Question 1 - What is a sub-prime mortgage?
The consumer financial protection bureau defines sub prime mortgage as
“A subprime mortgage is generally a loan that is meant to be offered to prospective borrowers with impaired credit records.”
A subprime mortgage is a kind of mortgage granted to borrowers with impaired or zero credit history. A prime or conventional mortgage is not offered to such borrowers as they have greater risk of defaulting. These loans are also called interest only loans and do not require any principle payments for initial few years, number of which is settled among the borrower and lender The interest charged on such loans is at a higher rate than the conventional interest rate. Lenders assume this increased rate as the price of taking additional risk associated with the poor credit history of the borrower.
Question 2 - What are Collateralized Debt Obligations?
Kimberly Amadeo (2011) explains Collateralized Debt Obligations as “sophisticated financial tools that banks use to repackage individual loans into a product that can be sold to investors on the secondary market.”
These are a kind of derivatives that are backed either by mortgage securities or by corporate debt, hence are called mortgage backed securities and asset backed commercial papers respectively. Examples of these packages are; credit card debt, auto loans, mortgages or corporate debt etc.
Question 3 - Explain how the sub-prime mortgage market led to the GFC.
Michele Fratianni and Francesco Marchionne consider high level of debt as the reasons behind the GFC
“The ultimate point of origin of the great financial crisis of 2007-2009 can be traced back to an extremely indebted US economy”
The wave of sub prime mortgages touched every interested investor as it was highly appealing and easy to attain loans, the bad part started when the investors lost the confidence in the value of these sub prime mortgages causing the liquidity crisis. This subprime crisis triggered initially the US financial sphere and ultimately spread over larger financial and non financial institutions. American Federal Reserve raised the key interest rate which fuelled the defaults on mortgage payments that lead to insolvency. The consumer lost the confidence as the upcoming situation was highly unpredictable. The fall of Lehman Brothers on 14 September, 2008 was marked as a key factor of the financial crisis as this firm was the one which anticipated and encouraged the sub prime mortgages the most. How ever analysts are of the view that this all did not happen in a day, it was seeded and watered for quite long time.
Question 4 – What role did Lehman Brothers (and other institutions) play in exacerbating the GFC? Were they acting ethically?
Lehman brothers adopted a highly aggressive leverage policy, accompanied by lack of transparency, bad regulation and market complacency. The fall of Lehman brothers is considered to be the biggest case of bankruptcy in the history of the US. The news of demise of the firm impacted the financial world adversely. The Dow Jones Industrial Average dropped by 500 points in one trading session and the market collapsed subsequently.
Researchers have found notable negligence and unethical practices being done by the firm which lead the economic world to such chaos.
Morin and Maux stated in a conclusion; “gross negligence” in their duty of disclosure” (Morin & Maux, 2011, p. 38).
The company was found guilty of being involved in unethical practices. The managers did not follow proper rules of disclosure and presented fabricated statements in order to attract consumers. Accounting manipulations were used extensively; Repo 105 which is a balance sheet window dressing technique was exercised by the company very frequently. This exercise allowed Lehman to remove around $50 billion liabilities from its balance sheet, artificially reducing the net debt level, which let Lehman remove roughly $50 billion in commitments from its balance sheet in June 2008, and artificially reduce its net debt level via wagering on the collateralized mortgage/ loan market.
Question 5 – Do you believe financial institutions should be more regulated? If so, how? What would you recommend?
The financial institutions do need to be more regulated, learning from the past there shall not be such loops and holes that can allow managers to manipulate the accounting practices and principles.
Elizabeth Friesen is of the view; “At present the international financial system is unprecedented in scope and scale. It is too big to fail and yet it is failing states”
The government policy on the banks that are considered to be ‘ too big to fail’ shall be tightened because having too much leverage of their size these financial institution will simply engage into speculation as they would know that in case of shortage of funds the taxpayer or government will intervene and bail them out.
Lastly the Glass Steagall Act shall be implemented. This act separates the powers of investment and commercial banks and protects the depositors’ funds as it curtails the banks from investing the depositors’ funds into risky investments.
Question 6 What are the most important lessons you learnt from this activity?
Many lessons can be learnt from this activity, especially from the demise of the biggest financial institution in the history of the US. Adding new methods of predicting an economic disaster and modifying different accounting practices are few of the lessons to be named.
According to CNBC report on Market Tips: Lessons Learned from Lehman Collapse
“The first lesson of the financial crisis is there has to be control of the financial markets,”
Unachievable business strategy shall be avoided, as the Lehman did in pursuit of higher growth business strategy. The businesses shall hold high ethical standards and shall eliminate dubious accounting practices. Corrupting the accounting policies, window dressing and fabricated financial statements are highly unethical practices and businesses shall not take the benefit from these as they might produce expected results, but this will not last long and will have adverse affects afterwards.
Otmar Issing, former ECB Chief Economist, is of the view that in the future a highly credible system shall be devised that would be efficient enough to figure out and punish the investors for their mistakes.
References
Greenfield, H. (2010). The decline of the best: An insider's lessons from Lehman Brothers.
Leader To Leader ,2010(55), 30-36.
GRETCHEN MORGENSON.(2007)Inside the Countrywide Lending Spree.The new York Times. Retrieved from. http://www.nytimes.com/2007/08/26/business/yourmoney/26country.html?adxnnl=1&adxnnlx=1234390068-jSIFzx8jUb8xOg6qz8+d4A&_r=0
Kimberly Amadeo .(2011). Collateralized Debt Obligations .Retrieved from. http://useconomy.about.com/od/glossary/g/CDOs.htm
Elizabeth Friesen.(2012). Privatizing profits and socializing losses. Retrieved from http://networkedgovernment.ca/article/?nav_id=1020
Wilchins, Dan & DaSilva, Silvio (2010). Graphic: How “Repo 105” Worked, blogs.reuters.com/reutersdealzone/2010/03/12/graphic-how-repo-105-worked
Michele Fratianni and Francesco Marchionne.(2011). The Role of Banks in the Subprime Financial Crisis. Retrieved from. http://ideas.repec.org/p/anc/wmofir/23.html
Subprime Mortgage. (2012). Retrieved from. http://www.consumerfinance.gov/askcfpb/110/what-is-a-subprime-mortgage.html
GBC. (2013). The role of subprime mortgages in the recession. Retrieved from. http://www.findingdulcinea.com/guides/Reference/Global-Financial-Crisis.pg_01.html#01
