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Welcome to Knowledge at Wharton's
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special report on the subprime crisis.
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In this report, we dissect the causes of
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the credit crisis that was triggered by
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the explosion of subprime lending and
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the repackaging of those loans into what
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appeared to be investment grade products
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and will offer scenarios for how the
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economy may emerge from the wreckage
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along with suggestions for how such a
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disaster can be avoided in the future.
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The subprime crisis had its roots in the
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US housing boom that began early in the
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decade. Low interest rates allowed home
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buyers to take out larger loans and bid
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up home prices.
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It wasn't until 2000 that we actually
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had house prices that reached the
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previous peak, which was about 1988,
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1999.
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But many of those low interest rates
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were attached to subprime adjustable
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rate mortgages aimed at home buyers who
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might not qualify for a traditional
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loan.
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Well, there's not exactly a a standard
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definition of what a subprime mortgage
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is. The most common definition is to
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refer to a mortgage that has a low
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initial fixed interest rate, a teaser
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rate, and then it has a higher and
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frequently adjustable rate later. At the
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same time that these mortgages were
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proliferating, advances in loan
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securization and automated mortgage
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underwriting made it easy and profitable
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for Wall Street to convert newly issued
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mortgages into securities that could be
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sold to investors. Wall Street Alchemist
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found new ways to turn risky mortgages,
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subprime loans originally designed for
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borrowers with lowinccome or poor credit
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into securities that looked almost
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risk-free. Investors were eager to buy
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these securities which promised higher
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yields than US Treasury bonds and other
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safe holdings.
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Firms like Countrywide made money by
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selling uh mortgages
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and then they would get rid of them.
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It's like a Ponzi scheme.
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This is the first time in the US history
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since the Great Depression that we've
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had a national decline in home prices.
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So it is exceptional and part of the
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story is the 2006 explosion of credit.
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So that on the one hand we did have
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rates go up in 2006. On the other hand,
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standards eroded dramatically in 2006
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and it's the 2006 book of business that
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is under most stress. That's where the
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foreclosures are coming from. As of now,
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most subprime loans carried adjustable
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interest rates and growing numbers of
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borrowers were falling behind after
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annual interest rate resets pushed up
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their monthly payments. By the summer of
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2007, prices of securities based on
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subprime loans were in freefall as
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investors worried they would not get the
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interest in principal payments promised.
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So that there was a a machine being uh
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developed which created just a fantastic
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amount of this uh really junk uh and it
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was being repackaged as high quality and
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at some point that had to explode.
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Surprised about the depth of this
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problem, investors started to lose
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confidence in many other types of
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securities based on various forms of
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debt. Lenders became reluctant to lend
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and home values fell. People also lost
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faith in the underlying statistical
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models because the most sophisticated
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players in the business, the people who
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were really making markets in this, Bear
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Stern, City Bank, UBS, Meil Lynch, had
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major losses and indeed had trouble
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figuring out even what their exposures
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were. So, people completely lost faith
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in the valuation models.
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Once you see the the fire start, uh,
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everyone starts to realize it's going to
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spread. it's going to spread to other
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types of securities that have nothing to
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do with mortgages. And what we're
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learning is that this financial market
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of ours is very interconnected. And uh
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when you see a an reassessment of risk
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of one security, the market then very
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quickly reassesses risks on other
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securities. Worried that this credit
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crunch would stall the economy, the
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Federal Reserve began a series of
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interest rate cuts and initiated new
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lending programs to brokerage houses and
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commercial and investment banks,
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accepting risky mortgage back securities
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as collateral for the first time. The
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Fed even acted to save one investment
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bank, Bear Sterns, from collapse. The
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move stirred controversy, but Chairman
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Ben Bernani believed federal
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intervention was necessary. What the Fed
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could do, the Treasury could have done
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was to say, "Well, Bear Sterns, it's not
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the biggest investment bank in the
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world. Um, let's let the market work
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here." The great thing is that the head
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of the Federal Reserve, Ben Bernani, has
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actually done a study of what happened
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the last time the Federal Government let
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the banking system go down in a domino
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effect. And his study of the of the
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depression was, of course, one of the
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major studies of that period. And I
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think that informed them a great deal
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about what to do in this crisis because
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the worry is that if you allow Bear
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Sterns to go under, you allow them to
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dump all their securities in the market.
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Remember this is a very highly levered
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firm. Uh what happens is an awful lot of
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other firms
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in the United States as well as in
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Europe and elsewhere in the world are at
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risk. Congress and President Bush
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approved an economic stimulus package
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early in 2008, and Washington was thrown
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into a debate over whether to help the
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estimated 2 million homeowners at risk
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of foreclosure.
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A bailout of homeowners is a bailout of
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the lenders. Whenever people say they're
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going to bail out the homeowners,
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they're bailing out the lenders. And
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that creates a horrible precedent. Now,
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many of these uh homeowners uh didn't
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put much down. So they're not going to
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be losing very much if the homes are in
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default. The lenders will and that's
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probably where where it should be.
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While the credit crunch is showing signs
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of easing, debate is likely to continue
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for some time. How can borrowers and
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lenders be helped without encouraging
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risky behavior in the future? Should the
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system for turning loans into securities
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be modified? Is the patchwork of
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regulatory agencies pieced together
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since the 1930s equipped to handle
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today's financial and economic issues?
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For example, if the Federal Reserve is
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going to take responsibility for
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rescuing errant investment banks, should
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it have more oversight over those banks?
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The Fed had to go in and provide funding
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to an investment bank. That's expanding
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the Fed Fed's role. And if you're going
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to expand their responsibility,
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I think you have to expand their ability
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to oversee these institutions.
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I think they're engaged in a very
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interesting experiment. I I I think
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we're in territory which we have very
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little idea of how things are going to
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play out going forward. So, they've cut
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rates to try and save the real economy
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and stop us going into recession and
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stopping what happened in Japan. That's
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often uh discussed as the rationale. No
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one's really tried this in this way and
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it may well be it works out in which
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case maybe a year two years from now
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things will be fine everything will be
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back to normal. These and other concerns
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are explored in this special knowledge
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at Wharton report. The full report
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includes articles deconstructing the
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Fed's reaction to the crisis and laying
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out frameworks for avoiding future
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similar crises. An interactive feature
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shows how the crisis unfolded like
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dominoes toward a recession. plus a
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glossery and timeline. And there are
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extended videos of the interviews with
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Wharton faculty who appear in this
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summary video. After you've digested it
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all, please share your thoughts and
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observations and come back from time to
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time. We'll continue to update this
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special report as developments dictate.
