"A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities." (Mishkin, 1992,page 115). The term "financial crisis" describes the several situations where financial institutions lose their values. Financial crisis are related to defaulting, subprime, currency crisis, stock market crashes, banking crisis, recession, securitization, wrong rating, common chocks and many others.
Many empiric models have tried to explain the financial crisis. Principally, the first, second and third generation and the non-conventional models should be taken into account. The models' examination started since 1979, by way of the first generation models that describe the unstable financial crisis, as an anticipatable but unavoidable event, resulting from the changeability of monetary policy with the exchange and fiscal rate. The second generation models existed in the mid-80, where anticipations examine the act of the auto crisis, where a financial crisis may or may not happen. The third generation models appeared after the East Asia financial crisis and join the economic crisis and the delicacy of the financial sector and infection from other countries. Kaminsky & Reinhart (1998), state that the second generation models cannot be used to explain other financial crises where the trade balance is not an indicator of monetary crisis, as well as the first generation models. In addition to all that, regarding the non-conventional models of financial crisis, the events of the 90´s financial crisis have encouraged the improvement of models in order to convey an empiric action which helps understand and simplify these events; and try to reduce the adverse impacts on the economy (Ramírez et al., 2008)
The latest credit crisis started in 2007 in the subprime mortgage market in the United States. The term "Subprime" describes the classification of the mortgagees who are not qualified for prime mortgage rates. The reason is their poor and impaired credit history or low income. Their low credit put forward for consideration that they are risky costumers because they are more likely to default on paying back the dept. Subprime lending carry more credit risk (or default risk) and a very high interest rates. Some mortgagees are considered as subprime borrowers even with their good credit history since they did not provide enough verification of the assets or income while applying for a loan. Taking for example, an employee who has a good salary and a good credit history (with no existing liabilities, charge offs, payment delinquencies or a low credit scores) applied for a loan but has elected to not provide the needed verification of her income. This costumer will be considered a subprime and charged a higher interest rate on the loan because she is considered a risky borrower who has a chance of defaulting.
Many previous studies considered the factors and the aspects of the subpime mortgage crisis. Velde, in 2008, imply that the financial crisis is producing a slowdown in most developed countries and segments, and governments predict that "the worst is not yet over". All regions have suffered declines in growth. According to World Bank estimates, the global economy contracted by 1.7 per cent in 2009, the first decline on record in world output (World Bank, 2009). Moreover, the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation, in 2009, explained that the risk of falling into deflation cannot be treated as unworthy of serious consideration for many chief economies and that the basis causes for the crisis should be identified.
1.1_Purpose of the study
A country's economy and banking system have a major effect, directly or indirectly, on the citizens' budget, and thus, on their entire life. Therefore, the purpose of this study is to shed light on the latest financial crisis and comprehensively discuss its aspects. It is important to study financial crisis in order to prevent their happening all over again.
1.2_Research Question
The latest financial crisis was nothing like any other crisis that happened before, taking into consideration its wide variety of economic aspects. Therefore, what are the different factors that have contributed in the subprime mortgage credit crisis, its consequences and the policy responses?
Chapter Two: Literature Review
2.1_Economic and Banking Systems
You will never find a "strong" country with a weak economy. The development of the financial position of public and private sectors in a country in addition to the average development of the financial position of each individual, which represent the Gross Domestic Product (GDP), determine the economic growth. Economic growth is measured as change in GDP by subtracting the amount due to inflation. The comparison between the economic growth of a country and that of its competitors, identify the local growths that are made or kept up. If there is no growth, or the economy is growing really slowly, then this is going to significantly have an impact on business strength. Economic growth can offer improvements in all the country's segments. Even a small rise in annual economy can have great impacts thereafter.
Bankers play very important role in the economic life of the country. The health of the economy is strictly associated to the soundness of its banking system. Even though, banks generate profits only from their borrowing, lending and related activities facilitate the process of production, distribution, exchange and consumption of wealth. Thus, they become very effective partners in economic development. Today, modern banks are very useful for the utilization of the countries' resources. The banks are mobilizing the savings of the people for investment purposes. If there would be no banks then a great portion of a capital of the country would remain idle. A bank as a matter of fact is just like a heart in the economic structure and the capital provided by it is like blood in it. As long as capital is in flow, the economy will remain sound and healthy.
2.1.1_Financial Crisis Affects the Economic and Banking Systems
The latest subprime mortgage crisis which started in 2007 caused the global economic system to tremble. It began in the financial sector and had a major effect on the economy. More essentially, the crisis spread widely and unexpectedly. Researchers, internationally, tried to find out how to stop the crisis of happening (Buti & Szekely, 2009) or how to reduce its possible impacts. The financial sector was well known to be very exceptional. Banks have several roles in the economy and are critical to the financial system and the real economy too. Above all, they perform an important role in corporate governance. Banks increase a big portion of their capitals by demandable deposits and investments in long-term assets. The maturity does not match between their assets and liabilities and their joinable through the interbank markets and the payments system, however, reveal financial institutions to the risk of insecurity and systemic crisis. Additionally, the good dependence on leverage and property information that banks hold on their borrowers and mortgagers may convince them to take too much risk. (OECD, 2009)
2.2_The Subprime Mortgages Crisis
In the summer of 2007, "subprime mortgage crisis" was a widely used term to refer to the U.S. mortgage market, and losses from mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) backed by subprime mortgages (kirk, 2007).
"Mortgage-backed securities resemble bonds, instruments issued by governments and corporations that promise to pay a fixed amount of interest for a defined period of time" (Chadda, 2008, page 3).
2.2.1_Types of Subprime Mortgages
There are different types of subprime mortgages. They can be categorized in three types. The first type is the "Interest-only mortgages" that let borrowers to pay only interest for a period of time (usually 5-10 years). The second type is the "Pick a payment loans" that let borrowers choose their monthly payment which can be full payment, interest only, or a minimum payment (may be lower than the payment required to decrease the balance of the loan). The third and last type of subprime mortgages is the "Initial fixed rate mortgages", it can be changed to variable rates (Chadda, 2008)
2.2.2_The Securitization of Subprime Mortgages
Black's Law Dictionary defines securitization as a structured finance process in which assets, receivables or financial instruments are acquired, classified into pools and offered as collateral for third-party investment.
Financiers and lenders frequently securitize mortgages into MBS bonds sold to investors. Principal payments and interests on MBSs originate from the borrowers' payments on the mortgages backing the bonds. Securitized subprime mortgages (as MBSs) are distributed into portions of bonds so as the cash flow from the bonds may go well with certain investment necessities. Every portion is given a credit rating by rating agencies. By this credit improvement process, MBSs backed by subprime mortgages may get investment grade status in spite of the basic collateral is a poor quality. MBS bonds are paid in order of seniority, and more senior bond portions pay before lower portion. In case the cash flow received from the basic mortgages is not sufficient, then lower portions may not be paid. Taking into account, that the lower portions of the bonds have a high risk that they will not be paid, they obtain higher returns and profit. Higher risk means higher return. Furthermore, investment banks have securitized lower level portions of MBSs into collateralized debt obligations (CDOs). CDOs create portions for their bonds as well. Investment banks have been capable to get the highest credit rating for senior CDO portions despite the fact they contain MBS bonds rated below investment grade. MBSs and CDOs backed by subprime mortgages are hard to rate since they do not trade on active markets. Investors are frequently required to rate MBS or CDO bonds by marking them to market, or valuing them according to the price they think they can get in the current market. While default rates on subprime mortgages backing MBSs and CDOs began to go up, and less cash flow is available to pay lower bond portions, investors may have to revalue those securities. This can result in cash or collateral calls by entities that borrowed money to the investors with the intention of investing in the MBSs or CDOs (Kirk, 2007)
2.2.3_Risks Associated with Subprime Mortgage Crisis
There are four types of risks related to subprime mortgages and can cause a subprime crisis. The first risk is the credit risk; it is borne by the lending financial institutions and it represents the potential that the issuer of a debt security (in this case MBS) will not be able to meet its obligation to make periodic interest payments or repay principal to investors. In order to reduce the lender's credit risk, the lender may perform a credit check on the borrower or seek a third party guarantee. The second type of risk is the asset price risk; it is about the valuation of MBS, if it will be capable to overcome the credit risk or not. However, valuation of MBS is a personal perspective. It is resulted by computing the chances of subprime mortgage beside the presence of viable market into which these assets can be sold. Because the mortgage delinquency rates are rising, the MBS value began to decrease. Nevertheless, Banks and Institutional investors have recognized significant losses on adjustment of their securities downwards because of Mark to Market accounting. This is caused by asset price risk. Thirdly, there is the liquidity risk; it is on account of decliner of liquidity in market on account of the two risks previously mentioned. Many firms depend on access to short-term funding markets, such as commercial papers and repurchase market, in order to run their operations and make profits. Frequently, firms get short-term loans through issuing commercial paper by pledging MBS. Investors deliver cash in interchange for the commercial paper, receiving money-market interest rates. However, concerning the value of the MBS due to subprime crisis, the capability of many companies to issue such paper has been considerably impacted initiating liquidity risk. The last type of risks is the counterparty risk; it is on account of associated parties impacted by the brutal circle of subprime crisis. Investment banks support firms and governments increase money by issuing and selling securities in the capital markets, whether they are equity or debt, besides giving advices on transactions. Foremost Investment Banks and financial institutions have taken important positions in credit derivative (MBS) transactions. However, concerning the previously discussed risks, the financial health of investment banks has taken a southward position, possibly bringing a higher risk to their counterparties and creating additional uncertainty in the market (Chadda, 2008).
2.3_The Rise and Fall of the Subprime Mortgage Market
2.3.1_The Subprime Boom
In the early years of this decade the residential and property prices went up, and securitization provided more working capital for mortgages, criteria level was deteriorated by lenders in order to issue more mortgages. Simultaneously, investors asked for higher returns on their investments and asked more for MBSs and CDOs backed by subprime mortgages. Between 1995 and 2005, subprime mortgages raised from 5 percent to 20 percent of the mortgage market. In 1994, $35 billion were made in subprime mortgages, and by 2006, that number had risen to more than $600 billion. Moreover, between 2003 and 2006 AMP originations tripled for residential mortgages. The most important cause for this boom seems to be the rise in the securitization of mortgages. Securitization provided financiers and lenders with supplementary capital to issue more mortgages, as well as a higher number of AMPs, and to pass off the risk of defaults to investors (Kirk, 2007).
2.3.2_The Deterioration of the Subprime Market
It appears that a combination of industry trends and economic and financial factors combined to create the current crisis in the mortgage markets. In 2006, short-term interest rates rose while the value of homes leveled off or dropped. Borrowers with financial difficulties could not refinance or sell their homes to pay off mortgages when they were unable to make monthly payments. Further, in 2006 and 2007, borrowers suffered "payment shock" when teaser rates on many hybrid ARMs expired and higher variable rates became effective. As a result, default rates on subprime and Alt-A mortgages increased significantly in late 2006 and 2007. Early payment defaults, where a borrower fails to make a payment within the first several months of the loan, became more common in 2006. With rising defaults, purchasers of mortgages sought to force lenders/originators to buy back nonperforming mortgages. Many smaller lenders that were inadequately reserved and unable to comply with such repurchase demands filed for bankruptcy. Rising defaults on subprime and Alt-A mortgages have caused rating agencies to downgrade MBS and CDO bonds backed by subprime mortgages. Investors in those securities have already suffered substantial losses, and uncertainty in the financial markets about the value of such securities and potential losses has adversely impacted liquidity in the financial markets. Some commentators believe that losses from MBSs and CDOs backed by subprime mortgages could exceed $100 billion. To date, however, it remains unclear which entities are invested in MBSs and CDOs backed by nonperforming subprime mortgages, and whether and when those entities will be forced to decrease the value of those securities held on their books (Kirk, 2007).
2.4_Countries at Risk
The latest financial crisis had major effects on developing countries. Some types of countries are more expected to be at risk. The crisis has further effects on countries with important exports, whether direct exports or indirect, to other affected countries like the United States and European Union countries. Other countries are those exporting products that their prices are impacted or those with high income pliability; taking for example, Zambia would eventually be hit by lower copper prices, and the tourism sector in Caribbean and African countries will be hit). In addition to that, countries that depend on remittances are also affected; taking for example, Indians who work in London with no bonuses, will have less to remit. There will be fewer migrants coming into the United Kingdom and other developed countries, where attitudes might toughen and job opportunities are being rarer. Moreover, countries depending greatly on FDI, portfolio and DFI finance to address their current account problems should be also mentioned besides the countries with sophisticated stock markets and banking segments with weakly regulated markets for securities. Even more, countries with a high current account deficit with pressures on exchange rates and inflation rates are also included; South Africa cannot meet the expense of decreasing interest rates by way it needs to appeal investment to address its current account deficit. Over and above, countries with high government deficits; for example, India has a weak fiscal position which means that they cannot put schemes in place. And finally, countries that rely on aid (Velde, 2008).
2.4.1_List of Countries Affected
According to the European Commission, in 2012, the countries affected by the subprime mortgage crisis are: Belgium, Bulgaria, The Czech Republic, Denmark, Germany, Estonia, Ireland, Greece, Spain, France, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Hungary, Malta, The Netherlands, Austria, Poland, Portugal, Romania, Slovenia, Slovakia, Finland, Sweden, The United Kingdom, Croatia, The former Yugoslav Republic of Macedonia, Iceland, Montenegro, Serbia, Turkey, The United States of America, Japan, China, EFTA, and the Russian Federation
2.4.2_Social and Economic Effects
Even though the effects change from country to country, but there are common economic and social effects that can be generalized and applied for all affected countries. The economic effects include weaker export revenues, further pressures on current accounts and balance of payment, lower investment and growth rates, and lost employment. While the social effects include lower growth translating into higher poverty, more crime, weaker health systems and even more difficulties meeting the Millennium Development Goals (Velde, 2008).
2.5_The Size and Length of the Contraction
The variety of previous crises means that averaging them to get an approximation of the possible effects of the crisis could be ambiguous. But as a substitute of considering these variations a negative aspect, it should be considered as an opportunity. This could happen by using the variance through time in order to comprehend the elements of the length and cost of the contraction following crises by conditional models. The goal is to have a better comprehension of the length and relentlessness of the existing contraction. (Cecchetti, et al, 2009).
2.6_Gaps in Literature
After reviewing several studies, articles and reports regarding the subprime mortgage crisis and related subject as well, many information gaps were present and need to be filled. The international reporting of indicators of current financial health and soundness of financial institutions are not as strong as they should be, they should expand the number of reporting countries; the data assemblies on cross-border banking flows and nonbank financial institution activities are weak (IMF Staff and the FSB Secretariat , 2009).
