The Cupidity that triggered the Subprime Crisis

Mahatma Gandhi once said, "Earth provides enough to satisfy every man's need, but not every man's greed".

The maxim has come true stridently as far as the SUBPRIME CRISIS is concerned. This post is an attempt to look at the basic reasons of the onset of the exigency and how it can be forefended in future.

2002: The Root Cause
In previous decades, most mortgages were backed by the Federal Housing Administration and government-authorized companies Fannie Mae and Freddie Mac, which bought mortgages and bundled them into high-grade securities that were then sold to investors in the form of bonds(thru invesment banks like Lehman Brothers). Investors shared rights to homeowners' principal and interest payments.
But from 2002 through 2006 the market changed and a growing portion of mortgages were issued by firms not backed by Fannie, Freddie and the FHA -- and not bound by the same legal requirements to deal only in investment-grade loans and securities.
Wall Street had taken over the role of packaging the mortgages into marketable securities!!

2002-2006: The Honeymoon Period for all

Lenders offered subprime loans to people who could not qualify for ordinary prime loans because of poor credit or inadequate income. To help them qualify, lenders offered low teaser rates -- sometimes only 3 or 4% -- to produce a low monthly payment.However, If prevailing rates went up, the rate charged on the loan might jump over the years from 4% to 8%, perhaps even higher. Monthly payments could more than double.

Also, Underwriting standards hit bottom in 2006. Many lenders required no down payment at all, no longer demanded proof of an applicant's income and offered very low teaser rates.The flood of easy money gave borrowers more to spend.
In 2004 through 2006, home prices rose by more than 20% in much of the country, and by more than 25% in California, Florida and some other hot markets. This was due to the low interest rates charged by the lenders.
It seemed like an elegant, market-based solution that served everyone. People got mortgages. Mortgage originators and Wall Street firms earned high fees. Investors got top-rated securities. Builders sold more homes and home prices soared.

The avariciousness disseminates
Although the growing risks were clear to people who understood the mortgage and housing markets, lenders kept lending because they could earn big up-front fees. They were not terribly concerned if homeowners defaulted later because the loans were converted into securities that passed the risks on to investors.
All of this was abetted by investors' growing appetite for mortgage-backed securities, which offered higher yields than safe investments like U.S. Treasuries. The Federal Reserve had been helping the economy recover from the dot-com collapse by driving rates down, with the fed funds rate falling to a mere 1% in June 2003.
"In the extremely low interest rate environment of 2002, 2003 and 2004, people got very hungry for yields," says Wharton finance professor Jeremy Siegel. "They were saying, 'Oh, I don't want to accept 1% or 2%, I want to get it a little bit higher".

The bubble bursts-2007
Then, in 2007, it came apart. Growing numbers of homeowners facing their first rate resets found their monthly payments jumping by 25% or 50%, sometimes more. Since incomes were only inching up, many found they could not afford the higher payments. Lenders started to tighten up on underwriting standards, making less mortgage money available.
While many subprime borrowers had expected to refinance to less-expensive fixed-rate mortgages after their payments went up, they now could not because their homes were not valuable enough to serve as collateral on new loans.
Foreclosures rose from less than 200,000 in the third quarter of 2006 to more than 600,000 in the first quarter of 2008. Rising default and foreclosure rates drove down the prices of mortgage-backed securities, since investors worried they would not get the principal and interest payments they had been promised।

No faith on each other
Big financial firms became wary of doing business with one another for fear that the other parties, if hit with unexpected losses, would not make good on deals. No one had a map of the minefield, and the markets were locked in a credit crunch -- a universal unwillingness to lend.
The foreclosures were dumping homes onto the market in huge numbers at fire-sale prices, driving down values for neighbors who are merely innocent bystanders and threatening to throw the economy into a deep recession.

The Way out

Underwriting standards should be made stringent.

Many of the newer types of mortgage securities were highly customized and difficult to trade, so computer models were used to determine prices. That turned out to be a poor substitute for supply and demand,notes the Wharton professor, Wachter. She believes mortgage securities need to be standardized to encourage lively trading that would set prices more accurately. Mortgage securities would thus be something like the standardized contracts for corn, oil and other commodities that trade on futures exchanges. "Without standardization, there is no trading," she says.

In another area, some experts say the ratings agencies need reform। Red-faced after their AAA-rated securities collapsed, they are working to improve their process. But some experts suggest ratings should be paid for by the buyers of rated securities rather than the sellers.

Also, the compensation system on Wall Street has come in for criticism for emphasizing short-term results over long-term ones. In research with her colleague Andrey Pavlov, Wachter found that that the banking crisis that has undermined the Japanese economy over the past 20 years was largely driven by excessive focus on fee-making in the short-term. "The same problem seems to have occurred in the subprime crises", she says.

**With help from- knowledge Wharton site, Wikipedia, CFA magazine, and ofcourse, the Google