Why is sub-prime crisis of America called the sub-prime crisis? Are US sub-prime crisis and US financial crisis different events? Is the latter an epiphenomenon of the former?
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James C B.
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Hi Prashant,
The problems with our current 'crisis' actual go back to the U.S. Laws which were written in 1933, 1934 & 1940 (in another era) - Congress has simply failed to act to update these laws:
- $62 trillion credit-default swaps - 'largely unregulated', the NY Fed has taken the lead in organizing this market defining them in recent weeks as an insurance product and trying to clear them (through 'tear-ups' the last few months down to $54 trillion). The Bank for International Settlements cites the total outstanding notional amount of OTC derivatives at $596 trillion (12/ 2007) - $400 trillion are interest rate derivatives.
- $12 trillion of U.S. mortgages - 'failing non-prime', this July the Federal Reserve's issued new regulations for mortgage lenders: banning repayment penalties, prohibiting lenders from issuing loans to borrowers that cannot repay while requiring the verification of their incomes and assets, and requiring escrow accounts for property taxes and homeowner's insurance, as well as: actual appraisal of a home's value and good faith lending practices.
- Housing bill signed into law: creating the FHFA (Federal Housing Finance Agency, GSE's regulator) for Fannie Mae and Freddie Mac (increasing limits to $625,500 from $417,000), modernizes/authorizes the FHA to insure up to $300 billion in refinanced mortgages, creates an affordable housing trust fund and $15 billion of home buyer's tax credits (States can offer an additional $11 billion to refinance subprime loans while increasing down payments to 3.5% from 3%) and grants $3.9 billion to buy and rehabilitate foreclosed homes.
- FHFA (Federal Housing Finance Agency) places Fannie Mae (with Herb Allison of TIAA-CREF) and Freddie Mac (with David Moffett of U.S. Bancorp) into conservatorship - dividends on both the common and preferred shares will be eliminated. Interest and principal payments will continue to their companies' securitized bonds and subordinated debt. The Treasury will 'backstop' both agencies with up to $100 billion (each) of a special class of stock - the Treasury through senior preferred stock and warrants will own 79.9% of each agency. Their portfolios "shall not exceed $850 billion as of 12/31/09, and shall decline by 10% per year until they reach $250 billion" - Fannie's is $758 billion and Freddie's is $798 billion.
- $3.35 trillion of money market funds - 'uninsured', Paulson's Treasury using its authority protects US money market mutual funds in the past days with insurance (using a $50 billion fund) - as some of the $3.35 trillion of funds 'broke the buck'.
$2-3 trillion Hedge funds / naked-shorting - 'largely unregulated', now reporting of short-selling. Short selling by Hedge funds of $100 million must now report positions to the SEC. SEC issues rules for short sales requiring delivery of securities by the settlement date, effective Sep 18. SEC rescinds the 'tick test rule', repealed on July 6, 2007.
Emergency Economic Stabilization Act of 2008 (EESA) a $700 billion rescue of financial institutions by purchasing devalued mortgage-linked assets (Paulson's Treasury Dept. will administer the Troubled Asset Relief Program, or TARP) - protection and tax beaks for taxpayers (equity positions in the financial institutions participating), limits on executive's compensation, independent oversight and transparency, help to prevent home foreclosures (modifying troubled loans), raises FDIC to $250k from $100k and an insurance option into which banks would pay. Federal Reserve receives authority to pay interest on reserves and the SEC receives the power to change mark-to-market accounting rules.
The US Congress doesn't act until after the disaster - public concern/outrage will bring about new laws. Failing to write laws to cover the above mentioned areas caused the problems.
JC Brandon
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Nora S.
Research assistant at Universiteit Gent (vakgroep Financiele economie)
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Dear, although this may appear as a very simple question, I believe there are still people using these terms without knowing what they are talking about. Simple question requires simple answer, and I will try to give you one:
The current financial crisis (in the USA and worldwide) is triggered by the sub-prime crisis, but they are different events. Sub-prime crisis started because of the defaults in the sub-prime loans which were granted, as the name says, to sub-prime borrowers. Hence, as the borrowers could not repay their loans anymore, the Pandora box opened: their loans were repackaged into more complex market instruments, which started losing value after the defaults. Now, there is a lot of discussion for why things went wrong afterwards, but in a nutshell: deteriorated instruments were held by financial institutions, and marked to market in the books. Market value dropped, the assets were shrinking, which required capital. Not only capital was in danger, but also liquidity squeezed in the meantime because of the opacity in the market and hiding of subprime losses. Summa summarum, US financial crisis is a consequence of the sub-prime causes, among other causes...
Jerry Y.
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Prashant,
You are correct, the sub-prime crisis is the key to the overall financial crisis. Unfortunately, there are those who have a significant stake in placing the blame for the crisis. They prefer to refer to the crisis as a "sub-prime crisis" so they can focus the rhetoric of the argument on housing.
This is foolish but real.
I hope this helps,
thanks
jerryork@gmail.com
please feel free to invite/link!
Lynn W.
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There were two sides of this ... with toxic CDOs getting triple-A credit ratings, sitting in the middle.
Toxic CDOs were used two decades ago to package up low-value mortgages, obfuscate this underlying value ... and sell the CDOs at much higher value than warrented by the underlying properties. In the current scenario, the obfuscated, CDO underlying value was further obfuscated by triple-A credit ratings.
It used to be that home owner market was indirectly regulated, loans would be by regulated financial institutions that used deposits ... and they would keep the mortgages on their books ... so there was significant motivation to pay attention to loan quality.
With triple-A rated, toxic CDOs, unregulated mortgage originators could fund their operations as well as unload mortgages off their books almost immediately. As a result there was little motivation to pay attention to loan quality. Sub-prime mortgages were normally targeted at low-income, first time home buyers. However, no-documentation, no downpayment, 1-2 percent introductory rate ARMs, possibly with interest only payments ... started to be picked up by speculators. Speculators were able to treat the home owners market like the unregulated 1920s stock market with this sub-prime mortgages. As a result of the speculation, there was a huge, ugly pimple/boil inflation in the home owner market (a lot of market segments where you wouldn't ever find low-income, first time home owners).
Plot avg. home prices as well as avg. home prices as percent of avg. salary going back to 1970. There is start of huge, ugly pimple/boil inflation in the home owner market starting in the early part of this decade and has only about halfway deflated (boil is much more appropriate than bubble since the underlying factors are a lot more putrid than what would be found in bubble).
The speculation also created the impression that demand was much larger than it actually was. As a result there were a lot of institutions doing "normal" borrowing as part of meeting this demand; builder getting construction loans putting up housing projects, strip malls, etc ... to meet this big spike in demand. The boil bursts and the real estate isn't selling, and they are getting into trouble paying off loans.
There were also municipalities selling bonds as part of putting in utilities (sewer, water, roads, etc) for all these new developments. They are running into problems because the real estate hasn't sold, since the tax revenue is slow to materialize to make payments on the bonds. Earlier this year the bond market also froze up because loss of confidence in the rating agencies (after they had given out all those triple-A rating on toxic CDOs) which created a lot of ambiguity in value of the bonds. Warrent Buffet stepped in to at least unfreeze the municipal bond market.
On the institutional side of the triple-A rated toxic CDOs, there are unregulated investment banks and/or investment banking arms of regulated banks heavily leveraged buying up this (subprime motrage backed) triple-A rated toxic CDOs (some cases leveraged 50-80 times).
There is also institutions using short term 30day commercial paper to buy these (30yr sub-prime mortgage backed) toxic CDOs ... recent quote:
Best practice transfer pricing calculations would have made it clear that neither Bear Stearns nor Lehman Brothers had more than a marginal chance of survival when funding 30 year sub-prime mortgage loans with thirty day borrowings.
... there are examples dating back centuries of insttitutions and countries going under, playing the game using short term borrowing to fund long term investments.
Links:
- http://www.linkedin.com/answers/management/organizational-development/MGM_O...
- http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
- http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-si...
Clarification added October 16, 2008:
on the institution side playing long/short mismatch .... recent related answer
http://www.linkedin.com/answers/management/organizational-development/MGM_ODV/343639-20737334
along with a couple URLs discussing institutions/countries playing the long/short mistmatch
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-siv-ent-fin-cx_bh_1113hamiltonmatch.html
Clarification added October 20, 2008:
recent answer about the agencies giving out triple-A ratings to those toxic CDOs.
A couple weeks ago, one of the TV business news shows had a guest from one of the credit rating agencies on to discuss downrating of some companies. The host spent quite a bit of the time attempting to get the guest to taking responsibility for the current crisis.
Poor Performance of Credit Rating Agencies
http://accounting.smartpros.com/x60011.xml
from above:
December 2007 Soon after Merrill Lynch disclosed its $8.4 billion write-down because of problems with collateralized debt obligations (CDOs) and other financial instruments relating to subprime mortgages, the credit rating agencies started downgrading the securities. But, this is like the proverbial soldier who watches a raging battle from afar; when the war is over, he proceeds to bayonet the wounded.
... snip ...
the above article makes a point that rating agencies were paid quite a bit of money for giving triple-A rating to the toxic CDOs ... the article makes the following point:
Third, on page 42 of the report, the SEC promises to explore whether these credit rating agencies "should implement procedures to manage potential conflicts of interest that arise when issuers [pay] for ratings." Either the SEC did not keep its promise or such actions are inadequate. Clearly, the credit rating agencies have not responded any differently to the CDO problem than they did with Enron's circumstances.
... snip ...
regarding the this SEC report:
Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets; As Required by Section 702(b) of the Sarbanes-Oxley Act of 2002
http://www.sec.gov/news/studies/credratingreport0103.pdf
Actually sub-prime was the trigger for this turmoil. We've had nice financial products backed with "good" portfolio of loans (usually home equity loans"), nicely presented by a rating agency - result: every body who wants a "good' investment bought such instruments. Ultimately those "good" loans portfolios proved to be loans granted based on faked data or without considering the real indebtness ratio (remember loans granted with interest like 2-3% in the first 2-3 years and after that variable interest linked to market conditions)....default go up and these baked portfolios starts not to be considered a real assurance for the nicely investment products and of course people starts to sell of...first impact Banks problem...after….as you can see
Ashutosh G.
An experienced CMA (AICWA) professional, Unit Finance Controller in a reputed Print Media Group
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sub-prime crisis of America and US financial crisis are co-related, interlinked BUT are two separate events. One can also assume that latter is an epiphenomenon of the former as a matter of wider consequential impact.
Simply speaking sub-prime crisis did arise due to defaults in the re-payment of the loans granted to sub-prime borrowers BUT QUESTION ARISES WHY?????
-why in so much Huge quantity
-why by overlooking the regulations, security and credit worthiness
-wherefrom such money come and who were the stakeholders
-why the original stakeholders did not object to that
-why the regulatory authorities remain the silect spectators
-why the Auditors did not report that scam in their reports
-what motivated to such a scam to happen with
-why the Financial packages/Insturments/Derivatives were developed with such inherent risk, cheap qualitative aspects and WHY the Credit Rating agencies have lied upon, intentionally defaulted in their duties
-why for the sake of short term benefits whole system was put into fire
- the current global financial crisis is not the effect of one day but did take to erupt adequate time in sequences and series of which sub-prime crisis was one event did happen as a precedence to overall crisis BUT it is gross concealment and deriliction of the duties by the concerned Bankers, FIs, Auditors, Credit Rating Agencies, Stakeholders and Govts. too.
To answer so many WHYs we need take up them one by one because each one is a distinctive topic and would figure out the real nexus and culprits.
Therefore, would welcome the participants to discuss each 'why' in details.
Regards
CMA Ashutosh Kumar Gupta
Dear Prashant,
The sub prime crisis and the financial crisis are interlinked but are different events.
1) The Sub prime crisis started when the housing boom resulted in increasing home loans and the banks sold their loans to bigger ones. This was further converted to complex trading instruments. When the banks ran out of good repaying cm's they went for defaulting cm's but there was a tag. HIGHER INTEREST. More interest means more business and bigger ones started buying the loans and raising funds from the markets by way of bonds and showing the housing loans as collaterals. The housing boom stopped and the price of the houses came down. At a point it was more profitable to just default a loan than to pay it. Since the price of the houses was cheap and the loans on them was high. So the number of deafulters rose and the banks had huge amounts in defaults and they had to pay the lenders. This lead to the fall of big banks and financial institutions.
2) The financial crisis is much more complex. It involved problems like Balance of payments.Eg US imports goods from China and for paying them they again borrow money from china. All MNC the main contributor for the US income has moved their operations to ASIA and Africa. Expensive Wars were fought in Afghanistan, Iraq etc....Huge chunk was given to pakistan and other allies to maintain peace. The rising of other currencies like Yuan, EURO. The economic boom of China and India were sufficient domestic demand is available and no assistance from US was required. Most important the credir card spending based economy where the demand for goods was the key for the revenue of the country.
The sub prime crisis is a part of the above mentioned financial crisis. US needs more stringent economic policies and business practices to revive teh economy. But the fear is that US might not be super power any longer. It could be replaced by China and India in the next few years if things don't improve
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Nothing worse than this ever happened........
