Sharp Rise In The Us Subprime Mortgage Finance Essay - Free Essay Example

Sample details Pages: 13 Words: 3774 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Argumentative essay Did you like this example? The sharp rise in the US subprime mortgage attracts global attention during the recent past; it not only has had impact on the real estate market, but also on the financial market, labor market and many other markets. Research about the subprime has linked the subprime crisis to the housing bubble, higher financial risk government policy and other factors. However, the term subprime is not consistently defined in the literature. Don’t waste time! Our writers will create an original "Sharp Rise In The Us Subprime Mortgage Finance Essay" essay for you Create order For the borrowers, a good credit record is easier to get mortgage loans in the US, but many people who just have a limited or lack of credit history have to be rejected for loans, which prevent the renters from becoming homeowners. From the lenders perspective, the subprime mortgage loan is seeking for borrowers who are suffering from a constraint creditability record but in the demand for the loans. Therefore, naturally, the cost of the subprime mortgage loan is more expensive than the conventional or prime mortgage  [1]  , according to Chomsisengphet and Pennington-Cross (2006); it is typically around 2 percent. Another characteristic of the subprime loan is that it has very loose underwriting standards; subprime lenders are more likely to accept the borrowers limited documentation of their asset or income, in Kiff and Mills (2007). It is noticed that the loan-to-value ratios are usually high: over 85 percent and the debt-to-income requirements are not very stringent: abo ve 55 percent  [2]  Subprime loan can vary a lot from one type to another in the terms of payment amount and payment terms. Summarizing the literature in the prior study, the term of the subprime mortgage can be defined as one kind of mortgage loans to higher-risk borrowers with no or uncertain income and spotty or limited credit history, once the borrowers have difficulties in paying back the loans due to various causes, the disclosure occurs. It is vulnerable loans in many aspects; this will be discussed in detail in section 2.1. Subprime mortgage lender targets borrowers who either have a lack of insufficient credit record, or those borrowers who have been denied due to bad credit history. Because of its loose credit record investigation process, the subprime loan has become many borrowers first resort to home-financing; therefore subprime loan has overtaken several other loans in the mortgage market. As a matter of fact, the mortgage lending market has more than quadru pled between the years 1995 and 2003 (Aoun,2009), it grew into $665 billion in 2005 from $35 billion in 1994 and accounting for nearly a quarter of the whole mortgage loan market in 2005. Subprime mortgage is one of the multiple optional sources for home-purchase cash inflows, however, in Schloemer, et. al. (2006), it is highlighted that the majority of the US subprime loans originated in the last decade have been for the purpose of refinancing rather than for home purchase. At the mean time, the financial market has been experiencing an increased securitization. Securitization is the repackage and re-assembly of the subprime loans in order to attract more third-party borrowers, these loans can diversify the risk and spread the risk into investment portfolio, thus attract more investors. The motivation of obtaining a subprime loan is becoming speculative rather than for realistic purposes. Once the appreciation of house price approaches, borrowers have the incentive to pay the loan off, however, if the borrowers are facing difficulties such as unemployment, increased consumer price index or reduced expected income, they are less likely to clear the debt, thus, the creditor has to place the property for foreclosure, the lenders have reported 847,000 foreclosure filings in 2005 (Schloemer, et. al., 2006). Once the defaults became widespread, the process could snowball, putting more homes on the market and driving prices further down. Some banks and other holders of mortgages could see their highly leveraged portfolios greatly impaired due to such foreclosures. Problems of illiquidity of financial institutions could result in the insolvency (Feldstein, 2007). US is the origination of the subprime mortgage crisis and its remarkable size of the subprime amount makes it become a typical empirical sample, because from 1994 to 2005, the subprime home loan market grew from $35 billion to $665 billion, the subprime share of the total mortgage originations has b een reached to 23 percent in 2006 from 10 percent in 1998 (Ernst, Keest, Li and Schloemer, 2006). What is more, the subprime mortgage loans have resulted in extraordinarily losses in more than one area, homeowners lost their physical shelter, borrowers have to resort to higher default rate in order to recover from the crisis and even some countries are facing bankruptcy risk. It is beneficial for them to know the causes of the higher foreclosure rate in order to guide their future investment or funding decisions, or at least, to keep the losses to a minimum. This paper is organized as follows: Section 1 will give an introduction of the subprime mortgage, in which the definition of the related terms will be investigated, and the background of the subprime mortgage crisis in the US market will be presented; Section 2 is the related literature review, this part explored the past literature about the foreclosures and its causes in the past and try to find the correlation between them ; Section 3 is the empirical analysis where some variables have been selected and were fit into the regression model. The empirical correlation between them will be investigated, the methodology and the result will be discussed; In the section 4, the causes of the high foreclosure rate will be analyzed to provide realistic practice advice about the home financing as well as the remedy action to the subprime mortgage crisis; Section 5 is the conclusion, in which part it summarizes the result of the whole dissertation. Literature Review This part reviews the related literature, this is a very recent topic and the researchers have reviewed it in many aspects. However, this paper only selects a certain part of the literature and tries to indentify the relationship and logic between them. There are three key areas which draw the researchers circle of attention the most: firstly, the causes of the subprime foreclosure; secondly, the results of the subprime foreclosures, and finally a brief summary of underlying lessons. The policy recommendations will be discussed comprehensively in Section 4. 2.1 Literature Assessing Causes of the Subprime Foreclosure Foreclosures occur when householders are unable to meet their house payments. Borrowers who are unable to get their payments have the option of selling their house in the periods that house price is appreciating. In other words, borrowers have the ability to manage the financial budget to make profit from it, when the prices go down, borrowers may find that their mortgage size is greater than the value of their property. Foreclosure becomes a necessary option when the loan-to-value ratio goes over 100 percent (Capozza, Kazarian, and Thomson 1997). Moreover, many factors have been attributed to the termination of the subprime mortgage loans. Variables include loan size, house pricing, family income, the number of ownerships, the unemployment rate, and so on. In the literatures reviewed in this paper, more than one cause has been analyzed in a single paper and the results are mixed. For instance, Aoun has confirmed that lending standards and income have contributed to the high default rate (2009); Loose underwriting, predatory lending, inadequate oversight played a significant role in the deterioration of the real-estate market (Ernst, Keest, Li and Schloemer, 2006, Ellis, 2008); High initial housing cost may compel the potential homeowners to seek financing beyond their normal spending budget. Generally, weak or unstable employment situati on increases unemployment, promotes personal bankruptcies (Kaplan and Sommers, 2009), (Papadimitriou, Hannsgen and Zezza, 2007). Richter (2008) found that low income level, low credit scores and high rate of vacancy are associated with higher neighborhood foreclosure rates. Richter (2008) also demonstrated that more regulated legal environment is conducive to lower foreclosure filings. By summarizing all the causes in the literature, three main aspects causes have been discussed in detail in the following section. 2.1.1 Financial System Aspect Causes Mayer and Pence (2008) also find that lending activity in depressed housing markets is more likely to be subprime. At the same time, these markets high rates of foreclosure were coupled with previous high rates of vacancy and abandonment contributing to the worsening of spillover effects in neighborhoods (Community Research Partners, 2008). The relationship between information asymmetry  [3]  and subprime mortgage crisis is a very recent study and the related literature and empirical analysis appears around and after 2005. In Kau, et. al. (2010) information asymmetry is identified as one of the parameters of the subprime mortgage crisis, they argued that within the three kinds of participants: the borrower, the originator (primary lender) and the ultimate investor (secondary lender), the borrower have the most information about the future repayments and the possibility of foreclosure. The originator (primary lender) have some sort of familiarity with the borrower as they have to approve the loan, however, secondary lender is the party that know the least information and for whatever reason fail to exploit the information. Furthermore, Keys et. al. (2010) compare the performance of securitized subprime loans originated by 48 banks against those of 57 independent lenders, and find the quality of the former loans to be poorer. That is to say, the information asymmetry creates an information gap between t he lender and the borrower, which reduces the publicly available information in the market and that becomes one important factor which can trigger the crisis (Green, 2008). Hartarska and Gonzalez-Vega (2006) conducted the research on the effectiveness of the low-income borrowers credit counseling and found out that the foreclosure rate is reduced especially for the subprime borrowers who have been counseled before applying for the loan. It is not very easy to get the credit counseling data for the author; therefore, this argument is not practically testable as detailed by the author. This is a very fresh research and therefore needs to be looked into more detail to verify the creditability of the research. Poor underwriting standards may result in subprime crisis, according to Foote et. al. (2008), they pointed out that loose underwriting standards create the loans that are highly sensitive to the falling prices, which can be seen from the historical data that subprime default ed in greater numbers than the prime when the housing prices were falling down. Ellis also held the same conclusion (2008). 2.1.2 Government Organization Aspect Causes US regulated organizations played a crucial role in the off-balance financing for the houses, such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), as well as the Veterans Administration (VA) and the Federal Housing Administration (FHA). Jaffee and Quigley (2007) reinforced the role of government sponsored enterprises. Besides, some articles have been deep into government organizational aspects, such as Bostic and An (2006) they found that the increased government sponsored enterprises  [4]  purchases activities are associated with the decline in the subprime mortgage volume. They also demonstrate that the phenomenon is becoming stronger in the neighborhoods with minority groups and subprime-purchase groups and this is consistent with the st udy by Wyly et.al. (2006) and Passmore et. al. (2005). The effectiveness of the government policies are also doubtful, for instance, the federal program making home available program  [5]  has proved to be an inability program (Winter et. al., 2010), this statement is in contrary to the conclusion made by Hartarska and Gonzalez-Vega (2006). The key to this question lies in the cost and benefit of the counseling. They estimated the cost but it is hard to evaluate its correctness. 2.1.3 Sociology and Microeconomic Causes Another unique perspective is derived from sociological and physiological point of view, in Nettleton and Burrows (1998). They argued that the sense of insecurity speeds up the desire for the ownership of houses, which increases the chances for a family to fall into mortgages loans. Their argument is based on the UK market data but the empirical result can been seen as a general conclusion in the research field. Moreover, in Williams et. al. (2005) and Wy ly et. al. (2006) their arguments demonstrated that the race segment is one factor contributing to the sense of insecurity, therefore, that is why some minority regions enjoyed higher foreclosure rate. One of Gerardi, et. al. (2007) papers key finding is that appreciation of house prices is a key impact factor to the foreclosure. They divided the data into two groups; the ownerships with a 20% house price appreciation and another with a 20% depreciation. The results showed that the latter group had a default rate of fourteen times more than the former group. In short, they confirmed that the house value is the main driving force for the foreclosure. This is the consistent with the results supported by Papadimitriou et. al. (2007) and (Calomiris, Longhofer and Miles, 2008) The understanding about the causes of the subprime loan is very complex by Follian and Dunsky (1997). They pointed out that the demand of debt is highly responsive to the tax treatment of the deductibility of mortgage loan interests, but the relationship between after-tax income and demand for loans are not linear, however, their result is new and require more in depth analysis of the situation. Ellis made a comprehensive comparison between different countries and also believed that the tax deductible loan interest system encouraged higher leverage (2008) Gerardi, Shapiro, and Willen (2007), argued that it is impossible to know when the borrowers are starting a subprime for the initialization of the ownership. A borrower can start financing a house by various types of loans, however, in Gerardi, Shapiro, and Willen (2007), they addressed that homeownerships funded by subprime mortgage ended up into foreclosure six times more frequently than the prime loans  [6]  . The Role of Subprime Mortgages House is the physical shelter for human, the security sense arising from the ownership of the house will affect peoples personal life. This part the author reviewed the related paper s that link the subprime foreclosure to financial market, real estate market and also personal sociological influences. Immergluck and Smith (2006) find that higher foreclosure levels do contribute to higher violent crime rate. And a few authors confirmed that the subprime affect the sense of security, however, the most widely discussed effects arising from it focused on the financial and housing market, therefore, only the first two aspects will be evaluated in the following sections. 2.2.1 The Role of Subprime Mortgages in the Financial Market It is agreed widely that the declining houses price is one of the parameters of the housing crisis; however, the appreciation of house prices pushed borrowers turn to the subprime market for their expensive houses. Foote et. al. (2008) argued that the widespread of the subprime loans had put upward pressure on the house prices. On the other hand, the wide availability of the subprime loan products triggered the increase of home owne rship. According to Papadimitriou et .al. (2007), it is called the democratization of the credit market. The subprime borrowers do not benefit when they take out unaffordable loans, which in turn leads to the possibility of defaults. Whether it is the appreciation of house prices or the subprime loans which lead to high rates of defaults and foreclosures and the failure of mortgage firms, the large losses incurred by financial institutions is far from simple to define (Coleman IV et. al., 2008). Another perspective is that subprime loans was designed for forcing frequent refinancing, within which fixed-rate mortgage (FRM) is a lower cost refinancing tool managed by the government via the government sponsored enterprise (Ellis, 2008, Gordon,2008). Once the demand for funds increased, the inexpensive FRM is a preferable loan than the adjustable-rate mortgage and any other loans, which result in a higher ratios of origination and outstanding. The US market can be seen as the trigger for the recent finance turmoil with the oversupply of house construction at the late periods, in turn, the US market witnessed the sharp fall in housing prices and high rate of foreclosures due to the loose crediting standards. 2.2.2 The Role of Subprime Mortgages in the Housing Market It is inevitable that subprime mortgage has connection with the housing market, but in which direction does it affect the real estate market is a controversial debate up to now. The pros and cons for them will be analyzed later. In the most cases of the reviewed papers, the disclosure has a negative effect on the house prices, technically, the price and the defaults interact with each other. It is hard to distinguish between the cause and result. The rest part recorded that house price is relatively sticky, because in the analysis, even in the extreme circumstances, the average change of house price is comparatively small to the foreclosure rate fluctuation (Calomiris, Longhofer and Miles, 2 008). Another tricky argument is that subprime loans facilitate the increasing ownership of house in the US, namely, for the most house-tenants, subprime mortgage is the easiest resort to own a house, it is should not be blamed for the bubble of real estate market and the subprime crisis. In Coleman IV (2008), he confirmed that: The widespread availability of subprime loan products during this period, while arguably increasing consumption levels and homeownership rates, has been broadly blamed for this bubble. (Coleman IV et. al., 2008, p.272). Weicher (2007) shown the optimistic view about the crisis, he stated that the crisis is only a short-term event, the developed information technology and the advanced finance literacy will cut off the negative effect of the subprime. In sum, subprime has attracts praises and blames in the academics and it is seems too simply to define its effect on the market, more research need to be done to reveal its effects. Implications of the Subprime Mortgage Foreclosure From the causes and effects of the subprime mortgage, some implications can be drawn, however, this part is only a brief review, more detail implications and suggestions will be discussed in depth in section 4. 2.3.1 Legal and Regulatory System An effective regulatory environment that reduces information asymmetries and promotes a better functioning of the markets ultimately enhances new social surplus. Lower foreclosure rate can be explained by better regulations (Richter, 2008, Feldstein, 2007). It is widely agreed that the government should be partly responsible for the subprime mortgage crisis, but it is known that there is no long-run trade-off between price stability and achieving full employment and growth. From the macroeconomic view, Feldstein argued that the cut in the federal funds rate is a signal for the reduction in residential constructions and will alleviate the worsening economy, but the trade-off between different economi c variants need to be considered before putting into practice (2007). An alternative argument about the government regulations is to oversee the low income borrowers in order to prevent them from steering into the subprime mortgage market. It is oversimplification treatment of the question and as such it is impossible to fulfill the task. However, from another point of view, Bernanke is in strong support for a transparent system rather than for the regulations (2007) by maintaining that the system will warn the potential risk and punish the risky behavior. This requires a joint effort by congress, government administration, financial agencies and other parties involved. 2.3.2 Reducing the Information Asymmetry As for the detection of moral hazard and adverse selection, the easiest solution is to close the information gap in the secondary mortgage market: the firms buying loans must collect and analyze as much objective information as possible, and then classify the mortgages a ccordingly. Other alternative is to force the primary lender to retain an interest in the loan so that the originator will try to keep a reputation. The asymmetry problem faced by the originators themselves in the primary mortgage market seems more difficult to resolve. However, the primary lender have the incentive and ability to take more care in the approval of loans by a return to more traditional practices, such as by acquiring more personal knowledge of the borrower, which the lender is less likely to at such a great informational disadvantage (Kau et. al., 2010). 2.3.3 Establishment of the Credit Counseling System The purpose of the credit counseling is to help the low income borrowers to be aware of how much loans they can serve and to prevent defaults from occurring. However, counseling programs may vary by terms of delivery, desired outcomes, qualifications, counselors professional judgment of the counselors and program content. Therefore, it is very hard to have a s tandard system to evaluate the borrowers credit worthiness. It becomes a necessity to set up a systematic network to keep the subprime mortgage market in order if the counseling can reduce the default rate (Hartarska and Gonzalez-Vega, 2006, Quercia and Watcher, 1996). 2.3.4 Full Utilization of Government Managed Organizations Within the two main organizations held by the government-the HARP and HAMP (see section 2.2), HAMP becomes more important but more controversial in practice. According to Winter et. al. (2010), there is two ways that can be used to modify loans, the first is a direct incentive modification of 1000 dollars to the investors, and the second is a variation modification limit to the 31 percent loans against to the borrowers income. However, Winter et. al. (2010) also claim that only a small proportion (66465/902626 in year 2009 in St, Louis) received permanent modifications. Therefore, the result of the program is effective but limited with some scope. Curren tly, the government loan modifications seem like burdening the counseling agencies. The defaults are obvious and widespread unless right sorts of modifications, incentives and policies are placed for the borrowers in order to help them manage their debt in a timely and effective manner. The cost and benefit of the agencies need more discussions in depth further. The policy maker cannot foretell future trends of the house price, but they are critical in cutting down the unemployment rate, in the argument of Wray (1998), an effective job-creation program could alleviate the losses by offering government jobs who ask for them. Nonetheless, the remedy seems likely to challenge the US congress and government, as the burden of offering jobs is too huge. 2.4 Conclusion and Summary According to Foote et. al. (2008), the recent researches about the subprime only focused on limited data resources  [7]  and ignored the linkage between various mortgages for the same borrower over t ime. The literature review mainly focused on US market, Shiller (2007), however, notes that the appreciation in house prices has occurred widely in American, Australia  [8]  , Canada, China, France, India, Ireland, Italy, Korea, Russia, Spain, and the United Kingdom. Moreover, Shiller regarded the boom in house price as a typical speculative bubble, driven by extravagant expectations for future return. In the US, the territory focused mainly on some states such as Massachusetts (Gerardi et. al., 2008) and St. Louis (Winter et. al., 2010). Valverde and Fernandez (2010) analyzed the interaction between house prices and subprime loan in Spain market from 1990s to 2007, their findings show the same result as most mentioned papers in section 2.2.1, increased house price and mortgage loan occurred before the crisis, especially by large part of the subprime have been securitized. Haji has done a very promising report on the forecast of the subprime effects on the short-medium econom ic condition.