ABSTRACT
This study explores on the effects of the subprime financial crisis (SFC) on the United States (US) that lasted between 2007 and 2011. Key to understanding the foregoing requires further exploration of the history of subprime lending in the US and its implications to the SFC. A qualitative review of studies under the provided brief literature review provides the methodology for the accomplishment of this study. Findings show that apart from worldwide economic effects, the US greatly suffered from the collapse of its subprime lending market, the decline of financial institutions due to providing too much allowance to granting and foreclosure of real estate properties. The practice of financial institutions and their susceptibility to subprime lending coinciding with real estate appreciation help explains why the US suffered the alarming effects of the SFC.
1- Motivations
Understanding the reasons behind the subprime financial crisis (SFC) that adversely affected financial institutions in the United States (US) between 2007 and 2011 is a central motivation for the conduct of this study. The US, being the largest economy in the world, hosts several financial institutions that contain not only domestic investments, but also international ones coming from foreign governments and corporations. Thus, the omnipresent force of US financial institutions on the world economy featured a grave decline when subprime borrowers – those who have difficulty maintaining loan repayments, of loans in the form of mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) defaulted. The massive impact of the SFC, manifested through the downfall of major financial institutions in the US, resonated throughout the world economy. The global effect of the SFC also stands as a crucial motivation for the efforts this study undertakes. The status of the US as the largest economy in the world does not just provide domestic implications, but also consequences the world economy must prepare to face.
2- Brief Literature Review
Brescia (2008) considered the SFC in recommending laws as trust-creating mechanisms that would prevent its recurrence. The SFC proved a devastating malady to the entire US economy, it being a problem arising from a single sector (loans and securities) that has affected other sectors not only domestically but also internationally, as it affected investments in US financial institutions from foreign governments and corporations. Foreclosures, in particular have become the most manifested problem of the SFC, given that many of those who have defaulted from MBSs and CDOs were homeowners who were also subprime borrowers. Initial analyses have provided the finding that “asymmetry of information and inadequate legal protections created market incentives that led to the collapse of [the loans and securities] sector,” largely affected by the lack of “trust and mutual interdependence” (Brescia, 2008) that is supposed to characterize the creditor-debtor relationship. In this case, the weakness of subprime borrowers in terms of maintaining loan repayments serves as a violation of mutual trust that should exist between their relationships with financial institutions that granted them with MBSs and CDOs. In introducing legal protections for the loans and securities sector to protect against a return of the SFC, it is important to recognize the possibilities of trust-related changes in markets, in that non-legal mechanisms informally enforcing high trust may lose effectiveness over time with the presence of “a legal vacuum where abuse of trust could thrive” (Brescia, 2008).
Demyanyk and Van Hemert (2011) provided elaborated understandings on the SFC through an analysis on the quality of subprime loans issued prior to 2007. Performance adjustments accommodating borrower characteristic differences, features present in loans and circumstances pertaining to the prevailing macroeconomic regime. Due to subprime borrowing, subprime loans featured a drastic decline in quality during the six years that immediately preceded the SFC. Despite the awareness, albeit partial, of securitizers on the declining quality of subprime loans, they were unable to prevent the SFC that unfolded in 2007. The resultant decline of the loans and securities sector in the US owes to the “classic lending boom-bust scenario” that led to the collapse of subprime lending. Unsustainability from the foregoing emerged from the very instance financial institutions allowed the issuance of subprime loans – a decision that gained hazardous effects with the surge of subprime borrowers and their eventual decision to default. The connection of subprime loans to real estate further explains the perilous circumstances that emerged when the SFC unfolded. The rising prices of houses, many of which subprime loans have covered, became a concealing factor that prevented securitizers from taking further actions against subprime lending (Demyanyk & Van Hemert, 2011).
Hellwig (2009), in focusing on the systemic elements of the SFC, noted that while the MBSs and CDOs granted to subprime borrowers constituted only a “small part of the overall system”, it nevertheless transpired into a global economic crisis. Mortgage securitization, Hellwig (2009) explains, allowed for risk allocation from investments made in real estate, yet such system failed in the US and catalyzed the SFC. Moreover, systemic risks emerged from the SFC, with two identified by Hellwig (2009): the excessiveness of maturity transformation and the interaction between market breakdown, fair accounting practices in light of insufficient equity capital at financial institutions and the effects of practical regulation to the system. The failure of financial institutions in the US resulting from the SFC attributes not only to subprime lending decisions already identified by securitizers, but also to severe imperfections contained within the financial system, which is mostly related to mutual trust and reliance and transparency. The foregoing asserts that systemic changes benefiting financial institutions in the US must go hand-in-hand with supervising and incentivizing individual actors involved, specifically within the loans and securities sector of the US, in order to prevent the SFC from happening again (Hellwig, 2009).
Kliff and Mills (2007) noted that while the SFC became a national issue upon its unfolding in 2007, its effects did not immediately spilled over central financial institutions in the US. Through a description of the history and structure of subprime lending in the US, findings reveal that “new origination and funding technology” have provided an image of stability for the SFC without due attention to its perils on the welfare of consumers. The SFC entailed the closure of financial institutions, notably those that have granted subprime loans and frequent foreclosures and delinquencies, amidst constricted regulations on subprime lending. The incentive of financial institutions to issue subprime loans heightened when the real estate market in the US enjoyed a sizable period of appreciation, in effect masking the underlying dangers of subprime lending centered on the ability of subprime borrowers to maintain loan repayment. The emergence of the SFC arising from the foregoing scenario entailed the collapse of financial institutions in the US despite the presence of tight regulations in subprime lending. Thus, Kliff and Mills (2007) recommends for a policy model that considers setting a balance between making the securitization model more viable and protecting consumers from perils arising from subprime lending and other high-risk lending practices of financial institutions. “The need to limit future predatory lending excesses” (Kliff and Mills, 2007) while maintaining the viability of subprime lending without inflicting costly consequences to the ability of subprime borrowers to replenish payment sources emerges as a perplexing yet beneficial regulatory undertaking for financial institutions and consumers alike, as they look for preventing a repeat of the SFC.
Lim (2008) explored on explanations behind what caused the SFC and its consequences to the entire US economy. Understandably, the SFC arose from a specific activity within the loans and securities sector of the US, subprime lending. While subprime lending, with its tight regulations, only constitutes a small part of the loans and securities sector of the US, its unregulated practice supported by the concealing effects of real estate appreciation led to the unfolding of the SFC in 2007. Further findings by Lim (2008) indicate that the SFC bore daunting similarities to the savings-and-loans crisis in the US during the 1980s and the Asian Financial Crisis of 1997, in that it featured essentially the same kinds of financial strategies (financial risk mismatching and leveraging) alongside financial innovations. As the “old wine in a bottle” adage mentioned by Lim (2008) in the title of his article articulates, the problems encompassing the SFC incorporate those that featured in previous financial crises. Yet, Lim (2008) further expounded on the subject matter by distinguishing the SFC through its causes, particularly on deregulation, weak restrictions on monetary policies of financial institutions and excess liquidity (Lim, 2008).
Purnanandam (2011) cites the originate-to-distribute (OTD) lending model as among the main reasons behind the SFC. Under the OTD lending model, the originator sells the loan to different third parties. Many of the loans originated through the OTD lending model prior to the SFC were of low quality, but such does not pertain to poor property locations, quality of borrower that is readily observable and capital costs of financial institutions with high and low engagement in OTD lending. Rather, Purnanandam (2011) provides findings pertaining to the fact that many borrowers, understood as subprime under OTD lending, did not undergo rigorous screening processes. OTD lending also caused severely adverse effects to financial institutions with capital constraints. Therefore, it should be within the prerogative of financial institutions to focus and invest on screening their borrowers in order for them to prevent a similar instance to the SFC from recurring in the future. The viability of borrowers in terms of rendering repayment is a key consideration for ensuring high quality for OTD loans (Purnanandam 2011).
Samuel (2009) outlined his main considerations for preventing the SFC from recurring through the following items: “disclosure, compliance and cure”. Full market disclosure, in light of the SFC, stands as a necessary solution in lieu of inflexible regulations that may not meet the needs of the constantly changing arena of global finance. Intensive monitoring of all activities rendered by financial institutions and all other related organizations would result from full market disclosure. Considering the foregoing, full market disclosure is “necessary both to the operation of efficient markets and to the maintenance of fundamental fairness in the market” (Samuel, 2009). Afterwards, the establishment of a regulatory body ensuring full market disclosure will provide incentives to compliance for financial institutions, as they prove that they are not engaged in any form of dishonest activities. For the long term, however, it is crucial to develop an environment of compliance within financial institutions wherein actors voluntary comply rather than act on the pressure of external forces. The SFC serves as the effect of an environment encompassing financial institutions that lacks full market disclosure. Thus, to prevent the reemergence of the same problems that led to the SFC, financial institutions must observe full market disclosure for them to show their prudence in lending practices (Samuel, 2009).
Sanders (2008) agreed that the SFC featured a boom-bust scenario that originated from the prevalence of subprime loans and real estate appreciation. Prior to 2005, findings show that local forces per US state drive mortgage and real estate price trends. Yet, the increased number of subprime borrowers looking to purchase real estate properties unified the movement of mortgage and real estate price trends in US states, particularly in Arizona, California and Nevada. Econometric models focused on historical data underestimated the rapid increase of subprime loans connected to real estate in the years approaching the SFC. Given the foregoing regard, financial institutions take much of the blame simply because they failed to understand the implications of real estate appreciation to the then-growing number of subprime borrowers, many of them having chosen to default, collectively causing the SFC (Sanders, 2008).
Schwarcz (2008) took on his understanding of the SFC by emphasizing on the importance of disclosure. The growing complexity of the actions of financial institutions that led to the SFC provided for the reason behind the failure of disclosure therein. Findings generally point to the failure of disclosure in the event complexity within financial institutions increases. Yet, Schwarcz (2008) provided several “second-best” but crucial responses to the problem of complexity confronting disclosure – a factor that could lead financial institutions away from the recurrence of the SFC. After all, there is an understanding that perfect solutions to the foregoing have yet to emerge. Some of the recommended responses include the requirement for “originators to take a reasonable first-loss position” while ensuring remedies to information failure by originators, reduction of agency costs connected to conflicting personal and institutional interests of workers in institutions by institutional investors and efforts by rating agencies to improve “private certification” quality via securities ratings. Whereas none of the foregoing responses proves perfect given the flexible dynamics of the financial system, such ensure that the SFC would not recur and imperil anymore (Schwarcz, 2008).
Shirai (2009) provides in her study that the SFC has marked a negative impact on cross-border capital movements between the US, United Kingdom (UK) and East Asia, considering the collapse of US financial institutions that emerged resulting from the unsustainable number of defaulting subprime borrowers. The prevalence of subprime lending in the US, which has owed to lax restrictions and lack of stringent screening processes on the part of financial institutions originating mortgages for real estate, has imperiled not only domestic investments, but also the investments of foreign governments and corporations. The central role of the US in the global economy, being the home of financial institutions containing investments and deposits of government and corporate actors from different nations, made the impact of the SFC felt throughout several parts of the world, as manifested through economic growth, international trade, exchange rates and other similar indicators (Shirai, 2009).
3- Analysis
3.1. Introduction
The brief literature review on the SFC underlines its urgent nature as a catalyst for the so-called “Great Recession”, which refers to its repercussions to the global economy. The failure of financial institutions in the US to screen borrowers of mortgages for real estate stringently characterized the practice of subprime lending as a harmful precedent for the SFC. Financial institutions took for granted the real estate appreciation in entertaining several subprime borrowers through granting mortgages they know they cannot pay on a maintained basis. The increased amount of mortgages that have low quality due to their subprime borrowers led financial institutions to have difficulties in reselling their loans, particularly when many have defaulted from repayment. The result of the massive number of defaults that transpired in 2007 led to the SFC, pulling along with it as its mammoth collateral the billions of dollars in investments by foreign governments and corporations in US financial institutions. Further portraying the causal flow of the SFC, as summarized in the foregoing based on the brief literature review, are data pertaining to the following aspects: the amount of securitized subprime loans originated by financial institutions and defaults portrayed by delinquencies. Said data provides insights on what happened in the US during the SFC.
3.2. Subprime Financial Crisis
Source: Demyanyk & Van Hemert, Understanding the Subprime Mortgage Crisis (2011)
The market for subprime loans, which grew steadily in six years prior to the onset of the SFC in 2007, coincides with the appreciation of real estate properties in the US that took place during the same period. Such is pertinent to the prevailing reasons provided by existing literature as stated in the brief literature review, which pertains to the complacency of financial institutions in lending subprime mortgages to subprime borrowers in light of real estate appreciation. The housing bubble that emerged in the US duly provided for the increase in subprime lending activities by financial institutions in the nation. With prices of houses having greatly appreciated, consumers have gained incentives for taking our subprime mortgages as their second loans for financing their houses. Yet, with many subprime borrowers eventually defaulting by 2007, the market for subprime loans in the US collapsed at around the same time. Several financial institutions in the US reeled from the effects of numerous defaulting subprime borrowers and eventually failed, thus causing a crisis of worldwide proportions that damaged the investments and deposits of foreign governments and corporations. More importantly, however, the integrity of the market for subprime lending in the US featured at the center of the controversy, given its devastating effects on consumers, investors and depositors alike due to the involvement of maladies such as inadequate screening processes and lack of disclosure on the part of financial institutions (Demyanyk & Van Hemert, 2011; Samuel, 2009; Schwarcz, 2008).
Source: Demyanyk & Van Hemert, Understanding the Subprime Mortgage Crisis (2011)
The collapse of the market for subprime loans in 2007 has taken place following the number of defaulting subprime borrowers that steadily increased six years prior to the SFC. Both of the figures shown above provide that there have been a significant number of defaulting subprime borrowers starting from 2007. In the first six years (2001 to 2006), the yearly actual delinquency rate (ADR) steadily increased, with data (left side) showing that subprime borrowers with longer loan ages featured higher delinquency rates. The ADR for hybrid mortgages measured yearly (left side) drastically rose from an estimated 11% in 2006 to nearly double at an estimated 18% in 2007, while the same for fixed-rate mortgages (FRMs) stood relatively stable at nearly 10% for both 2006 and 2007. Such provides that the more complex the subprime loans, the more that subprime borrowers drive themselves towards defaulting. FRMs allow subprime borrowers to have a clear knowledge that they are only supposed to pay a set fee during a given payment period, hence allowing them to avert difficulties associated with the complexity of hybrid mortgages (Bernanke to Demyanyk & Van Hemert, 2011). Such duly connects to the active trend of foreclosures during the SFC. Many people in the US, specifically subprime borrowers, lost their homes resulting to the bursting of the real estate bubble in the nation connected with the SFC. US consumers greatly weakened due to the devastating effects of the SFC on the loans and securities sector leading to the closure of major financial institutions and the collateral exposure of other markets domestically and internationally (Kliff & Mills, 2007).
4- Conclusions
What happened to the US during the SFC? The brief literature review and analysis this study has previously presented provides for robust findings supporting the following answers: the market for subprime lending collapsed, financial institutions collapsed due to defaulting subprime borrowers pointing to both institutional and individual mistakes and massive real estate foreclosures have followed. Given the peril caused by the SFC, it has become important to consider the implementation of a viable regulatory measure for financial institutions in the US concerned with their lending activities. Disclosure emerges as a highly critical issue for regulating financial institutions in the US, given that it ensures transparency and honesty towards averting risk-prone decisions such as lending subprime mortgages. Urging compliance in disclosure through legal postulations stands as another key recommendation for the problem this study has posited, although such requires flexibility given the flexible dynamics of the financial system.
References
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Demyanyk, Y., & Van Hemert, O. (2011). Understanding the subprime mortgage crisis. The Review of Financial Studies, 24(6), 1848-1880.
Hellwig, M. (2009). Systemic risk in the financial sector: An analysis of the subprime-mortgage financial crisis. De Economist, 157, 129-207.
Kliff, J., & Mills, P. (2007). Money for nothing and checks for free: Recent developments in US subprime mortgage markets (Working Paper No. 188). Retrieved from International Monetary Fund website: http://www.imf.org/external/pubs/cat/longres.aspx?sk=21200.0
Lim, M. (2008). Old wine in a new bottle: Subprime mortgage crisis – causes and consequences. (Working Paper No. 532). Retrieved from Levy Economics Institute of Bard College website: http://www.levyinstitute.org/publications/?docid=1061
Purnanandam, A. (2011). Originate-to-Distribute Model and the subprime mortgage crisis. Cleveland State Law Review, 24(6), 1881-1915.
Samuel, D. (2009). The subprime mortgage crisis: Will new regulations help avoid future financial debacles? Albany Government Law Review, 2, 217-258.
Sanders, A. (2008). The subprime crisis and its role in the financial crisis. Journal of Housing Economics, 17, 254-261.
Schwarcz, S. (2008). Disclosure’s failure in the subprime mortgage crisis. Utah Law Review, 3, 1109-1122.
Shirai, S. (2009). The impact of the US subprime mortgage crisis on the world and East Asia. (MPRA Paper No. 14722). Retrieved from Munich Personal RePEc Archive website: http://mpra.ub.uni-muenchen.de/14722/
