lot of criticism has been directed at the rating agencies and underwriters of the CDOs and other mortgage-backed securities that included subprime loans in their mortgage pools. Some argue that the rating agencies should have foreseen the high default rates for subprime borrowers, and they should have given these CDOs much lower ratings than the 'AAA' rating given to the higher quality tranches. If the ratings had been more accurate, fewer investors would have bought into these securities, and the losses may not have been as bad.

The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency

Fuel to the Fire: Investor BehaviorJust as the homeowners are to blame for their purchases gone wrong, much of the blame also must be placed on those who invested in CDOs. Investors were the ones willing to purchase these CDOs at ridiculously low premiums over Treasury bonds. These enticingly low rates are what ultimately led to such huge demand for subprime loans.

Final Culprit: Hedge FundsAnother party that added to the mess was the hedge fund industry. It aggravated the problem not only by pushing rates lower, but also by fueling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem.

there is a type of hedge fund strategy that can be best described as "credit arbitrage". It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem.

Because many subprime borrowers intend to refinance their adjustable-rate mortgage before, or at the end of, the fixed interest rate period, they frequently do not pay attention to how the fully indexed interest rate is calculated, ignore the mortgage's interest rate cap structure, or are sometimes ignorant of the fact that the mortgage has a prepayment penalty.

The bad news is that there are even worse bets out there. There are credit default swaps written on subprime mortgage securities. It's bad enough that these subprime mortgage pools that banks, investment banks, insurance companies, hedge funds and others bought were over-rated and ended up falling precipitously in value as foreclosures mounted on the underlying mortgages in the pools. What's even worse, however, is that speculators sold and bought trillions of dollars of insurance that these pools would, or wouldn't, default! The sellers of this insurance (AIG is one example) are getting killed as defaults continue to rise with no end in sight.

What happened to AIG is simple: AIG got greedy. AIG, as of June 30, had written $441 billion worth of swaps on corporate bonds, and worse, mortgage-backed securities. As the value of these insured-referenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded on Monday evening, the company had to post even more collateral, which it didn't have.

The subprime lending increased the homeownership rate in the United States significantly and about 5 million people went from tenants to homeowners. As a result, rents went down and house prices went up till they reached unsustainable heights relative to rents.

Thus, when the rise in housing prices stopped in 2006, inevitably many subprime borrowers had difficulty making their mortgage payments. The housing bubble and particularly the excesses of the subprime mortgage market became even more evident when many subprime mortgage lenders began declaring bankruptcy around March 2007.

Confidence in many financial institutions was shaken and the stock market witnessed systemic weakness across financial sectors. The share prices for large, small, and investment banks all significantly dropped and between July 2007 and March 2008, lost about a third of their value. What is more, banks stopped trusting other banks and interbank lending was disrupted.

In the United States, homeowners' net equity as a percentage of home value has plummeted from around 65% to 45% over the last two decades. with more than half that drop coming since 2000. In Canada, on the other hand, this ratio has remained stable at between 65% and 70% since the 1980s.

Less off-balance-sheet mortgages. The frenzy of mortgage securitization that gripped the United States in recent years (famously explained/satirized in this comic strip) never really took off here. According to Scotiabank "The majority of mortgages are held on balance sheet in Canada, with only 24% having been securitized." That's huge, because it is the radioactive quality of these securities — many of which contain a tangled welter of mortgages of varying quality — that has really sunk the U.S. credit market: Since no one knows how much these complex instruments are really worth, they still haven't established an equilibrium price level, thereby freezing the credit market for any entity that has a large number of them on their books. (What's more, even those 24% have mostly been securitized through the CMHC, a Crown corp. with government backing.)

Finally, there is the fact that Canada simply has a different — and more prudent — banking culture:

Canada banks continue to apply prudent underwriting standards. In other words, they have always checked, and continue to check, incomes, verify job status, asks for sales contracts, etc.,

On average, Canadian home prices are roughly 200% what they were in 1989. In the United States, the corresponding ratio peaked at 260% before crashing down to 220%.

This is the most shocking stat of all. In the United States, a full 4.5% of mortgages are in 90-day arrears (i.e. the local sheriff is ready to move in and tack a notice to the door). In Canada, the figure is one 20th that level — just 0.27%.

All in all, what do these figures show? A prudent, risk-averse, well-regulated Canadian real estate and mortgage community that — on both the seller, mortgagor and buyer sides — has avoided the pitfalls swallowing up the United states.

The statistics provided by these samples, according to Mr. Johnson and Vicki Beal, a senior vice president at Clayton who also testified before the inquiry commission, indicated that only 54 percent of the loans met the lenders’ underwriting standards, regardless of how stringent or weak they were.

Some 28 percent of the loans sampled over the period were outright failures — that is, they were unable to meet numerous underwriting standards and did not have positive factors that compensated for their failings. And yet, 39 percent of these troubled loans still went into mortgage pools sold to investors during the period, Clayton’s figures showed.

At Goldman Sachs, 19 percent of loans failed to make the grade in the final quarter of 2006 and the first half of 2007, but 34 percent of those loans were still sold by the firm. Throughout this period, Goldman Sachs was also betting against the mortgage market for its own account, according to documents provided to government investigators.

A Goldman Sachs spokesman said the percentage of deficient loans that went into its pools was smaller than Clayton’s average, indicating that the firm had done a better job than its peers. Because these loan samples were provided to the Wall Street investment banks that commissioned them, they could see throughout 2006 and into 2007 that the mortgages they were financing and selling to investors were becoming increasingly sketchy.

A more proper procedure, analysts said, would have been for lenders like these — New Century Financial and Fremont Investment and Loan among them — to buy back the problem loans and replace them with higher-quality mortgages. But because these companies did not have enough capital to do that, they were happy to sell the troubled mortgages cheaply to the brokerage firms.

To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy.

prey in restless bankers - and even more restless borrowers who had no income, no job and no assets.

environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold.

Fed continued slashing interest rates, emboldened, perhaps, by continued low inflation despite lower interest rates

Fed lowered interest rates to 1%, the lowest rate in 45 years.

everything was selling at a huge discount and without any down payment.

the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments.

trouble started when the interest rates started rising and home ownership reached a saturation point

Federal funds rate had reached 5.25%

home prices started to fall

many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans

financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting

could not solve the subprime crisis on its own and the problems spread beyond the United State's borders

interbank market froze completely

central banks and governments around the world had started coming together to prevent further financial catastrophe

Fed started slashing the discount rate as well as the funds rate

Federal funds rate and the discount rate were reduced to 1% and 1.75%

The central bank, in essence, pumped liquidity, the lifeblood of credit markets, into the circulatory system of an economy that was experiencing a potentially fatal heart attack.

“I think our actions prevented an even more disastrous outcome,” said Donald L. Kohn, who was the Fed’s vice chairman during the crisis. Without the Fed’s help, he said, “liquidity would have dried up even more than it did, asset prices would have fallen even more than they did, and economic activity and employment would have fallen further and faster then they did.”

Fed should have forced banks to restrict executive pay and reduce the financial burdens on mortgage borrowers as a condition of its aid.

European Central Bank drew the most heavily on these currency arrangements, the records show, but nine other central banks also made use of them: Australia, Denmark, England, Japan, Mexico, Norway, South Korea, Sweden and Switzerland.

The market in credit-default swaps and other complex instruments known collectively as derivatives has become huge and lucrative in recent years, but is unregulated. Observers expect Congress and the regulators to make the field more transparent and to introduce new regulations.

Reserve requirements could be established. Commercial banks, for example, are generally required to keep on hand $1 of cash for every $10 they owe to account holders or they loan out. (Investment banks typically have no such requirements, and keep only $1 for every $30 or more they borrow to invest. They have made fortunes. But when investments go bad, they have few reserves to cover their losses.) Perlow, the attorney, expects Congress to debate amending the Commodity Futures Modernization Act of 2000, which kept derivatives unregulated