American Federal Reserve made an unpredicted action to prevent the collapse of Bear Stearns, the fifth largest U.S. investment bank.
By this step Fed pointed // that it would assist other significant brokerage companies if necessary. After two days Fed cuts interest rate to 2,5 percent.
March 19 edition of famous economic magazine the Economist mentions that FED action showed us the following two aspects of the US economic crisis: analytical one – the world needs new approach towards finances generally and risk analyses and the second – credit crisis enteres a new, more dangerous phase.
It cost USD 30 billions for Fed to back the company that had successfully been functioning, although the action avoided even greater danger. Collapse of Bear Stearns would have cased cataclysms of the world financial system, as the company was an intermediary in about USD 10 trillion swap agreements. Its worth noting that JP Morgan purchased 39 percent of Bear Stearns shares for $2 since Bear Stearns received the above mentioned USD 30 billion loan from Fed while the company’s share price was more than $ 100 in September.
Sub prime Mortgage Lending Crisis
Sub prime lending is a new type of a loan. It’s also referred as a ‘second chance’ loan. It implies issuing loans at higher than normal rates to those with weak credit histories or those who do not meet necessary requirements to get an access to an ordinary credit.
Mortgage crisis accelerated in the United States in late 2006 and triggered a global financial crisis during 2007 and 2008.
The crisis began with the bursting of the US housing bubble and high default rates on “subprime” and other adjustable rate mortgages (ARM) made to higher-risk borrowers.
Total value of these type of loans amounted to USD 1,3 trillions by 2007. Major condition for loan /// was the rise of prices on real estate. However, once housing prices started to drop moderately in 2006-2007, it increased mortgage loan interest rates. As a result, majority of non-guaranteed sup-prime loans faced failure. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity. As of December 22, 2007, The Economist estimated subprime defaults would reach a level between U.S. $200-300 billion. The mortgage lenders were the first to be affected, as borrowers became unable or unwilling to make payments.
Major banks and other financial institutions have reported losses of approximately U.S. $200 billion as of April 1, 2008. Owing to securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Therefore, unpaid mortgage loans damaged investors and the world securities market as well.
The widespread dispersion caused by these events forced banks and other financial institutions to make loans at higher interest rates. Stock markets in many countries declined significantly.
The liquidity concerns drove central banks around the world to take various actions.
The subprime crisis also placed downward pressure on economic growth, because fewer or more expensive loans decrease investment by businesses and consumer spending. A surplus inventory of homes on housing market has resulted in a significant decline and it effected the country’s GDP growth dynamics. The U.S. Federal reserve to cut interest rates and President George W. Bush signs the economic stimulus package. Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
The reasons for the crisis (like of other depressions) are varied and complex. Understanding and managing the ripple effect through the world-wide economy poses a critical challenge for governments, businesses, and investors. The crisis can be attributed to a number of factors, such as the inability of homeowners to make their mortgage payments primarily due to loss of employment or health related issues; poor judgment by either the borrower and/or the lender; inappropriate mortgage incentives such as buydowns and short fixed term adjustable rate mortgages, coupled with rapidly rising adjustable mortgage rates. Further, declining home prices have made re-financing more difficult. Due to innovations in securitization, it was thought the risks related to the inability of homeowners to meet mortgage payments had been distributed broadly, with a series of consequential impacts. The following are primary categories of risk involved:
· Credit risk: that is transferred to third-party investors as a result of securitization, it is also transferred a right to mortgage payments.
· Asset price risk: MBS and CDO asset valuation is done through real and market prices. Possibility of their guaranteeing mortgage loans as well as their liquidity is taken into consideration while their estimation
· Liquidity risk: Companies often obtain short-term loans by issuing commercial paper, pledging mortgage assets or CDO as collateral. Because of concerns regarding the value of the mortgage asset, the ability of many companies to issue such paper has been significantly affected (dropped).
· Counterparty risk: Major investment banks and other financial institutions have taken significant positions in these processes. Later it has caused important financial troubles to them (for example to Bear-Stearns).
As we have mentioned above, major precondition of issuing non-guaranteed credits was a housing price increase. Between 1997 and 2006, American home prices increased by 124%. Some homeowners used the increased property value experienced in the housing bubble to refinance their homes with lower interest rates and take out second mortgages against the added value to use the funds for consumer spending. U.S. household debt as a percentage of income rose to 130%. This excess supply of home inventory placed significant downward pressure on prices. As prices decline, more homeowners are at risk of default and foreclosure. The price decline in December 2007 versus the year-ago period was 10.4%.
A variety of factors have contributed to an increase in the payment delinquency rate for sub prime ARM borrowers, which recently reached 21%, roughly four times its historical level.
Easy credit, combined with the assumption that housing prices would continue to appreciate, also encouraged many subprime borrowers to obtain mortgage loan. Once housing prices started depreciating, refinancing became more difficult. Some borrowers began to stop paying their mortgage loans as their loans reset to higher interest rates and payment amounts. Some homeowners, facing declines in home market value or with limited accumulated equity, left their homes. They essentially “walked away” from the property, allowing foreclosure, despite the impact to their credit rating.
Easy loans lead to the fact that clients presented artificially increased or fraud income data and documentation.
US Department of the Treasury suspicious activity report of mortgage fraud increased by 1,411 percent between 1997 and 2005. (See table 2)
The world economy has recently witnessed an interesting tendency that keeps economic growth caused by Bull trend. Virtual demand is created to provoke real demand and maintain sustainable supply. This is exactly what happened on the US property market. Majority of pub-prime loans were put on Bull trend. As borrowers were not able to cover their debts, they put a future value of their house or other asset as a guarantee. To put it in other words, if a borrower became unable to pay, the growing price of house should have fully covered investor’s losses. From classical economic theory point of view increasing prices can not stimulate a demand.
But, as it turned out, this paradox is a characteristic of modern economy. Quick growth of prices created an expectation that future cost of assets would have grown significantly. Accordingly different financial actors used this factor to increase today’s demand with future incomes.
‘Theory of creativeness’ 1 analyses this event. According to it today’s boom on demand is an outcome and a result of a person’s influence and comes in contrast / opposes classical natural order theory. People create virtual resource to stimulate economic growth. This system somehow resembles a time machine by means of which future values are transported into present. To put this machine into action, to make it really work, its engine needs to be filled with prices growth tendency, with bull trend. This did not happen in the US, the bull trend could not meet its
expectations. One of the results of theory of creativeness is a securitization. It implies selling mortgage loans to investors by means of securities. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank. Nowadays a lender as a rule sells its own demand (to a borrower) to a third party.
The thisd party in the US may be governmental organizations: The Government National Mortgage Association (GNMA, also known as Ginnie Mae), The Federal National Mortgage Association (FNMA) commonly known as Fannie Mae, as well as private corporations. Third parties group purchased mortgages in portfolios and make emission of mortgage securities. These securities are sold to various investors. However this is not an end of mortgage travel, as investors are able to sell the securities again and so on. Let us lake an example, an emmittent has 1 000 mortgage debtor liabilities and each of them cost $100 000, 30 year term and 6,50% rate. One can use these assets to issue 10, 000 securities where each of them will cost $10 000, 30 year term and 6% rate. We can see that profit is issued from monthly mortgage payment and basic amount is paid after having full amount of mortgage loans.
0,50% is used for covering other expenses related to issuing securities and other transactions. The securitized share of subprime mortgages (i.e., those passed to third-party investors) increased from 41 % in 1996, to 71% in 2006.
Former Fed chairman, Alan Greenspan stated that the securitization of home loans for people with poor credit — not the loans themselves — were to blame for the current global credit crisis. Securitization implies using mortgage loans as the third-party’s guarantee of securities.
Let us take a look at a scheme of issuing sub-prime loans to understand the reason of its crisis. It is obvious that the major player in partly guaranteed loans is a high interest rate that will cover high risks.
The above provided table clearly shows the reason due to which American banks began to issue unguaranteed loans. First interest rate is 6.0% that increases to 10% little by little. According to Banks calculations unpaid credit rate should be 8.0% in on year, per each unpaid credit 30% would be a loss, general loss would be 8,0* 30,0=2,4%. Therefore interest rate after deducting losses would be 10-2,4=7,6%. Being 2,8 % more than AAA rated loans. If sub-prime loan market is 1,2 trillions then issuing loan on this market annually is 33,6 billions more profitable. It amounts to 235,2 billion USD in 7 years. The model clearly shows that the major point for investors calculations was a growing bull trend.
According to script B rate of losses reached 15% instead of 8% . Due to a fact that important part of loans remained unpaid housing prices had fallen. As a result actual difference between AAA rated loans and sub-prime rates turned into a negative unit. If creditors had to divide 2,8% of profit on their own mortgage loans in script A, now they had to cover 2,3% of loss. This equals to $27 billion loss instead of $33 billion annual profit. Unexpected and sudden collapse has shown that securitization, ratings and other insurance tools didn’t work. Investors faced these problems without any security mechanism. As a result of the above mentioned processes the US economy entered recession that developed little by little and appeared at the last stage. Basic hampering factor of recession are people. They are aware that something goes wrong. It changed their economic behavior and they become more careful, decrease risks as well as investment. Besides, extra amount of real estate already exists on market. Therefore, C script depicts more dramatic events.
Recession doubles indicators of annual losses’ shares and increases losses on unpaid loans from 50% to 60%. Accordingly losses grow and reaches significant figures (see script C).
USD exchange rate drop against Euro caused important economic problems to Europe. It sharply increased prices on Europe’s export while American export prices decreased. Second problem that the US crisis caused to Europe is that increased prices on real estate began to fall. It has already begun in England and Spain. For example Central Bank of England has cut discount interest rates already for the fourth time. what is the US crisis effect on Georgia? Unlike European countries Georgia doe not have a direct, close trade or financial relationships with the US. However it implements trade with number of countries in USD. Artificial stability of Gel against USD increased Georgia’s export even more. It certainly is negatively reflected on balance of payment. On the other hand crises in developed countries will definitely cause the decrease of implemented investment projects in developing countries (including Georgia). Dollarisation level of Georgia’s economy is quite high. USD deposits share is 65,5%, accordingly USD fall causes the devaluation of more then two-third of deposits. Therefore the fact that foreign currency depositing structure has changed. USD share decreased from 89.2% to 78.6%. Euro share increased from 10.3% to 20.6%. according to National Bank’s forecasts Georgia’s economic growth will be less effected as the country has indirect contacts to the world’s developed states’ financial markets. Georgia’s approximate economic growth will be 8% by 2008. Monetary policy committee meeting on April 16 noticed that risks affecting inflation has increased. In spite of this fact, by means of increased interest rate till 12, National bank hopes to keep 8% inflation. It’s worth noting that initials of creative approaches can be seen in Georgian reality. Investor and the sector where price rise is fixed had already been found – banking and construction sectors. It is obvious that both these sectors are quickly developing. Although there is one significant difference. Increased prices on real estate in Georgia have been caused by absence of alternative ways of implementing investment. Georgia’s financial and stock exchanges do not even have real derivatives. There is another factor as well, people feel secure and safe while investing their own capital in real estate and besides, they receive quite nice ‘dividends’. Government should direct efforts to creating new, alternative investment tools and form real financial means for investing in production sector. Gel exchange rate should be freely formed. This will be positively reflected in Georgia’s production in a long term perspective.
So, what should the US expect? According to a famous magazine ‘The economist’ crisis will not significantly damage America’s and developed countries strong economies. However, the process of overcoming this challenge will be quite difficult and will require a lot of time. Just like all other crisis, current crisis will give new categories, forms and theories to science. The US ministry of Finance has started to work out a new model of financial sector regulation. Major art of election program of candidates for the US presidency elections consist of crisis overcoming plans.
There is no doubt that Europe and America will overcome the crisis. The world economy will change as a result of new experiences, new knowledge and XXI century first season crisis.