Background of the study The Sub Prime Mortgage Crisis maimed the US Economy as house prices were inflating exponentially; a bubble in financial terms. This eventually burst and causing the assets tied to the different real estates to shrink and devalue. A financial crisis as such had been one of the most alarming circumstances that hit the United Stated and all of its stakeholders.

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The said tragedy impinged all bouts of growth and placement from such fast growing economy to a stagnant crawl to recovery. The Sub Prime Mortgage Crisis was basically a result of unregulated and misperceived credit default swaps. These are debt instruments used to insure the debt of an entity against default. The misprinting was caused by the lack of projection for credit risks that are above the line such as systematic risks. As these instruments were engineered to compensate for the certain risk using historical data analyses, the “soft” information was not accounted for.

When the economy recovered and payments on their mortgage loans shoot up, they had no choice but to default on heir loans. Also, with the growth of the housing sector, people were buying houses that they cannot afford seeing the possibility that house prices will continue to rise. As the homeowners witnessed the prices of their houses decrease when the housing price bubble burst, they foreclosed, and as the value of selling their houses were less than their mortgages.

This alarmed the banks as they bought mortgage-backed securities resulting them to be afraid of lending to each other because they did not want these toxic loans as collateral. This also added up to the woes of the economy. II. Statement of the problem Given the supreme mortgage crisis caused a rapid inflation and devaluation of house pricing and volatile shifts of house pricing indices and interbrain rates, the issue that has been raised is which of the components of the economy were affected.

The significance of the study is to evaluate and classify the economic impacts of the supreme mortgage crisis in the United States. As the Philippines is on the route

Page 2 The Subprime Crisis and Its Impact in the Financial Sector Essay

in financial liberalizing, the study will prove useful in analyzing the different preventive measures needed in safeguarding the economic components of countries that prove potential to the said crisis. IV. Objectives As a first hand objective, the research is aimed to identify the factors which significantly impacted the interbrain rates by measuring the scare effect of the banks to the supreme crisis by taking a look at the aforementioned rates.

The researcher deem the importance of how the study with the hope of using the said information to conduce preventive measures in the bouts of these occurrences happening in the Philippines. With the study, definite sectors of the economy of the Philippines can be given a contingency plan in the case of the same crisis would happen in the Philippines. Review of Related Literature l. Supreme Mortgage Crisis a. Supreme Mortgage A supreme mortgage is conventionally a loan offered to borrowers who actually has a below par credit rating.

These borrowers essentially are risky to deal with so lenders developed a meaner to compensate them with dealing with these kind of borrowers. Lenders imposed higher interest rates to these supreme mortgage loans they are offering to somehow compensate the risk they are taking in dealing with supreme borrowers. According to the study made by Accomplishment and Pennington-Cross (2006), the extinguishing feature of supreme mortgages appears to be the higher costs associated with these kind of loan which includes upfront and continuing costs.

In order to give rise to the creation or development of a supreme mortgage, upfront costs like application fees and appraisal fees have to be dealt with by the borrowers. On top of the upfront costs, continuing costs like mortgage insurance payments, principal and interest payments, and additional fees and fines for delinquent payments and locality demands are needed to be complied by the borrowers. Based on the academic work of Mayer and Pence (2008), these supreme mortgage mans offered to the public can be acquired through smaller down-payments and little documentation of income to get hold of the houses.

This allowed new buyers to access credit and have an easier time to refinance loans and withdraw cash from houses which appreciated in value. It was also said that these supreme mortgage loans were offered in locations in which it is difficult to obtain credit as it is focused prevalent with countries showing high unemployment rates. According to the Financial Crisis Inquiry Report (201 1), supreme lenders lend out supreme mortgages to borrowers who are yet to establish credit histories or had rubble financial histories which could be reflected through setbacks such as unemployment, divorce, and medical emergencies to name some.

As much as banks would refuse to lend to these borrowers, a supreme lender would be very much willing to lend to these borrowers if compensated by higher interest rates for the additional risk. B. History of crisis Birth, L’, Panamanian & Yoga (2008) stated that over the past two centuries, the residential mortgage market of the United States was working very well. Despite a few periods of disruption in the market, none was as devastating as the supreme Ortega meltdown in the summer of 2007.

A recession was caused by the decline in home prices, the rise in foreclosures, and the tightening of credit standards by lenders. All of which slowed the growth of the economy. The Bush administration pushed for a voluntary freeze on interest rates for a select group of roughly 600,000 borrowers with supreme hybrid mortgages in response to this troubling situation. Prior to 1980, the vast majority of all residential home mortgage loans were made by savings and loans. These institutions originated, serviced, and held these loans in their portfolios.

But as early as 1970, the combining of these three functions by a single institution began to change as residential home mortgage loans were increasingly securities. The characterization process contributed to the unbinding of the home mortgage process insofar as savings and loans no longer had to hold these mortgages in their portfolios. At the same time, investors in the securities backed by home mortgages provided an additional source of funding beyond the deposits of savings and loans. The origination and servicing of mortgages also became separate functions not entirely performed by savings and loans.

There were only 7,000 U. S. Mortgage brokers in 1987, but that figure had increased to 53,000 by 2006. The unbinding of the home mortgage process into these three separate functions (funding, origination, and servicing) meant there were also three separate sources of revenue to be earned. Unlike the savings and loans, investors who ultimately purchased securities based upon pools of home mortgage loans became further removed from the homes serving as collateral, and therefore relied heavily on rating agencies for accurately assessing the credit quality of these securities.

In the summer of 2007, substantial problems began to emerge in the supreme loan arrest when several supreme mortgage lenders filed for bankruptcy and other financial firms suffered heavy losses on supreme securities. Furthermore, the rate of foreclosures on supreme loans increased from 2000 to 2006. Some estimates indicate a near doubling of the foreclosure rate over this period, and for loans made in 2006 the foreclosure rate of 5. Percent after Just six months from origination November 2007, there was one foreclosure for every 617 households, according to Realty’s. This troublesome situation has led to many condemnations of supreme mortgage loans (particularly hybrid loans) and characterization. Most importantly, the factors that cause individuals to enter foreclosure are generally not based on the type of product they receive, but rather the financial circumstances they find themselves in after they obtain mortgage loans.

These factors include unemployment, divorce, health problems, and especially declines in housing prices that leave homes worth less than their outstanding mortgage balances. C. Factors 1 . Foreclosures Based on the Financial Crisis Inquiry Report (201 1), there is an estimate between 8 million to more than 13 million foreclosures since the housing bubble burst and it could take years to recover even if the economy begins to boom again.

Historically before 2007, the foreclosure rate has been less than 1% but due to the collapse of the housing market it increased to 2. 2% in 2009 or there was 1 foreclosure filing for every 45 houses. In 2010, 1 out of 11 outstanding residential mortgage loans was at least one payment past due but not yet in foreclosure. There are two main causes of foreclosure, first, people are unable to pay monthly due to unemployment, other financial problems or because mortgage payments increased.

Second, the value of the home becomes less than the debt owned. In 2009, 22. 5% of households with mortgages owe more mortgages than the real value of their house. According to the senior managing director of Amherst Securities Laurie Goodman (as cited in the Financial Crisis Inquiry Report), “The evidence is irrefutable, negative equity is the most important predictor of default. When the borrower has negative equity, unemployment acts as the one of many possible catalysts, increasing the probability of default. In the work of Gerard’ and Willie (2008), they analyzed the impact of the supreme crisis on urban neighborhoods in Massachusetts. It is discussed that homeowners ho used supreme mortgage to pay for their purchases have significantly higher default rate compared to those who used prime mortgage. Using their own data from their previous work Gerard’, Shapiro and Willie (2007, as cited in Gerard’ and Willie 2008) there is a 20% chance for borrowers who used the supreme mortgage to lose their homes which is 7 times as great for those who used prime mortgages.

Unmerciful and Smith (2004, as cited in Gerard’ and Willie 2008) discovered that in the Chicago metropolitan area, supreme lending was the most important determinant of foreclosure rates, they estimated that there are 9 foreclosures for very 100 additional supreme mortgage from 1996 to 2001. 2. Unemployment In the Financial Crisis Inquiry Report (201 1), it was reported that the impact of the crisis was still lingering as the unemployment rate was at about 10% in of 2008, reached its peak of 10. % in October 2009, but the underemployment rate was above 17% and the share of unemployed workers without Jobs for more than 6 months was a little bit above 40%. A statement by then CEO of JP Morgan Jamie Idiom when he thought of the possibility of facing a 20% unemployment rate: “The markets were very bad, the volatility, the liquidity, some things couldn’t trade at all, I mean completely locked, the markets were in terrible shape. We could have survived it in my opinion, but it would have been terrible. I would have stopped lending, marketing, investing … ND probably laid off 20,000 people. And I would have done it in three weeks. You get companies starting to take actions like that, that’s what a Great Depression is. ” When the recession began in 2007, it had a very large impact on the Job market as evidenced by the speed of falloff in Jobs and rise in number of the underemployed. 3. 6 million Jobs were shed off by the economy in 2008 and another 4. Million Jobs in 2009 although it regained 1 million Jobs in 2010, it was a meager number compared to the number of lost Jobs.

An, et. Al (2010), in their study mentioned that unemployment is a possible reason for a mortgage default since if a borrower has no Job, the loan cannot be repaid. According to them, recent research by Demeaned and Hemmer (2008) found out that unemployment is a significant risk factor for supreme loans. 3. Leverage Ratio According to the Financial Crisis Inquiry Report (201 1), “We conclude a combination of excessive borrowing, risky investments, and lack of transparency put he financial system on a collision course with crisis. Years before the crisis, financial institutions and households kept on borrowing and borrowing that left them very vulnerable to even the slightest decline in their investments. An example was made of the 5 major investment banks which included Bear Stearns, Goldman Cash, Lehman Brothers, Merrill Lynch and Morgan Stanley. All 5 were operating with very thin capital as their leverage ratios were as high as 40 to 1, meaning for every $40 in assets only $1 in capital is available to cover up for the losses and the firm could be wiped out if the asset value had a 3% drop.

Making matters worse was that their borrowing was short-term which meaner that it has to be renewed everyday, the firm has to pay a big if not large amount everyday, Financial firms were not the only ones that were borrowing as households were digging themselves a hole as well, from 2001 to 2007, national mortgage debt and mortgage debt per household rose more than 63% while wages or salaries remained the same so when the crisis struck, financial institutions and households alike were affected.

Bank managers also monitored their leverage because too much leverage might endanger the bank itself nice leverage is used to amplify return but it must not be forgotten that as much as it amplifies return, it also amplifies losses. In the study of Kalmia-can, Sorensen and Yeastiest (2012), it was discussed that as the price of an asset increases so will the value of equity or the net worth of a bank as a percentage of assets. If everything else remains fixed, the rising price of asset prices would in turn leads to a higher leverage ratio.

Adrian and Shin (2008-2010, as cited) stated that leverage patterns are countercyclical for non- financial sectors and is the opposite for investment banks which have a prototypical tatter. 4. Housing Price Index In the study of Downs (2007), in 2000 when a large amount of capital was poured into real estate, it generated a worldwide upward movement in real property prices. According to Freddie Mac’s (as cited) home price index of 381 US metropolitan areas, there was a 46. 5% rise in housing price through the sass’s but there was another price increase of 59. 8% from 2000-2006.

The capital inflow into real estate was an important factor in influencing the housing prices and the boom of housing production after 2000. Between 2004 to 2005, the housing industry built 2 million nits when economically it only needed to build 1. 3 million which meant that the housing industry was reaching into future demand. From 2006 to 2007, home prices from 314 of the aforementioned 381 metropolitan areas continued to rise by an average of 7. 3% while in the remaining 41 areas prices decreased by an average of 3. 4%. At that time, there were concerns about supreme lending because it was possible that it could paralyze the economy.

Supreme lenders and borrowers liked each other because the lenders had higher interest rates and borrowers with poor credit were able to buy houses when in fact they could not afford to. When prices began to decline in 2005, supreme defaults started to rise. According to the study of Guatemalan, Penn and Yen (2009), the supreme mortgage crisis was preceded by a sharp increase in housing price in the early sass where economists interpreted it as a classic housing bubble. They argue that forecasts of future increases in home-loan collateral values may have affected the demand and supply of mortgages.

It was discussed from the results that past price appreciation did in fact increase mortgage applications and the prices of homes purchased. II. FINANCIAL IMPACT a. The Financial Sector According to the work of Sutton and Jenkins (2007), the financial services sector is vital to the growth and development of the economy. It helps the people save money, build credit, and a protection against uncertainty through banking, savings and investment, insurance, and debt and equity financing while at the same time allowing banks to start up, expand, and be more efficient to do well in the competitive field of local and international markets.

It also aids the poor in finding their way out of poverty by enabling them to manage the assets available to them in meaner that can generate income and provide options as well. Large firms including domestic and multinational commercial banks included in the financial sector have the expertise and basically the meaner to have a direct significant impact to the way the markets operate through engagement and example.

They are progressively using deliberate strategies to widen economic opportunities through business models that will see they are looking to shape policy frameworks in the region in which they operate and build human and institutional capacity from their initiatives. Based on the study of Carlson, King, Lewis (2008), the growth of the economy is irately attributed to the contribution of the financial sector by facilitating the flow of funds from the investors to the borrowers. The disruptions that interfere with the financial sector as they act as an intermediary in the movement of funds might therefore also hinder economic growth.

There is a possibility that the deterioration in the health and solvency of the financial sector of the economy will give rise to the increase in the cost of intermediation. In other cases, the failure of a financial institution will lead to the disappearance of valuable banking relationships which will dead to a more restricted access to credit and reduced investments. Financial institutions also rely on debt financing for their operations so if their condition worsens, they would have to incur higher borrowing costs which they would also pass on to the borrowers.

This rise in lending rates would affect investment decisions. The health of the financial sector somehow determines whether there would be a change in economic conditions. B. Interbrain rates As banks and other financial intermediaries base their lending and borrowing rates from interbrain rates which are consolidated rated from high investment rating banks room a said proximity, say a country or union, the said rates vary with the regards of monetary supply and demand and the restrictions brought about by the policies of the Federal Bank that promulgates a contraction and expansionary effect to the economy.

Interbrain offer rates assist commercial banks in the said proximity as they are used in the loans and credit products. One major factor in the fluctuation of these rates come from the availability of liquidity in the market. The definition is clearly defined by the study of Murphy (2010) regarding the analysis of the 2008 Financial Crisis. Interbrain rates were used in the study to serve as a marker for the panic of financial sectors in terms of its volatility.

Aligned to the study of the United States Financial Crisis Inquiry in 2010, the interbrain rates were said to be volatile in terms of its fluctuations before and during the crisis. Framework l. Theoretical Framework A. Supply & Demand Demand is the rate at which consumers want to buy a product. Economic theory holds that demand consists of two factors: taste and ability to buy. Taste, which is the desire for a good, determines the willingness to buy the good at a specific price. Ability to buy meaner that to buy a good at specific price, an individual must possess sufficient wealth or income. Rises, more of the commodity will be available to the buyers. This is because the suppliers will be able to maintain a profit despite the higher costs of production that may result from short-term expansion of their capacity. Buyers and sellers react in opposite ways to a change in price. When price increases, the willingness and ability of sellers to offer goods will increase, while the willingness and ability of buyers to purchase goods will decrease. (Whelan &Messes 1996). B.

Neo-classical Alienable Fund Theory of Interest The Neo Classical Alienable Fund theory of interest recognizes that money can play a disturbing role in the saving and investment processes and would thereby cause variations in the level of income. According to this theory, the rate of interest is the price that equates the demand for and supply of alienable funds. Hence, the fluctuations in interest rate arise from variations either in demand for loans or supply of loans also referred to as credit funds available for lending. Alienable funds are the sums of money supplied and demented at any time in the money market.

The supply of credit or loans would be influenced by the savings of the people and additions to the money supply. Thus, the supply of alienable funds is composed by the savings (S) plus new money supply resulting from credit created by banks (M) resulting to the equation of S + M as the total supply of alienable funds. On the other hand, the demand of alienable funds would be determined by the demand for investment and the demand for hoarding money. It is noted that if hoarded money increases, it would correspond to a decrease in the supply of alienable funds.

While a decrease in the hoarding of money, would entail an increase in the supply of enable funds. Thus, the demand for alienable funds is composed by the invested expenditure of a demand for invertible fund (l) plus net hoarding (H) such as the demand for alienable funds for use as inactive cash balances resulting to the equation of I + H for the total demand for alienable funds. Consequently, the alienable funds theory suggests that the rate of interest is determined when the demand for alienable funds (l + H) and the supply of alienable funds (S + M) balance each other.

The alienable funds theory sees the interest rate as the function of four variables namely the savings(S), investment(l), the desire to hoard(H), and the money apply(M). [ r = ] The rate of interest is determined by the intersection of the alienable funds demand curve (l + H) and the alienable funds supply curve (S + M). This intersection will indicate the level of the market rate for interest. (Partisanship, 2012) C. Moral Hazard The work by Deg (2009) examines and attempts to determine whether moral hazard was a motivating factor leading to the supreme mortgage crisis.

Due to the low interest rates and long term trend of rising housing prices, borrowers were encouraged to apply for the mortgages believing that they would be able to quickly finance at more favorable terms but in fact they cannot. In 2006 and 2007, interest Initial terms expired which caused default and foreclosure to increase dramatically compounded by the failure of house prices to increase, it resulted to house price less than the mortgage loan and this provided financial incentive to enter foreclosure. This situation was the main cause of the supreme mortgage crisis.

Another situation in the study of Deg (2009) was when Grumman (2009, as cited) explained that financial institutions responsible for originating the mortgages to rowers may have been motivated to relax their standards in lending. Traditionally, the financial institution as the originating source retained the default risk which was collateralized model. Characterization, which meaner that originating sources were no longer required to hold mortgages until maturity, gave way to the distribute model wherein through mortgage-backed securities, financial institutions sold the mortgages and distributed credit risk to investors.

By selling to investors, the originating source was able to issue more mortgages thereby generating a lot more transaction fees which was a main source for money. There is moral hazard as agents of the originating source were focused on processing the transactions fee rather than ensuring good credit quality and when the borrower could not pay the mortgage, there was little impact on the issuer. II. Conceptual Framework This paper aims to explain how the banks and financial institutions reacted to the different factors brought about by the supreme crisis.

Subsequently, the scare effect of the banks and different financial institutions will be measured by the volatile changes of the interbrain rates from before and after the supreme crisis. As to which the said rates react constrictive against any foreseen anomalous growth in defaults. A. Foreclosure Rates As more and more foreclosures occurred due to the default of payments by the homeowners who were granted supreme mortgages, more and more houses were available in the market.

Since there were so many houses for sale in the market creating more supply than there was demand, housing prices were not rising anymore but instead plummeted. This created a problem from the homeowners who were still paying their debts, since house prices were decreasing dramatically, they o decide to stop paying their loan as the increase in supply of houses for sale in their neighborhood made the house that they were still paying worth much less. It was impractical for them to keep paying more than what their house was already worth now. B.

Unemployment Rates In addition to this, cities with high foreclosure rates experienced an increase in unemployment, crime rate, and prostitution for the reason of the lack of available payments which ultimately led them to homelessness through foreclosure. C. Leverage Ratios Since real estate prices appreciate over time, this caused the investors to see less risk in this investment. The leverage ratios of banks started to increase as their assets depended on credit-backed securities. The banks who held these mortgages also sold these assets to investors and other financial institutions.

So now, everybody had a hold of these assets. However, greed took the better of them, and they wanted more mortgages because it amplified the possible returns. This is also referred to moral hazard. The problem was, every consumer who qualified for a mortgage already had one. This is where supreme mortgages came into the picture. Where a homeowner can obtain a supreme mortgage with easier requirements like no down payments, o proof of income and at other times no documents at all. This made the mortgages very risky as there was a high chance that the borrowers would default on their obligation.

Not surprisingly, the homeowners defaulted on their mortgages, and the lender gets the house instead. Mortgages seemed to be a very good investment for financial institutions and investors because they lend money to the borrower plus interest and if ever the borrower defaults on his obligation, the lender will acquire the property. D. House Pricing Index House price indices not only stopped increasing but decreased dramatically. Consequently, the mortgage-backed securities held by the investors had no worth anymore as no money was flowing in and house prices were not worth as much anymore.

Basically, everyone was holding toxic assets (assets with no value). The whole financial system froze and nobody was able to pay their debts, homeowners and financial institutions alike. As a result, everyone goes bankrupt. Ill. Operational Framework A. Variable List Presented below are the variables relevant to this study: Variable I Definition I BOOR I Variance of Interbrain Offer Rates -The volatility of the rate of interest harmed on short-term loans made between banks.

Source of data: Remuneration I FCC I Foreclosure Rates – Rate of a homeowner’s right to a property is terminated, usually due to default. Source of data: World Bank I U I Unemployment Rates -The percentage of the total labor force that is unemployed but actively seeking employment and willing to work. Source of data: World Bank I LORD I Leverage Ratio -A general term for any technique to multiply gains and losses. Source of data: Remuneration I HIP I House Price Index -Measures the price of residential housing. Source of data: Remuneration I B. Reason for choosing variables

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