United States Housing Market Correction - Major Downturn and Subprime Mortgage Collapse, 2007 - Subprime Mortgage Industry Collapse

Subprime Mortgage Industry Collapse

In March 2007, the United States' subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates, with more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale. The stock of the country's largest subprime lender, New Century Financial, plunged 84% amid Justice Department investigations, before ultimately filing for Chapter 11 bankruptcy on 2 April 2007 with liabilities exceeding $100 million.

The manager of the world's largest bond fund PIMCO, warned in June 2007 that the subprime mortgage crisis was not an isolated event and will eventually take a toll on the economy and whose ultimate impact will be on the impaired prices of homes. Bill Gross, "a most reputable financial guru", sarcastically and ominously criticized the credit ratings of the mortgage-based CDOs now facing collapse:

AAA? You were wooed Mr. Moody's and Mr. Poor's, by the makeup, those six-inch hooker heels, and a "tramp stamp." Many of these good looking girls are not high-class assets worth 100 cents on the dollar. ... And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone? ... AAAs? he point is that there are hundreds of billions of dollars of this toxic waste and whether or not they're in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. he subprime crisis is not an isolated event and it won't be contained by a few days of headlines in The New York Times ... The flaw lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere ... except for their mortgages that is. Mortgage payments are going up, up, and up ... and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ¾ of which are subprimes ... This problem—aided and abetted by Wall Street—ultimately resides in America's heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address—Main Street.

Financial analysts predict that the subprime mortgage collapse will result in earnings reductions for large Wall Street investment banks trading in mortgage-backed securities, especially Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch, and Morgan Stanley. The solvency of two troubled hedge funds managed by Bear Stearns was imperliled in June 2007 after Merrill Lynch sold off assets seized from the funds and three other banks closed out their positions with them. The Bear Stearns funds once had over $20 billion of assets, but lost billions of dollars on securities backed by subprime mortgages.

H&R Block reported that it made a quarterly loss of $677 million on discontinued operations, which included subprime lender Option One, as well as writedowns, loss provisions on mortgage loans and the lower prices available for mortgages in the secondary market for mortgages. The units net asset value fell 21% to $1.1 billion as of April 30, 2007. The head of the mortgage industry consulting firm Wakefield Co. warned, "This is going to be a meltdown of unparalleled proportions. Billions will be lost." Bear Stearns pledged up to US$3.2 billion in loans on 22 June 2007 to bail out one of its hedge funds that was collapsing because of bad bets on subprime mortgages.

Peter Schiff, president of Euro Pacific Capital, argued that if the bonds in the Bear Stearns funds were auctioned on the open market, much weaker values would be plainly revealed. Schiff added, "This would force other hedge funds to similarly mark down the value of their holdings. Is it any wonder that Wall street is pulling out the stops to avoid such a catastrophe? ... Their true weakness will finally reveal the abyss into which the housing market is about to plummet."

The New York Times report connects this hedge fund crisis with lax lending standards: "The crisis this week from the near collapse of two hedge funds managed by Bear Stearns stems directly from the slumping housing market and the fallout from loose lending practices that showered money on people with weak, or subprime, credit, leaving many of them struggling to stay in their homes."

In the wake of the mortgage industry meltdown, Senator Chris Dodd, Chairman of the Banking Committee held hearings in March 2007 and asked executives from the top five subprime mortgage companies to testify and explain their lending practices; Dodd said, "predatory lending practices" endangered the home ownership for millions of people. Moreover, Democratic senators such as Senator Charles Schumer of New York are already proposing a federal government bailout of subprime borrowers in order to save homeowners from losing their residences. Opponents of such proposal assert that government bailout of subprime borrowers is not in the best interests of the U.S. economy because it will simply set a bad precedent, create a moral hazard, and worsen the speculation problem in the housing market.

Lou Ranieri of Salomon Brothers, inventor of the mortgage-backed securities market in the 1970s, warned of the future impact of mortgage defaults: "This is the leading edge of the storm. ... If you think this is bad, imagine what it's going to be like in the middle of the crisis." In his opinion, more than $100 billion of home loans are likely to default when the problems in the subprime industry appear in the prime mortgage markets. Fed Chairman Alan Greenspan praised the rise of the subprime mortgage industry and the tools with which it uses to assess credit-worthiness in an April 2005 speech:

Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country ... With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. ... Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.

Because of these remarks, along with his encouragement for the use of adjustable-rate mortgages, Greenspan has been criticized for his role in the rise of the housing bubble and the subsequent problems in the mortgage industry.

Read more about this topic:  United States Housing Market Correction, Major Downturn and Subprime Mortgage Collapse, 2007

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... Examples pertinent to this crisis included the adjustable-rate mortgage the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized ... of CDO's declined from 2000 to 2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets ... As described in the section on subprime lending, the CDS and portfolio of CDS called synthetic CDO enabled a theoretically infinite amount to be wagered on ...
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... During a period of intense competition between mortgage lenders for revenue and market share, and when the supply of creditworthy borrowers was limited ... Sponsored Enterprises (GSEs) policed mortgage originators and maintained relatively high underwriting standards prior to 2003 ... originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated ...
United States Housing Bubble - Housing Market Correction - Subprime Mortgage Industry Collapse
... In March 2007, the United States' subprime mortgage industry collapsed due to higher-than-expected home foreclosure rates (no verifying source), with more than 25 subprime lenders declaring ... The stock of the country's largest subprime lender, New Century Financial, plunged 84% amid Justice Department investigations, before ultimately filing for ... The manager of the world's largest bond fund, PIMCO, warned in June 2007 that the subprime mortgage crisis was not an isolated event and would eventually take a toll on the economy and ...

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