Subprime mortgages have been described as the spark that lit the fuse to the credit crunch, leading to global recession and a deeper financial crisis that continues to be resolved to this day. As the name suggests, sub-prime mortgages are understood to be less than the best, often referred to as “liar loans” or “Ninja loans”- No income, No job or Asset loans (Cable, 2009). But how could someone with no income, no job or assets obtain a mortgage? The answer lies on Wall Street.
The Community Reinvestment Act (CRA) of 1977 was passed under the Carter administration and sought to impose obligations on banks to lend to lower socio-economic families. As such banks began to take the market share of loans to lower-income families away from government-backed agencies, affording the chance to step onto the property ladder to millions of Americans who never believed they would have the opportunity. The legislation worked well for the next two decades but in 1997 a significant event occurred which would change the mortgage market forever. The American bank, Bear Stearns, created the first securitisation of CRA loans and Freddie Mac, one of the US’ top two mortgage lenders, guaranteed these securities with the top triple A rating. In essence, Bear Stearns had managed to take on a large base of lower income families, repackage the risk associated with their loans and spread it throughout the industry and off of their balance sheet (Gamble, 2009).
In 2001, following the 9/11 attack in New York, Bear Stearns had been trading in CRA securities for four years and various other well respected organisations such as JP Morgan had done so to, dealing largely in credit default swaps following the end of the dotcom bubble and the Enron crisis. The effects of 9/11 on the US economy had a damaging impact, leading chairman of the Federal Reserve, Alan Greenspan to lower interest rates in the face of crisis as he had done in 1987 (Black Monday) and in 1997-98 (Asian Financial Crisis) (Brummer, 2008). Then came the banks eureka moment; the trading of high yield bonds, largely focused around mortgage based securities, relied on high-risk loans; credit default swaps- the removal of large risks from banks balance sheets- ironically also relied on high-risk loans. This meant that the banks needed a ready supply of high-risk borrowers, but where could they be found? Greenspan’s falling interest rates meant that the base line for adjustable mortgage rates, indexed to the Fed, were also low and the poor neighbourhoods Carter had reached out to in 1977 were filled with citizens eager to borrow, and so the banks had their answer. America’s poorest regions were flooded with irresistible loan offers and so the subprime mortgage was born.
Subprime mortgages were offered to anyone and everyone looking to take a loan. People with poor credit ratings, or unable to prove their income, or pay a deposit were able to borrow sums of money in excess of 100% of the value of their property with seemingly affordable repayments. Alex Brummer, in analysing the early days of the subprime phenomenon writes:
“It was easy to see why sub-prime was attractive to lenders fed up with low returns. Here was the latest chance to make a lot of money in an otherwise jaded market. Never ones to heed the lesson, the banks, fresh from burning their fingers in the dotcom boom, had marched straight in to the enticing world of sub-prime lending, barley stopping to pass ‘Go’”
(Brummer, 2008, p20)
However, subprime mortgages were never confined to the ghettos of Baltimore or Detroit. The temptation of such large and easy credit spread across all socio-economic groups and millions of Americans who could have obtained a prime mortgage were drawn in to the sub-prime world. They did so because the loans were structured to look so attractive and because 100% of the value of a property is relative to the consumer. Whilst $50,000 dollars is a lot of money to someone living in a $50,000 dollar home, $1,000,000 is a lot of money to someone living in a $1,000,000 home. Second homes became popular among the wealthy and as many as 13% of all high-rate loans were for properties not occupied by their owners, furthermore a 2007 study showed that 55% of all subprime loans went to people with credit scores high enough to get a better deal- the temptation had proved too much (Brummer, 2008; Wall Street Journal, 2007).
Following a brief period of uncertainty surrounding employment levels in the US in 2001-2002 and the inevitable defaults on mortgage repayment associated with being out of work, subprime mortgages were established as unemployment plummeted post-2004. As such, subprime mortgages gained a prominent role in the market, accounting for 35% of all mortgages in the US. At its peak the value of the sub-prime market reached £6,000bn (Brummer, 2008).
The increasing number of readily available mortgages teamed with low interest rates meant that between 1997 and 2005 property prices rose a staggering 75% in the United States representing some of the highest returns on investment in the marketplace (Gamble, 2009). Greenspan appeared to have masterminded an American recovery post 9/11 and the housing market was testament to that, as was his honorary knighthood for services to economic stability in 2002. The on-going success of the economy led Greenspan, the Fed, banks, and investors to believe that the housing boom would not end, that the markets had become too complex to fail, and that the economy would simply go on growing. Andrew Gamble writes:
“At the height of the boom it seemed possible, against all historical experience to the contrary, that this time it might really last forever. The era of boom and bust had passed away, and the global economy was now so sophisticated, so flexible, so independent, that its break down was now unthinkable. It performed miracles of coordination every day, and the fact that no-one properly understood how they were accomplished only added to the marvel and the mystery.” (Gamble, 2009, p2)
Greenspan had overseen several bubbles in the market throughout his time as chairman of the Federal Reserve and believed that even if the housing boom was eventually found to be a bubble the banks had become so adept at creating and collapsing them that the results of such would be minimal. Robert Lucas, chairman of the American Economic Association agreed with this sentiment, stating in 2003 that “depression-prevention” was no longer necessary (Krugman, 2009).
This belief, advocated by not only investors and banks, but also by the regulatory bodies, that the economy would simply continue to drive forward, and at worst would have to jump from one boom to the next, was made possible by the introduction in both the US and the UK of a new financial growth model established in response to the stagflation of the 1970s. The shift from a large manufacturing economy to a services economy on both sides of the Atlantic represented the neo-liberal ideologies of both President Ronald Reagan and Prime Minister Margaret Thatcher and their Republican and Conservative administrations respectively. Both nations’ sought to place their financial industries at the heart of what they hoped would become a globalised economy. They did this through a number of measures most notably the privatisation of much of the public sector, and the deregulation of the private sector, particularly the markets. The overall drive to free the markets and increase availability of credit seemed to have reached its optimum goal by the early millennium. Despite social issues associated with privatisation and market dips in the late 1980s and 1990s, the invisible hand appeared to be feeding anyone who wanted to eat.
However, the invisible hand of the market did have something propping it up. The credit ratings which banks received became of increasing importance with regards to the amount of credit they could obtain. The very beginnings of the success associated with the subprime mortgage revolution had only been made possible by the triple A rating obtained by Bear Stearns in 1997 on the securitisation of their CRA loans. As such, the securities and credit default swaps conducted by banks relied on good credit ratings to allow them to continue. Payments from banks to credit agencies doubled in the years of sub-prime boom to $6bn in 2007 appearing to indicate a huge increase in the number of high ratings being given to banks (Mason, 2010).
Parallels of what was happening in the United States were also taking place in the other major global financial player it had shared the neo-liberal uprising with throughout the 1980s. The United Kingdom was experiencing a credit explosion and a relaxation on mortgage lending, however banks such as Northern Rock refuted the allegation that many of their mortgages could be described as subprime. Like other UK banks they were offering special low-start loans, or deals to consolidate credit card debt alongside a mortgage. One example of such offers was Northern Rock’s ‘Together’ mortgage offered to young professionals, often with outstanding student debts. Such offers exceeded 100% of property value, and often rose to 125%. However, Northern Rock along with many banks offering similar mortgages in the UK believed that the annual salary increases and set career paths of such borrowers was enough to justify their loans.
Despite Northern Rock’s claims that they in no way dealt in subprime mortgages, concerns were being raised in the UK towards the number of loans and mortgages being taken out by consumers who did not have to provide evidence such as proof of income to obtain large funds. A report by leading British academics in 2005 named ‘Lending to Higher Risk Borrowers’ was motivated by a concern over the increasing vulnerability of such borrowers and the sustainability of home ownership to such persons. The report notes:
“Many of these products are heavily promoted and may encourage people to take on more debt than they can really afford. For example, the willingness to lend without proof of income may encourage borrowers to overstate their capacity to repay”.
(Munro et al, 2005)
As the markets continued to boom on a wave of credit both sides of the Atlantic, the Federal Reserve took the decision in 2004 to begin a rise of interest rates in order to stabilise the American economy and allow growth to continue. This was not an unusual policy and the Fed believed that after fully recovering from the mini recession of 2001-02 a rise was justified and the squeeze on credit would only serve as a positive in the housing cycle. They believed that a slight fall in property prices would bring even more buyers to the market, and as such credit would become more freely available again, and house prices would continue their upward spiral. This process of interest rate hikes was expected to gradually increase mortgage default levels, but only for a short period, what happened however was very different indeed (Gamble, 2009).
Between 2004 and 2007 US interest rates rose from 1% to 7%, a steep but not unfamiliar hike. What was unfamiliar to the market was the type of mortgages that were being defaulted on. The initial increases had minimal effects between 2004-05, however cracks began to appear in 2006 as rates headed towards their peak. It was at this point that borrowers began to realise that their sub-prime mortgages really were less than the best.
At the beginning of the subprime revolution, many borrowers were enticed by the simplicity of obtaining such funds as lenders offered to take care of all paperwork. This of course appeared to be the easiest options for consumers, many of whom had never borrowed money before, or studied a contract as complex as a mortgage agreement. Borrowers were merely told to sign on the dotted line and their dreams would come true. As such, most borrowers, certainly those from lower socio-economic backgrounds, did not realise the terms and conditions of their repayment plans- duped by short term interest rates known as ‘teasers’. Many believed that these rates would continue throughout their mortgage, remaining low making repayment possible. Typically the teaser rates offered by banks would last for two to three years before increasing to a rate that better reflected the risk associated with such loans. However, between 2001-05 the end of teaser rates had been masked by low interest rates, leading to only a very small increase in repayments. As interest rates reached their peak throughout 2006-07 teaser rates were no longer masked and huge increases on repayment expectancy lead to a huge rise in defaults.
It is at this point that the ‘inverted pyramid’ the financial services had created on the back of subprime lending took its first steps towards collapse. Andrew Gamble writes:
“In ordinary times this would have had serious consequences for a large number of borrowers who could no longer meet the repayments on their loans. But it would not have had wider implications for the whole financial sector.”
(Gamble, 2009, p21)
But this was no ordinary time for lenders, they had proved ingenious at bundling together high-risk loans and securitising them, selling them in to the market as high-yield bonds with the best possible credit ratings. This in turn allowed the banks selling bonds to boost their balance sheets and increase their own lending. Gamble continues:
“In this case, however, far from being sound the bonds were hollow. There were no secure income streams behind them, and once many mortgagees started to default on their loans, the precariousness of the imposing financial structure, which the financial services industry had created, was exposed.”
(Gamble, 2009, p22)
By mid-2007 the severity of the situation surrounding subprime was coming to fruition. Following losses being recorded by specialist US subprime lenders earlier in the year, and the bankruptcy of the second largest of such banks, New Century Finance, Bear Stearns, the bank which started the subprime revolution in 1997 was forced to collapse two of its hedge funds and write off $1.9bn from the value of its mortgage related assets (Kary, 2008; Foley, 2007).
Inevitably the credit agencies which had afforded the likes of Bear Stearns triple A ratings were called into question. In July 2007 the US financial watchdog published a report suggesting that the scale of new business from 2002 onwards had overwhelmed many agencies and as such they had failed to undertake the correct measures in their risk assessment. Bond issuers paying for their own products to be rated by such agencies also presented a serious conflict of interest, going someway to explaining the aforementioned doubling of payments from banks to agencies during the boom. Agencies such as Standard & Poor’s and Moody’s came to believe that if they did not award the required rating, then the next agency would, receiving a healthy sum for doing so.
Following the collapse of one of the subprime markets leading lenders and two Bear Stearns hedge funds, the severity of these losses was transmitted throughout the financial system during the tail end of 2007. Banks began to realise that they no longer had any means of assessing the value of their assets, they could no longer rely on credit ratings which continued to be undermined by further losses, and as such they began to hoard cash, cutting back on their lending to both consumers and other financial institutes. They could not afford to lend money to shore up others bad debts. This drying up of liquidity came to be known as the ‘credit crunch’.
In the eighteen months following the collapse of New Century Finance attempts were made to encourage lending, interest rates were dropped by the Fed, but confidence in the markets had been lost, lost not only by banks and investors, but also by the industries indirectly handling funds associated with subprime, such as bond insurers, who in September 2007 would have their credit ratings slashed. Throughout the months leading up to September 2008 signs suggested that the repercussions of the credit crunch were unlikely to be contained easily; a run by consumers on British bank Northern Rock in late 2007 led the government to insure customers savings and was followed by its nationalisation in March 2008. Shortly after Northern Rock’s bail out, Bear Stearns, the banks at the heart of subprime was bought out by JP Morgan Chase for $240mn. One year earlier it had been valued at $18bn.
What happened in September 2008, the bailing out of Freddie Mac and Freddie Mae, the US’s two largest mortgage companies, for $200bn, followed by the collapse of Lehmann brothers, the 185 year old Wall Street behemoth, sent reverberations around the globe. The credit crunch had taken on a new dimension. The series of events which followed would lead to a widespread financial crisis and ultimately a global recession (Pallister, 2008; Clark, 2009).
The subprime mortgage market had played a leading role in the creation of the credit crunch, by definition a mortgage is the largest type of loan any borrower is likely to take, the collapse of a market involving such large sums of money was inevitably going to have widespread repercussions. The dispersion of risk throughout the financial industry in the form of bonds associated with the high risk proved a decisive factor in the severity of the banks’ downfall, acting like a disease, spreading its way throughout the industry.
The neo-liberal market philosophies bestowed upon the American and British populations following the 1970s strived for a market all but free from regulation, a market that would stretch from each corner of the globe and all points in between. It is the globalisation of world markets which has meant the impact of an American crash has been felt the world over. On a visit to the London School of Economics in November 2008 the Queen is famed for having asked staff why no one spotted the oncoming crisis. The same question has been posed by many since the formation of the credit crunch with some suggesting that whilst profits were rising we were too busy staring at the sky to notice the ground shifting beneath us. Andrew Gamble writes:
“The great booms of capitalism have thrived on exuberance, and the readiness to take risks and to embrace change. The longer a boom lasts the more complacent and careless many people become, from those in charge of government and banks down to the humblest investor. The calculations of risks change. By degrees everyone comes to believe that the boom will last for ever, and that finally, the secret of everlasting growth has been discovered.”
(Gamble, 2009, p37)
The psychology of the boom, as documented by Gamble, appears to represent the series of events which gripped the world of finance for the early millennium. Energised by the world of subprime, investors tirelessly pumped air in to a housing bubble. The air was later discovered to be hot, hot and infected. The bursting of this bubble released a toxic gas around the globe. The stench of which has not yet been removed from the pores of the global financial system.
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