The U.S. Subprime Mortgage Crisis: Credit Crunch and Global Financial Meltdown

Communication                                                                Artha Vijnana
                                                 Vol. L, No. 3, September 2008, pp. 268-287

The U.S. Subprime Mortgage Crisis: Credit Crunch and
Global Financial Meltdown

Shalendra D Sharma

What began in mid-2008 as a downturn in the U.S. housing market soon plunged
the world economy in the worst financial crisis since the Great Depression. In
response, governments and central banks have been forced to bailout failing and
failed financial institutions -- directly through capital infusions and indirectly by
providing a wide array of liquidity facilities and guarantees. Why did a
seemingly localized problem set off a global financial meltdown? Financial
institutions around the world by purchasing over a trillion dollars of complex
mortgage-backed securities, especially the so-called subprime loans based on
inflated real-estate values made themselves extremely vulnerable to market
sentiments. When house prices fell and subprime mortgage defaults increased, a
credit crunch ensured and quickly spread. These developments in turn led to
bank failures and sharp increases in the spreads on funds in interbank markets,
and into a global crisis. While over the short-term providing liquidity to the
markets is essential, over the long-term recovery of the housing market is critical.
      The months of August and September 2008 will forever be known for the
economic tsunami on Wall Street. September 7 witnessed the collapse of the
venerable “models” of mortgage finance -- the government-sponsored enterprises
Fannie Mae and Freddie Mac -- which were placed into conservatorship in the
hopes of stabilizing the housing and mortgage finance markets. September 15
saw the collapse of the 154 year-old Lehman Brothers and the fire-sale of the
investment-bank and stock-market “Bull” Merrill Lynch to Bank of America.1
On 16 September the insurance giant, American International Group (AIG, the
nation’s largest insurer) received a large bailout totalling $85 billion in the form
of an emergency credit line from the Federal Reserve to facilitate an orderly
downsizing of the company. By the second week of September, funding markets
had come to a virtual standstill in the United States (and many other countries),
with bank funding markets essentially ceasing to function at terms longer than
overnight. Moreover, corporate bond spreads widened to all-time highs, equity
markets experienced sharp declines, and foreign exchange volatility increased
sharply. Finally on September 19, the “hands-off” U.S. Treasury Secretary Hank
Paulson and the Bush administration finally woke-up to the spiralling financial

Shalendra D. Sharma, Professor, Department of Politics, University of San Francisco, St. Ignatius
Institute, 2130 Fulton Street, San Francisco, CA 94117-1080, USA, Email: sharmas@usfca.edu
1
  Lehman Brothers had survived the American Civil War, two World Wars, and the Great
Depression. Its collapse was the largest corporate bankruptcy in world history. Merrill Lynch was
acquired by Bank of America for $50 billion. In 2007, it was valued at $100 billion.

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turmoil and cobbled together an unprecedented “rescue plan” (to critics a
“bailout plan”) via the creation of a government agency with the authority to
purchase as much as $700 billion of distressed assets from failing and failed
private financial companies.2
      However, even as the bailout plan was being announced the economic
landscape in the United States was fast changing. Within days not only many of
the mighty had been swept away as the era of the independent investment bank
came to an ignominious end, the country which had long prided itself for its free
markets and individual enterprise was now contemplating “socialist” state
intervention. Just a few months earlier there were five major investment banks,
but end-September 2008 there were none. Bear Stearns and Lehman Brothers had
simply collapsed; Merrill Lynch sold itself to Bank of America, while the
remaining two, Morgan Stanley and Goldman Sachs announced on September 22
that they were becoming commercial banks. Both have two years in which to
conform to federal supervision and the capital requirements and other rules that
govern such commercial banks as Wells Fargo, Bank of America and Citigroup.
However, if one thought the bleeding to be over they were sadly mistaken. On
September 26, Washington Mutual, a $300 billion thrift, announced that most of
its assets would be acquired by JP Morgan. On 29 September, Citigroup
announced that it would acquire the banking operations of Wachovia Corporation
in a deal facilitated by the Federal Deposit Insurance Corporation (FDIC).
Citigroup agreed to absorb up to $42 billion of losses from Wachovia’s $312
billion loan portfolio, with the FDIC covering any remaining losses.
      On September 29 the markets reacted negatively to Congress’s rejection of
the bailout plan. The stock market sell-off was dramatic: the Dow fell nearly 7
percent -- a one-day drop that has been matched only 17 times since the index’s
creation in 1896. With dire predictions of another Great Depression and
unrelenting political arm-twisting of members of Congress by Congressional
leaders, the White House (including the two presidential candidates) finally led
to the passage of the $700 billion rescue on October 3 -- the biggest bailout in
U.S. history.3 However, the unprecedented fiscal stimulus underwritten by the
U.S. government failed to stop the bleeding. Rather, eight days later panic
gripped the world financial and the United States and the rest of the world found
itself confronting the spectre of the worst financial shock since the Great
Depression.

2
  The Emergency Economic Stabilization Act of 2008 authorizes the Treasury Secretary to
purchase troubled assets from financial institutions through December 31, 2009. The law places
limits on compensation and prohibits “golden parachutes” for senior executive officers whose
company assets are purchased under the plan.
3
  Milton Friedman and Anna Schwartz argued in their seminal book, A Monetary History of the
United States: 1867-1960, that the root cause of the Great Depression was not the stock-market
crash but a “great contraction” of credit due to large-scale bank failures.

270                                    Shalendra D Sharma

The Root of the Ills

How did this state of affairs come about in the United States long known for its
resilient and innovative system of capitalism? What has been the impact on both
the proverbial Main and Wall Streets? What explains the rapid global contagion
and what can be done to prevent such crisis in the future? Simply put, the origin
of this crisis and its world-wide domino effect lies in the coming together of two
irresistible forces: the U.S. housing market and the “democratization of credit”
made possible by dramatic advances in information technology and financial
innovations, in particular, the securitization of debt. If most previous crises were
restricted to sovereign entities and private financial institutions whereby key
participants could resolve matters behind closed boardroom doors, in this crisis
numerous actors from the high-powered world of capital and finance, small-time
investors and legions of “six-pack Joes” representing all manner of residential
real estate are involved. This has what made the fallout first domestic, then
global, and exceedingly difficult to contain.
      For decades the residential mortgage market in the United States worked
remarkably well enabling millions of people to achieve the dream of owning
their home. Most homebuyers had only one option for borrowing money: put
down a fair down-payment and meet the requirements of a rather strict mortgage-
lending standard to receive a 30-year fixed-rate loan. This practice offered
stability in equal monthly payments. With homeownership rate reaching a record
70 percent in 2004, politicians from both parties boasted about the American
“ownership society” and their desire to extend the inalienable right to the pursuit
of the “American dream” to the excluded 30 percent. Beginning in the 1990s,
advances in information technology fostered enormous innovation of the
financial markets, especially the “securitization of mortgages” coupled with the
relaxing of underwriting standards would make this dream possible for all.4 In
particular, the rapid “real-time” securitization of debt lowered transaction costs
by allowing lenders and an array of financial brokers to quickly price a loan with
instantaneous credit-scoring technology and then extend credit to a wider
spectrum of possible borrowers. Such easy accessibility to credit and no-down-
payment requirement would finally make the dream of home ownership possible
for the first-time homebuyers (for most this meant a “starter home” of no less
than 2,000 finished square feet with two full baths and garage for two large

4
  Securitization involves the bundling loans into packages which are then sold to outside investors.
This meant that when homeowners paid their monthly payments these were collected by the
servicing agent and passed through to investors as interest payments on their bonds. Such an
approach was seen as win-win as it spread risk. That is, banks earned fees for originating loans
without the burden of holding them on their balance-sheets while investors got assets that yielded
more than government bonds and represented claims on a diversified group of borrowers.

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American-made cars), as well as others (speculators) keen to invest and expand
their portfolios in real estate.5
      If in the past mortgage lenders usually held onto the entire mortgage until it
was fully repaid, securitization allowed lenders to put many such mortgages into
a single pool and dividing the interests into different asset groups or “tranches”
colourfully named “senior,” “mezzanine” and “equity.” Each tranch not only
offered differing yields and access to mortgage repayment flows, but also
differing levels of payout risk (for example, “senior” was least risky and “equity”
most risky) because each tranche could be sold to several investors thereby
spreading the risks of any one mortgage among many lenders. That is,
securitization allowed mortgages to be assembled or “bundled” together into
thousands of types of loans and bonds which were then sold-off to investors.
Indeed, the more creative lenders took the securitization process a step further by
creating mortgage-backed securities into even more-complicated structured
products such as the collateralized debt obligations (CDOs) custom-tailored to
meet the needs of different kinds of investors. Moreover, securitization coupled
with adjustable-rate mortgages not only provided a more diverse source of
funding for residential home mortgages, but also a wider range of mortgage
products for borrowers. According to the IMF, the issuance of selected structured
credit products in the United States and Europe grew from $500 billion in 2000
to $2.6 trillion in 2007.6
      While the subprime crisis is widely seen as a case of “market failure” – the
inevitable result of “Wall Street greed,” the reality is that the U.S. government
and politicians (both Republican and Democratic) were just as much responsible
for the crisis. Over two decades of bipartisan push by Congress to create
universal home ownership led to the implementation of a series of laws and
regulation, including the sharp expansion of the activities of two government-
sponsored enterprises: the Federal National Mortgage Association (Fannie Mae)
and the Federal Home Loan Mortgage Corporation (Freddie Mac). Beginning in
the early 1990s, Congress pushed both Freddie Mac and Fannie Mae to increase
their purchases of mortgages targeting low and moderate income borrowers. In
1996, the Department of Housing and Urban Development (HUD) gave Fannie
and Freddie an explicit target: 42 percent of their mortgage financing had to go to
borrowers with income below the median in their area. The target increased to 50
percent in 2000. Fannie and Freddie met these targets by pumping billions of
dollars of loans, a bulk of being subprime and adjustable-rate loans to borrowers
who bought houses with usually less than 5 percent to zero down. In fact,
Freddie and Fannie soon became the primary securitizers of home mortgages as

5
  While the securitization of home mortgages began in the early 1980s it was the technological
innovation in the 1990s that made its reach worldwide.
6
  International Monetary Fund (2007), Global Financial Stability Report (October), World
Economic and Financial Surveys, Washington, D.C.; and International Monetary Fund (2008),
Global Financial Stability Report, World Economic and Financial Surveys, Washington, D.C.

272                                   Shalendra D Sharma

they used their state guarantees to purchase more risky loans and expand the sub-
prime market. In 2003, effort to bring Freddie and Fannie under tighter
regulatory control was defeated in Congress by the Democrats concerned that
tighter regulation would hamper these agencies ability to meet affordable
housing goals. Clearly, without Freddie and Fannie’s implicit guarantee of
government support the mortgage-backed securities market, especially the
subprime portion of it would not have expanded so rapidly. Rather, the actions of
Freddie and Fannie not only led to over-investment in residential real estate, the
implicit government guarantee also created widespread systemic risk.7
Compounding this was the Community Reinvestment Act (CRA). Under the
CRA Congress made banks to serve the “common good” by requiring them to
increase the percentage of their “affordable loans” to low and moderate-income
households, including individuals with bad credit histories.8 In fact, beginning in
1995, the government threatened banks and thrifts with regulations and punitive
legal challenges if they did not extend more loans to poor neighbourhoods.
     For private lenders all this provided a huge opportunity. Lenders such as
large mortgage finance companies and banks including Countywide, Washington
Mutual, First Franklin, Lehman Brothers and Ameriquest among others made
huge profits by developing and selling mortgage loans to Wall Street investment
firms such as Morgan Stanley, Barclays, Merrill Lynch, Bear Stearns, Goldman
Sachs, Deutsche Bank, Credit Suisse, JP Morgan and Citigroup without much
oversight. In part, this was a logical outgrowth of the evolution of financial
markets over the past decade, especially the widespread use of financial products
that have allowed banks to engage in “disintermediation” or to shift assets off
their balance sheets. Compounding this, Republicans with their free-market
ideology were convinced that self-regulation would be more effective than
government regulation, made certain that the watchdog Securities and Exchange
Commission (SEC) saw on evil and heard no evil -- thereby allowing investment
banks to regulate themselves. With such free reign, these firms in turn developed
even more complex financial instruments, including varieties of subprime
mortgages, securitization, derivatives, credit default swaps and an array of
hedge-funds and bundling them into mortgage-backed securities. Some of the
investment banks were motivated purely by the transaction fees and had little
stake in the ultimate performance of the loans they helped to arrange. For a hefty
fee sold them to Freddie and Fannie and to investors in the United States and
around the world, who in turn sold it, sometimes recklessly, to individuals with
limited resources or capacity to pay. However, this was still not enough to get
everybody a piece of the American dream. Beginning in the second half of the

7
  While we now know that many politicians from both parties were recipients of campaign
contributions from the Fannie and Freddie slush funds, the Democrats were the major beneficiaries,
especially Barney Frank in the House and Chris Dodd in the Senate. These two individuals were
major obstacles to reform and transparency.
8
  The CRA was first passed in 1977 and “strengthened” in 1995.

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1990s, a new type of mortgage loan, the so-called “subprime mortgage loans”
gained widespread popularity among borrowers and lenders alike. By 2007,
subprime mortgages had contributed to a dramatic rise in homeownership. Yet,
subprime like too much of a good thing also came with risks.

The Subprime Mortgage

While there is no agreed definition of what constitutes a subprime mortgage loan,
unlike the “prime,” the subprime are deemed to be lower-quality mortgages. In
the U.S. there are broadly four types of mortgages. These include: (a) prime
mortgages made to credit-worthy borrowers who meet requirements that enable
originators to sell them to government-sponsored enterprises such as Fannie Mae
and Freddie Mac; (b) jumbo mortgages which exceed the limits set by Fannie
Mae and Freddie Mac (the 2008 limit set by Congress is a maximum of
$729,750); (c) alt-A mortgages which carries a potentially higher default risk
because it has a higher loan-to-income ratio and a higher loan-to-value ratio; and
(d) subprime mortgages which fall below alt-A mortgages as the alt-A loans are
viewed as having a lower risk (and carry lower interest rates) than the subprime
loans. The subprime covers mortgages to individuals with poor credit histories,
including a previous record of delinquency, foreclosure, bankruptcy, and a credit
score of 580 or below.9 Consequently, there was greater penalty for borrowing in
the subprime market, including much higher up-front fees (such as application
and appraisal fees), higher insurance costs, punitive fines for late payment or
delinquency, and much higher interest rates. Although, borrowers were granted
some “protection” under the subprime mortgages such as allowance to spread
loan payments over time, overall the terms decidedly protected the lender – in
particular, “allowing” the lender greater discretion in underwriting standards, and
most importantly, to set interest rate dependent on a “loan grade” assigned in
light of the borrower’s credit history. Subprime mortgages came with both fixed
and adjustable interest rates.
     For example, the interest rates on the “hybrid” adjustable rate mortgages
(ARMs) could be pegged to a benchmark rate such as the six month Libor rate or
the one-year Treasury bill rate. However, the most common ARM was the so-
called “2/28” or “3/27.” A 2/28 hybrid ARM carried a fixed rate for two years
after which the loan would “reset” and becomes an adjustable-rate mortgage for
the remaining 28 years. As noted, the interest premium on the subprime were
quite high (averaging about 4 percentage points) to cover the apparently higher
risk of default these loans posed. For example, a 30-year, $250,000 loan at the
subprime rate of just 2 percentage point higher than the prime would require

9
  Though standards vary, in general a credit score of 660 or higher qualifies one for a prime loan.
The near-prime alt-A category of loans borrowers need credit scores between 580 and 660.
Subprime borrowers usually are those with credit scores lower than 580. Many subprime
mortgages were called “ninja” loans – meaning “no income, no job, and no assets.”

274                                Shalendra D Sharma

monthly payments of $1,904 compared with $1,563 for a prime loan -- a
difference of more than $4,000 a year. Subprime lenders justified this on the
grounds that their loans were not intended as long-term financing for houses.
Rather, they were designed to help borrowers who lacked the necessary down
payment or a good enough credit history to qualify for the prime (or even alt-A)
financing. In fact, subprime ARMs came to be described as “bridge loans” – a
short-term fix allowing borrowers to redeem themselves by rebuilding their
credit record, accumulating equity in their house, and eventually refinancing into
a lower-priced mortgage.
      The subprime market began to expand rapidly around the beginning of
1997. Analysts note two periods of exceptional subprime mortgage growth. The
first phase was during the late 1990s when the volume of subprime lending rose
to $150 billion or some 13 percent of total annual mortgage originations. This
expansion slowed rather sharply during the dotcom bust of 2001. However, a
second, even more spectacular expansion took place between the years 2002-06
when the subprime component of residential mortgage originations rose from
$160 billion in 2001 to just over $600 billion by 2006 -- representing more than
20 percent of total annual mortgage originations. This means that by 2006 one in
five mortgage borrowers not only had a combination of low credit scores, high
levels of debt compared with income, high mortgages compared with their homes
value, but these high-risk borrowers were also buying houses with minimal or no
down payments.10 With house prices notching double-digit gains in 2004 and
2005, the subprime rapid expansion was not only fuelled by an insatiable
national obsession to get a piece of the housing market before it was too late, but
also because cheap credit in the form of massive flows of capital into the United
States provided an abundant and seemingly endless source of liquidity, including
allowing the Bush administration to finance its ever-increasing current account
deficits resulting from tax cuts and expanding expenditure. In turn, an array of
financial innovations allowed new and “creative” ways to intermediate this
capital by packaging and reselling them as assets under intricately entwined
bundles.
      Specifically, asset-backed securities made-up of subprime mortgages were
packaged and sold to banks, individual investors, pension funds and equities
worldwide. Some of the new packages were made-up of non-traditional
mortgages, including interest-only mortgages, negative amortization mortgages,
and mortgages with “teaser” rates. The low teaser interest rates, interest-only or
negative amortization payment options were designed to make them seem more
affordable to borrowers, but created payments problem when the teaser rate
expired or principal repayments began. Even more complex were the credit-

10
   Calomiris, Charles W. (2008), Not (Yet) a ‘Minsky Moment,’ in Andrew Felton and Carmen
Reinhart (Eds.), The First Global Financial Crisis of the 21st Century,
www.voxeu.org/index.php?q=node/739, and Jaffee, Dwight W. and Mark Perlow (2008),
Investment Bank Regulation After the Bear Stearns Rescue, Central Banking, 18, pp. 38-44.

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market instruments such as derivatives on asset-backed securities and the
structured investment vehicles (SIVs). Perhaps most pervasive and pernicious of
the securitized credit was the mortgage-backed securities (MBS), in particular,
the residential mortgage-backed securities (RMBSs).11 These loans were
purchased from firms originating the loans such as banks and mortgage
companies and then repackaged into complex bundles. These RMBSs,
representing claims on the principal and interest payments made by borrowers on
the loans in a bundle were then sold to investors. For decades the securitization
of residential mortgages was dominated by Fannie Mae and Freddie Mac whose
primary task was to extend securitized loans to credit-worthy borrowers.
However, under the subprime market all this changed with the proliferation of
the so-called private-label RMBSs issued by banks, brokerage firms, and even
large private investors.
      The sharp increase in home ownership increased the price of real estate
inevitably creating a housing “bubble.” In the United States as house-price
appreciation jumped to dizzying heights the resultant growth in housing demand
was accompanied by further increase in the availability of mortgage loans,
especially subprime loans and expanding limits on credit cards.12 In this
seemingly win-win environment all caution was thrown to the wind as lenders, in
particular mortgage brokers (who could earn fees while passing along any credit
risk) went to great lengths to provide mortgage credit to borrowers, including
winking at underwriting standards on mortgage debt, deliberately ignoring
critical data such as debt-to-income requirements, and most egregious, not
demanding proper documentation of borrowers’ credit history, employment
status, income and assets in their zeal to extend credit. In fact, not subject to
government regulation brokers and other intermediaries bent all rules to lure
people into mortgages that they could not afford. On their part, investors holding
RMBSs remained complacent because rising home prices and securitization by
spreading risk created an aura of invulnerability.13 In any case, even if one could
review their portfolios, the bundling assets into complex financial packages made
it exceedingly difficult to accurately value the complex structured credits. As a
result, lending institutions and investors in securities tended to underestimate the
riskiness of subprime loans. Rather, most institutions and private investors
looked to credit rating agencies for assessments of risk. In fact, since a very large
share of the value of structured investments originally was in highly rated
tranches (AAA or AA), most concluded that their investments were safe. In
hindsight, we can now conclude that rating agencies not only failed conduct
effective independent credit assessments, they also made overly optimistic

11
   The CMBS are the commercial mortgage-backed securities
12
   Home prices increased nationally at an average annual rate of nearly 9 percent from 2000 to
2006.
13
   Apparently many investors and borrowers believed that home prices would not fall, but, in the
worst case scenario rather “moderate” in a “soft landing.”

276                                  Shalendra D Sharma

assumptions on new and untested types of mortgages. Finally, low interest rates
added fuel to subprime lending. For example, the Federal Reserve lowered
interest rates from 6.5 percent to 1 percent between 2001 and 2003, and the ten-
year Treasury note rate fell from 6 percent in 2000 to 4 percent in 2003 -- before
rising to 4.8 percent in 2006. Predictably, lenders and investors seeking higher
yields turned to the subprime mortgage market.14 Thus, the claim that the Federal
Reserve’s easy-money policy (creating too much liquidity and driving interest
rates to artificially low levels), set in motion the conditions for a housing bubble
is not without merit. As it turned out, all the ingredients of a perfect storm: an
environment that fuelled substantial optimism among lenders, investors and
borrowers were now in place.

U. S. Response to the Subprime Meltdown

Problems in the subprime market became increasingly evident in 2006 as house
prices not only stopped its upward trajectory, but also began to decline in many
parts of the United States, including strong markets such as California and
Florida. Since like a giant Ponzi scheme the subprime mortgages could only
remain viable in an environment of continued easy credit and rising home prices
most borrowers of subprime mortgages, including many with the alt-A
mortgages realized that they had overextended themselves -- especially those
who had bought homes at the peak of the market or had drained equity by
borrowing against the price appreciation of their house. Exacerbating this was the
unspoken reality that many borrowers, lenders, brokers and appraisers had
grossly inflated house prices and borrowers’ incomes on loan applications. Now,
more realistic (that is, lower) appraisals made it difficult for borrowers to
refinance and possibly avoid foreclosure. Without the continuing house price
appreciation many of these mortgages simply became unaffordable to maintain.
Since most borrowers’ ability (and willingness) to remain current on payments
was largely based on the rate of appreciation of their house’s market value, the
declining home prices took away this incentive and ability. If in the past a robust
housing sector with rising prices allowed even the most lax borrowers the ability
to avoid default by selling the property or refinancing the mortgage, declining
house prices and equity closed this window. The only remaining option was
either mortgage delinquency or outright default. Not surprisingly, many
borrowers who fell behind on payments have responded by simply walking away
from their homes.
     It seems that by the second half of 2006 it finally dawned to market
participants that the problem in the housing sector was not localized but nation-
wide and endemic. As this reality sunk-in the deterioration in the performance of
subprime loans was sudden, sharp and painful. This was in part because despite

14
   The nominal federal funds rate was below 3 percent continuously from September 2001 through
June 2005.

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the structured nature of the investments (with each tranche representing a
different level of risk) proved to be fictitious – a selling gimmick. The “senior”
rated tranche which was assumed to have little correlation with the riskier, lower-
rated tranches proved to be false – despite the AAA ratings.15 As the poor quality
of the subprime loans became apparent and the securities were downgraded, the
various tranches began to fall like dominos in value together. Consequently,
throughout the second half of 2006 to early 2007 subprime mortgage
delinquencies continued to steadily rise. When finally the subprime mortgage
originations ceased after several subprime mortgage lenders filed for bankruptcy
following the financial market turmoil in August 2007, “negative equity” or
mortgage debt greater than the market value of the house skyrocketed resulting in
growing defaults.16 By October 2007, nearly 1.3 million U.S. housing properties
were subject to foreclosure activity. Suffice it to note that for lenders, reselling
foreclosed properties in a declining housing market have been major challenge.
      Even as the default on subprime mortgages continued to rise in 2008, it is
important to note that subprime loans form a relatively small part of all mortgage
originations in the United States. In fact, only about 13 percent of residential
mortgages are estimated to be subprime loans, or looked another way, the
residential mortgage in trouble have been estimated at about $500 billion or less
than 3 percent of the outstanding $22 trillion in U.S. equities. Thus, why did a
relatively small volume of losses on subprime mortgage loans lead to such
broad-based financial meltdown? Clearly the securitization and the mispricing of
risk played a major role in forcing millions of households to lose their homes
through foreclosure.17 As the housing bubble began to lose steam it also exposed
deep-rooted problems in financial intermediation that were not limited to the
original subprime loans. The liquidity shock and the bursting of the bubble 2008
raised concerns about all leveraged positions effectively ending the credit boom.
The resultant loss of confidence in credit ratings and revaluation of risks led
investors to pull back from a wide range of securities, especially structured credit
products. The spillover effects have been fast and furious resulting in the current
credit crunch, chaos in the stock markets, the banking industry, and the global
money markets. The spillover or contagion has been particular painful because
the balance sheets of many banks and financial institutions are burdened by
illiquid, impaired assets. Although financial institutions worldwide have been
aggressively trying to deleverage (or offload at acceptable prices some of their
stock of impaired assets and bring down their leverage ratios), this has proven to
15
   In a cruel irony, the credit spreads on AAA-rated U.S. residential MBSs have been priced at
about the same level as BBB-rated corporate bonds since August 2007.
16
   Negative amortization occurs when the monthly payments do not cover all the interest owed. The
interest that is not paid in the monthly payment is added to the loan balance. This means that even
after making many payments one could owe more than at the start of the loan.
17
   On the other hand, Jacques Artus has noted, “People that purchased a house with a subprime
mortgage with negative amortization did not lose a house they did not have one to begin with. They
enjoyed a nice house for free for a few years.”

278                                     Shalendra D Sharma

be extremely challenging, in part, because illiquid assets made-up of mortgage-
backed securities are difficult to value during times of crisis. Not surprisingly,
credit markets have become tight as banks and other financial institutions have
tried to reduce their exposure to each other.18 Banks are reluctant to lend because
of deep concerns over counter-party risk: that is, who owns the impaired
mortgage backed and other assets, and what are the odds of repayment in the
inter-bank market for funds. The tightening of credit is not only reflected in the
interbank lending in the United States and abroad, but also in the sharp
contraction in availability and cost of credit to even good credit-worthy
borrowers. Rather, maturities have shortened, the cost of hedging against default
risk has risen and the range of assets accepted as collateral has narrowed.
     As demand for liquidity has grown the U.S. Federal Reserve introduced a
new liquidity facility called the Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility (AMLF). This facility is designed to provide
liquidity to markets by extending loans to banking organizations to finance their
purchases of high-quality asset-backed commercial paper (ABCP) from money
market mutual funds. Its full impact and that of the $700 billion bailout on the
economy remains to be seen. Investors and governments around the world still
remain cautious waiting for details on how exactly the U.S. Treasury is going to
buy $700 billion of U.S. banks’ mortgage assets. Not surprisingly, Treasury bill
yields has remained extremely low suggesting that investors such as money
market mutual funds were still sticking to the safety of short-term government
debt rather than short-term corporate debt known as “commercial paper.”
     On October 7, the Federal Reserve announced a radical plan to buy massive
amounts of short-term debts to break through the credit crisis. In more normal
times about $100 billion of these short-term IOUs are outstanding at any given
time, sold by companies to buyers that included money market mutual funds,
pension funds and other investors. But this market has virtually shrunk as
investors have become too jittery to buy paper for longer than overnight or a
couple days. Invoking Depression-era power under “unusual and exigent
circumstances,” the Feds agreed to buy commercial paper that companies rely on
to finance their day-to-day operations, such as purchasing supplies or making
payrolls.19 On October 8, the Federal Reserve in a coordinated international
effort with other central banks cut a key U.S. interest rate by half a percentage
point (from 2 percent to 1.5 percent) to calm investors worried about the stagnant
credit markets. For millions of Americans, the Fed’s cut means borrowing money
becomes cheaper. Home equity loans, credit cards and other floating-rate loans

18
   The dollar interbank credit contraction is a worldwide because the loan portfolios of U.S. banks
and financial institutions are mostly dollar-denominated. Most foreign banks are in the same boat
as they also have sizeable portfolios in dollars.
19
   The $99.4 billion daily market for this crucial financing has virtually dried up as investors have
become too jittery to buy paper. This has made it difficult and expensive for companies to raise
money to fund their day-to-day operations.

Mortgage Crisis in U. S.                                   279

all fluctuate depending on what the Fed does. Bank of America, Wells Fargo and
other banks cut their prime rate by half a point to 4.5 percent -- the lowest in
more than four years. The Bank of England cut its rate by half a point to 4.5
percent while the European Central Bank reduced its rate to 3.75 percent. Similar
actions were also adopted by the central banks of China, Canada, Sweden, and
Switzerland. However, the credit markets failed to show any immediate signs of
relaxing apparently concluding that a rate reduction may not help make credit
availability easier for businesses and consumers anytime soon. When all this still
failed to unlock the credit markets, on October 10 the Treasury Department
announced the government’s intention to take stakes in major financial
institutions, rather than simply buying those institutions illiquid assets.

The Contagion Spreads to Western Europe and Beyond

Underscoring that in this age of globalization no country is an island, the
mortgage crisis fallout quickly engulfed Western Europe.20 The German
government and financial industry responded almost immediately agreeing to a
$68 billion bailout for commercial-property lender Hypo Real Estate Holding,
while France’s BNP Paribas agreed to acquire a 75 percent stake in Fortis’s
Belgium bank after a government rescue failed. While governments in Germany,
Ireland and Greece publicly stated that they will guarantee bank deposits, it was
not enough to quell fear and panic. While the complacent British authorities were
initially happy to blame the contagion entirely on the U.S., the fact that the
contagion hit the U.K. particularly hard did not come as a surprise to market-
watchers. Although British banks do not have a subprime mortgage problem, like
U.S. banks they have a regulations problem (bank regulation in Britain is light by
European standards), and have for years issuing easy credit which they are now
finding it difficult to recover. As U.K. banks became besieged, the British
government was forced to announce an $87-billion bailout of the banking
system, in addition to establishing a separate liquidity fund of at least $348
billion to offer short-term loans to financial institutions to help them cover their
day-to-day operations. Although this meant that some of the country’s biggest
banks, including Barclays, Lloyds TSB, and the Royal Bank of Scotland (will be

20
    The only major OECD exception has been Canada. Major Canadian banks, including
Scotiabank, TD Bank Financial Group, RBC Royal Bank and CIBC are healthy and solvent with
no subprime exposure. The World Economic Forum has ranked Canada’s banking system as the
soundest in the world. The U.S. came in at No. 40, Germany and Britain ranked 39 and 44
respectively. The average capital reserves for Canada’s Big Six banks -- defined as Tier 1 capital
(common shares, retained earnings and non-cumulative preferred shares) to risk-adjusted assets --
is 9.8 percent or several percentage points above the 7 percent required by Canada’s federal bank
regulator. The average capital ratio is about 4 percent for U.S. investment banks and 3.3 percent for
European commercial banks. Moreover, Canada’s investment banks are subject to the same strict
rules as commercial banks, while in the U.S., investment banks were subject to light supervision
from the Securities and Exchange Commission.

280                              Shalendra D Sharma

partially nationalized, and in return for the infusion of capital, the British
government will get “preference shares,” these efforts failed to (at least at the
time of this writing) calm investors or encourage banks to lend.
      Iceland’s troubles illustrate another dimension of the credit crunch problem.
The island-nation’s fast rise and precipitous fall is a cautionary tale about the
paradox of economic globalization. Throughout much of its history Iceland was
little more than a port of call for the North Atlantic fishing fleets trawling the
waters between Greenland and the Faroe Islands. However, the fortuitous
combination of advancements in information technology together with
innovations in financial instruments made Iceland’s geographical isolation
irrelevant. Financial globalization enabled this island nation with a population of
roughly 320,000 to dramatically scale-back its traditional dependence on fishing
and aluminium smelting and make financial services its new leading sector. In
less than a decade, the capital Reykjavik (where much of Iceland’s population
resides) was transformed from a sleepy provincial port into a bustling
cosmopolitan metropolis boasting all the amenities (and pleasures) offered by the
likes of Paris, London and New York. In 2005 the United Nations noted that
Icelanders not only enjoyed the highest per capita incomes in the world, they had
also ousted the perennial favourites, Norway, in human development indicators
such as education, health care and life expectancy. Not surprisingly, Icelanders
were said to be the happiest people in the world and the secrets of their success
an example for others to emulate.
      However, the “miracle” was built on shaky ground. Following the
deregulation and privatization of the banking sector in the mid-1990s, Iceland’s
three largest banks (Kaupthing, Landsbanki and Glitnir -- then called
Islandsbanki), came up with a novel, and at that time, an eminently reasonable
idea. That future prosperity demanded Iceland must diversify away from its
traditional bases in fisheries, farming, aluminium smelting and geothermal
power. The solution was an ambitious one: by drawing on its well-funded
pension system and borrowing money on the international money markets
Iceland could become a leading centre of global finance. Over the next few years
the banks along with the newly established Stock Market in Reykjavik
simultaneously raised (or more appropriately, borrowed) billions of dollars and
went on spending spree – not only buying large chunks of eastern Europe’s
telecommunications market, UK’s high-end stores like the House of Fraser, the
iconic Hamley’s toy store, and the West Ham soccer team, but also foreign
financial firms in Britain and Scandinavia and investing aggressively in high-
yielding securities, including subprime mortgages. The credit boom transformed
the local economy. The average family’s wealth grew by 45 percent in five years
(2000-05), and GDP accelerated to six percent a year. Like their banks,
Icelanders used their new found wealth by going into a spending spree, including
snapping-up real estate not only at home, but also abroad. To facilitate this, credit
companies sprang-up offering 100 percent loans, many in foreign currency such
as Japanese yen or Swiss francs, euros, and dollars. Foreigners hoping to cash-in

Mortgage Crisis in U. S.                         281

on Iceland’s boom took large positions in its high-yielding currency (the krona),
and foreign firms poured money into the country’s numerous “sure-thing”
projects
      In those heady times it seemed that Iceland had achieved its ambitious goal.
Indeed, in less than five years the three banks went from being almost entirely
domestic lenders to major international financial intermediaries. The massive
cash flows allowed these banks to earn huge dividends as they used short term
funding to invest in high yielding securities. All caution was thrown to the wind
as the investors, banks and Iceland’s government was assured by its own
regulators and U.S. rating agencies, among others, that the funds were well
invested and the banks were financially sound. So unprecedented was the
borrowing binge that on the eve of the crisis the foreign debts owned by
Iceland’s banks were in excess of nine times the country’s GDP. Stated more
bluntly, Iceland’s top three banks held foreign liabilities in excess of $120 billion
-- debts that dwarf Iceland’s gross domestic product of $14 billion. This house of
cards began to unravel when the “unexpected” happened. Spooked by the
subprime meltdown in the United States and the fast-spreading contagion the
fickle foreign lenders demanded their money back. After all, if the subprime
crisis taught them anything it was not to underestimate risk anywhere. But
Iceland’s banks, which for all practical purposes were functioning more like
hedge funds had nothing to offer. When it finally dawned investors that Iceland’s
banks lacked tangible assets (and in the wake of the crisis were frozen out of the
credit markets and therefore unable to make good on short-term payments), panic
set in and a destructive bank run ensued. For both banks and its lenders the
problem was further compounded by the global credit crunch problem. Not only
were foreign investors heading for the exit in droves, no sovereign, not even the
brethren Nordic countries were prepared to come to the aid of the besieged island
nation. Unlike the United States which because of the sheer size of its economy
will have countries like China and Japan prepared to pour billions of dollars into
U.S. securities to keep the debt-ridden American economy afloat, Iceland as a bit
player in the big-stake game of international finance had no such benefactors.
      Starved of liquidity (given the almost complete shutdown of inter-institution
lending), Iceland’s heavily exposed banks began collapsing under the weight of
debts incurred by lending and spending in the boom times forcing the Central
Bank of Iceland to fix the value of the Icelandic krona to 131 against the euro
following a more than 40 percent decline since the start of September. With
government bailout out of the question as Iceland’s bank assets are more than 10
times greater than its gross domestic product, a default became inevitable.
Finally on 5 October the government used “emergency powers” rushed in by
parliament to place Landsbanki and Glitnir in receivership under the new created
Icelandic Supervisory Authority. The agency immediately began to restructure
the bank, announcing it plans to sell it to Finnish and Swedish businesses.
      The new powers also give the government authority to dictate banking
operations, including the ability to push through mergers or even force a bank to

282                              Shalendra D Sharma

declare bankruptcy. On 9 October the authorities took control of Kaupthing (the
country’s largest bank) and suspended trading on its stock exchange for two
days. However, it all seemed too little and too late. The bank collapses were
already causing ripples throughout Europe, where tens of thousands of people
have accounts with subsidiaries of the Icelandic banks. When Icelandic
authorities promised to guarantee domestic depositors while reneging on
guarantees to foreigners, especially the 300,000 account holders in the U.K
depositors in the U.K. and elsewhere in Europe rushed to Landsbanki branch
offices to withdraw their deposits. It also led to a diplomatic spat as British Prime
Minister Gordon Brown threatened to sue Iceland, including using
counterterrorist legislation to take over Icelandic bank assets and operation. True
to his word Brown used anti-terror legislation to seize billions of pounds of failed
Icelandic banks’ British assets and accused Reykjavik of “acting irresponsibly.”
Iceland’s Prime Minister Geir Haarde, in turn harshly criticized the British
government accusing Brown of “bullying a small neighbour.” The financial crisis
had now veered into unfamiliar territory.
      Beyond Iceland, on October 13, at a summit chaired by French President
Nicolas Sarkozy, leaders of the 15 countries using the euro ended their much
criticized “country-by-country” plans that lacked a credible joint-strategy,
announced a joint effort to revive the crippled credit markets and halt panic
among investors. Taking to heart Sarkozy’s claim that “none of our countries
acting alone could end this crisis,” the European leaders pledged to guarantee
until the end of 2009 bank debt issues with maturities up to five years and use
huge sums of taxpayer money to keep distressed lenders afloat.
      There is a real potential for the crisis to spread to emerging markets,
including Russia, South Korea and Brazil. The last global financial crisis in the
late 1990s hit these countries particularly hard because when the inflows of
dollars dried-up their economies spiralled into a recession. As protection against
such uncertainty these countries took the advice of the IMF and build-up huge
reserves of dollars and euros, including restricting much of their borrowing in the
domestic markets. Unfortunately, their private sector did not share their
government’s caution and remained oblivious to risk. In Russia, for example,
private banks and corporations continued to borrow from abroad because dollar
interest rates were much lower than the rubble rates. Thus, even as the Russian
government was accumulating an impressive volume of foreign exchange,
Russian corporations and banks were accumulating an equally impressive foreign
debt. The credit crunch will hit them hard. On the other hand, while China’s also
has a housing bubble problem, its banks are better prepared to withstand falling
house prices than their American counterparts because Chinese buyers are
required to put down a minimum deposit of 20 to 30 percent down-payment and
as much as 40 percent on second homes. Moreover, since China’s banks fund
their loans through deposits rather than capital markets they are better insulated
from the global credit crunch than Western banks.

Mortgage Crisis in U. S.                                   283

     On 21 October, in its latest effort to break through a credit clog the Federal
Reserve announced that it will start buying commercial paper (a crucial short-
term funding mechanism many companies rely on for day-to-day operations such
as to pay workers and buy supplies) from money market mutual funds.21 This is
necessary as money market mutual funds have been under intense pressure as
worried investors demand withdrawals. The U.S. government’s unprecedented
bailout has come at a cost. It has pushed the already bloated federal deficit to an
estimated $1 trillion or about 7.5 percent of GDP -- the highest percentage since
World War II. To bring this spiralling debt under control the authorities will have
to rein in spending and raise taxes to service the debt. This will not be easy as
both presidential candidates have not only promised tax cuts, but also additional
so-called bailout or “stimulus” plans.22 However, such a status-quo may not be
acceptable to foreign lenders who could scale back their purchases of U.S. debt,
thereby sharply pushing interest rates.
     On the other hand, seeking security in an uncertain time, foreign
governments have poured billions into dollar and yen denominated holdings
reversing the long trend that saw steep declines in both currencies. On October
25, the dollar jumped to a two-year high against the euro, besides rising sharply
against the British pound, the Swiss franc, and the Canadian and Australian
dollars. Of course, the unprecedented surge of the U.S. dollar is hardly warranted
by fundamentals but reflects a desperate search for a safe haven. However, it is
the yen sharp rise or more appropriately its volatility that is a major concern.
This is because the yen’s sharp spike can not only stall the growth of one of the
world’s largest economies the global financial sector is vulnerable because of the
yen “carry trade.” That is, investors have taken out massive loans in hitherto low-
interest rate currencies (like the yen), exchanged the money to higher-interest-
rate currencies (like the dollar or the euro), and reloaned it out. They made
money from the higher interest on the second loan than they paid on the first one.
Of course, this worked as long as interest rates and currency valuations remained
steady. Now with the U.S. Federal Reserve and European Central Bank cutting

21
   The Fed plans to buy an array of commercial paper from the funds, including some that is not
backed by assets, those with remaining maturities of 90 days or less, and dollar-denominated
certificates of deposit. The Fed hopes this will make banks and other financial institutions to lend
to each other and to consumers and businesses.
22
   John McCain’s “American Homeownership Resurgence Plan” and “Pension and Family Security
Plan,” and Barack Obama’s “Rescue Plan for the Middle Class” are all very costly gambits. On top
of this McCain wants to shore up the equities markets by halving taxes on capital gains for two
years and for the government to spend $300 billion of taxpayers money buying troubled mortgages
at face value. This rewards banks and other imprudent lenders, besides setting a bad precedent of
moral hazard. For this part, Obama announced a 90-day moratorium on home foreclosures
(basically postponing the inevitable for many over-the-head homebuyers), a new two-year plan that
would provide a $3,000 tax credit for each new employee a business hires (which presumably will
benefit companies), and allowing everyone to withdraw up to $10,000 from their retirement
accounts tax-free – a terrible incentive to the already spendthrift American public.

284                                     Shalendra D Sharma

their benchmark interest rates carry traders, including some large financial
institutions are now facing potential huge losses.
      What seems certain is that over the medium and long-term home prices
must stop falling if there is to be a sustainable recovery. However, the prognosis
looks grim: the housing sector remains weak and the US housing market is still
far from reaching the bottom. A glut of unsold homes, particularly in California,
Florida and Arizona, rising unemployment and foreclosures, as well as tightening
credit conditions, mean that it will be sometime before home prices stabilize
Indeed, housing starts have not only declined sharply, the inventories of unsold
new and existing homes remain high. With oversupply, house prices in most
markets have continued to decline, while tightening credit have led many
potential home buyers to wait. Without a signal that the worst has passed, the
banks will be in no mood to lend. Therefore, although the massive Wall Street
bailout may initially help the credit system with healthy securities, the problem is
that as long as the foreclosure crisis remains a burden on households, the credit
market will continue to haemorrhage. Thus, a program of loan conversion to help
the some 400,000 households who need to convert variable to fixed-rate
mortgages to forestall foreclosures is sorely needed – of course with the
provision that the original lender must incur the full loss on the transaction of
converting the variable to fixed-rate mortgages at the going market rate.
      Finally, beyond massive injections of liquidity by national governments,
there is another option. Indeed, another source of global liquidity that has hardly
been mentioned given the protectionist political climate in the United States.
That is allowing foreign countries, in particular, the sovereign wealth funds to
diversify their U.S. dollar portfolios beyond Treasuries.23 Sovereign wealth
funds are among the few sources of liquid capital available worldwide. Sovereign
wealth funds could help the U.S. financial sector by purchasing assets such as
Japan’s Mitsubishi Bank is has done with Morgan Stanley and Nomura
Securities has done with Lehman’s non-U.S. assets. Many U.S. companies have
done this in Europe and Asia after their financial crises. Of course, this means
that the U.S. government must be willing to accept that foreign governments,
including China, may end up controlling significant financial assets in the United
States. Finally, what began as a credit problem due to the mis-rating of structured
products soon evolved into to a liquidity crisis. The weak capital position of

23
   A Sovereign Wealth Fund is a state-owned investment fund composed of financial assets such as
stocks, bonds, real estate, or other financial instruments funded by foreign exchange assets. SWFs
can be structured as a fund or as a reserve investment corporation. The types of acceptable
investments included in each SWF vary from country to country. For example, countries with
liquidity concerns limit investments to only very liquid public debt instruments. A number of
countries have created SWF to diversify their revenue streams. For example, United Arab Emirates
(UAE) relies on its oil exports for its wealth. As a result UAE devotes a portion of its reserves in an
SWF that invests in assets that can act as a shield against oil-related risk. The amount of money in
SWF is substantial. As of May 2007, the UAE’s fund was worth more than $875 billion. The
estimated value of all SWF is estimated to be $2.5 trillion.

Mortgage Crisis in U. S.                             285

banks has literally brought a virtual halt interbank lending. Thus, getting out of
this liquidity and credit crisis quickly also mean recapitalizing the banking
sector. While it is critical that financial institutions bear the full liability for their
traders’ actions to discourage future irresponsible behaviour, in the short-term
taxpayers will have to bear the financial cost of the bailout.
      Protecting the global financial system from the recurrent bouts of
speculative excesses and painful contractions is not easy given the
internationalization of markets. The unprecedented pace of change makes it
difficult, if not impossible, for the bureaucratic world of regulation and
supervision to keep pace. While the conventional view (not surprisingly
promoted by politicians) blames deregulation for the current problem, it is
important to keep in mind that the U.S. financial services industry is not without
its fair share of regulations and red-tape. In fact, numerous laws and regulations
are already on the books and a plethora of government agencies, notably the
Securities and Exchange Commission (SEC) in America and its British
equivalent, the Financial Services Authority (FSA), have significant powers to
implement and supervise these rules. Clearly, more bureaucratic red tape is not
the answer. Yet, a regulatory backlash is almost certain to follow the government
bailout. However, what must be avoided is politically driven legislation. Rather,
targeted supervision in the area of intermediation to guarantee effective
reconciliation of the economic needs of businesses and individuals for long-term
credit on predictable terms is critical. To the authorities in charge of banking
regulations this means that if a bank is “irresponsible,” they should require the
bank to take immediate corrective measures, and if it does not, they must close
the bank, and if the bank is too large to fail, it should be taken over by the
authorities. This will go a long-way in instilling confidence. However, as Milton
Friedman pointed out long ago, government intervention must be strictly
regulated because over the long-term markets are far more efficient at allocating
capital than bureaucrats.
      Finally, what to make of the oft-repeated claim such as by French President
Nicolas Sarkozy that “the all-powerful market that always knows best is
finished”? Needless to say, such statements are gross exaggerations. No doubt,
we are witnessing a crisis of confidence in capitalism forcing champions of
laissez-faire to implement policies and programs that were simply unthinkable
just weeks ago. Who could have imagined that the government of the United
States would have intervened in markets by bailing-out private banks through
recapitalizations, or buy assets directly from private firms with tax-payer dollars
and provide blanket guarantees to bank deposits. It seems that President George
W. Bush captured the temper of the times more accurately by echoing John
Maynard Keynes that U.S. bank takeovers were “not intended to take over the
free market, but to preserve it.” As Keynes, during the depths of the great
depression warned, free markets will not always “self-correct” and therefore
government intervention is necessary to protect the capitalist system against its
own excesses.