Introduction
The year 2007-08 brought nightmares for the US economy and its participants because least anyone had expected that the world’s biggest economy will cripple and face the worst ever recession after the Great Depression of 1929-1930. While Wall Street lost more than trillion dollars in value, thousands of Americans were left unemployed and the businesses, even the one who had more than 100 years of their presence in the United States, were filing for bankruptcy. On the other hand, Federal Reserve Bank, which once cited economic bubble as the natural event that cannot be prevented( courtesy the ideology of the then Fed Chairman, Alan Greenspan), was now paying the price as every economic policy was turning impotent and the entire US economy was witnessing the financial carnage. Needless to say, the effect of this economic carnage was felt throughout the globe for years, while many nations are still trying to recover from the dismal situation imposed by the economic crisis.
While we all agree and must be aware that the central element of the financial crisis was the housing bubble, however, the real cause of such a widespread effect of the financial crisis was the irrational exuberance surround this bubble in the form of cowboy financing practiced by the financial institutions, both commercial banks and the securities firm, in the name of financial innovation, that led the US economy into so much trouble.
In this essay, we will describe how the irrational means of financial innovation adopted by the financial institutions and their greed of earning short-term gains while ignoring the long-term detrimental effect on their existence, fueled the financial crisis in the economy while forcing many of the financial institutions to file for bankruptcy and eventually crash in a way that placed unprecedented strain on the country’s financial system.
Literature View
The financial crisis of 2007-08 had brought in a lot of attention of the academicians, institutions and even global organizations, who were willing to evaluate the reason that proliferate the effect of the financial crisis to such an extent and how financial institutions violated all the ethical principles and opted for an incentive structure that placed an enormous premium on short-term profits, but at the expense of long-term profit and in this case, at the expense of the whole economy.
For instance, International Monetary Fund(IMF) cites that the financial institutions were highly optimistic about the asset prices and the risk profile they held. Moreover, these institutions were further lulled by a low interest rate environment and changes in the financial landscape that allowed them to mask the leverage amount and the risk embedded in their capital structure, because of which they eventually faced the flak in the form of bankruptcy and shut downs. In another research paper authored by Antonio Argandona, who performed his research work from the ethical dimensions involved within the financial institutions, the researcher’s point of view as very straightforward as he blamed that excessive reliance on securitization, that allowed the financial institutions to transfer the ownership of the mortgage loans to other parties, created an incentive environment for these institutions to distort the true value of mortgage assets and the level of risk embedded in it. This, coupled with lack of transparency, also affected the solvency and the existence of the financial institutions and other corporations that were connected as the counterparties to the operations of these financial institutions.
Additionally, Dean Baker, who was one of the first researchers to issue a research paper on the causes of the financial crisis, cited the presence of incentive structure within the financial institutions and weak regulatory reforms as the reason that encouraged these institutions to adopt the risky behavior. It is considerable that the biggest income for the corporate flowed in the form of fees, which they had generated by issue of mortgage securities. In 1996, the financial sector accounted for 16 percent of the total corporate profits, but this percentage increased to 30 percent by 2006. However, a significant portion of these profits were illusionary because these profits were fees on the transactions that eventually lead to large losses for the companies.
Discussion and Analysis
We might have noticed that all of the literature evidence we discussed above, signals toward over-optimistic attitude of the financial institutions that the bubble will continue to inflate forever, and their high-risk instruments to benefit from the fueling bubble, which had no fundamental support for it and was just growing on the speculative basis. To understand as what were the problems associated with the financial institutions that eventually imposed a threat to their existence, we have divided this section illustrating the real causes:
- Support to the growth of Sub-Prime Mortgage Market by commercial banks
Following the burst of the decade long dot-com bubble in the US, the US economy was suffering from negative economic growth as business continued to shed jobs throughout 2002 while consumer spending was reaching record lows. As a result, with a quest to boost the economic stimulus, Federal Reserve eased the monetary policy decreasing the interest rates to 50-year low, at 1% during June, 2003. Accordingly, the commercial banks followed the interest rate path and slashed the mortgage interest rates to 5.25% during 2003.
The record low mortgage interest rates accelerated the demand for mortgage loans as individuals and the institutions were now willing to be part of the increasing real estate prices, which had increased by 7.1% annually from 2002 to 2006. As the housing prices grew out of line with the fundamentals, rather than being alarmed by the situation, commercial banks adopted so called financial innovations to support this growth and pocket in the profits. The two most important aspects of this non-sophisticated growth was the unprecedented growth of sub-prime market and securitization. Important to note, with the quest to add more mortgages to their portfolio, commercial banks relaxed their lending standards and allowed the sub-prime mortgage market to explode. Important to note, sub-prime mortgage loans are issued to borrowers with poor credit history or the one with a non-stable employment record or who had defaulted on his loans in the past. The interest rates on these loans were two to four percent higher than the one for other mortgage buyers.
It is considerable that while sub-prime mortgage had always been part of the mortgage portfolio of the commercial banks, however, this time, it was different because of misplaced incentives involved in the sale of mortgage financing and the appraisal of the mortgage application. Important to note, as soon as the banks receive mortgage application, they pass on the appraisal activity to independent contractors for individual appraisal of the house property being considered by the application. In the years prior to the era of the housing bubble, commercial banks always seek an honest appraisal from the appraisers and be sure that the house that will serve as collateral for the mortgage loan is having sufficient value to cover the value of the mortgage loan. However, as soon as the commercial banks witnessed record applications for mortgage loans, they relaxed their lending standards and also the appraisal process. In any case, mortgage issuers wanted to be sure that the appraisals are high enough to justify the mortgage, and eventually asked appraisers to inflate the appraisal value of the house because if they do not adhere to the requirement of the mortgage issuer, their contract with the bank will be terminated. Henceforth, commercial banks forced the appraisers to adopt a high-side bias in their appraisal.
The relaxed lending standard soon gave the opportunity to the sub-prime borrowers to be the part of the housing bubble knowing that the banks will issue them loans in any case. In many cases, it was also found that while many commercial banks issued mortgage loans without complete documentation or income-proof, other issued loans to the full value of the appraised property, thus requiring no down-payment for the mortgage borrowers at all. Similarly, some of the commercial banks were issued as interest-only loans as part of which, the borrowers were only required to meet interest payments on their mortgages. In short, commercial banks created a whole environment of cowboy financing where they exploded the sub-prime mortgage market, which were nothing but a whole portfolio of liar loans, which could bombard any time owing to high loan to asset value. The share of subprime loans in the mortgage market exploded from 9 percent in 2002 to 25 percent in 2005, and reaching up to 40 percent at the peak of the housing bubble. Ironically, it will be incomplete to suggest that commercial banks did that all on their own because it is very much evident that the explosion of subprime mortgage loans should have given sufficient evidence to the regulators and at least, Federal Reserve that commercial banks are building a serious problem for the regulators because during 2002 to 2004, even when the labor market remained weak and wages lagged behind inflation, the number of credit worthy people more than doubled.
-Securitization
A nascent reader of the financial crisis will always wonder at why the commercial banks were taking such a high risk by adding more and more sub-prime mortgage loans in its portfolio. Ironically, commercial banks were earning money by issuing mortgages and not holding as they were shifting the risks to other third parties through a process called securitization. In fact, the reason because of which the commercial banks were asking the appraisers to inflate the house values were because as soon as the banks issued mortgage loans, they used to bundle these loans as a financial security and then sold it in the fixed income market to the securities firm. Stated otherwise, it was the securitization process that gave incentive to the commercial banks to approve risky mortgages where they knew that there is a high probability of default. However, they were least concerned as eventually, they were selling these loans to securities firm in the form of derivative securities, and the only thing that they had to ensure that mortgage, at least on papers, appears to be of sufficient quality to be sold to third parties in the secondary market.
One such example of derivative security issued by banks was Mortgage Backed Security(MBS) as part of which banks bundled the sub-prime loans and sold them in the secondary market to investment banks, who then sold these securities to retail investors. Another financial instrument issued by commercial banks with similar structure was Collateralized Debt Obligation(CDO), which included mortgage securities and other risky assets held by the bank. Therefore, banks were issuing everything on mortgage backed securities(MBS), which were nothing but a pool of risky mortgages with high probability of default. Another twist in the whole scenario was the role of credit rating agencies and how commercial banks used them for their own interests. It is considerable that commercial banks would have not been able to sell record amount of mortgage backed securities (MBS) and Collateralized Debt Obligation(CDO) without obtaining a good credit rating from the rating agencies. Therefore, in order to avoid losing customers, who were demanding mortgage related securities, these banks influenced the rating agencies and obtained ‘AAA’ and ‘AA’ rating for the majority of these instruments. At the same time, since these instruments were new to the secondary market and had no history to base the analysis upon, credit rating agencies did not hesitate in issuing a high rating of the securities that were being backed by high risk mortgages owned by sub-prime borrowers.
-Absence of diligence
While commercial banks were least concerned with the risky portfolio of sub-prime mortgages as they were earning by issuing mortgage loans and also by issuing mortgage backed securities, it is considerable that even the purchasers of these instruments, the big investment banks, who bought these securities for millions of dollars, failed to understand the true values underlying these risky assets, rather many of them indulged into the mortgage market by acquisitions of mortgage lenders d continued to acquire more and more mortgage securities using leverage amount. For instance, Lehman Brothers, at the peak of e housing bubble, Lehman Brothers had acquired five mortgage issuers, he majority of whom were dealing with sub-prime markets. Just like other mortgage issuers, even Lehman Brothers were aggressively issuing mortgages and at the same time, purchased huge inventory of mortgage backed securities well above to what it could afford. For instance, beginning the year 2007, the financial leverage of the company had reached 31 times and the company purchased mortgage securities, even when the turbulence had already started in the mortgage market. In 2007, the company underwrote mortgage backed securities than any other firm by accumulating $85 billion worth of mortgage related securities. This was four times the shareholder equity of the firm and the whole transaction was supported through leverage amount. Eventually, Lehman Brother filed for bankruptcy in $619 billion in debt and $639 million in assets, which largely comprised of mortgage backed securities that the company was unable to sell. Similarly, Bear Sterns, who was the second largest holder of the mortgage securities also faced the debacle once the bubble busted. Ironically, even when investors were losing their money on mortgage securities, the company was still purchasing more mortgage securities through additional leverage.
These events clearly showed that while the commercial banks created the whole camouflage of mortgage backed securities, which were high-risk mortgage loans, it was the over-optimistic attitude of the investment banks and securities firm because of which they ignored to perform due diligence for these securities and end up being bankrupt.
Conclusion
While it was easy for us to tell the story with hindsight, but we must admit that the financial institutions performed the worst abuses in mortgage issue, their securitization and then repackaging of the mortgage loans to the banks, who, owing to their extreme and unwarranted confidence in the real estate bubble and the low pricing environment fell prey the low transparency of the mortgage securities and either went bankrupt or were sold to other firms. However, more than the securities firm, we believe that commercial banks and investment banks, who influenced and forced the mortgage appraisers and credit rating agencies to issue the results in the bank’s favor clearly indicates that the bank executives were profoundly hunting for fees from the mortgage issue while they completely disregarded the impact of their actions on the US economy. Hence, when the bubble eventually busted with Fed is increasing the interest rates, the banking sector saw the record number of mortgage defaults and because the supply of housing units was far exceeding the demand now, the price of mortgage units was low enough to impose billion dollar losses to the banks, who were never able to recover the mortgage amount. On the other hand, securities firms, who had purchased mortgage base securities in billions, were left as spectator after the default in the mortgage markets eroded significant amount of their investment.
References
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