Class: Economic environment
Subject: US subprime crisis and its impact on Polish economy
Date: 18 November 2013
Introduction
In this paper we will try to present the summary of events that led to the US subprime
crisis and analysis of its impact on the performance of Polish economy. We will start with
brief description of the foundations, which resulted in US crisis which transformed into
global financial turnmoil. We take the view that the analysis of the situation in Poland
cannot be conducted without understanding of economic environment in the European
Union – the economic and political block affecting Polish economy in a major extent.
Therefore, we decided to include brief description of Eurozone crisis, which beginning
corresponds with the market volatility caused by the situation in the US. Then based on
commonly used economic metrics we will try to evaluate relative performance of Polish
economy during that time.
US subprime crisis
Until the beginning of 2008 many believed that that the property prices in the US can only
grow with only minor corrective adjustments. This was supported by the trend that was
observed from the mid 70-ies as presented in the schedule below (after Societe Generale
Cross Asset Research, later “SG”).
The idea of constantly growing residential property prices was also supported by the strong
American desire to own a house. One of the most cited statements regarding housing
prices comes from the Fannie Mae’s 2001 Annual Report where its CEO Franklin Raines
stated: “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 1990’s”. Less than a decade later the reality brought the excessive optimism
down to earth.
Interestingly there was a minority, who claimed that housing market may be subject to
speculative bubbles as any other market, especially after Japanese lesson ended up with
lost generation of young overleveraged people who need to pay off their mortgages
substantially exceeding current property value after market collapse. It goes without saying
that these voices remained minority for quite some time.
In order to slightly better understand the systemic foundation for the housing bubble let us
try to look at the home finance evolution in the US. Historically the most popular housing
finance scheme was fixed 30-year mortgage with no prepayment penalties. It means that
the borrower was obliged to pay fixed monthly installments over the life of the loan.
Absence of prepayment fees allowed the borrower to refinance its obligations when
interest rate went down, thus reducing monthly costs of servicing the debt. The
abovementioned characteristics combined with natural cyclicality of the interest rate and
inflation allowed homeowners on an aggregate basis grow out of the debt when their salary
rose.
From the perspective of Savings & Loan Associations popular at a time the situation was
not that positive. S&Ls allowed for asset-liability mismatch on their balance sheets
financing long-term mortgages with short-term funding. When short term interest rates
declined clients refinanced, but when rates increased clients were not entitled to increase
payments. The negative spread between mortgage rates and costs of deposits led to the
collapse of almost half of S&Ls by the end of 80-ties. In order to prevent run o S&L’s the
government insured deposits and created dedicated institutions to buy S&L assets.
The collapse of S&L system fueled development of securitization and increased the role of
government-sponsored entities (GSE). These entities were created for the purpose of
buying and pooling mortgaged loans on the asset side and at the same time issuing
mortgage-backed securities (MBS) on their liabilities side. Very important characteristic of
such structure was the guarantee provided by the GSE to the investors. Given their
government-backed status investors assumed GSEs to be close to risk-free and the only
risk that they were buying was the prepayment risk.
The system worked well because before 1990 GSE used very prudent credit scoring tools,
accepting almost exclusively senior loans with LTV below 80%, good credit scoring of
individuals willing to have their loan in the system and avoiding low quality
neighborhoods. The first major step towards acceptance of creditors with worse credit
history was enabling the creditors to apply for loans in a traditional system with Federal
Housing Administration (FHA) insurance. The FHA loans experienced substantially higher
default rates and GSEs repackaged and securitize them. The FHA loans were introduced as
a political tool to increase home ownership rate and transfer a portion of credit risk from
private to public sector.
The origination business in the subprime market segment was very lucrative and during the
90-ties and the number of credit originators started to increase rapidly. Each major
investment bank acquired credit originator business in order to gain access to the market
generating fees and commissions allowing to recognize substantial profits. It goes without
saying that the fees as well as the spread in the subprime market exceeded traditional
market segment. In the banking industry new portfolios need some time to start
deteriorating, but the decision-makers assumed that even in case of personal financial
distress of the individual creditors the increase in property values on a aggregate basis will
allow homeowners to refinance securing portfolio performance.
Another very important step, which increased the risk was introduction of 2/28 mortgages.
During the first two years the borrower was obliged to pay fixed rate and for the remaining
period the floating rate. From the borrower’s cash flow perspective the product was
