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   ISSUES AND ETHICS IN FINANCE (FIN657) NBF9D 1 US Subprime Mortgage Crisis 2007   The US subprime crisis is the largest crisis in the history and it was turning point in the US economy and global culture. The subprime mortgage crisis was rise in home foreclosures, started in the United States in late 2006 and became a global financial crisis during 2007 and 2008. There were some millions of the homes that were closed down but no one was there to buy them. The crisis began with the bursting of the housing bubble in the U.S. and high default rates on subprime and other adjustable rate mortgages (ARM) made to higher-risk borrowers with lower income or lesser credit history than prime borrowers. Loan incentives and a long-term trend of rising housing prices encouraged borrowers to assume mortgages, believing they would be able to refinance at more favourable terms later. However, once housing prices started to drop in 2006-2007, it became more difficult to refinancing. ARM interest rates reset higher that makes defaults and foreclosure activity increased dramatically. The industries that were hit the hardest were the banking industry, real estate and the construction. The mortgage lending market is divided in two sectors prime and subprime. Prime  borrowers are marked by high income, strong credit rating and sound savings while subprime mortgages are named for the borrowers that the mortgages are given to subprime for those who have struggled to meet those standards. People who are approved of subprime mortgages historically have low credit scores, no savings, blemished credit history and problems with debt. They often have tremendous difficulty getting approval on a mortgage, also considered riskier by the lending institutions and are generally assessed at higher interest rates than normal. How subprime mortgage crisis happen   The sub  prime mortgage market emerged and flourished in the 1990’s. The new trend of extending loans or credit to borrowers with less than perfect profiles was adopted in 1990’s and continued until 2005, resulting in increased homeownership recording 64.1 % in 1993 and 68.9% in 2005 (Carpenter,2008). The expansion of the sub-prime market improved the access of credit and resulted in the boom in the real estate market. This led to the expansion of credit to those borrowers whose credit was blemished. This period was also backed by strong overall housing market with increasing value of the home prices. Though this trend did not continue and in 2006 the housing market began to slow down, which resulted in rising late mortgage payments, foreclosures and defaults. This resulted in the collapse of the US subprime mortgage market and had impact on the borrowers, investors, financial institutions, securitization, and mortgage broker which led to more involved government regulation. In 2007, the US economy experienced the worst mortgage crisis ever that led to panic and financial challenges all over the world. The primary cause of the mortgage crisis was excessive borrowing and unfeasible financial projection. The projection relied on the assumption that the local prices only increased. Subprime borrowers defaulted as a result of change of mortgage interest rates. The unfolding of the mortgage crisis can be illustrated through an analysis of the issues that culminated to the crisis. Other factors that intensified the crisis are fraud and greed.   ISSUES AND ETHICS IN FINANCE (FIN657) NBF9D 2 In the early 2000s, interest rates on house payments were quite low. More and more  people that struggling credit were able to qualify for subprime mortgages with manageable rates. This sudden increase in subprime mortgages was due in part to the Federal Reserve's decision to significantly lower the Federal funds rate to spur growth. People who couldn't afford homes or get approved for loans before were suddenly qualifying for subprime loans and choosing to buy which make American home ownership rose exponentially. Real estate purchases rose for subprime borrowers and for Americans as well. As  prices rose and people expected a continuation of that, investors who got burned by the  bubble of the early 2000s and needed a replacement in their portfolio started investing in real estate. While the housing prices rising rapidly, the number of subprime mortgages given out was rising even more. By 2005, some began to fear that this was a housing bubble. From 2004 until 2006, the Federal Reserve has raised the interest rate over a dozen times in attempt to slow down and avoid more serious inflation. End of 2004, the interest rate was 2.25% and by mid-2006 it rise to 5.25% but this was unable to stop the inevitable, the  bubble burst. In 2005 and 2006 the housing market crash back down to earth and make subprime mortgage lenders begin laying thousands of employees off, filing for bankruptcy or shutting down entirely. The subprime mortgage crisis or the Great Recession, has many parties that share  blame for it. For one are lenders who were selling these as mortgage-backed securities. After the lenders approved and gave out the loan, then the loan would be sold to an investment bank which then bundle this mortgage with other similar mortgage for other parties to invest in, and the lender as a result have more money to use for home loans. It is a continuous process that had worked in the past, but the housing bubble saw an unusually large number of subprime mortgages that approved for people who struggled with credit and income. Loans became more expensive and the borrowers found themselves unable to pay it off when the Fed began raising interest rates over and over Lenders were give away so many risky loans at once assuming that housing prices would continue to rise and interest rates would stay low. Investment banks also seem to had similar motives, getting bolder with their mortgage backed securities investments. The banks and the lenders started to force the people to get the maximum amount of loans that they could ensure the alone and they could not be repaid. Though these parties has took advantage of people with bad credit in need of a place to live, homebuyers and the distinctly American pursuit of owning a home also played a small role in this. Their dream to upward mobility and owning larger homes led the people to riskier with their own real estate investments, and lenders were all too ready to help them. Another party that create the mess was the hedge fund industry. It not only pushing rates lower, but also aggravated the problem by fuelling the market volatility that caused investor losses. The failures of a few investment managers also contributed to the problem. Credit arbitrage was a hedge fund strategy which involves purchasing subprime bonds on credit and hedging the 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 fuelling the problem. Leverage was involved and set the stage for a spike in volatility, which is exactly what   ISSUES AND ETHICS IN FINANCE (FIN657) NBF9D 3 happened as soon as investors realized the true, lesser quality of subprime CDOs. There’s  losses and many hedge funds shut down their operation as they ran out of money in the face of margin calls because they use a significant amount of leverage. Risks Involve In The Subprime Crisis There are three primary risk categories involved in the subprime crisis: 1)   Credit risk The credit risk would be assumed by the bank srcinating the loan. Due to innovations in securitization, credit risk is now shared more broadly with investors  because the rights to these mortgage payments have been repackaged into a variety of complex investment vehicles, generally categorized as mortgage-backed securities (MBS) or collateralized debt obligations (CDO). A CDO is a repacking of existing debt, and MBS collateral has made up a large proportion of issuance in recent years. In exchange for purchasing the MBS, third-party investors receive a claim on the mortgage assets, which become collateral in the event of default. MBS investor has the right to cash flows related to the mortgage payments. In order to manage their risk, mortgage srcinators such as banks or mortgage lenders may also create separate legal entities called special purpose entities (SPE), to both assume the risk of default and issue the MBS. The banks effectively will sell the mortgage assets to these SPE and then SPE will sells the MBS to the investors. The mortgage assets in the SPE become the collateral. 2)   Asset price risk CDO valuation is complex and related to fair value accounting. Due to lack of  precedent and rising delinquency rates, this valuation fundamentally derives from the collectability of subprime mortgage payments is difficult to predict. Banks and institutional investors have recognized substantial losses as they revalue their CDO assets downward. Most CDOs require a number of tests to be satisfied on a periodic basis, such as tests of interest cash flows, market values or collateral ratings. For deals with market value tests, if the valuation falls below certain levels, the CDO by its terms to sell collateral in a short period of time, often at a steep loss, much like a stock  brokerage account margin call. If the risk is not legally contained within an SPE or otherwise, the entity owning the mortgage collateral may be forced to sell other types of assets to satisfy the terms of the deal. In addition, credit rating agencies have downgraded over U.S. $50 billion in highly-rated CDO and more such downgrades are possible. Certain types of institutional investors are allowed to only carry higher-quality assets, there is an increased risk of forced asset sales, which could cause further devaluation. 3)   Liquidity risk A related risk involves the commercial paper market, a key source of funds for many companies. Companies and SPE called structured investment vehicles (SIV)   ISSUES AND ETHICS IN FINANCE (FIN657) NBF9D 4 often obtain short-term loans by pledging mortgage assets, issuing commercial paper or CDO as collateral. Investors provide cash in exchange for the commercial paper, receiving money-market interest rates. However, the value of the mortgage asset collateral linked to subprime loans and the ability of many companies to issue such paper has been significantly affected. In addition, the interest rate that charged by investors to provide loans for commercial  paper has increased substantially above historical levels. Effects of the Subprime Mortgage Crisis During the subprime mortgage crisis, home prices has fell tremendously as the housing bubble completely burst. This has crushed many of the recent homeowners, who were seeing interest rates on their mortgage rise rapidly as the value of the home deteriorated. People are unable to pay their mortgage on a monthly payment and also unable to sell the home without taking a massive loss. So many of them had no choice because the banks foreclosed on their houses and make homeowners were left in ruins, and many suburbs turned into ghost towns. Even homeowners with good credit who qualified for standard mortgages struggled with the steadily rising interest rates. At the time these homes were foreclosed upon, they had cratered in value which meant  banks were also losses on real estate. Investors effected as well, as the value of the mortgage- backed securities they were investing was in tumbled. People still buying homes even as the  bubble began to burst in 2006 into early 2007   which was made more difficult because loans were still being given out and taken as sales slumped. Investment banks who bought and sold these loans that were being defaulted on started failing and lenders no longer had the money to continue giving them out. When 2008, the economy was in complete freefall. Government help to bailed out some institutions while other banks, who had gotten so involved in the mortgage business, were not so lucky. Action to manage the subprime crisis Homeowners and lenders both may benefit from avoiding foreclosure, which is a lengthy process and   costly. Most of the lenders have taken action to reach out to homeowners to provide more favourable mortgage terms such as loan modification or refinancing. Home owners have also been encouraged to contact their lenders to discuss alternatives. Loan modification programs has been introduced to assist a corporations, trade groups, consumer advocates and types of homeowners. There is also some dispute regarding the appropriate measures, sources of data, and adequacy of progress. A report issued in January 2008 showed that mortgage lenders modified 54,000 loans and established 183,000 repayment plans in the third quarter of 2007, a period in which there were 384,000 new foreclosures. Consumer groups claimed the modifications affected less than 1 percent of the 3 million subprime loans with adjustable rates that were outstanding in the third quarter.

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Oct 7, 2019

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Oct 7, 2019
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