The Impact of Toxic Debt - Essay Example

Following the sub-prime crisis and the impact of Toxic debt is there a future for the securitization of commercial property? Table of Contents Introduction 3 Origin of subprime crisis 3 Impact of Sub Prime Crisis and ‘Toxic’ Debts 10 Future of Securitization of Commercial Property 11 References 14 Bibliographies 15 Introduction In the mid of 2007, many leading banks in US and Europe collapsed due to value of mortgage-backed securities. These banks were themselves responsible for such packaging of complex credit derivatives. It was observed that majority of their asset base turned out to be poisonous. After facing such a situation these financial institutes started hoarding cash and this resulted into credit crunch liquidity crisis. The Wall Street brokers and investors lost around $175 billion of capital within the July 2007 to March 2008 (Blackburn). This crisis occurred when the world was enjoying a phase of strong macro-economical growth and a low interest rate. But soon turbulence came with sudden loss of confidence within the securitization and financial engineering sector. The present statistical model for assessing & pricing credit risk can be blamed for the disastrous situation that engulfed the entire financial world. The most surprising fact about the crisis was that it originated in those countries which were believed to have the most efficient risk management technology. (Caprio, Demirgüç-Kunt & Kane, 2008, p. 2). With the unfolding of the crisis, the financial world witnessed a series of unpredicted and unprecedented events which uncovered the fault of AAA credit rating system used in UK banks for more than 150 years. The crisis, also known as meltdown, even highlighted the default of US safety net for covering major insurance banks; investment banking and government sponsored housing finance companies. Downfall in the major economic drivers led to sharp plunge in world wide stock and capital markets. This crisis soon migrated from US to other developed countries and economies like that of Australia, Ireland, and Germany. It can be estimated that the loss caused by this financial crisis lies in between the ranges of $1 trillion to $2 trillion (Caprio, Demirgüç-Kunt & Kane, 2008, p. 2). Origin of subprime crisis The crisis that engulfed the financial market since august 2007 had its origin in the housing mortgage market of the United States. Housing markets in other countries like Australia, Canada, Spain, and United Kingdom were also facing high rise in prices along with the highly leveraged mergers and acquisition. But none of these countries faced financial crisis due to the housing bubble, so this makes the fact clear that there were certain distinguished features with in the US housing finance system that gave birth to such enourmous financial crisis. The prime factors can be segregated as below: 1. The construction boom created excess supply Housing construction peaked in the United States by early 2006. But by the end of the same year, tremendous fall of around 40 percent was noticed in housing sector. Unlike other countries where demand was still high for housing, in US higher demand was met with high supply. In fact, the supply soon exceeded demand and this had major role to play as the background for the present financial crisis. Later when the boom in housing sector healed, US housing market was left with overhang of excessive demand. It was observed that number of empty and vacant houses was quite high in US which were the clear indicator of over supply. The ratio of housing construction to GDP also went low with passage of time. The picture becomes more when this ratio was compared with other countries housing construction to GDP ratio. Housing construction as percent to GDP US housing vacancy percent rate (Source: Ellis,2008, p. 2) 2. Lending standards seem to have eased more in the United States US maintained a loose lending system as compared to other countries. It kept the rules quite lenient in documentation standards, loan to valuation ratio, and also it allowed such loans where prices are not paid at the early stage of their lives. As the consequence of this, longstanding homeowners ended up with zero or in some cases even negative value. The reason behind for misbalance between rates was due to legislative and policy changes that were made by government to encourage development in non-conforming lending sector. The other factor was that the federal government wanted to reduce dominance of Government Sponsored Enterprises (GSE) in home mortgage market. It was observed that referencing wave of 2003 had fallen with an overall fall in fee income within entire industry. As per the report by Federal Reserve’s 2004 Survey of Consumer Finance, around 45 percent of the houses with first mortgage were refinanced within the time lag of three years. US MBS issuance Subprime lending standers in peercentage (Source: Ellis,2008, p. 6) The lenders were responsible for such ease in underwriting standards. Their prime objective was to give a strong competition to non-conforming mortgages as they were gaining strong market. Soon the lending banks made their entry into mortgage market through their mortgage lending subsidiaries. All these factors resulted into such scenario that promoted increase in arrears and default rates. While providing the loan, lenders hardly cared about the repaying ability of the borrowers; rather they where paying importance toward the collateral value. Another reason for formation and development of financial crisis in US was the early rise in mortgage rates. The rates rose with great pace which was not at all anticipated. This was an exceptional case where as the mortgage arrear rate increased with moderate speed in other countries. Surprisingly, the increment in rate occurred before the macro economical down turn was triggered and melt down in housing sector started. It was observed by Federal Reserve’s Survey of Consumer Finance that home equity loans increased from 5 percent in 2001 to 8.6 percent in 2004. This was due to increased use of secondary mortgage, called piggy back. These loans became highly popular and people find these loans more attractive compared to paying for mortgage insurance. These piggy back loans were not disclosed to the first mortgage originators. Hence, this silent second line accounted for nearly 25 percentages of securitised subprime loans and 40 percent securities in 2006. The loan-to-value (LTV) ratio went on increasing and soon crossed the 100 percent financing standard. The same state in LTV ratio was also observed in UK and Netherland. Many US buyers used third party funding while making down payments. Such involvement of third partly acted as a catalyst for accelerating LTV ratio. Interest only and negative amortisation loans also gained high popularity in US during 2006 onward. As per the Loan Performance data, interest only-loans accounted for 33.7 percent of the total securitised purchased loans in US during first quarter of 2007 and 7.3 percent of the loans were negatively amortised. These negative amortisation products were commonly known as Option ARMs or pay-Option ARMs and they played a vital role in sending borrowers into a negative equity. 3. Arrears rates deteriorated before the economy did Before the onset of housing sector fall, high rise was noticed in mortgage arrear. As the result rates started in moving up with a faster rate and continued just before the economical downfall. This upward trend in economy was seen even before the rate of unemployment started booming. But as soon as the credit standards got tightened, arrear rate slowly lost their momentum. Arrear rates and unemployment (Source: Ellis,2008, p. 10) Through tightening of the credit rate, lenders tried to reduce availability of subprime loans but this set was taken quite late, so it was unable to reduce the primary default which had already taken place. Conditions were exactly opposite in other countries. The movement in arrear rate was quite unusual if one compare it to the fall in housing prices. Arrear rates and housing prices (Source: Ellis,2008, p. 10) If all the factors where taken together, it will be parity clear that it was not the subprime loans that actually lead to formation of such a gigantic financial crisis that had engulfed whole world and in spite taking so much of efforts, countries are still unable to come out completely from the phase of depression and recession. This might be that people still don’t understand the exact meaning of subprime. As per the definition provided by Deportment of Housing And Urban Development (HUD) the loans which originated through subprime lenders are called subprime loans. These subprime lenders use to provide loan to the lenders without under taking customers’ FICO scores into consideration. 4. Other factors responsible for subprime crisis One of the major differences between US and other countries’ housing sector is the difference in demand elasticity. It was noticed that demand was much more elastic in US as compared to other countries. As per the theorists such elasticity is good as it keeps a check on price movement and limits overvaluation. The US legislative and regulatory bodies were also responsible for making the housing demand flexible. As the regulations were less stringent in many parts of US, so it was much easier to carryout construction in those areas. The impact was high demand and high prices in housing sector. Relative housing and labour market performance (Source: Ellis,2008, p. 16) Impact of Sub Prime Crisis and ‘Toxic’ Debts Sub prime crisis mainly was the consequence of a dramatic rise in the foreclosure rate in the United States that adversely affected almost all banks and financial institutions world-wide. With a decline in the US home prices, the Adjustable Rate Mortgages started mounting up, and as a consequence, mortgage delinquencies heightened up as well. However, in order to forward these loans, the banks had sold securities to a number of financial firms which have found them lucrative previously as they yielded greater rates of interest than the securities backed by prime loans. However, as the Federal rates started lowering, and the mortgages kept against subprime loans started losing their value, it led to a severe liquidity crunch world-wide, as all those firms which had previously invested in those securities eventually started losing their asset value. The fall in value of these mortgages resulted to a default on part of the banks and other loan forwarding financial institutions on the payment of interest on the securities that the former had sold to the financial firms, thus leading many global financial institutions who had invested in such securities to declare themselves bankrupt along with the banks who had previously forwarded the loans to the subprime lenders. The banks were in no position to recover from these losses, since the people who had taken loans against these mortgages, i.e., the sub prime lenders, voluntarily .walked out of these loans when they saw that their value have fallen. They found it more profitable to walk away with the loans rather than repaying back the debts and freeing away their mortgaged assets. So, the banks had no option but to write off these subprime debts. But writing off these debts meant a huge loss for the banks and they were now in no position to forward any more loans – actually after falling face-to-face with such enormous loss amounting to billions of dollars, the banks were not confident enough to forward anymore loans, and hence in a way stopped any further lending, and especially to the subprime sector, which previously had appeared to be very lucrative to the banks due to the high rate of interest that could be extracted from them. This liquidity crisis or credit crunch throughout the world, made it very difficult for the investors to raise or borrow money for further investments. As a consequence, the rate of investments throughout the world came down. The situation arising from a fall in the number of investments throughout the world due to a lack in the necessary credit is termed as a liquidity crunch or a credit crunch. This fall in the number of investments resulted to a slowdown in the financial markets worldwide and affected the growth and developmental structure of almost all economies throughout the world. This slowdown was evident from various stock indices throughout the world and was reflected in the downward trend in almost all crucial stock prices throughout the world. Future of Securitization of Commercial Property One of the most important features of subprime loans that resulted to the crisis situation, is their securitization. These loans were mainly financed through Mortgage-Backed Securities being sold to big financial firms that seeked out high risk investment that would yield higher rates of interest in case there is any profit (Martin T. & Watt C., August 2008, pp 2). During the period when subprime lending reached its peak, i.e., at the beginning of the 21st century, the Federal Rates were low and people found it convenient to take loans during that phase. Now the people who could not afford to keep mortgages amounting to the value of the loan, i.e., the subprime lenders, agreed to mortgage against an asset of a lower value and the banks also agreed to it as those loans derived a higher rate of interest. However at that time the Fed had kept the rate of interest low for which both the banks and the borrowers found it lucrative to grant and take the loans respectively. But soon after 2006, when the Fed started hiking the fed rate, it was no more profitable for the borrowers to hold on to these loans and gradually they started to walk out of their agreements with the banks voluntarily. This was because, the higher the rate of interest is, the lower will be the price of real estate assets and the more will people want to hold on to them. Thus, as the price of real estate assets fell, people found it to be the ripest time to invest in them as they were now available at almost half the price prevalent even six months before. Thus, the same amount of money could now be used to invest in an asset available at a higher value previously. This resulted in the sub prime lenders to voluntarily leave out their lower valued assets and use the loans to invest in an asset with a greater value. The banks now had no way left to recover their loan amounts as the mortgages had now declined in value and thus they had to write off a huge amount as bad debts. Along with those banks, the financial institutions which had invested in the mortgage backed securities also went bankrupt as the banks who sold them the securities could no more pay interest against them. Now this frightful impact on the financial firms caused by investing in securities backed by subprime lending caused many such institutes who were thinking of investing in such securities to back off. In fact, the investors who had invested in such securities lost their confidence in themselves and their power of assessing the riskiness of an asset. As a result, the securitization of loans by banks has become a difficult task, since the previously risk lover investors have now to be convinced about the low risks associated with a particular project. This will result to a fall in the investments throughout the world and hence a slowdown in all economies worldwide and this is reflected in the stock indices throughout the world. However, the government of United States, where the impact was mostly noticeable, although has injected millions of dollars into the capital market of the economy, and has promised to advance any further help if need arises, it is actually going to take some time for the investors to get back their confidence and go about with their business as before without hesitations. References Blackburn, R. 2008. The Subprime Crisis. Washington. [pdf]. Available at http://faculty.washington.edu/sparke/blackburn.pdf. [Accessed on August 12, 2009] Caprio, G., Demirgüç-Kunt, A. & Kane,E. J. November 23, 2008. The 2007 Meltdown in Structured Securitization: Searching for Lessons not Scapegoats. [pdf]. Available at: http://www2.bc.edu/~kaneeb/The%202007%20Meltdown%20in%20Structured%20Securitization-Searching%20for%20Lessons%20not%20Scapegoats.doc [Accessed August 12, 2009]. Ellis, L. September 2008. The housing meltdown: Why did it happen in the United States? Bank for international settlement. Switzerland: Press & Communications. Krishnamurthy Arvind, n.d., Debt Market in the Crisis [pdf]. Available at http://www.kellogg.northwestern.edu/faculty/krisharvind/papers/debtmarkets.pdf. [Accessed on August 12, 2009] Martin T. & Watt C., August 2008. The Subprime Crisis: A Comprehensive Analysis from a Systems Thinking Perspective. The Ohio State University. Bibliographies Fabozzi Frank J. (ed.) 2000. Handbook on Mortgage-backed Securities. (6th Edition) McGraw-Hill Publishers. Rodgers William M. 2006. Handbook on the economics of discrimination. Edwardt Elgar Publishing House. Shiller Robert J. 2008. The Subprime Solution. Princeton: Princeton University Press. Read More