Analysis of the 2007-2008 U.S.

Subprime Mortgage Crisis

Table of Contents
Introduction................................................................................................................................2

Causes of the Crisis....................................................................................................................2

The Housing Bubble..............................................................................................................2

Securitizing subprime mortgages into complex financial products.......................................3

Mispricing of risk by credit rating agencies...........................................................................4

The Crisis's Progression.............................................................................................................5

Consequences and Contagion Effects........................................................................................7

Policy Response.......................................................................................................................10

Fed's monetary policy..........................................................................................................10

U.S. government fiscal policies............................................................................................11

Regulatory reforms...............................................................................................................11

Conclusion................................................................................................................................12

References................................................................................................................................13

Figure 1: Non-Mortgage, Asset-Backed Securities Outstanding...............................................4

Figure 2: Securitization Process.................................................................................................5

Figure 3: S&P CoreLogic Case-Shiller U.S. National Home Price Index.................................6

Figure 4: Trends in GDP growth (annual)..................................................................................9

Figure 5: Annual unemployment rate.......................................................................................10

Figure 6: OPEC Brent crude oil price and output....................................................................10

Figure 7: Monthly gold and platinum prices............................................................................10

Introduction

The financial crisis has been a common economic phenomenon that over time has taken
different forms including banking crisis, currency crisis, and sovereign debt crisis. This has
its own varies characteristics and consequences which often results in major disrupts to the
markets, institutions, as well as the lives of many people. One of the most conspicuous
financial crises of the recent time is the U.S. sub-prime mortgage crisis (SMC) of 2007-2008
which had its origins from the country’s real estate market and then the globe economy was a
victim to its impact through a severe economic recession (Bernanke, 2010). This paper is
focused on uncovering the underlying factors leading to the 2007-2008 U.S. SMC and their
consequences for individuals and institutions, major policy responses included.

Causes of the Crisis

The Global Financial Crisis of 2007-2008 was an intricate multi-vector event with many
intertwined causes. The bubble was formed when low interest rates, growing demand for real
estate, and the trust that housing prices would go only up (Bernanke, 2010) earned excessive
popularity. This section will explore three key causes of the crisis: real estate bubble,
securitization of such protege loans, and evaluation of credit-risk by the credit rating
agencies.

The Housing Bubble

It was during those years before the crisis when the U.S. housing market was enjoying a
booming period, and the prices of homes were hitting new records at the same time. Lenders
were less reluctant to lend and borrowers were encouraged to grow their credit products as
interest rates were lower than the norm. This translated into a significant growth in housing
sales. The FED policy set interest rates low in the early 2000s, in an effort to aid economic
recovery post-dot-com-crash and 911-terrorist attacks (Bernanke, 2010). Beyond that, low
interest rates cannot address the formation of housing bubble. The second determinant,
however, equally contributed to this problem. With the regulation of lending standards not
tight enough, amount of people with lower credit scores now qualify for mortgages, as well
as those with less verification of their income and asset documentation (Dell'Ariccia et al.,
2012). The lenders peddled subprime mortgages with higher interest rates, and fees; which
were however targeted to those who couldn't make it to prime mortgage loans (Mayer et al.,
2009). As a result of the low interest rates and not-so-strict lending standards passive lending
rocketed especially in the subprime sector of mortgage borrowers.

Securitizing subprime mortgages into complex financial products

One of the factors that made the massive growth in subprime lending possible is
securitization, a process that allowed mortgage originators to package those mortgages and
sell them to investors as MBS as well as CDOs. The securitization principle enabled the
lenders to sell quickly the mortgages that they have issued so that the capital would be
available to make more loans. On the other side, the risk of failure was now shared among
investors.

Figure 1: Non-Mortgage, Asset-Backed Securities Outstanding

Securitization process got more and more complex with MBS as well as CDOs which were
broken into tranches with various risks and sold to many buyers. This involved a multi-
section deal that the investors had to assess to single out the real risk faced which was several
steps away from the underlying mortgage (Gorton 2010). The increased demand for these
high-return securities prompted borrowers not only to offer more subprime mortgages but
also as the loans turned more risky.

Figure 2: Securitization Process

Mispricing of risk by credit rating agencies

Credit rating agencies, by rating the MBS and CDOs associated with the subprime market
with high ratings, filled the role of the mechanism that inadvertently misled investors into
believing these products were extremely safe investments. These ratings are on the basis of
the complex mathematical models that heavily lodged on historical data and expected trends
of the housing sector and the possibility of defaults among mortgages (Coval et al., 2009).
Nevertheless, credit rating agencies frequently apply models that are not at all realistic in this
sense, particularly when it comes to subprime mortgages (Benmelech & Dosiag, 2013).
Ratings agencies were corrupt mainly because of their deals with the issuers of securities, so
it was in their interest to give good grades (White, 2010). The investments in MBS and CDOs
came to acquire top ratings that caused them to be desired by a lot of investors who included
pension funds, insurance companies, and banks that contributed to the surge in demand for
these instruments.

The combined elements in this situation including the real estate bubble, securitization of
mortgages up to subprime category, and the risk mispricing done by the credit rating agencies
—perfect storm— culminated in the 2007–2008 financial crisis. When the drop in housing
prices started and subprime borrowers began to default on their mortgages, a domino effect
was triggered and it became apparent how a system with such a complicated structure can
have inner weaknesses and turn into a systemic risk to the whole economy.

The Crisis's Progression

The financial meltdown in the US kicked off in different steps, going from the defaults in
subprime mortgage to the ultimate meltdown of the global economy. This crisis was a
precursor which emerged in early stages of 2007, when subprime mortgage delinquencies and
defaults began to increase. The re-setting of adjustable-rate mortgages (ARMs) to higher
interest rates was the most common reason for defaults. As a result, the monthly payments
became a real problem for the borrowers. As the economic crisis unfolded, borrowers with
subprime mortgages started to default in increasing numbers, devaluing the MBS and CDOs
that, in turn, led to losses for investors.

Figure 3: S&P CoreLogic Case-Shiller U.S. National Home Price Index

Following the increasing number of defaults on the subprime mortgages, the U.S. real estate
sector started experiencing the pressure on the price levels. The house prices started falling in
the middle course of 2006 as the once unsustainable rate of increase came to an end, with this
serving as the ultimate marker of the housing bubble. The slowdown of home prices began in
2007 and 2008, with the index of American Homes of Price, reporting values decreased more
than 27%, from July 2006 to February 2012 (S&P Dow Jones Indices LLC, 2021). The
collapse of the housing bubble led to further turbulence in the US economy since many
borrowers were hit with mortgages priced higher than the market value of their homes; it was
a case of negative equity or in more colloquial terms, being underwater (Mayer et al., 2009).
As a result, it passed into the loan, which made it harder for the borrowers to refinance their
mortgages or sell their homes, and the value of their homes was lower as well, thereby
introducing an additional factor of more foreclosures and defaults.

The implication of MBSs and CDOs on the other hand became more stern for the financial
institutions heavily exposed especially when the SMC starts to bite in. In March 2008 the
Federal Reserve negotiated Bear a deal of attracting JP Morgan Chase as by an investment
bank Bear Sterns, which is the largest in the United States, was the reason of liquidity crunch.
(Brunenmeier, 2009). The grasping of the bearstead bank was therefore the most dangerous
moment as, demonstrating the weakness of the most successful banks, it showed that nothing
could be considered as safe enough. The climax of the crisis brought September 15, 2008,
when Lehman Brothers, another biggest investment bank, filled for bankruptcy after
struggling to find a buyer, and neither did it get government assistance (Paulson, 2010).
Lehman's demise began a chain of events that had a devastating impact on the entire global
monetary system, triggered an unprecedented fall in the stock exchanges and paralyzed credit
markets. The bankruptcy of Lehman Brothers, the foremost commercial banker, in due course
preceded the very close vicinity of American International Group (AIG), a big insurance
company which had issued CDSs of MBSs and CDOs.

The failure of the big financial institutions and a systematic decline of MBS and other
structured products narrowed the funding sources for commercial banks and caused extreme
lack of liquidity within the global financial system. Banks and other financial firms got
extremely cautious in the lending process to each other as they were scared to find out the
losses in subprime-related threat of their counterparties (Gorton & Metrick, 2012). This
resulted in the LIBOR-OIS spread rising dramatically, as a gauge of the rise in the cost of
short- term borrowing as per the London Interbank Offered Rate (LIBOR)- the Overnight
Index Swap (OIS) rate (Brunnermeier 2009). Demand for both credit and liquidity suffered a
severe drop during the crisis of the credit crunch and liquidity crisis, therefore causing the
economic activity to sharply contract exaggerating the initial contraction (Ivashina &
Scharfstein, 2010). A severe liquidity crunch and substantial fall in asset prices occurred in
the U.S. in the month of December 2007, which according to the NBER (2008), was the first
official sign of a country’s slipping into a recession. The subsequent downturn quickly spread
across the borders causing a global economic meltdown. The evolution of the SMC clearly
points out that the same risks had compounded to destabilize the financial system. Due to the
complicated web of securitization and derivative transactions, the tight link among financial
institutions, a single institution or drop in asset value very rapidly could affect other areas of
the system, and a wave-like event that lead to a global economic crisis will develop
consequently.

Consequences and Contagion Effects

The SMC triggered a severe recession in the United States, which officially began in
December 2007 and ended in June 2009 (NBER, 2010). During this period, the U.S.
economy experienced a significant contraction in output, with real GDP falling by 4.3% from
its peak in the fourth quarter of 2007 to its trough in the second quarter of 2009 (Bureau of
Economic Analysis, 2021). The recession was characterised by a sharp decline in consumer
spending, business investment, and employment. The labor market was particularly hard hit,
with the unemployment rate rising from 4.6% in 2007 to a peak of 10% in October 2009
(Bureau of Labor Statistics, 2021). The crisis also led to a wave of home foreclosures, with
approximately 4 million foreclosures completed between 2008 and 2011 (CoreLogic, 2012).
The combination of falling home prices, job losses, and tightening credit conditions led to a
significant decline in household wealth and consumption, further exacerbating the economic
downturn.

The SMC quickly spilled over to the global economy, as many foreign banks and investors
had significant exposure to U.S. MBS and other related financial instruments. The crisis led
to a contraction in global trade and a sharp decline in commodity prices as demand for raw
materials and manufactured goods fell. The global nature of the crisis was reflected in the
synchronized downturn in economic activity across countries. In 2009, the world economy
contracted by 0.1%, the first decline in global output since the Great Depression
(International Monetary Fund, 2021). Advanced economies were particularly hard hit, with
the Eurozone, the United Kingdom, and Japan all experiencing recessions (Claessens et al.,
2010). Emerging economies, while initially resilient, also experienced a slowdown in growth
as global demand weakened and capital flows reversed.

The 2008 Subprime mortgage issue had very massive impacts on the global economy; this is
seen by the changes in the key macroeconomic indicators. The entire crisis started in
advanced market economies and then it spread to the whole world. The figure is 7.5% of real
GDP as Q4 2008 shows (World Economic Outlook, 2009). Nevertheless, world GDP at
market exchange rates obtained 3.6% during 2010 and this growth was preceded by a
contraction of 2.4% in the coming year (World Trade Report, 2011).

Figure 4: Trends in GDP growth (annual)

Source: WB & IMF database (2017)

Unemployment rates went up after the crisis, reaching a level of more than 210 million
people during the period, shown as a growth of 30 million compared to 2007 (IMF,
2010). The highest rate of unemployment in the EMU was in the U.S. with 9.6% in the first
quarter of 2009, the U.K. with 7.9% and Japan with 5%. (World Bank Data, 2016). In 2015,
the number for unemployment in developed countries dropped by 6.7 percent, according to
an ILO report (International Labour Organisation Report 2016).
 Figure 5: Annual unemployment rate

Source: World Bank database (2017)

Contribution of world trade to the deterioration of world trade volumes in second half of
2008 and early 2009 was not more than +2% against the background of the same indicator for
2008 was +6% in 2007 (World Trade Report, 2009. While merchandise exports had jumped
to a record high of 14.5% in 2010 as world output rose (World Trade Report, 2011), the
services exports declined to 8.3% in the same year (World Trade Report, 2012).

Figure 6: OPEC Brent crude oil price and output Figure 7: Monthly gold and platinum prices

Source: Quandl database (2017) Source: South African Reserve Bank (2017)

Apart from stock markets and housing prices, it was commodity prices that were also
vulnerable to the crisis. The price of Brent crude oil went down to $33.73 for a barrel in
December 2008 but later rose by as high as 62% in the first half of 2009 (Financial Stability
Review, 2009). Another factor consistent with the theory of safe haven asset is the substantial
gold price, reaching a peak of $1875.25 in 2012 during the euro crisis since June 2011
(SARB data, 2017).

The above figure demonstrates the how severe the economic downturn was after the
subprime mortgage crisis, reflected into falling GDP growth, increase of unemployment, and
shrinking of global trade coping mechanism. Financial turmoil was not just confined to
advanced economies and emerging markets but glaringly goes beyond these boundaries,
which explain the significant interdependency among the financial systems throughout the
world. Despite the fact that the policy interventions helped in the short-term economy
stabilization, yet the downsides are quite observable in the long term as reflected by declines
in output, employment, and trade.

Policy Response

The intensity of the SMC and its influence on the world's economy resulted in a massive
policy A response from the FED, the government of the U.S., as well as from the authorities
on regulation. The next section will talk about how the FED adopted monetary policy and
U.S. government initiated a set of fiscal policy measures in order to fight the financial
troubles. Then the regulatory reforms which took the place after the crisis will be discussed.

Fed's monetary policy

 Lowering of the federal funds rate: As for the response to this crisis, the FED
immediately lowered its key tool which is the federal funds rate from September 2007
that was sitting at 5.25% to a target range of 0-0.25% by December 2008 (Bernanke,
2012). This measure was enacted with a purpose of decreasing a short-term rate, to
revive lending, and boost the progress of the economy.
 QE programmes: Because the federal funds rate is close tot zero already, the FED
had to resort to an unconventional monetary policy which is referred to as quantitive
easing (QE). It was conducted through purchasing long-term Treasury securities and
mortgage-backed securities as a whole in considerable volumes causing a drop in
long-term interest rates and sustain the well-functioning of credit markets that, in turn,
accelerated the recovery of economy (Fawley and Neely, 2013).
U.S. government fiscal policies

 Economic Stimulus Act (ESA) of 2008: In February 2008, the US government

passed through the ESA where tax rebates were offered to individuals and businesses,
and a focus was placed on business investment incentives (Blinder & Zandi, 2010).
The purpose was that it helped the consumers to make more purchases and, thus, the
economy develop in spite of the exogenous risk.
 Troubled Asset Relief Program (TARP): In the month of October 2008, the U.S.
government unveiled the TARP through which the Treasury Department was
permitted to purchase $700 billion distress assets majorly from financial institutions
(Blinder & Zandi, 2010). TAF targeted instability in the financial system, restored
confidence, and thereby was intended to prevented further the deterioration of the
economy.

Regulatory reforms

In July 2010, the USA passed the Dodd-Frank Act, an around-the-world financial reform
program since the Great Depression period in which the bill introduced various implications
in the way that was meant to strengthen financial stability, enhance transparency, and protect
consumers. The law featured many elements, including the creation of the Financial Stability
Oversight Council (FSOC) to monitor systemic risk, the creation of the Consumer Financial
Protection Bureau (CFPB), along with the adoption of the Volcker Rule to regulate
proprietary trading by banks. The Dodd-Frank Act came into play with important regulatory
reforms aimed at addressing the reasons behind the crisis, which included systemic risk,
disrespect of transparency, and concerns for consumers. As per Admati & Hellwig, (2013), on
the other hand, object that these changes did not entirely solve the question of so-called "too
big to fail" and various risks embedded in the shadow banking system.

The policy measures of the SMC, encapsulating monetary, fiscal and regulatory channels,
become quite important in that they helped to rebuild the system, and hence initiated the
economic recovery. Nevertheless, the efficiency of this type of policies are still yet to be
known among the economists and policymakers. Fed’s policy of aggressively cutting down
the federal funds rate and the initiation of quantitative easing programmes reduced energy
costs for firms and made the credit markets stable (Bernanke, 2012). Moreover, fiscal
symptom plans like the Emergency Economic stimulus Act of 2008 and the TARP helped the
consumers and financial institutions. Many of these policies did work well in softening the
effects of the financial crisis, though there remains the question of whether it instigated moral
hazard with the result of an even more fragile future financial system (Taylor, 2009).

Conclusion

An effective risk-based financial regulation approach will be the solution of policymakers to

avoid any future crises which are associated with the financial system. They should focus on
implementing macroprudential policies to deal with the systemic risk. To support this, one
could use countercyclical capital buffers, leverage ratios and stress testing for financial
institution. Another dimension to be considered is promoting transparency and alignment of
incentives in the financial system to involve reducing the moral hazard and over risk-taking.
In the end Emergency procedures adopted by the SMC managed to balance the financial
system and conserve economic output but there is still a necessity to upgrade the response
aiming at root level of the crisis to prevent panic and instability. No doubt, policymakers need
more comprehensive strategy of financial regulation to be facilitated by macroprudential
tools and the financial system to become more transparent and the payment for the service
provided retained.
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