OUR PRINCIPLE: The so-called ‘credit crunch’ is an unintended consequence of the rise in subprime lending that has accompanied record homeownership rates. The resulting strain that has been placed on the world’s credit markets has created anxiety for investors. The Federal Reserve has taken several steps to address this pressing issue and is prepared to act as needed.
Over the last decade or so, with low interest rates, a competitive marketplace, and various government policies encouraging homeownership, a record number of Americans have had the opportunity to purchase homes. Many consumers were able to purchase and use the equity in their homes because of the subprime lending market, which provides millions of Americans with credit that they may not have otherwise been able to obtain.
- These borrowers rely on the subprime market, which offers more customized mortgage products to meet customers’ varying credit needs and situations. Subprime borrowers pay higher rates and servicing costs to offset their greater risk.
- Nationally, subprime mortgage originations have skyrocketed since the early 1990s. In 1994, just $34 billion in subprime mortgages were originated, compared with over $213 billion in 2002 and $665 billion in 2005.
- The proportion of subprime loans compared with all home loans has also risen dramatically. By 2002, the share had risen to 8.6 percent, and by the fourth quarter of 2006, the share had grown to 12.75 percent.
We are witnessing a period of market correction as many of the homeowners who took advantage of these loan products are now having difficulty paying them back. As a result, some lenders have been forced out of business and others have stiffened their lending standards.
- Currently there are about 13 million so-called subprime loans, and roughly five percent of them are entering foreclosure according to the Mortgage Bankers Association.
- The Center for Responsible Lending has said that 19.4% of all subprime loans issued during 2005-2006 would default.
- Lehman Brothers (LEH) issued an equity research report in late December predicting that 30% of the subprime loans issued in 2006 would go into default.
The increase in subprime lending has in some instances given rise to abusive lending practices that have been targeted at more vulnerable populations.
- Known as “predatory lending,” these abusive practices include excessively high interest rates and fees, balloon payments, high loan-to-value ratios, excessive prepayment penalties, loan flippings, loan steering, and mandatory arbitration. Both regulators and lawmakers have appropriate roles to play in cracking down on such practices.
- At the same time, there are going to be situations where families who take out mortgages are unable to repay them and may end up losing their homes. While this is unfortunate, it is a reality of the market.
The Federal Reserve has taken definitive action to remedy this situation, and is prepared to act as needed going forward.In addition to adding more than $120 billion in liquidity into the banking system, the Fed cut its discount rate – which covers loans the Fed makes to banks – by half a point, to 5.75 percent.
- “The central bank on Aug. 17 cut the so-called discount rate half a percentage point to 5.75 percent to direct more cash to companies starved for short-term financing while avoiding an emergency reduction in its broader lending-rate target. Banks can borrow at the discount rate with a wide variety of collateral, including everything from mortgages – the market that sparked the credit crunch after defaults rose to the highest in five years – to municipal bonds.” (Bloomberg News, 8/22/07)
- The world’s premiere financial institutions – including the nation’s four biggest banks – have already demonstrated the effectiveness of the discount rate cut: “More banks have stepped forward and said they have availed themselves of the Federal Reserve’s discount-lending rate cut amid the credit market’s turmoil last week. The four biggest banks in the United States – Citigroup, J.P. Morgan Chase, Bank of America and Wachovia – said that they each borrowed $500 million through the so-called discount window by taking out loans directly from the Fed.” (The New York Times, 8/22/07)
Underlying indicators speak to the overall health of the U.S. economy.Our economy – the greatest engine of opportunity and prosperity in the world – has demonstrated its resilience time and again over the last six years.
- The Conference Board announced this week that its index of ten leading economic indicators rose nearly half a percent for July after falling the month before. (Release, 8/20/07)
- Economic growth increased at an annual rate of 3.4% in the spring, well above the 0.6% rate first reported. (CNNMoney.com, 7/27/07)
- The U.S. economy has added jobs for 47 straight months, with more than 8.3 million jobs created since August 2003. (The White House, 8/3/07)
- Treasury Secretary Henry Paulson: “We've got a very healthy economy. What's going on right now in the capital markets will in all likelihood take a penalty, take a toll out of economic growth, economic growth will be less than it ordinarily would have been but it is my view that the underlying economy remains healthy and I expect to see the economy continue to grow, to create jobs, and to raise the standard of living.” (CNBC’s “Squawk on the Street,” 8/21/07)
NOTE: Much of the material in this document is courtesy of the Financial Services Committee.
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