American Housing and Global Financial Essay Example for Free

American Housing and Global Financial EssayTo do this, lawmakers undeniable to understand what had happened, particularly because housing had until then seemed like such(prenominal) a bright spot in the US economy. The US housing bubble in the other(a) 21st century In his 2001 letter to shareholders, Fannie Mae CEO Franklin Raines wrote, Housing is a safe, leveraged investment the only leveraged investment available to most families and it is one of the best returning investment to make. Home will continue to appreciate in value. Home values are expected to rise even faster in this decade than in the 1990s. His optimism was due in part to the importance Americans attributed to owning a family. The importance was reflected in Fannie Maes motto, which was Our Business in the American Dream. Raines was not alone(predicate) in touting the services of housing as an investment. While house harms in particular region had suffered temporary dec quarters at various points, aver age housing prices across the linked States had risen fairly steadily since at least 1975 (see Exhibit 1). This trend accele lay outd in 1996, and reached active 12 percent per annum in late 2005 and early 2006.Many observers felt that this rise in prices was due in part to the federal Reserves policy of maintaining low interest rates subsequently the 2001 recession. In the period from 1980 to 2001, the federal Funds rate (an anyplacenight interest rate that bank charged each other and which the Federal Reserve targeted) had mostly tracked economic conditions (see Exhibit 2). later on 2001 and until July 2004, however, the Fed kept interest rates low in spite of signs of growth in output and prices. possibly fearing a recession that did not materialize, the Federal Funds rate was set to only 1 percent fromJuly 2003 to July 2004. After this, anxiety about inflation seemed to benefit the upper hand and interest rates were increased steadily, with the Federal Funds rate reac hing 5. 25% in September 2006. A debate over house prices started around 2004. Some economists, such as Dean Baker, the co-director of the Centre for Economic and Policy Research claimed at the time that house prices were like a bubble ready to burst, and that the economy needed to brace itself for a loss of $2 to $3 trillion in housing wealth.Others felt that, even though increases in housing prices had far outstripped increase in residential rents, this was reasonable in light of the low interest rates. Even in October 2005, when it was green to distinguish mentions of a housing bubble, developer Bob Toll disagreed and complained Why cant legitimate estate just have a boom like every other industry? Why do we have to have a bubble and then a pop? Meanwhile, several economists pointed out that house price increases were concentrated in particular areas such as San Francisco and New York, where zoning restriction made it difficult to expand the housing stock.Professor Chris Maye r of Columbia University axiom the attraction of these areas coupled with the inability to increase supply as furnishing house prices in these areas to remain high basically forever. Nothing that Tokyo real estate was still more(prenominal) expensive than real estate in Manhattan, he stated Theres no natural law that says US housing prices have to stop here. None. While house prices reached eye-popping levels in what Chris Mayer called superstar cities, construction was booming elsewhere.Cities like Phoenix, as well as many communities in Florida and around Los Angeles, saw such a torrid pace of construction that builders had difficulty even procuring the cement they needed. New houses in these areas were often snapped up by eager investors and newspapers relished reporting on individuals who managed to resell houses at a gain even before they took possession of them. According to Loan Performance Inc, more than 12% of Phoenix-area owes were obtained by investors in 2004, as co mpared to just 5. 8% nationwide in 2000.Home finance before the 1990s In the United States, it was common to talk about the Traditional fixed 30 twelvemonth mortgage. This instrument required the borrower to make a constant stream of monthly payments during the 30 year term of the loan. These payments were specified in advance so the interest rate on this loan was fixed. Many of these traditional loans allowed borrowers to pre-pay their mortgages without penalty. When interest rates declined, borrowers often took advantage of this feature and refinanced their homes at lower rates.Savings and Loan Associations (SampLs) already offered mortgages with constant payments before the Great Depression, though they were typically less than 12 years long. At the time, other lenders mostly offered short-term mortgages that needed to be refinanced because they had balloon payments at the end. During the Great Depression, many households went into default in part because this refinancing became difficult. One brass solvent was to create the Home Owners Loan Corporation (HOLC), which made simultaneous offers to borrowers and lenders.If they both agreed, lenders received HOLC obligations in exchange for their claims against households, although this exchange required bank to recognize a loss on their assets. Households, meanwhile, freed themselves of their previous obligation by accepting new self-amortizing mortgages with fixed payments whose wrong were establish on new assessments of their homes worth. After WWII, banks and SampLs originated many fixed 30 year mortgages and held them to maturity. The results were not always happy.When short-term interest rates rose in the early 1980s, the yield on mortgage assets fell below the cost of paying depositors for their funds. This mismatch was one of the causes for the failure of about half of the 32,234 SampLs that existed in 1986. Because the politics insured the SampLs depositors, it incurred considerable losses and had t o set up a special institution to dispose of the failed SampLs assets. The SampL crisis also boosted the securitization of mortgages by cardinal governments sponsored enterprises (GSEs), Fannie Mae and Freddie Mac.Fannie Mae was originally created in 1938 as a government agency. Like Freddie Mac, a twin that Congress chartered in 1970, Fannie Mae eventually became a privately own publicly traded company. Starting with bundles of mortgages purchased from mortgage originators, the GSEs created and sold mortgage-backed securities (MBSs), which delivered to holders the payments made on these mortgages. In exchange for a fee, the GSEs guaranteed the interest and principal on these loans.This meant that, assuming the GSEs remained solvent (or that the government came to their rescue if they ensnare themselves in financial trouble), the only payment risk faced by the holders of these MBSs was the risk that the underlying mortgages would be repaid before they were due (Known as prepaymen t risk). Congress capped the size of the loans that GSEs could accept. In 2006, for example, the maximum loan for single-family homes was $417,000. To limit their credit risk, the GSEs used standards that were similar to those of traditional originators.To secure sufficient collateral, they took only of age(p) mortgage and generally required the loan-to-value ratio (LTV) to be below 80 %. The LTV was computed as the ratio of the mortgage to the propertys market value at the time of origination. Before underwriting loans, the GSEs also looked at the borrowers income and employment status, level of other assets, and history of foreclosures and bankruptcies. Consistent with the rules of GSEs, home lenders before the 1990s only change to borrowers they deemed credit worthy, and generally required documentary evidence on these variables.Until the praxis was penalized by a 1977 law, most lenders also denied mortgages to people living in indisputable redlined communities, where these w ere predominantly inner city neighborhoods with large black populations. An avenue that remained open to borrowers with problematic credit histories was to apply through conventional lenders for loans insured by the Federal Housing Administration (FHA). The lenders then had to verify that the loan met FHA requirements and the process for doing so was somewhat more time-consuming than in the case non-FHA mortgages.In spite of these standards, about 8 % of FHA loans were past-due in 1993, while the delinquency rate on standard mortgages was only 3 %. FHA loans were packaged into mortgage-backed securities by Ginnie Mae, a government owned bay window that dealt exclusively with federally guaranteed mortgages. Innovation in the mortgage In the 1990s new firms started to lend money to borrowers that did not qualify for prime mortgages. Rather than impart directly, many of these firms sought the help of mortgage brokers to whom they paid commissions. TheUS Department of Housing and Urba n Developments list of lenders who specialized in such subprime loans increased from 63 lenders in 1993 to 209 in 2005. Wall Street firms Lehman Brothers, Bear Stearns, Goldman Sachs, Merrill Lynch and Morgan Stanley all acquired such lenders, though all but Lehman Brothers and Bear Stearns did so only in 2006. One obvious difference between subprime and prime loans was that the former had higher interest rates and fees. There was, however, no precise dividing line between the two, so that there was no consensus on how to measure the fraction of subprime loans.According to one definition, the value of these loans grew from about 1% of new mortgages in 1993 to 20% in 2006. At the same time, the FHA share dropped from 11% to 1. 9%. An independent analysis by the Wall Street Journal concluded that 29% of the home loans made in 2006 had high interest rates. A large fraction of these loans refinanced existing loans. In many cases, these refinancing loans increased the borrowers mortgage debt and thereby made it mathematical for households to keep some cash for other purposes.From being virtually unknown in the 1980s, Countrywide Financial became the largest mortgage lender in 2005. A 2003 government report showed that it was also the leading mortgage lender to minority homeowners, as well as one of the largest providers of home loans in low-income communities. When this report was released, Countrywides CEO Angelo Mozilo said Were extremely proud of our accomplishments, as they clearly demonstrate our long-standing commitment to provide all Americans with the opportunity to achieve the dream of homeownership.These results accent our ongoing efforts to discover new approaches to turn individuals and families into homeowners, to develop new loan products that reduce or eliminate the obstacles to homeownership and to make it easier for families to qualify for loans. Contrary to what had been standard practice in the past, lenders such as Countrywide did not offer th e same interest rate to all borrowers. This customization was facilitated by the use of automated statistical models that predicted the likelihood of default on the footing of borrower characteristics.Interestingly, the first statistical tools that came into wide use were those developed by Freddie Mac (called Loan Prospector) and Fannie Mae (called Desktop Underwriter). These were introduced to make it easy for mortgage originators to know whether their loans would be acceptable to the GSEs, though their use expanded well beyond this purpose. One variable that played a key role in these models, and which had apparently been absent from previous methods of qualifying borrowers for mortgage, was the borrowers credit score.While there were several approved commercial credit score formulas (regulators did not allow scores to depend on race, gender, marital status or national origin), the most popular one was the FICO score invented by the Fair Isaac Corporation. This score, which rang ed from about three hundred for poor credit risks to about 850, appeared to give considerable weight to the punctuality with which borrowers had paid their previous obligations. One reason these scores became important in mortgage applications was that studies by Freddie Mac had shown a strong correlation between FICO scores and defaults on mortgages in the pre-1995 period.One type of mortgage that became popular among subprime lenders was known as 2/28 because its rate was fixed for 2 years and then became variable for the remaining 28 years. This mortgage was quite different from adjustable rate mortgage (ARMs) offered to prime borrowers. The introductory rate on 2/28 was above the typical rate offered on 30-year fixed mortgages, whereas ARMs for prime borrowers had sign rates below those on fixed mortgage. Also, rates on 2/28s rose considerably when they were reset subsequently 2 years.According to the President of the Federal Reserve Bank of Boston Eric Rosengren, the average initial rate for subprime mortgages issued in 2006 was 8. 5% (when the conventional 30-year mortgage rate was below 6. 4%) and reset to 610 basis points above the 6-month LIBOR rate (which averaged about 5% in 2006) after 2 years. In the case of reasonable 2/28 mortgages, there were pre-payment penalties if the mortgage was pre-paid in the first two years but there was no cost associated with pre-paying right before the interest rate was reset.From the point of view of mortgage brokers, this system was attractive because it ensured that many borrowers would refinance after two years, allowing brokers to collect new origination fees. Borrowers were also told that this arrangement was good for them because, if they made timely payments, their FICO score would cleanse and they would be able to refinance at a lower rate. There were widespread allegations that some borrowers in this period received home loans on terms that were substantially less favorable than those of conventional o r FHA loans for which these borrowers would have qualified.It was also claimed that unsophisticated borrowers had been duped into signing mortgage that continued to have severe pre-payment penalties even after interest rates had been reset to high levels. A lawsuit in Michigan claimed that a mortgage broker working for a unit of Lehman Brothers disordered and pressured an elderly couple so that they would sign a loan whose interest rate would reach 17. 5%. Several borrowers told Federal officials that they had simply been laid to regarding their proximo monthly payments. What is certain is that some borrowers agreed to make payments that were impossible for them to keep up with over time.A 79-year old retired engineer named Robert Pyle, for example, moved from a $265,000 to a $352,000 mortgage in 2005 and cleared his credit card debts in the process. Almost immediately after signing the mortgage, which involved over $33,000 in fees, he found himself unable to cover the $2200 month ly payment. Terry Dyer, the broker who issued Robert Pyles mortgage said, Its clear he was living beyond his means, and he might not be able to afford this loan. But legally, we dont have a responsibility to tell him this probably isnt going to work out.Its not our obligation to tell them how they should live their lives. Some subprime loans required less documentation than was traditionally demanded. Instead of requiring proof of income of independent appraisals of the value of the home, some subprime mortgages were based only on stated income or stated value. Stated income loans were very convenient for borrowers who had casual jobs that were difficult to document, though they opened the door to baloney by both borrowers and brokers. Another dimension in which some subprime loans departed from traditional ones was in their down-payments requirements.