Ethics Review Of Subprime Meltdown 2008

The subprime crisis has started hurting not only the U.S. economy but also the worldwide economy and has not made its entire appearance yet. This invisible fear tumbled the worldwide stock market in mid of August 2007 and came again in late November. It has not been figured out how big its impact and how long will it take to overcome it, though many economist and financial firms have been working on figuring out them. We would like look into this crisis from ethical viewpoint.

Since the subprime crisis is complicated and somewhat systematic crisis, it is very important to understand the subprime market related to financial systems to identify who involved in the system, what kind of roles they took, how the crisis happened, what kind of ethical issues each party had, why we could not prevent it, and how we will be able to prevent similar crisis in future. After clarify these point, we look into the crisis from ethical view point.

Good old days

Until mid 1980, the loan system was simple and straight forward. Borrowers borrowed money from financial firms such as banks and loan lenders and paid for the capital and the interest periodically until they finish repaying all borrowed money. The financial firms lent the money from their assets that gathered as deposits and savings, and took the capital risks such as default. Financial firms clearly understood total loan amount and controlled the capital risks. There were clear limitations of total loan amount, since they depended on the financial firms' assets. To minimize the capital risks, financial firms required at least 10% to 20% of down payment to borrowers and checked their financial back ground thoroughly.

Current complicated system

In mid of 80s, it became obvious that growth of loan demand exceeded the growth of financial assets that the financial firms were able to lend. And the limitation started restricting entire economic growth. To solve this problem, the financial firms started securitizing the loan and selling it to investors. The security that is backed by assets or collateralized by cash flow from loan payments is called the Asset-backed Security (ABS).

Now financial firms found that they were able to lend money as long as investors bought the security and no longer nee to take any capital risk. Instead of the capital risks that financial firms needed to take, investors took market risks and liquidation risks. No capital asset limitation applied to the financial firms. So they started lending money to riskier customer with riskier conditions with higher premium such as 11% APR under the name of subprime loan. They no longer required down payment, and started offering the teaser period that provided introductory lower interest such as 7% for normally 2 years but up to 7 years for the promotion. Once the teaser period finished, the interest rate was reset to higher interest rate such as 11%, as the result, the monthly payment increased drastically.

While upheaval of real estate market from 2003 to 2006, not only lower income family, but also high income investor used subprime loans. Investors who wanted to earn profit from flipping real estates without any cash out from their pocket used these loans instead of down payment. As shown in the Figure-1, number of subprime loans soared dramatically.[1]

Figure-1. Subprime soar in slumping market

Subprime meltdown (Behind the scene)

Now we need to know more in details who take what kind of roles step by step:

1) Loan lenders

Loan lenders sold the loans to other companies called Special Purpose Vehicles (SPV) or Special Purpose Entities (SPE) that are usually subsidiaries of the lenders. Lenders are able to write off the loan assets and count the sales. With the sales, the lenders are able to lend new loans to the new customers without capital limitation and earn service charge. No break of capital limitation applies to them anymore.

2) Special Purpose Vehicles (SPV)

SPV buys pools of loans from a loan lender or loan lenders, securitize them, and sell them to investors. SPV applies two techniques called credit enhancements and tranche in the process to meet investors' demand.

Credit enhancements enable SPVs to improve the credit rating of the securities than its originators. For instance, a SPV whose credit rating is BB is able to issue securities which credit rating is AAA. The major tricks are follows:

a. Excess spread:

If the interest rate of the original loans is 11% and the coupon rate of securities is 6.5%, there is 4.5% of interest rate difference. This is the excess spread. With this spread, SPV is able to keep paying the coupon even some underlying loan payments are late or default.

b. Over-collateralization:

Over-collateralization is a commonly used form of credit enhancement. With this support structure, the face value of the underlying loan portfolio is larger than the security it backs, thus the issued security is overcollateralized. In this manner, even if some of the payments from the underlying loans are late or default, principal and interest payments on the ABS can still be made.

c. Reserve account:

A reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve.

d. Wrapped securities:

A wrapped security is insured or guaranteed by a third party. A third party or, in some cases, the parent company of the ABS issuer may provide a promise to reimburse the trust for losses up to a specified amount. Deals can also include agreements to advance principal and interest or to buy back any defaulted loans.

e. Letter of credit:

With a letter of credit (LOC), a financial institution--usually a bank--is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount.

In addition to the credit enhancement described above, SPV apply a technique called tranche which means slice or section in French.

All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are generally paid sequentially from the most senior (usually Senior Secured) to most subordinate (generally unsecured). For instance