The current financial crisis that we find ourselves in, today, referred to by many as an economic meltdown or credit crunch, is considered to rival the Great Depression of the last century. The beginnings of this crisis can be traced back to the sub-prime mortgages in the United States. Once considered by financial institutions as one of their more profitable operations, the sub-prime mortgage business started to unravel in the beginning of the year 2007. In February, the Federal Home Loan Mortgage Corporation (Freddie Mac) announced that it will no longer acquire the sub-prime mortgages and related securities with the highest risk levels. Soon after that, New Century Financial Corporation, a leading sub-prime mortgage lender in the United States, started proceedings for protection under the now infamous chapter 11 bankruptcy laws (Wall Street Journal 123).
To add to the woes, news came that the Federal National Mortgage Association (Fannie Mae) was facing a crisis too. Before going into further details of the economic turmoil created by the sub-prime mortgage crisis, it is important to understand what exactly sub-prime mortgages are and what exactly did these two corporations, central to the crisis, actually do.
Basically, the difference between a prime and a sub-prime mortgage stems from the credit of the borrower. In the United States, a borrower with a FICO score of less than 660 was considered to be sub-prime. Another form of instruments that played a major part in causing the sub-prime crisis is an Alt-A mortgage. A mortgage in which the quality of the mortgage or the underwriting is considered to be deficient is referred to as an Alt-A mortgage. These deficiencies may include the lack of proper documentation, low or no down payment, basically, anything that makes the mortgage more likely to default than a prime mortgage (Brooks and Simon 12).
Edward Pinto, a former credit chief officer for Fannie Mae says that the start of the sub-prime crisis goes back even to 1993 when both Freddie Mac and Fannie Mae started to purchase risky loans and represented them as prime mortgages while they actually were sub-prime or Alt-A mortgages. Fannie Mae has admitted to this practice in a third quarter 10-Q report in 2008 (Wallison 9-13).
It is easy to understand why such a practice is being referred to as one of the principal causes of the financial crisis that the world is in today. The market, particularly, rating agencies and investors, was unaware of the actual number of sub-prime or Alt-A mortgages which had infested the financial system in 2006 and 2007 (Wallison). The majority of these mortgages were in the possession of Freddie Mac and Fannie Mae. As of 2008, the total sub-prime and Alt-A mortgages outstanding was around 26 million, out of which a whopping 10 million were held or guaranteed by Freddie Mac or Fannie Mae. 5.2 million was held by other government agencies while the four largest US banks held or guaranteed 1.4 million of these sub-prime or Alt-A mortgages (Brooks and Simon 12).
The securities issued by these organizations understated the actual amount of sub-prime and Alt-A mortgages that formed the underlying instrument. As a result, credit rating agencies, issued higher ratings to these securities based on the historical rates of default common among prime mortgages. However, since a large part of the mortgages labeled as prime were in fact sub-prime or Alt-A, the actual rate of default was much higher. When these actual rates started to show themselves in 2007, it became apparent that the securities had been wrongly classified and when losses began to show, the investors lost all confidence in the ratings mechanism. As a result they fled the market for mortgage backed securities, even for all sorts of asset backed securities, causing the mortgage backed securities market to collapse in its entirety (Wallison 124).
The US government sprung into action under President George Bush and the Housing and Economic Recovery Act of 2008 was passed by the United States Congress on the 24th of July 2008. The act has been primarily designed to allow the US government to address the financial crisis ebbing from the sub-prime mortgages. The act is intended to restore the public confidence in Freddie Mac and Fannie Mae and authorizes the Federal Housing Administration to guarantee 300 billion in new 30 year fixed rate mortgages for sub-prime borrowers. It also authorizes states to refinance sub-prime loans using mortgage revenue bonds. The Act also establishes two new federal entities, the Federal Housing Finance Agency out of the Federal Housing Finance Board and the Office of Federal Housing Enterprise Oversight.
On the 7th of September 2008, James Lockhart, the director of the Federal Housing Finance Agency (FHFA), announced that Freddie Mac and Fannie Mae were being placed under conservatorship run by the FHFA. The decision received public support by Henry Paulson, the then United States Treasury Secretary and Ben Bernanke, the Chairman of the Federal Reserve Bank.
When these two organizations were first bailed out in September 2008, the Congress had put in place a 200 billion limit, a 100 billion for each as the federal assistance. Last year the Congress revised its estimates and raised this limit to a total of 400 billion. On Christmas eve 2009, the Treasury once again revised its estimates and removed the 400 billion cap for the amount of assistance the government believes will be needed to keep Freddie Mac and Fannie Mae in business. (Hagerty and Holzer,pp.98-100)
Many observers believe that when back in 2005, the Senate Banking Committee had adopted tough regulatory legislation which would have led to more auditing requirement and a higher degree of oversight and scrutiny for the two organizations, could have saved America from the sub-prime debacle. However, the legislation was passed out of the committee and never came to vote (Wallison 12).
The issues underlying the Freddie Mac and Fannie Mae debacle are numerous. The companies have already stated that they will only be able to pay the preferred dividends they owe stockholders by further making more borrowings. Even though the companies are still no where near profitable, the Government needs them to prevent foreclosures on default mortgages. The government has directed both the organizations to pursue this loss-incurring strategy and this is the reason why the Treasury had to lift the cap from the limit on financial assistance (Wall Street Journal 123).
As confusing as things already are, the picture gets even more blurry. The outlays on Freddie Mac and Fannie Mae are still not being accounted for as federal outlays, even though the government basically controls both organizations. Even more worrying is the fact that the combined loan of 5 trillion in mortgages that are part of the two companies balance sheet is not being accounted for as part of the national debt (Wall Street Journal 12).
Political critics of the Obama administration are also calling the timings of the removal of the cap a subterfuge. After the 31st of December, the administration wouldve needed the consent of the Congress to increase the exposure of the taxpayers beyond 400 billion (Wall Street Journal).
Another reason behind the removal of the cap is the phenomenon known as rolling the dice. Interestingly enough, this is also being touted as one of the reasons that caused the sub-prime mortgage crisis in the first place. With a multitude of players including the Federal Housing Administration, both Freddie Mac and Fannie Mae and a host of Wall Street banks, all competing for loans to create mortgage-backed securities, the incentive to lower risk measurement standards was very high (Wallison 95-100).
On Christmas Eve 2009, the Treasury also took a lenient view of a key requirement of the 2008 bailout package. The Treasury does not require Freddie Mac and Fannie Mae to shrink their own portfolios of mortgages, which go up to a combined total of 1.5 billion. Consequently, risk taking will increase and the two troubled organizations will again indulge in rolling the dice (Timiraos 45-48).
The crisis in the housing industry and the problems associated with managing Freddie Mac and Fannie Mae were not the only outcomes of the whole sub-prime mortgage fiasco. On the contrary, this was just the beginning of a difficult period for the global economy as the aftershocks from the failure of two Americas biggest financial institutions set off a reaction that toppled banks worldwide and tested governments all over the world.
Bear Stearns, the fifth major Wall Street bank was the first victim. Bear Stearns was one of the banks which had heavily invested in the incorrectly rated mortgage-backed securities. By the time the whole sub-prime mortgage fiasco became public knowledge the crash had already begun and the cash strapped Bear Stearns went running to the Federal Reserve which was able to offer a lifeline in the form of an emergency funding deal in collaboration with JP Morgan Chase (Wallison 12-14).
While the emergency funding line may have rescued the failing bank from bankruptcy, it was not enough to restore the markets confidence. In short, investors simply retreated. Bear Stearnss stock fell down by more than 45 and lost market capitalization to the tune of around 3.2 billion. The news also had an effect on other financial stocks and markets across the globe experienced a sharp downturn as Wall Street started to wobble. The Dow Jones index went down 194 points and the FTSE Eurofirst 300 index, which comprises of companies from all over Europe, went down 1.1. In both the indexes, the fall was led by the stocks of banks and financial institutions (Craig, McCracken and Lucchetti 56).
The Federal Banks decision to come to the rescue of Bear Stearns had a sort of a signaling effect on the financial markets. Market participants believed that in case other banks and financial institutions found themselves in the same situation, and there were signs then that this was very probable, the United States government and its agencies, and perhaps others, would come to their rescue as well (Wallison 45).
As the world was soon to find out, this was not to be the case. When Lehman Brothers found itself in troubled waters and unable to find a buyer, the Federal Reserve and the US government stood by while the fourth largest bank on the Wall Street filed for bankruptcy. Had the market participants believed that the government would not rescue any more banks, they might have had perhaps hedged themselves better against counterparty risk and the repercussions of the failure of Lehman Brothers might have been controlled. This is an entire debate and one that is futile for now (Wallison 45).
After the fall of Lehman Brothers, market participants realized that they had to take stock of their counterparty risk and this realization led to the freezing of inter-institution or inter-bank lending. This freeze, many analysts believe, is the actual start of the financial crisis that was to devastate economies across the globe (Karnitschnig, Solomon and Pleven).
Sunday, the 13th of September 2008, proved to be a crucial day for the American financial markets. With the governments refusal to provide a financial backstop for Lehman Brothers, two of the most potential buyers, Barclays PLC and Bank of America dropped out of the picture. On the same day, Bank of America took over another Wall Street giant, Merrill Lynch for 50 billion, buying every share each for a price of 29 (Craig, McCracken and Lucchetti 78).
As the negotiations concerning the sale of Lehman fell apart and the news spread, brokerage firms, traders and hedge funds started to gauge their exposure to Lehman and to separate themselves from trades with the unfortunate bank. Lehmans specialists traded in about 200 blue chip stocks and regulators rushed about trying to reassign them to the remaining brokers to facilitate trade on Monday when the New York Stock Exchange would open (Karnitschnig, Solomon and Pleven 98).
Other banks and financial institutions also sprang into action and a group of 10 major commercial and investment banks announced that they would form a pool to create their own borrowing facility. Made up of about 70 billion of their own money, would use the pool to try and ride out the looming crisis. Major players in the pool included the Citigroup Inc., Credit Suisse Group and Deutsche Bank AG also reaffirmed their commitment to mitigate the market volatility (Craig, McCracken and Hilsenrath 65).
Another cause of concern for Wall Street honchos on that fateful Sunday was American International Group Inc (AIG). Executives at Americas largest insurance giant worked the weekend trying to raise 40 billion they thought were necessary to avoid a downgrade of its credit rating which wouldve proved to be very costly for all stakeholders.
The crisis intensified on Monday as the credit rating of the insurance giant was downgraded and AIG was forced to post 14.5 billion as collateral. The Treasury and the Federal Reserve decided on Tuesday that the consequences of letting a giant such as AIG fall would be too far widespread and could prove to be catastrophic for the American economy. Under the terms of the agreement, the Federal Reserve will lend 85 billion to AIG while obtaining control of 79.9 of its shareholding through equity participation notes, a form of warrants (Craig, McCracken and Hilsenrath 63).
September 2008 will be remembered as the month in which the landscape of Wall Street was changed forever. Two of the largest independent brokerages firms were swept out of the picture while the government was forced to engineer rescues that will allow it to influence and control the housing and insurance industries for the years to come.
On 17th February 2009, President Barrack Obama signed the 787 billion economic stimulus package into law. The package is designed to address core issues with investments in healthcare, energy, infrastructure, education and is touted to create or save as many as 3.5 million jobs. The package also contains a variety of tax cuts, approximately amounting to 282 billion. The White House has also promised unprecedented transparency and accountability (Meckler 91).
The US President has the unenviable task of ensuring that stimulus package is enough to put the American economy back on track and the American people back to their jobs. A year into the stimulus package and President Obama is facing lower and lower popularity ratings but remains a staunch supporter of his stimulus package.
To add to the woes, news came that the Federal National Mortgage Association (Fannie Mae) was facing a crisis too. Before going into further details of the economic turmoil created by the sub-prime mortgage crisis, it is important to understand what exactly sub-prime mortgages are and what exactly did these two corporations, central to the crisis, actually do.
Basically, the difference between a prime and a sub-prime mortgage stems from the credit of the borrower. In the United States, a borrower with a FICO score of less than 660 was considered to be sub-prime. Another form of instruments that played a major part in causing the sub-prime crisis is an Alt-A mortgage. A mortgage in which the quality of the mortgage or the underwriting is considered to be deficient is referred to as an Alt-A mortgage. These deficiencies may include the lack of proper documentation, low or no down payment, basically, anything that makes the mortgage more likely to default than a prime mortgage (Brooks and Simon 12).
Edward Pinto, a former credit chief officer for Fannie Mae says that the start of the sub-prime crisis goes back even to 1993 when both Freddie Mac and Fannie Mae started to purchase risky loans and represented them as prime mortgages while they actually were sub-prime or Alt-A mortgages. Fannie Mae has admitted to this practice in a third quarter 10-Q report in 2008 (Wallison 9-13).
It is easy to understand why such a practice is being referred to as one of the principal causes of the financial crisis that the world is in today. The market, particularly, rating agencies and investors, was unaware of the actual number of sub-prime or Alt-A mortgages which had infested the financial system in 2006 and 2007 (Wallison). The majority of these mortgages were in the possession of Freddie Mac and Fannie Mae. As of 2008, the total sub-prime and Alt-A mortgages outstanding was around 26 million, out of which a whopping 10 million were held or guaranteed by Freddie Mac or Fannie Mae. 5.2 million was held by other government agencies while the four largest US banks held or guaranteed 1.4 million of these sub-prime or Alt-A mortgages (Brooks and Simon 12).
The securities issued by these organizations understated the actual amount of sub-prime and Alt-A mortgages that formed the underlying instrument. As a result, credit rating agencies, issued higher ratings to these securities based on the historical rates of default common among prime mortgages. However, since a large part of the mortgages labeled as prime were in fact sub-prime or Alt-A, the actual rate of default was much higher. When these actual rates started to show themselves in 2007, it became apparent that the securities had been wrongly classified and when losses began to show, the investors lost all confidence in the ratings mechanism. As a result they fled the market for mortgage backed securities, even for all sorts of asset backed securities, causing the mortgage backed securities market to collapse in its entirety (Wallison 124).
The US government sprung into action under President George Bush and the Housing and Economic Recovery Act of 2008 was passed by the United States Congress on the 24th of July 2008. The act has been primarily designed to allow the US government to address the financial crisis ebbing from the sub-prime mortgages. The act is intended to restore the public confidence in Freddie Mac and Fannie Mae and authorizes the Federal Housing Administration to guarantee 300 billion in new 30 year fixed rate mortgages for sub-prime borrowers. It also authorizes states to refinance sub-prime loans using mortgage revenue bonds. The Act also establishes two new federal entities, the Federal Housing Finance Agency out of the Federal Housing Finance Board and the Office of Federal Housing Enterprise Oversight.
On the 7th of September 2008, James Lockhart, the director of the Federal Housing Finance Agency (FHFA), announced that Freddie Mac and Fannie Mae were being placed under conservatorship run by the FHFA. The decision received public support by Henry Paulson, the then United States Treasury Secretary and Ben Bernanke, the Chairman of the Federal Reserve Bank.
When these two organizations were first bailed out in September 2008, the Congress had put in place a 200 billion limit, a 100 billion for each as the federal assistance. Last year the Congress revised its estimates and raised this limit to a total of 400 billion. On Christmas eve 2009, the Treasury once again revised its estimates and removed the 400 billion cap for the amount of assistance the government believes will be needed to keep Freddie Mac and Fannie Mae in business. (Hagerty and Holzer,pp.98-100)
Many observers believe that when back in 2005, the Senate Banking Committee had adopted tough regulatory legislation which would have led to more auditing requirement and a higher degree of oversight and scrutiny for the two organizations, could have saved America from the sub-prime debacle. However, the legislation was passed out of the committee and never came to vote (Wallison 12).
The issues underlying the Freddie Mac and Fannie Mae debacle are numerous. The companies have already stated that they will only be able to pay the preferred dividends they owe stockholders by further making more borrowings. Even though the companies are still no where near profitable, the Government needs them to prevent foreclosures on default mortgages. The government has directed both the organizations to pursue this loss-incurring strategy and this is the reason why the Treasury had to lift the cap from the limit on financial assistance (Wall Street Journal 123).
As confusing as things already are, the picture gets even more blurry. The outlays on Freddie Mac and Fannie Mae are still not being accounted for as federal outlays, even though the government basically controls both organizations. Even more worrying is the fact that the combined loan of 5 trillion in mortgages that are part of the two companies balance sheet is not being accounted for as part of the national debt (Wall Street Journal 12).
Political critics of the Obama administration are also calling the timings of the removal of the cap a subterfuge. After the 31st of December, the administration wouldve needed the consent of the Congress to increase the exposure of the taxpayers beyond 400 billion (Wall Street Journal).
Another reason behind the removal of the cap is the phenomenon known as rolling the dice. Interestingly enough, this is also being touted as one of the reasons that caused the sub-prime mortgage crisis in the first place. With a multitude of players including the Federal Housing Administration, both Freddie Mac and Fannie Mae and a host of Wall Street banks, all competing for loans to create mortgage-backed securities, the incentive to lower risk measurement standards was very high (Wallison 95-100).
On Christmas Eve 2009, the Treasury also took a lenient view of a key requirement of the 2008 bailout package. The Treasury does not require Freddie Mac and Fannie Mae to shrink their own portfolios of mortgages, which go up to a combined total of 1.5 billion. Consequently, risk taking will increase and the two troubled organizations will again indulge in rolling the dice (Timiraos 45-48).
The crisis in the housing industry and the problems associated with managing Freddie Mac and Fannie Mae were not the only outcomes of the whole sub-prime mortgage fiasco. On the contrary, this was just the beginning of a difficult period for the global economy as the aftershocks from the failure of two Americas biggest financial institutions set off a reaction that toppled banks worldwide and tested governments all over the world.
Bear Stearns, the fifth major Wall Street bank was the first victim. Bear Stearns was one of the banks which had heavily invested in the incorrectly rated mortgage-backed securities. By the time the whole sub-prime mortgage fiasco became public knowledge the crash had already begun and the cash strapped Bear Stearns went running to the Federal Reserve which was able to offer a lifeline in the form of an emergency funding deal in collaboration with JP Morgan Chase (Wallison 12-14).
While the emergency funding line may have rescued the failing bank from bankruptcy, it was not enough to restore the markets confidence. In short, investors simply retreated. Bear Stearnss stock fell down by more than 45 and lost market capitalization to the tune of around 3.2 billion. The news also had an effect on other financial stocks and markets across the globe experienced a sharp downturn as Wall Street started to wobble. The Dow Jones index went down 194 points and the FTSE Eurofirst 300 index, which comprises of companies from all over Europe, went down 1.1. In both the indexes, the fall was led by the stocks of banks and financial institutions (Craig, McCracken and Lucchetti 56).
The Federal Banks decision to come to the rescue of Bear Stearns had a sort of a signaling effect on the financial markets. Market participants believed that in case other banks and financial institutions found themselves in the same situation, and there were signs then that this was very probable, the United States government and its agencies, and perhaps others, would come to their rescue as well (Wallison 45).
As the world was soon to find out, this was not to be the case. When Lehman Brothers found itself in troubled waters and unable to find a buyer, the Federal Reserve and the US government stood by while the fourth largest bank on the Wall Street filed for bankruptcy. Had the market participants believed that the government would not rescue any more banks, they might have had perhaps hedged themselves better against counterparty risk and the repercussions of the failure of Lehman Brothers might have been controlled. This is an entire debate and one that is futile for now (Wallison 45).
After the fall of Lehman Brothers, market participants realized that they had to take stock of their counterparty risk and this realization led to the freezing of inter-institution or inter-bank lending. This freeze, many analysts believe, is the actual start of the financial crisis that was to devastate economies across the globe (Karnitschnig, Solomon and Pleven).
Sunday, the 13th of September 2008, proved to be a crucial day for the American financial markets. With the governments refusal to provide a financial backstop for Lehman Brothers, two of the most potential buyers, Barclays PLC and Bank of America dropped out of the picture. On the same day, Bank of America took over another Wall Street giant, Merrill Lynch for 50 billion, buying every share each for a price of 29 (Craig, McCracken and Lucchetti 78).
As the negotiations concerning the sale of Lehman fell apart and the news spread, brokerage firms, traders and hedge funds started to gauge their exposure to Lehman and to separate themselves from trades with the unfortunate bank. Lehmans specialists traded in about 200 blue chip stocks and regulators rushed about trying to reassign them to the remaining brokers to facilitate trade on Monday when the New York Stock Exchange would open (Karnitschnig, Solomon and Pleven 98).
Other banks and financial institutions also sprang into action and a group of 10 major commercial and investment banks announced that they would form a pool to create their own borrowing facility. Made up of about 70 billion of their own money, would use the pool to try and ride out the looming crisis. Major players in the pool included the Citigroup Inc., Credit Suisse Group and Deutsche Bank AG also reaffirmed their commitment to mitigate the market volatility (Craig, McCracken and Hilsenrath 65).
Another cause of concern for Wall Street honchos on that fateful Sunday was American International Group Inc (AIG). Executives at Americas largest insurance giant worked the weekend trying to raise 40 billion they thought were necessary to avoid a downgrade of its credit rating which wouldve proved to be very costly for all stakeholders.
The crisis intensified on Monday as the credit rating of the insurance giant was downgraded and AIG was forced to post 14.5 billion as collateral. The Treasury and the Federal Reserve decided on Tuesday that the consequences of letting a giant such as AIG fall would be too far widespread and could prove to be catastrophic for the American economy. Under the terms of the agreement, the Federal Reserve will lend 85 billion to AIG while obtaining control of 79.9 of its shareholding through equity participation notes, a form of warrants (Craig, McCracken and Hilsenrath 63).
September 2008 will be remembered as the month in which the landscape of Wall Street was changed forever. Two of the largest independent brokerages firms were swept out of the picture while the government was forced to engineer rescues that will allow it to influence and control the housing and insurance industries for the years to come.
On 17th February 2009, President Barrack Obama signed the 787 billion economic stimulus package into law. The package is designed to address core issues with investments in healthcare, energy, infrastructure, education and is touted to create or save as many as 3.5 million jobs. The package also contains a variety of tax cuts, approximately amounting to 282 billion. The White House has also promised unprecedented transparency and accountability (Meckler 91).
The US President has the unenviable task of ensuring that stimulus package is enough to put the American economy back on track and the American people back to their jobs. A year into the stimulus package and President Obama is facing lower and lower popularity ratings but remains a staunch supporter of his stimulus package.
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