In 2008, the subprime mortgage crisis led to the collapse and bankruptcy of a number of American companies, and the bailout or purchase of others.
The impact of the crisis was not limited to American financial institutions and intermediaries. European and Asian financial institutions were also affected through asset-backed securities (ABS) such as collateralized debt obligations (CDOs). The Asian and European stock markets also mimicked the plunge of the U.S. Dow Jones Industrial Average (DJIA). Investors' risk aversion increased. Liquidity concerns forced central banks around the world to provide ready credit to member banks with looming obligations.
This study covers events that led to the current subprime crisis from March 2007 to September 30, 2008. For an analysis on the crisis's effect on the Philippine stock market, we present data up to October 27, 2008, when the Philippine Stock Exchange (PSE) experienced a circuit break after losing 10 percent of the PSE composite index (PSEi) value within one trading session. Notwithstanding the trading halt, the PSEi closed 12 percent lower that day. An update of events affecting Philippine markets and institutions up until March 2009 is also provided.
The research proposes lessons from the crisis for Philippine financial markets and institutions. We evaluate existing financial market regulation and policy responses, and conclude with recommendations to further minimize the adverse impact of similar crises in the future.
THE SUBPRIME CRISIS
After the burst of the dot com bubble and the terror of September 11, 2001, the Federal Reserve slashed interest rates. Borrowers were offered enticing introductory non-traditional mortgage schemes. Initial loan payment schemes were purely 'interest-only' with principal repayments to be made at a latter part of the loan period. The U.S. home ownership rate rose from 64 percent to 69 percent during 1995-2005, about 0.5 percent per year. Home prices appreciated because of increased demand.
As demand for subprime loans grew, financial institutions sought to remove risky assets from their balance sheets. Banks learned to offload subprime loans through securitization. Mortgage originators combined the riskiest subprime mortgages with other types of debt and created structured credit products like mortgaged backed securities (MBS) and collateralized debt obligations (CDOs). Special purpose vehicles (SPVs) and structured investment vehicles (SIVs) were set up to purchase risky loans from banks. SPVs issued CDOs and subprime residential mortgage backed securities (RMBS) in separate tranches with different credit ratings to meet varying investor risk-return tradeoff requirements. Outstanding RMBS grew from USD52 billion in 2000 to USD449 billion in 2005, a 763 percent increase over five years (Moore & Brauneis, 2008; Neal, 2008).
In early 2006, interest rates on 30-year fixed rate mortgage (FRM) was at 6.76 percent while the interest rate on 1-year adjustable rate mortgage (ARM) reached 5.79 percent. Higher interest rates led to: 1) borrowers' difficulty in refinancing mortgages; 2) fewer new loans; 3) subprime borrower defaults and increased foreclosures; and 4) falling property prices due to decreasing demand. To ease subprime borrowers' credit problems, the Fed lowered interest rates, with mortgage rates following suit. The 30-year FRM moved only slightly, from 6.1 percent in December 2006 to 5.92 percent in April 2007, and interest rates for one-year ARMs slid from 5.5 percent in December 2006 to 5.19 percent in April 2008 (Moore & Braunes 2008; Neal, 2008).
By August 2007, the effects of subprime loan delinquencies began to show. A liquidity crunch ensued as U.S. investment banks and other institutions incurred losses. Access to credit within financial institutions tightened as banks chose not to lend to peers due to the growing risk of counterparty default. …