Who Is To Blame For The Subprime Crisis?
Anytime something bad happens, it doesn’t take long before blame starts to be assigned. In the instance of subprime mortgage woes, there is no single entity or individual to point the finger at. Instead, this mess is a collective creation of the world’s central banks, homeowners, lenders, credit rating agencies and underwriters, and investors. Let’s investigate.
The end result of these key events was increased foreclosure activity, large lenders and hedge funds declaring bankruptcy, and fears regarding further decreases in economic growth and consumer spending. So who’s to blame? Let’s take a look at the key players.
Biggest Culprit: The Lenders
When the central banks flooded the markets with capital liquidity, it not only lowered interest rates, it also broadly depressed risk premiums as investors sought riskier opportunities to bolster their investment returns. At the same time, lenders found themselves with ample capital to lend and, like investors, an increased willingness to undertake additional risk to increase their investment returns.
In defense of the lenders, there was an increased demand for mortgages, and housing prices were increasing because interest rates had dropped substantially. At the time, lenders probably saw subprime mortgages as less of a risk than they really were: rates were low, the economy was healthy and people were making their payments.
As you can see in Figure 1, subprime mortgage originations grew from $173 billion in 2001 to a record level of $665 billion in 2005, which represented an increase of nearly 300%. There is a clear relationship between the liquidity following September 11, 2001, and subprime loan originations; lenders were clearly willing and able to provide borrowers with the necessary funds to purchase a home.
Partner In Crime: Homebuyers
As a result, when their mortgages reset, many homeowners were unable to refinance their mortgages to lower rates, as there was no equity being created as housing prices fell. They were, therefore, forced to reset their mortgage at higher rates, which many could not afford. Many homeowners were simply forced to default on their mortgages. Foreclosures continued to increase through 2006 and 2007.
In their exuberance to hook more subprime borrowers, some lenders or mortgage brokers may have given the impression that there was no risk to these mortgages and that the costs weren’t that high; however, at the end of the day, many borrowers simply assumed mortgages they couldn’t reasonably afford. Had they not made such an aggressive purchase and assumed a less risky mortgage, the overall effects might have been manageable. (To learn about moral debate surrounding all things subprime, read Subprime Lending: Helping Hand Or Underhanded?)
Exacerbating the situation, lenders and investors of securities backed by these defaulting mortgages suffered. Lenders lost money on defaulted mortgages as they were increasingly left with property that was worth less than the amount originally loaned. In many cases, the losses were large enough to result in bankruptcy.
Investment Banks Worsen the Situation
A lot of the demand for these mortgages came from the creation of assets that pooled mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize these mortgages into bonds, which were sold to investors through CDOs.
The chart below demonstrates the incredible increase in global CDOs issues in 2006.
Rating Agencies: Possible Conflict of Interest
Moreover, some have pointed to the conflict of interest between rating agencies, which receive fees from a security’s creator, and their ability to give an unbiased assessment of risk. The argument is that rating agencies were enticed to give better ratings in order to continue receiving service fees, or they run the risk of the underwriter going to a different rating agency (or the security not getting rated at all). However, on the flip side, it’s hard to sell a security if it is not rated.
Regardless of the criticism surrounding the relationship between underwriters and rating agencies, the fact of the matter is that they were simply bringing bonds to market based on market demand.
Fuel to the Fire: Investor Behavior
Much of the blame here lies with investors because it is up to individuals to perform due diligence on their investments and make appropriate expectations. Investors failed in this by taking the ‘AAA’ CDO ratings at face value.
Final Culprit: Hedge Funds
To illustrate, there is a type of hedge fund strategy that can be best described as “credit arbitrage“. It involves purchasing subprime bonds on credit and hedging these positions with credit default swaps. This amplified demand for CDOs; by using leverage, a fund could purchase a lot more CDOs and bonds than it could with existing capital alone, pushing subprime interest rates lower and further fueling the problem. Moreover, because leverage was involved, this set the stage for a spike in volatility, which is exactly what happened as soon as investors realized the true, lesser quality of subprime CDOs.
Because hedge funds use a significant amount of leverage, losses were amplified and many hedge funds shut down operations as they ran out of money in the face of margin calls. (For more on this, see Massive Hedge Fund Failures and Losing The Amaranth Gamble.)
Plenty of Blame to Go Around
It seems to be a fact of life that investors will always extrapolate current conditions too far into the future – good, bad or ugly.
For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.
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