The US Subprime Mortgage Crisis in 2007 has had a severe impact on the global financial system. The collapses of Bear Stearns and Lehman Brothers, the acquisition of Merrill Lynch by the Bank of America and the conversion of Morgan Stanley and Goldman Sachs into bank-holding companies have all resulted from this subprime crisis that shocked the world and directly triggered the greatest global financial crisis since the Great Depression. The underlying factors leading to the crisis were in fact the new inventions in the US housing market – the subprime mortgage lending and securitization technology that significantly magnified the impact of the default risk of these loans on the whole financial system. This report, hence, aims to provide an understanding of how the subprime mortgage lending and securitization played a part in bringing about the Subprime Mortgage Crisis in 2007. A case study would follow our discussion to provide a further look into one of the financial institutions that was a casualty of the crisis but has nevertheless survived, Morgan Stanley. Besides, external influences such as actions by the government and the central bank as well as the possible impact of the 2009 Financial Regulatory Reforms would also be addressed.
Subprime Mortgage Crisis – How did it all happen?
Credit Risk and Default Risk
Credit risk refers to the risk of loss arising from borrower or counterparty default when a borrower, counterparty or obligor does not meet its financial obligations . However, default risk, which is also known as credit risk, is often attached with subprime mortgage loans. Thus, we will use default risk instead of credit risk to describe the risk that borrowers of the subprime loans may fail to repay the principal and interests in a timely manner. 2.2
New inventions in the US mortgage market
Subprime mortgage lending
Subprime mortgages loans were invented more than a decade ago to target at people who could not qualify for the regular mortgages or could not make enough to afford mortgage payments. These loans have provided access to home ownership to more than 6 million households in the US over the past decade. Figure 1: Growth in subprime lending in the US
Subprime mortgage loan is a type of mortgage loans offered at interest rates higher than the normal prime rate to high-risk customers who are unable to qualify for prime-rate loans. For the traditional mortgage loans, qualification for loans is based on a number of factors such as income, assets and credit rating. However, for subprime mortgage loans, subprime borrowers are usually qualified for loans and the prices of the loans vary depending on the borrowers’ credit ratings, which means that the worse the credit rating is, the more expensive the loan will be. b.
Subprime Mortgage Securitization
With the rise in subprime lending, financial institutions also came up with a new method of managing the default risk of these subprime loans – securitization. Securitization is the process of pooling and repackaging of homogenous illiquid assets into marketable securities that can be sold to investors. Traditionally, how the mortgage lending system works is that banks originate loans to the borrower and retain the default risk of these loans. However, with the invention of securitization, banks instead adopted the “originate-to-distribute” model which enabled these mortgages to be repackaged into bonds called Mortgage-Back Securities (MBSs) and Collateralized Debt Obligations (CDOs) and sold to investors. Hence, the default risk of the underlying mortgage loans could then be transferred to the buyers of these bonds. The two types of securitized mortgages that played a critical part in the subprime mortgage crisis are MBSs and CDOs. 1.
MBSs are the products of the securitization of a portfolio of mortgage loans. They are, by definition, financial securities which are backed by the real-estates or...
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