The mortgage crisis its impact and banking restructure.

Author:Singh, Gaurav
 
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BACKGROUND OF THE MORTGAGE CRISIS

The subprime mortgage crisis is an ongoing real estate and financial crisis caused by a substantial rise in mortgage delinquencies and foreclosures in the United States, with unfavorable consequences for banks and financial markets around the globe. The crisis, which had shown signs in the closing years of the 20th century, became apparent in 2007 and has since resulted in weaknesses in financial industry regulation and the global financial system.

Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages (Lockett, 2008). After U.S. house prices peaked in mid-2006 and began their steep decline thereafter, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies increased. Securities backed with subprime mortgages, widely held by financial firms, lost most of their value. This resulted in a decline in the capital of many banks and U.S. government sponsored enterprises, tightening credit around the world.

The crisis can be attributed to a number of factors that were pervasive in both, the housing and credit markets and emerged over a number of years. The causes were prominent due to the inability of homeowners to make their mortgage payments, the adjustable rate mortgages resetting, borrowers over-extending, over lending and speculation during the boom period.

The risks to the broader economy created by the housing market downturn and financial market crisis were primary factors that were taken into consideration by central banks around the world, to cut interest rates and governments to implement economic stimulus packages. The effects were also extensive on global stock markets due to the crisis, resulting in an overall global melt down and leaving economies disconcerted and worried.

The mortgage industry played a vital role in the recession faced by the U.S. economy in 2008. An estimated 1.5 million households defaulted on their home loans and were driven to foreclosure in 2009 (Les, 2009). This has resulted in the restructure of the mortgage industry and consequently limiting individuals to purchase homes due to lack of flexibility. The purpose of this research is to determine how the mortgage crisis has impacted the U.S. economy.

The prevailing recession is a financial crisis that focuses on the U.S. housing market, where the affects from the subprime mortgage market are visible in the credit markets, as well as domestic and global stock markets. The subprime mortgage crisis has put the U.S. economy into the worst recession since 1982 (Amadeo, 2009). Between 2000 and 2006, the number of home foreclosures continued to rise in America. A number of studies and data analysis suggested a strong connection between the rise in foreclosures and the subprime mortgage lending market and thus, the federal government began to scrutinize the practices of subprime mortgage lenders. The adjustable-rate mortgage (ARM) loan has played a major part in the subprime mortgage crisis. In an adjustable rate mortgage, the interest rate will eventually reset or adjust at some future point in time. This type of loan starts with a relatively lower interest rate that appeals to borrowers, but in due course of time it will reset to a likely higher interest rate and sometimes a significantly higher interest rate.

Through the mid 90's and early 2000's, the number of subprime mortgage loans rose significantly (Cornett, 2008). This was partly due to the increased competition among lenders (largely from online mortgage lenders), which meant that lending institutions had to offer a wider range of mortgage products to a larger audience, in order to stay competitive. Many of these lenders began to focus almost exclusively on this type of lending practice, thus they became known as subprime lenders. These lenders took advantage of the opportunity, to beat the competition by extending loans to borrowers that their competitors were turning away. In other words, they offered subprime mortgage loans to subprime borrowers, usually with a much higher interest rate for the borrower and higher profit for the lender. As with most things in the financial world, this lending practice had an up-side and a down-side. The down-side eventually grew into a full-blown mortgage crisis.

The major advantage of the expansion of subprime mortgage credit is the rise in credit opportunities and homeownership. Due to innovations in the prime and subprime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods and use their homes to build wealth (Cornett, 2008). Although the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market raise issues. For mortgage lenders the real challenge is to figure out how far to go. If lenders do make new loans, can conditions be designed to prevent new delinquencies and foreclosures? These loans extended home ownership to a lot of Americans who probably could not have afforded a home otherwise, but at the same time, they were a contributing factor in the number of home foreclosures in the U.S.

The problem started with the subprime mortgage market, when a bunch of these high risk loans started to default. It was then that investors slowly started to take a realistic look at the risks they were holding in their investments, not just looking at the returns. There was speculation that perhaps there was way too much exposure and way too low a rate for the exposure in their portfolios. It became a crisis when a number of hedge funds at major brokerage firms collapsed as investors wanted to cash out. This caught the attention of the world and then in Europe, a huge French bank froze a $2.5 billion fund after it lost $400 million, which piled on to the uncertainties and worries (Gray, 2007). When these investors, largely through hedge funds needed to cash out, it meant sell everything in order to raise cash. They started by selling low-yield investments, but one can only sell if there is a buyer, and nobody wanted to buy these high risk loan portfolios. At that point, the market had pretty much dried up when investors realized that the risk they were taking on was too high for what they were being paid. Any and every buyer now wanted to do a thorough inspection before purchasing.

In 2008, severe changes were made in sub-prime lending. Before the changes, most people could walk into a mortgage office and they could probably qualify for a loan and hence people with bad credit had a fairly easy time getting qualified for home loans. Not surprisingly, a lot of these people did not pay their mortgage and defaulted on their loans. This led banks to reevaluate their policy on sub-prime loans. The changes were focused on credit history and individuals with a history of credit problems or poor credit, were no longer eligible for a loan. Individuals purchased homes they could not afford and struggled to make the payments for two years and then get foreclosed on. Therefore, it would be better for the banks to turn individuals down than to get them into loan programs. There is still quite a bit of tension in the financial markets that a lot of these loans are not going to be paid off. This is hurting a lot of the banks that own these loans because borrowers are defaulting and the loans are difficult to resale. It is also hurting new home builders, because people with bad credit generally go to new home builders who arrange easy loans.

In essence, homebuyers should be aware of ongoing changes in the mortgage industry and their overall financial capabilities when purchasing a home. To get the best mortgage rates, a comparison of current mortgage rates and closing costs is essential. Many brokers and lenders, low ball estimates and upon receipt of payment for an appraisal, they inform that the mortgage rate or closing cost have gone up. Home buyers should seek lenders that guarantee their closing costs up front and there is nothing wrong with No/Zero Closing Cost Loans. Individuals will be looking at higher mortgage rates in exchange or if refinancing, the closing costs could be included in the principal. Paying higher points and fees will result in lower mortgage rates. For example, at 7% you may have zero points and fees, while at 6% you may have points and fees of $3000. The example provided is a general illustration to show the correlation between interest rates, points and fees. To get the best mortgage rates, one must estimate the length of time they will have the mortgage, and to perform a complete analysis and comparison of mortgage products and fees.

The mortgage crisis is a result of a chain of reactions. The number of people who defaulted on their mortgages increased more and more which in return increased the number of houses on the market. The oversupply of houses and lack of buyers pushed the house prices down till they completely plunged in late 2006 and early 2007 (Cornett, 2008). It was at this point, people on Wall Street started to panic and they no longer wanted to buy risky mortgages. Mortgage companies, which used to sell risky loans, experienced the devastating consequences of going out of business and moreover, foreclosures keep springing up. In the past mortgages were held in the books of financial institutions such as banks, who had real interest in working with their borrowers and making sure that everything possible is done to pay back the loans. However, in the current situation, mortgages have been sold and resold and pooled together into securities and sold to investors in the financial market. It is hard to find or trace who the actual current owner of a mortgage is, and it is just as hard to prevent foreclosures.

"When a pebble is dropped into still water, it creates a ripple that will continue traveling until it meets resistance or...

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