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CURRENT ISSUES IN INTERNATIONAL & OFFSHORE BANKING GB 30403

What Causes Subprime Mortgage and Its Effect Toward Caribbean?

1.0 Introduction

The United States (US) economy has experienced its worst financial crisis since the
Great Depression. The financial crisis started in the home mortgage market,
especially the so called subprime mortgages, and is now spreading beyond
subprime to prime mortgages, commercial real estate, corporate junk bonds, and
other forms of debt. Total losses of US banks could reach as high as half of the total
bank capital, which would lead to a sharp reduction in bank lending, which in turn
could cause a severe recession in the US economy. The financial crisis distressing
the US economy would have already embarked the Caribbean into an economic
blackout. It is uncertain that this will happen but the external undulations of the
financial crisis in the US will cause an economic depression in the Caribbean(Smith,
2008).

The objective of this paper is to study and determine several key factors, which
are:
1. To understand what is subprime mortgage.
2. To understand how the subprime mortgage occurred in United States
3. To understand and identify what is the causes of subprime mortgage
4. To understand and identify what is the effect of subprime mortgage toward
Caribbean
5. To determine how to solution the subprime mortgage

2.0 Brief History in Subprime Mortgage Crisis
The subprime mortgage crisis of 2007 originated from the US subprime mortgage
market developed into a global financial crisis in 2008. Basically, banks lent too
much money to people who were unable to repay their debt. However due to the
close collaboration of world banks and Hedge Funds who make subprime mortgage
backed securities, the crisis leads to worldwide liquidity crisis.

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This starts whenmortgage lenders sanction loans to the borrowers who are not
mortgage
qualify for mortgages at market rates. These mortgages have easy initial payments
but it includes adjustable rates of interest if the market changed. During the time
when housing prices were increasing, several borrowers took on difficult mortgages,
s
thinking that as the value of their homes increased and they will be capable of
refinancethe properties (Smith, 2008) Unfortunately, the borrowers start to default
Smith, 2008).
on the home loans payment because it was expensive when the interest rate
increased rapidly.

Furthermore the borrower unable to refinance the properties as the housing
bubble came to an end. The property value also diminished. Consequently, the
lenders were unable to regain the money that they had invested previously on the
money
properties.

Graph 1: Housing Activity Drops Off

Sources: National Association of Realtors; Census Bureau; authors’ calculations

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Graph 1 describes that after booming the first half of this decade, US housing
activity has economized suddenly. DiMartino & Duca (2007) stated that the single-
family buildings authorities to have plunged 52 percent and existing-home sales
have dropped 30 percent since their September 2005 summits. An increase in
mortgage interest rates that started in the summer of 2005contributed to the housing
market's early weakness. By late 2006, though, certain signs pointed to improved
stability. However, they proved short-lived as loan-quality problems generated a
tightening of credit standards on mortgages, mainly for newer and riskier products.
The lenders reduce lending loan and the housing activity began to falteronce more
in spring 2007, accompanied by additional increases in delinquencies and
foreclosures. By late-summer financial-market disorder stimulated further
strengthening of mortgage credit standards.

3.0 What is subprime mortgage?
Subprime mortgage is a mortgage initiate of an asset to a creditor as security for a
loan to purchase the property or assets.The subprime mortgage crisis is a constant
financial crisis caused thru a dramatic escalation in mortgage negligence and
foreclosures in the United States, with major adverse effects on the banks and
financial markets all over the world. The crisis started in the year 2007 and has
revealed pervasive weaknesses in financial industry regulation and the global
financial system. Subprime mortgage is a financial innovation that normally occurs in
the situation which is relevant to the roots of subprime mortgage lending and the
existence of previously underserved borrowers and investors, the substance of
advances in technology and encouraging regulatory environment (Jaffee, 2008).

Furthermore, subprime mortgages are unsafe to the creditors and borrowers due
to the combination of high interest rates, bad credit history, and not clear about
personal financial situations often related with subprime applicants (Dell’Ariccia, Igan
and Laeven, 2009). The subprime mortgage market offers an almost ideal ground
for testing such theories because it is a less advanced credit market with significant

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informational irregularities. The USA financial crisis has a link between credit
growths and lending standards in the subprime mortgage market and also identifying
modifications in the structure of local credit markets as issues increasing this decline
in lending standards (Dell’Ariccia, Igan and Laeven, 2009).

Generally subprime mortgages would have an excessive risk of assessment
rating. However once the mortgage bundles got approved by other lenders, the
rating agencies offered these risky subprime mortgages a low risk rating.
Consequently, the financial system refused the extent of risk in their balance sheets.
These mortgages had an introductory duration of one to two years of very low
interest rates. At the end of this period, interest rates elevated. In 2007, the US was
required to raise the interest rates due to inflation. This approach showed that the
mortgage payment was very expensive.

On the other hand, many homeowners who had removed mortgages 2 years
earlier right now encountered ballooning mortgage payments as their introductory
period ended (Pettinger, 2011). Homeowners also encountered lower disposable
income due to developing health care costs, increasing petrol and food prices. This
triggered a rise in mortgage defaults; several new homeowners were unable to
afford mortgage payments. “A study in 2007 shows the monthly payments for 60%
of the total adjustable-rate mortgages created since 2004 will boost up by 25% of
more” (Sugunendran, 2008). These defaults indicated the end of US housing boom.
US house prices began to drop which started more mortgage problems. For
example, people with 100% mortgages now encountered unfavourable equity. It
signified that the loans were no longer secured (Pettinger, 2011). Even if the people
did default, the bank couldn’t ensure to collect the initial loan. A variety defaults
prompted many medium sized US mortgage companies to bankruptcies.

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Figure 1: New Model of Mortgage Lending

Source: BBC News

According to the Figure 1, The Traditional model Lending where banks grant
mortgage to the home buyer and the home buyer pays back to the bank but in the
subprime model lending bank sell mortgage bond to the mortgage bond market.
From this the bank obtains credit to grant mortgage to the home buyer. Than this
Th
home buyers pays back to the bank and the banks will pay back to the bondholders.
If one of them default any of the payment everyone will start defaulting the payment
because it is a domino effect.

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4.0 Subprime mortgage in United States
The subprime mortgage collapse which spread throughout the US economy and into
international markets. US mortgage lenders sold many inappropriate mortgages to
customers with low income and bad credit history record. It was estimated with a
booming housing market, the mortgages will remain economical. Nevertheless,
probably there were careless controls in the sale of mortgage products. The
mortgage brokers was paid for selling a mortgage because there was a benefit to
sell mortgages no matter if they were overpriced and might have high possibility of
default (Pettinger, 2011). In order to sell more profitable subprime mortgages where
mortgage companies included the debt into consolidation packages and sold the
debt to other finance companies. In other terms, mortgage companies borrowed in
order to lend mortgages. The lending was not financed through saving accounts, for
example. These mortgage debts were purchased by financial intermediaries. This
was to spread the risk but conversely it only just spread the dilemma.

Generally subprime mortgages would have an excessive risk of assessment
rating. However once the mortgage bundles got approved by other lenders, the
rating agencies offered these risky subprime mortgages a low risk rating.
Consequently, the financial system refused the extent of risk in their balance sheets.
These mortgages had an introductory duration of one to two years of very low
interest rates. At the end of this period, interest rates elevated. In 2007, the US was
required to raise the interest rates due to inflation. This approach showed that the
mortgage payment was very expensive.

On the other hand, many homeowners who had removed mortgages 2 years
earlier right now encountered ballooning mortgage payments as their introductory
period ended (Pettinger, 2011). Homeowners also encountered lower disposable
income due to developing health care costs, increasing petrol and food prices. This
triggered a rise in mortgage defaults; several new homeowners were unable to
afford mortgage payments. “A study in 2007 shows the monthly payments for 60%
of the total adjustable-rate mortgages created since 2004 will boost up by 25% of
more” (Sugunendran, 2008). These defaults indicated the end of US housing boom.

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US house prices began to drop which started more mortgage problems. For
example, people with 100% mortgages now encountered unfavourable equity. It
signified that the loans were no longer secured (Pettinger, 2011). Even if the people
did default, the bank couldn’t ensure to collect the initial loan. A variety defaults
prompted many medium sized US mortgage companies to bankruptcies.

Nevertheless, the losses weren’t confined to mortgage lenders. According to
Pettinger (2011) many banks lost billions of pounds during the bad mortgage debt
they had bought off US mortgage companies. Banks were required to write off large
losses which made them afraid to make any further lending, mainly in the now
dangerous subprime sector. The effect was worldwide which became very difficult to
increase funds and borrow money. Therefore, the cost of interbank lending has
increased significantly. Probably this made it very difficult to borrow any money after
all this. The markets dried up, hence impacted many firms who had been under the
subprime lending. It squeezed so many firms who now have difficulty borrowing
money. For example, biotech companies depend on ‘high risk’ investment and are
now unable to obtain sufficient funds (Pettinger, 2011). The slowdown in borrowing
has contributed to a slowing economy for the possibility of recession in the US.

It is anticipated that this subprime mortage might eventually last for a long time
due to house prices are still decreasing in the US, sinking the value of mortgage
loans. Several homeowners still encounter escalating interest rates, when their initial
periods come to an end. It also was difficult to recoup confidence in the financial
markets and the recession in the US and global downturn could cause a further rise
in bad loans.

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5.0 Causes of Subprime mortgage crisis
The subprime mortgage was first known early in 2007 however never really made its
appearance and in the later parts of 2007 leading to 2008, where it burst out and
caused significant damage to economies all over the world. There are various
causes however the subprime mortgage started in 2008.

5.1 Increase of housing bubble
The value or price of the US house amplified by 124% around 1997 and 2006
which allowed a lot of borrowers to be able to refinance their homes at lower
interest rates, and remove second mortgages secured by the price
appreciation (CrisisSite.com). However this collection of money
approximately doubled in amount, income generating from the investments
were unable to increase quickly.By 2003, the supply of mortgages begin at
traditional lending standards had been vanished entirely.

Graph 2: Subprime Mortgage Origination

Source: T2 Partners, LLC

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Furthermore strong demand regarding about Mortgage-backed security
and collateralized debt obligations started to drive down lending standards
which results it was difficult to maintain this speculative bubble. According to
the CrisisSite.com website by 2008 in the graph 2, there was a drop over
20% in the average US housing value.

5.2 The Waning of the Housing Market
Subprime mortgage caused by shrinkage in the market prices of previously
overinflated assets and defines the financial crisis that results from the drop
of prices. It is because of oversupply of housing stock, refinancing became
harder and the adjustable rates on mortgages kicked in, unleashing a wave of
defaults and foreclosures (Smith, 2008).The housing market which was a
great stimulating market of the US economy dropped to 5.25 million in 2007
as the average sales price dropped up to 4.2 percent with $211,700 (British
Broadcasting Corporation, 2007). This crucial decline in the housing market
triggered to an increase in the mortgage rates and homeowners found it very
difficult to obtain mortgages and change their homes using mortgages.The
effects of this were experienced beyond the regions of the United States due
to the credit risk no longer endure solely with US lenders however had been
transferred to investors all around the world (Smith, 2008).

5.3 The reckless and excessive lending
The reckless and excessive lending of subprime mortgage cause huge losses
for investors and lender’s the loans turn bad and the level of harmful debt
becomes obvious (Australian Property Forum, 2010). Banks might then
control the debt and increase the cost of debt by raising mortgage rates or
some other commercial rates. In critical cases, lenders were incapable of lend
money even though they wish to, because of their previous losses. There are
many factors identified which tend to cause lenders to prevent and reduce
their lending process. This resulted due to observation of bankruptcy risk in

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other investors and banks as well as the changes to monetary policy. At the
same time, governments may enforce new debt controls on the financial
system. BBC News (2007) stated that Washington Mutual is closed by US
government the largest failure of a US bank. Its banking assets are sold to
J.P Morgan Chase for US $1.9 billion.

5.4 Subprime lending
According to CrisisSite.com website there was a dramatic growth in U.S.
Subprime lending in the year 2004 to 2006. The borrowers with a bad credit
history faces a greater risk of defaulting loan than prime borrowers, made
good use of the easy credit regulation. This higher-risk lending also became
one of the main causes of U.S. subprime mortgage. For example, Bear
Stearns is US investment banks which controlled by Wall Street for
generations. BBC New (2009) stated that before the subprime mortgage
crisis, the bank had a market capitalization of $17 billion, assets under control
of $385 billion, and labor force of 15,000. The company had financed in sub-
prime mortgage instruments heavily and other securities which are extremely
risky and have collapsed suddenly in value.

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Graph 3: Falling Value Market Capitalization of Bear Stearns

Source: NYSE

BBC New (2009) also stated that the collapse of its share price, from a
highest of $169 decline to $2, which means it, has losses beyond 98% of its
value in the stock market due to the subprime mortgage crisis. In graph 3
crisis
shows that in 17 March 2008 Bear Stearns was bought by larger competitor
Stearns
JP Morgan Chase for $240m in a deal backed by $30bn of ce
central bank
loans.

5.5 The Central Banks Policy
Moseley (2009) stated that t
the laws were modified and enforcement made
ere mad
the financial system to grow weak. BBC News (2007) stated that the US
t
central bank, the Federal Reserve, has made a dramatic involvement in
financial markets by reducing rates to 4.75% from 5.25% to prevent the US
economy which is already slowing downthis can be seen in the graph below.
downthis

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Graph 4: US Interest Rates

Sources: US Federal Reserve

The governments and central banks will react to the financial slowdown by
reducing interest rates rapidly and presenting risky asset market stimulus.
This stimulus might be financed by the getting hold of consta
constantly more
government debt. When the central banks managed badly, this will result to a
renewed debt bubble even greater in quantity than the prior one (Clair &
Tucker, 1993).

6.0 Effect of Subprime mortgage toward Caribbean
When the subprime mortgage rises there is a reduction in availability of the credit
and thisresulted downturn on the economic which cause a major effect on the world
resulted
economy. The transmission of several impact of United States subprime mortgage
crisis on Caribbean economic growth are trade, tourism, remittances, finance and
Foreign Direct Investment (FDI).

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6.1 Trade
The failing of household consumption and business investment would directly
initiate a decrease of demand in the United States for foreign goods and
services. Such decreases are felt by countries with a huge share of their
exports to the United States (ECLAC, 2007). In 2006, 51% of the Caribbean
Community’s total exports of goods went to the United States market
(Economy Survey, 2008). It was significant for Caribbean countries that are
reliant on exports to progress their current account balances and foster
productive employment and growth (ECLAC, 2007). During the period from
2002 to 2006, Caribbean countries among the largest share of their exports to
the United States market are Bahamas, Belize, Trinidad and Tobago and St.
Kitts and Nevis with export percentages reaching from 32% to 62% (Economy
Survey, 2008). Therefore, these countries are affected by a slowdown in the
United States economy.

6.2 Tourism
Based on ECLAC (2007), tourism is a main revenue earner for a lot of
Caribbean countries subsidizing approximately 17 percent of GDP in
countries for instance the Bahamas and representing 60% of service export
of the Eastern Caribbean Currency Union (ECCU). About 29.9 million United
States outbound travellers, the Caribbean received 5.7 million or 19.2 percent
in 2006 (Economy Survey, 2008). The undesirable incomes results from the
subprime crisis and increased uncertainty because of recession.
Consequently it able to reduced travel demand from the United States and
affects the tourism sector. Besides that, the cost of travel is expensive as the
escalation oil prices that discouragement on travel (ECLAC, 2007). The
ECCU countries show extensive tourism sectors prior to aggregate output
than the other CARICOM countries. It might be most affected. During the
period 2002 to 2006, Anguilla, Antigua and Barbuda where the tourism was
reported for 23.6 percent and 21.7 percent of GDP (Economy Survey, 2008).
However, in the other countries the statistics are lesser approximately 8.8

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percent in Grenada to 15.8 percent in Saint Lucia (Economy Survey, 2008).
However, ECCU data for the first quarter of 2008 shows that an overall
improve in the number of visitors by 10.9% when compared with the first
quarter of 2007 about 4.1% (Economy Survey, 2008).Therefore, this appears
the tourism industry has not yet been negatively suffering from the slowdown
in the United States and that any impacts are commonly experienced during
the last quarter of 2008 (ECLAC, 2007).

6.3 Remittances
The Remittances because of the economic recession and the downfall of real
estate prices the construction sector which hires a huge number of
immigrants has been decreased. The remittance flows to the Caribbean
which including Cuba and Republic but however eliminating Belize, Guyana
and Suriname that is US$8.3 billion in 2006 (Economy Survey, 2008).
Remittances towards the country were mainly from the United States followed
by Western Europe. States like California, New York and Florida were the
main remittance states, thinking that the Caribbean has the same effect to
Latin America (ECLAC, 2007). The leisurelier job market and a housing-led
recession will then have a crucial effect on remittances when reduction of
jobs and limited income impact on immigrant home owners will transform into
less or no money to remit (ECLAC, 2007). During the period from 2003 to
2007, the effects of the slowdown in remittances are experienced especially
by the rural population in several Caribbean countries mainly in Guyana and
Jamaica even though remittances constituted 20.3% and 14.7% of GDP
(Economy Survey, 2008).

6.4 Finance and Foreign Direct Investment (FDI).
The United States economy has effect on Caribbean financial institutions.
Financial assets are less uncertainty rather than they were years ago and
several countries where involving Barbados which are approaching
investment status level (ECLAC, 2007). Besides that, the constant decline in

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interest rates in the United States creates the country attractive to capital
inflows to trigger the growth of asset prices. Conversely, entities like certain
central banks, commercial banks and others with investments and reserves
which are United States dollar denominated will definitely suffer capital losses
because of the devaluation of the dollar (ECLAC, 2007). The high levels of
uncertainty and the persistent bad update in the economy have triggered
foreign investors and creditors to anxiety financing which lead to in a credit
crunch. However most significantly, would the financial crisis get worse in the
United States as some experts fear, it will badly affect the global financial
system harming especially the other financial services reliant on Caribbean
countries (ECLAC, 2007). When it comes to ECCU countries, the weight of
the financial sector is higher in Anguilla that is 18.3 percent of GDP, St. Kitts
and Nevis are 14.1% and Dominica is 13.7 percent (Economy Survey, 2008).

7.0 Recommendation
As the Caribbean is actually uncertain to avoid the effect of a United States
recession, the following recommendations are targeted by permitting a soft cushion
towards this recession and expansion or reduce the potential reduction in economic
growth are:

7.1 Analysis other industry for their highest trades
To soften the effect of reduced import demand from the United States.The
CARICOM countries must analysis other industry for their highest trades. For
example, Trinidad and Tobago has to consider the trade of oil and gas to
China, Japan and India, where as Jamaica and Suriname must consider the
trade of bauxite and alumina to Canada and Europe (ECLAC, 2007).
However, there is required to develop the intraregional trade among
CARICOM countries by provided the statistic that intraregional trade in
domestic trades approximately 16 percent during the period 2004-2006, while
domestic trades to the United States about 52 percent during the same period
(ECLAC, 2007).

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7.2 Maximize their comparative advantage when it comes to their
geographical place
To reduce the downside effect on the tourism sector.The CARICOM countries
have to maximize their comparative advantage when it comes to their
geographical place. When compared with Europe and Asia, the Caribbean is
just five hours from the United States by air transportation and this gives an
opportunity for more reasonable and affordable tourism (Economy Survey,
2008). The low cost packages are commonly offered competitively in the
United States. The strength of the Euro currencies provides an excellent
opportunity to attract tourists from Europe which improves the aggressive
marketing (ECLAC, 2007).

7.3 Create a sustainable employment opportunities
There is a serious requirement for Caribbean governments appeared to be
proactive in creating sustainable employment opportunities, mainly for
individuals highly depending on remittances. The variation of the export
basket moving towards further value added items to increase employment
opportunities for Caribbean residents in the country thru the vertical
integration of industries associated to take advantage of resources (ECLAC,
2007). This will necessitate for active industrial policies on the Caribbean
governments.

7.4 The diversification of foreign reserves
The major consideration obviously is to provide the diversification of foreign
reserves through the country’s central and commercial banks. Reserves must
not only persist on United States dollar denominated but should include
combination of some other world currencies like the Sterling Pound and the
Euro (ECLAC, 2007).

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8.0 Conclusion
As a conclusion, we can bind that the subprime mortgage has been caused by
several reasons which had impacted the economy, financial institutions and
businesses operating within the economy quite severely; and this left with
considerable aftereffect to many. The main causes of the 2007 subprime mortgage
were identified as the increasing of housing bubble, the waning of the housing
market, reckless and excessive lending, subprime lending and Central Bank policy
while the effects of the subprime are quite critical for both the short and the long run.

The major effects of subprime mortgage toward Caribbean are trade, tourism,
remittances, finance and Foreign Direct Investment (FDI). The method and policies
that are being applied by Caribbean governments be determined bythe number of
factors. The countries that have advantage from commodity booms that permitted
them to accumulate financialreserves and international reserves are in a positive
position. The regulatory bodies and central banks also should plan a guiding
structure and a list of rules for precautions.

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9.0 References

Australian Property Forum. (2010, December 23). Retrieved January 27, 2010, from
The Credit Crunch Explained:
ustralianpropertyforum.com/blog/entry/3200746/4773/

BBC News. (2007, September 18). Retrieved 17, 2012, from Fed cuts interest rate
to 4.75%: http://news.bbc.co.uk/2/hi/business/6999821.stm

BBC News. (2009, August 7). Retrieved February 16, 2012, from Timeline: Credit
Crunch to downturn: http://news.bbc.co.uk/2/hi/7521250.stm

British Broadcasting Corporation. (2007, October 24). Retrieved February 2012, 24,
from Sharp Decline in US Housing Sales:
http://news.bbc.co.uk/2/hi/business/7060346.stm

Clair, R., & Tucker, P. (1993). Six Causes of the Credit Crunch. Economic Review,
1-20.

CrisisSite.com. (n.d.). Retrieved February 21, 2012, from Causes Of American Debt
Crisis: http://www.crisissite.com/answer-main-american-debt.html

Dell’Ariccia, G., Igan, D., & Laeven, L. (2009). Credit Boom And Lending Standards:
Evindence From The Subprime Mortgage Market. European Banking Center
Discussion Paper No. 2009–14S, pp.1-44.

DiMartino, D., & Duca, J. (2007, November). Federal Reserve Bank of Dallas.
Retrieved January 31, 2012, from The Rise and Fall of Subprime Mortgages:
http://dallasfed.org/research/eclett/2007/el0711.html

ECLAC. (2007). Retrieved April 13, 2012, from ECONOMIC SURVEY OF THE
CARIBBEAN :
http://www.eclac.cl/portofspain/noticias/noticias/8/32418/TheUnitedStatesSubpri
meMortgageCrisisanditsImplicationsfortheCaribbean.pdf

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Economic Survey. (2008). Retrieved April 13, 2012, from ECONOMIC SURVEY OF
THE CARIBBEAN: http://www.eclac.cl/publicaciones/xml/4/30224/L.138.pdf

Jaffee, D. M. (2008). The U.S. Subprime Mortgage Crisis: Issues Raised and
Lessons Learned. pp.1-50.

Moseley, F. (2009, April). International Socialist Review. Retrieved January 30,
2012, from The U.S. economic crisis: Causes and solutions:
http://www.isreview.org/issues/64/feat-moseley.shtml

Pettinger, T. R. (2011, March 12). MortgageGuideuk.co. Retrieved February 4,
2012, from Credit Crunch Explained:
http://www.mortgageguideuk.co.uk/blog/debt/credit-crunch-explained/

Smith, G. (2008, September 24). How the US Financial Crisis Impacts the
Caribbean.

Sugunendran, S. (2008). CreditCrunchDestroyer.com. Retrieved February 8, 2012,
from An Overview of the Credit Crunch:
http://creditcrunchdestroyer.com/articles/credit-crunch-an-overview/

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