Whilst reasons for the sub-prime mortgage crisis and consequent credit crunch are complex and diverse, it ultimately began with the bursting of the U.S. housing bubble and high default rates on sub-prime loans. The financial crisis, which became more apparent in 2007, continues today as a major ongoing global economic issue.

If we take our analysis back to the late 1990s, which saw the U.S. face recession, we can begin to see where the crisis developed. Following the tech. bubble and the fear of global terror attacks after September 11, the US Federal Reserve, rather than let their economy rebalance gradually, began to cut interest rates dramatically to help synthetically stimulate their economy. Interest rates fell from a high of 6.50 percent in May 2000 to 1 percent in June 2003, which in central banking idiom is essentially zero. The goal of the low federal funds rate was to expand the money supply and encourage borrowing, which in consequence should stimulate spending and investing… and that it did.

In 2002, as low interest rates and large capital inflows from outside the U.S. began to work their way into the economy creating a surplus
of loanable funds and easy credit, the U.S. housing market began to flourish. Suddenly, millions more Americans could afford to buy homes and the number of homes sold and the prices they sold for increased dramatically. This bubble fed itself as prospective homeowners rushed into the market to capitalise on price appreciation, and existing homeowners refinanced at lower rates, taking out second mortgages against the added value and using those funds for consumer spending.

However, as home prices continued to rise fewer people could afford traditional loans which led to banks and mortgage lenders offering sub-prime/adjustable rate mortgages (ARM). These loans (as the name suggests) had adjustable-rates, or offered attractive initial ‘honeymoon’ terms, which increased later, and they were given to people who did not conform to the normal banking parameters (owing to various risk factors such as level of income, size of down payment made, credit history and employment status). Typically, they were poorer working class families with a poor credit history and restricted access to credit. Now; however, they could obtain funds and purchase their dream home. Everyone was happy. There was a building boom and jobs were created. Real estate agents were profiting and lenders were getting their piece of the pie, until the summer of 2006 when cracks began to appear.

Overbuilding during the boom period had led to a surplus inventory of homes causing home prices to decline. The first of the ARM’s owned by sub-prime borrowers (who were encouraged by easy credit, combined with their assumption that house prices would continue to appreciate) began to reset and at rates which they simply could not afford. With house prices depreciating, refinancing became much more difficult, and homeowners who were unable to do so, began to default on their loans. Foreclosures and repossessions were becoming common place. Compounding this was the steady rise in interest rates from their low of 1 percent in 2003 to a high of 5.25 percent in June 2006.

In the background and on the other side of the equation, banks were aware of the risks inherent with these types of mortgages, which had been fuelled from a move from traditional banking to sub-prime lending.

Traditionally banks finance their mortgages with deposits they receive from their customers and they retain the risk of default – credit risk. Finance through this model is obviously limited and depends on the amount of money deposited by the banks customers. However, through sub-prime lending banks were able to expand their market by selling mortgages to bond markets and thus, gaining access to extra funds. We illustrate the two models in Figure 2 and 3.




Through this process, banks and mortgage lenders could sell the rights to the mortgages repayments (and related credit risk) to investors through a process called ‘securitisation’, which was based on the simple and core investment principle behind ‘Asset Backed Securities’ (ABS). ABS have been around for decades. They take a pool of assets and bundle them together into the one managed package that collects all the individual repayments and use the money to pay investors a coupon, with the underlying assets acting as collateral. They allow investors to acquire a diversified portfolio of fixed interest assets that pay income via one coupon payment.



Prompted by the real estate boom, which was fuelled by excess liquidity and loose lending standards in the market allowing banks and other lenders to borrow more, an updated form of ABS were created. Banks and other lenders sold their mortgages to secondary markets and investment banks that in turn created Mortgage backed Securities (MBS) and Collateralized Debt Obligations (CDO).

These products packaged up much of the $3.2 trillion ($3.8 trillion) of debt underwritten by Wall Street between 2002 and 2007 and offered to home buyers within the sub-prime category.

Sub-prime loans, with their high default risk, were placed into their own risk class or tranche, each with their own repayment schedule. Upper tranches were able to receive ‘AAA’ ratings, despite still containing sub-prime loans.

To compensate for the higher risk of default, lower tranches offered greater coupons leading to the bottom ‘equities’ tranche, which was a highly speculative investment.

Nearly 80 percent of the bundled securities became investment grade ‘A’ rated or higher, which were justified by credit enhancements such as over collateralization, credit default insurance and equity investors willing to bear the first losses.

The investment and credit rating agencies responsible for the rating of securitisation transactions (CDO and MBS), which were based on sub-prime loans, have now come under scrutiny.

Critics claim a huge conflict of interest was involved as agencies were paid by the firms that organised to sell the debt to investors, such as the investment banks, giving the mortgage securities higher valuations than regular sub-prime instruments would typically receive.

At the time however, the ratings were of no concern and like the new home owners, even the banks were happy. They could happily issue sub-prime mortgages (and collect their fees) because they could both quickly remove the mortgages off their books, and get top dollar for them. Foreign investors (who relied heavily on the investment ratings agencies for impartial advice) as well as domestic investors confidently snapped up the supposedly ‘safe’ and well rated mortgage investments. And so the spread of the sub-prime woes began.

During 2005 and heading into 2006 home prices were beginning to level off and home inventories started to build up. Interest rates, while still historically low, were on the rise, with inflationary fears threatening more increases. All the easy to underwrite mortgages and refinances had already been done and the first of the shaky ARMs were beginning to reset.

Suddenly the world woke up to the fact that the sub-prime mortgages were just that - sub-prime. Default rates were beginning to rise sharply and suddenly they did not look so attractive to investors seeking a yield. Mortgage lenders, with no more eager secondary markets or investment banks to sell their loans into, were cut off from what had become a main funding source with many declaring bankruptcy and reporting steep losses, and ultimately being forced to shut down their operations.

Flowing through to the product, as mortgages underlying the collateral began to decline in value (due to increased delinquencies and defaults), the banks and investments funds holding them faced the difficulty of assigning a precise price to their holdings. Consequently, American credit ratings agencies had to embarrassingly issue massive ratings downgrades and foreign, as well as domestic investors had to begin to accept that to get any bidders on their American mortgage portfolios they had to accept sharply marked down prices.

Hedge funds and other investment vehicles holding these securities began to seize up as investors became much more risk averse. They began to unwind positions in potentially hazardous MBS and any other fixed interest type of security, which was not paying a proper risk premium for the perceived level of risk. This became evident in July 2007 when investment bank Bear Sterns halted redemptions on two of its hedge funds sending world markets into a spin and was the trigger for an extraordinary chain of events to follow.

Amid the rush to quality, three month treasury bills, the safest type of investment, became the new ‘must have’ fixed income product despite yields falling to a mere 1.5 percent in a matter of days. Today this remains the case with yields now hovering as low as 0.70 percent. At the same time, spreads on corporate bonds and T bills began to widen dramatically. In less than a week the spread had widened from 35 basis points to 120 basis points. This may not mean much to the average investor, but with the modern fixed interest income markets built around leverage, a move of that scale can do a lot of damage by making money either a lot more expensive to borrow, or not available at all. This led to the credit crunch.

As the credit crunch evolved it became clear that the crisis would not be contained to America alone. The extent of the problems were far from what anyone could ever have anticipated. America’s trading partners were affected, and banks and mortgage lenders across Europe and America began to fail.

Many institutional funds all over the world began to face margin and collateral calls from nervous banks, which forced them to sell other assets such as stocks and bonds to raise cash. Increased selling pressure took hold of global stock markets with sharp declines evident worldwide, halting the strong market that had taken the Dow Jones Industrial Average to all time highs in July of 2007. Then we saw the first major casualty in Bear Sterns.
To help try and stabilise the markets and mitigate liquidity issues, central banks in the U.S., Japan and Europe began making cash injections to their money supply and cut both discount rates (the rate which financial institutions borrow from the Federal Reserve) and the federal funds rates. Despite all their efforts, from July 2007, and as outlined in the timeline, a series of unthinkable events occurred, which continues today as we wait nervously to see what is next to unfold.

Whilst the above is not an exhaustive explanation of what went wrong, it highlights the issues that have been most talked about in the media. Issues concerning excessive housing speculation, high risk loans, securitization practices, excessive underwriting of high risk mortgages, government policies and the policies of central banks, which have all contributed to the current global financial crisis.

Tara Jones
Senior Consultant
tjones@moorestephens.com.au