Summary
The global economic crisis that happened between the year 2000 and 2010 was largely due to the issue of mortgage securitization. Mortgage securitization emanated from firms developing new securities from the mortgage obtained by buyers and developing business with investors from these new securities. The development of mortgage securities begins with the buyer of a homeowner paying cash to secure ownership of the house. To obtain the cash, the buyer secures a mortgage using a mortgage broker who secures the mortgage from a securitizing firm. The securitizing firm then creates new securities, which it sells to potential investors. The mortgage broker and the securitizing firm normally charge fees, which increases the cost of the mortgage.
Approval of Sub-Prime Standards by regulators
Before 1990 and early 90’s, in order for an individual to secure a mortgage, securitizing firms had to ensure that the person had the income to sustain payments for the mortgage. This resulted in a few people being able to own homes. However, to increase the number of homeowners, laws were developed that allowed securitizing of nonqualified mortgages. The level of risk to investors increased.
Fed created a real estate bubble
Following the securitizing of nonqualified mortgages, increased demand for houses and prices were experienced. Following 9/11, the Fed decided to lower interest rates on mortgages in an attempt to avoid a recession. This then increased the number of individuals who could afford homes.
Payment plan for mortgages
Mortgages used to be paid using a fixed rate mortgage payment plan, which normally involved high costs. The introduction of ARM (adjustable rate mortgage) payment plan attracted a large number of homeowners who were willing to make low payments. However, the ARM option resulted to an increase in the total loan as the rates were adjusted every month to match the current market situation.
Mortgage brokers’ commission
Every transaction by the mortgage brokers resulted to their earning a certain commission. The more mortgages they were able to bring, the more the commission they earned. Thus, the brokers did not take the time to evaluate whether the homeowner had the ability to pay the mortgage.
Laxity of regulations and focus on quantity rather than quality of services
Regulations concerned with issues relating to mortgaging did not necessitate the need for brokers to validate the incomes of the borrowers and check their ability to pay the mortgage. Additionally, the securitizing firms were concerned with making profits rather than ensuring that services provided were of high quality. Mortgage brokers were encouraged to write additional mortgages as it increased the returns of the securitizing firms.
Manipulated Rating Agencies and Insufficient Models
Investors had to get information from rating agencies to ascertain whether the security was high or low risk. However, the securitizing firms had managed to pay rating agencies to provide ratings that would encourage investments by the investors. Models developed by professionals regarding the value of the new securities provided inaccurate information since the inputs used neglected most of the critical factors, which would provide accurate ratings for the collateralized debt obligations.
Impact of Mortgage Securitization
Defaulting on payments by the homeowners made the mortgage backed securities prices to decrease. Financial institutions collapsed. Banks were unable to lend money to customers, and this affected the manufacturing and construction industry where significant job losses were experienced.
