The Subprime Crisis was mainly experienced in the summer of 2007 when many leading banks in the US and Europe were hit by a collapse in the value of mortgage-backed securities which they were responsible for. These defaults fostered a crisis as all financial institutions hoarded cash and required ever widening premiums before lending to one another. Many financial institutions only survived by selling huge chunks of preferred stock, with guaranteed premium rates of return, to a string of ‘sovereign funds’, owned by various governments. Billion of new capital was injected into the banks, but it was not enough. Banks had taken on a lot of debt and lent other people’s money against desperately poor collateral.
The credit crisis was triggered by the rising defaults among subprime mortgages holders as interest rates were inched up to protect the falling dollar. This led to the failure of several large mortgage brokers, and the true scope of the problem began to register. At a time even the US Treasury encouraged three of Wall Street’s largest banks; Merrill Lynch, Morgan Stanley and Bank of America to set up a fund in October 2007 for establishing a clear value for threatened assets but this never resolved the credit crisis. the world’s central banks tried to pump vast amounts of liquidity into the global financial system, but the impact was temporary, and the banks remained unwilling to lend to one another. These subprime debacle and the drying up of credit, hastened the slide to recession in the US and global economy causing a threate of deterioration in gdp with between 1 and 1.5 per cent.
This was only saved when the US President and Congress swiftly agreed a stimulus packaged direct loan on easy conditions and low rates. Blame might be directed to the US Federal Reserve for keeping interest rates low, thus setting the scenes for cheap and easy loans but the question this paper trys to answer is what can be done today to overcome such sub prime mortgage crisis in future having learnt from the past.(United Nations, Pp iii).
The US mortgage industry has of late been put on the spotlight by unfolding events about the securities put on mortgages and the millions of loan applications granted which have unsteadied the global market. Research in the banking industry shows a wide spread agreement where periods of rapid credit growth tend to be accompanied by loosening lending standards. It appeared to be an unfortunate tendency among bankers to lend aggressively at the peak of a cycle and this prompts to most of the bad loans. In accordance with Blackburn on sub prime crisis, it is easy to argue that these were the periods when the country experienced extremely fast credit growth but the crisis was also alarming. Growth associated with fast rising asset prices and real estate prices were also more likely to end in crises. (2008)
Credit growth has been linked with banking crises especially the current mortgage delinquencies in the US sub prime mortgage market. Delinquency rates have risen more sharply in areas that experienced larger increases in number and volume of original loans. This relationship is linked to a decrease in lending standards, as measured by increase in loan-to-income ratios and a decline in denial rates, which are not explained by the underlying economic fundamentals.
Comparing deterioration in prime mortgage market, where loan denial decisions seem to be more closely related to economic fundamentals, lending standards in the sub prime mortgage market can be linked to five main factors. Mainly standards are determined by aggregated credit gain. Secondly low standards were associated with a fast rate of house price appreciation, where lenders anticipate these better housing prices and the fact that borrowers in default can always liquidate the collateral and repay the loan. Thirdly are the changes in the market structure where standards decline more in regions with new large aggressive lending institutions, which were, previously absent. The behaviors of the lender are also affected by increasing recourse by banks to loan sales and asset with lending standards experiencing greater declines in areas where lenders sold largely in proportion of instigated loans. Lastly are the lenders monetary conditions where they try to impersonate the Federal Fund rate and cycle of lending. (Blackburn, 2008)
low rates were subject for growth of banks in the US to allow them improve and expand in terms business. They sponsored hedge funds and private equity buyouts, packaged their own mortgage-related financial instruments, arranged bond insurance, and customized their own lines of credit. Some banks borrowed to buy assets worth so much compared to thier capital. This is how they became squeezed by rising costs and weakened revenue to sell the underlying assets in a falling market just like heavily mortgaged house buyers. First the home buyers faced higher interest rates then the banks followed suit. Many financial institutions took banking functions and loosened the rules that govern borrowing and lending. Although the hard way, at least now banks have learnt that structured finance products can generate less controllable losses than simple assets, whose value can never depreciate below zero. (Aspirationz, 2007).
Bankers high rates of long run equity returns reflect very thin capitalization and risk taking. The miracle of banking has always laid in the fact that bankers’ liquid assets are much less than their outstanding loans. Central banks insure against bank by controllling their risks though establishment of strict asset qualifications and capital/loan ratios but the bank’s levels of capitalization are deceptive in that they render problems created by the lending spree invisible in the balance sheets and rate liabilities as assets. (McFall, 132)
We cannot relay on risk models for protection against crisis but on market prices on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets and avoid systemic collapse but again this is the approach upon which we have stumbled. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. By use of regulatory and fiscal mechanisms, which counter the incentives that induce traders and investors to place highly, leveraged bets banks can avoid the crashes but a really complicated statistical model cannot work in time of crisis. Statistical modeling increasingly drives decision-making in the financial system, the problem lies where and how financial institutions package there sub prime loans ratings. The main problem with ratings is the incorrect risk assessment provided by rating agencies, who underestimated the default correlation in mortgages by assuming that mortgage defaults are fairly independent events. Of course, at the height of the business cycle that may be true, but mortgage defaults become highly correlated in downturns.
Financial modeling changes the statistical laws governing the financial system in real time. In accordance with Barney, market participants react to measurements and therefore change the underlying statistical processes (519). The modelers are always playing catch-up with each other. This becomes especially pronounced when the financial system gets into a crisis called endogenous risk where interactions between institutions in determining market outcomes becomes necessary. Models have a valuable use in the internal risk management processes of financial institutions, where the focus is on relatively frequent small events but they can also be used to forecast the probability of large infrequent events. However, such dependence is inappropriate. Not only are the models calibrated and tested with particular events in mind, but also it is impossible to tailor model quality to large infrequent events or to assess the quality of such forecasts.
The primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered not model quality. Better management and especially better regulations could have prevented the problem. The most important lessons from the crisis have been the exposure of the unreliability of models and the importance of management. The supervisors and the central banks need to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk and interactions between institutions and the risk at hand, coupled with a willingness to act when necessary.
The key problem to crisis lies with banks supervision and central banking. The dilution of risk is a good thing but any good thing has some drawback. In this case the drawback is that no one knows who holds how much of these bad loans. Things sour when financiers take off at light speed when everything starts going bad. Central bank ought to act as lenders of last resort by intervening sparingly at punishing cost. In this case they did not intervene as lenders of last resort. All central banks have the responsibility of assuring the orderly functioning of the financial markets. They ought to operate by announcing an interest rate, and this way they are able to change the rates any time they wish or sense danger. Large central banks have shown that they have leant the lesson from this past crisis and quickly moved to provide the required liquidity.
Nowadays banks are so tightly regulated to prevent such risks but banking is about lending, and lending is risky furthermore high-risk means high-anticipated returns. Naturally, bankers have responded to regulation by carrying on with lending, but they have been subcontracting the risk that they are not supposed to hold. The great securitization wave is partly a consequence of the great regulation operation. As stated by Ferguson on assessment and cause of crisis (84), financial markets exist to do risky things and using regulation to squeeze risk out of a segment of the market does not eliminate the risk, it just shifts it elsewhere.
Central banks and financial supervision
Argument for separation is the potential for conflict of interest because from the crisis it was increasingly clear that having the central banks supervisors separated from the liquidity provider placed added stress on the system. Central banks will be hesitant to impose monetary restraint out of concern for the damage it might do to the banks it supervises they protect banks rather than the public interest.
Making banks look bad makes supervisors look bad. So, allowing banks to fail would affect the central banker/supervisor’s reputation. At the same time according to McFall, the embarrassment of poor supervisory performance could damage the reputation of the central bank. (132). On the other hand as a supervisor, the central bank has expertise in evaluating conditions in the banking sector, in the payments systems and in capital markets more generally and incase of threat on spread of risk from one institution they are able to quickly evaluate and act. Importantly, the central bank will be in a position to make informed decisions about the tradeoffs among its goals, knowing whether provision of liquidity will jeopardize its macroeconomic stabilization objectives.
Appropriate actions require that monetary policy-makers and bank supervisors internalize each other’s objectives. Separation makes this difficult. Second, separation can lead central bankers to ignore the impact of monetary policy on banking-system health. A simple example of this is the potential for capital requirements to exacerbate business-cycle fluctuations. In line with the UN, when the economy starts to slow, the quality of bank assets decline. This, in turn, reduces the level of capital, increasing leverage. Banks respond by cutting back on lending, slowing the economy even further. Combating this requires that monetary policy-makers take explicit account of banking-system healthily when making their decisions and without adequate supervisory information, there is concern that they might not.
Most relevant to the recent experience is the fact that in their day-to-day interactions with commercial banks (and other financial institutions) central bankers needs to manage credit risk both in the payments system and in their lending operations. In the United States, for example, the Federal Reserve allows banks what are known as daylight overdrafts on their reserve accounts. That is, the Fed extends very short-term credit to banks that makes payments with insufficient balances. As the lender of last resort, central banks worldwide take on credit risk. To do so responsibly requires information about the borrower. The evidence suggests that this is nearly impossible without having fast and complete access to supervisory information. (McFall, 132)
The purpose of a financial institution’s capital is to act as insurance against drops in the value of its assets Financial institutions can reduce held capital though shift of assets to various independent legal entities. Instead of owning the assets, which would have attracted a capital charge, the banks issued various guarantees that do not require the banks to hold capital. The idea is that even if some portion of a bank’s loan portfolio goes bad, there will still be sufficient resources to pay off depositors. Since capital is expensive, bank owners and managers are always on the lookout for ways to reduce the amount they have to hold. It is important to keep in mind that under any system of rules, bankers will always develop strategies for holding the risks that they want as cheaply as they can, thereby minimizing their capital.
Both governmental and institutional rules restrict the choices to high-rated fixed-income securities but banks will always go for bonds that have a slightly higher yield than the rest. Liquidity risk difference creates a slightly higher probability of a loss. The banks know that they can only start experiencing difficulties if there is a system-wide catastrophe but they go ahead beating the benchmark against which performance is measured. There is no way to stop this because financial institutions will always search for the boundaries defined by the regulatory apparatus and this will be the guide for how to legally avoid the spirit of the law. This brand of ingenuity is very highly rewarded, so these strategies will continue.
Deposit insurance operates in a way that contrasts sharply with the lender of last resort. A standard system has an explicit deposit limit that usually protects small depositors from loss in the event that the bank fails. Deposit insurance is essential to financial stability. In accordance with the UN, in order to prevent the failure of solvent but illiquid financial institutions, the central bank should provide liquidity on demand to any bank that ask on good collateral at a penalty rate. Good collateral would ensure that the borrowing bank was in fact solvent, and a high interest rate would penalize the bank for failing to manage its assets sufficiently and cautiously. For this to work, distinction on illiquid from an insolvent institution is necessary. But due to lack of operating financial markets and prices for financial instruments during times of crisis, computing the market value of a bank’s asset is almost impossible. Because a bank will go to the central bank for a direct loan only after exhausting all opportunities to sell its assets and borrow from other banks without collateral, the need to seek a loan from the government draws its solvency into question. (Barney, 519).
The recent US example is typically a natural experiment of how the loss of depositors’ confidence, regardless of its source, can lead to a run. Central banks are extremely wary of taking on any sort of credit risk; in some cases there may be legal prohibitions against it. In lending operations, this translates into caution in the determining the acceptability of collateral because they have to determine if assets being brought as collateral are of sufficient value.
Both individuals and government officials need to make adjustments. Individual investors need to demand more information in a digestible form that is adhering to the principle of ‘trust, but verifying’. Asset managers and underwriters ought to disclose the detailed characteristics of what they are selling together with their costs and fees. This will allows for understanding of incentives that bankers face. As for government officials, most of the lessons point to clarifying the relative risks associated with various parts of the financial system by increasing the standardization of securities and encouraging trading to migrate to organized exchanges.
While policies alone may prove not very effective, effectiveness of macroeconomic, prudential and supervision polices in reducing credit and dealing with enhanced credit risk is essential. To target specific sources of risks such as limits on sectored loans, tighter eligibility and collateral requirements for certain categories of loans limits on foreign-exchange exposure, prudential policies and maturity mismatch regulations are utilized. Other measures may aim at reducing existing distortions and limiting the incentives for excessive borrowing and lending such as the elimination of implicit guarantees or fiscal incentives for particular types of loans, and public risk awareness campaigns. Capital account openness limits monetary tightening which can reduce both the demand and supply of bank loans as the case with US because of presence of a more advanced financial sectors, where banks have easy access to foreign credit, including from parent institutions. Secondly monetary tightening is an aspect, which can assist to significantly substitute between domestic and foreign-denominated credit. Thirdly although often not politically realistic, financial tightness is an aspect that can also help in the reduction of extension pressures associated with good credit. Lastly anti-predatory lending laws enacted by some states in the US are able to respond to aggressive lending practices by high-risk mortgages lenders However, UN research shows that the laws have not been effective in limiting the growth of such mortgages.
Problem with last-resort lending is that lending requires discretionary evaluations based on incomplete information during a crisis. Deposit insurance is sets of preannounce rules. The lessons learnt from this crisis have provided experience on how to design deposit insurance. A successful deposit-insurance system is one that insulates a commercial bank’s retail customers from financial crisis, has a number of essential elements such as ability of supervisors to close preemptively an institution prior to insolvency and it is part of the detailed regulatory and supervisory apparatus that must accompany deposit insurance. Since deposit insurance is about keeping depositors from withdrawing their balances, there must be a mechanism whereby institutions can be closed without any disruption to individuals’ access to their deposit balances.
A well-designed rules-based deposit insurance scheme should be the first step in protecting the banking system from future financial crises. Other than price stability, financial stability is also an essential foundation for maximum sustainable growth and flourished economy. To prevent crisis, governments regulates and supervises financial institutions and markets. And best practice dictates that financial stability is one of the primary objectives of the central bank.
Aspirationz. Indian IT industry’s blind craze for the US market begins to backfire. 9th September 2007 Available at ;http://forums.techarena.in/web-news-trends/815111.htm;Accessed 7th August 2008.
Barney, S and Hayre, L. Guide to Mortgage-Backed and Asset-Backed Securities.2001.John Wiley and Sons, Pp 519.
Blackburn, R. The Subprime Crisis. April 2008 Available at ;http://www.newleftreview.org/?view=2715;Accessed 7th August 2008.
Ferguson,R et al. International Financial Stability: Geneva Reports on the World Economy. 2008. United States Centre for Economic Policy Research.
McFall, J. The Run on the Rock Great Britain 2008. Parliament Treasury Committee: House of Commons. The Stationery Office. Pp 132
United Nations, World Economic Situation and Prospects 2008. 2008. United Nations Publications, Pp (iii)