Subprime Mortgage Crisis of 2007 2008 Research Paper

Excerpt from Research Paper :

The Subprime Crisis

There were a number of factors that led to the subprime crisis: Fannie Mae, Countrywide Financial, the Federal Reserve, Moody’s, Merrill Lynch, Bear Stearns, Goldman Sachs, AIG, Michael Burry, who shorted the mortgage backed securities being sold to investors that were full of subprime—and guys like him (the ones depicted in Michael Lewis’s The Big Short)—they all had a role to play in the subprime crisis of 2007-2008 (McLean, Nocera). But, truth be told, the lead-up to the crisis started well before the actual collapse of the market. It started with housing in the 1990s. But one could even go back further to the 1970s when Lewis Ranieri of Salomon Brothers invented the mortgage backed security (MBS)—a bond made up of thousands of home mortgages that were bundled together, sliced up and sold to investors who would collect the interest (Lewis). It was a way for the original lenders to offload the risk to other investors and a way for new investors to collect a nice ROI (return on investment), and it was ultimately at the heart of the subprime crisis. So long as the MBSs were legit—and with the ratings agencies doing their part to rate them accurately (they could give these securities a good rating of AAA—meaning the chance of default was slim to none, or a bad rating of junk—meaning default was likely imminent), they could work as a legitimate investment. It was when they were not rated well that the trouble began (or rather got worse). For example, junk bonds would pay a higher return—but the risk of getting nothing was also much higher. AAA-rated MBSs were supposed to be a sure-thing: little to no risk, and a decent, predictable return at a decent rate. When Moody’s and the other ratings agencies began getting sloppy in their ratings of MBSs leading up to the collapse in 2007, many investors failed to realize they were buying junk that was mistakenly rated AAA (Lewis). Yet, lenders also played a part because they had been incentivized by the government to give out home loans to people who genuinely could not afford them. That was another big part of the problem—and that led right back to the government and politicians trying to promote the American Dream and make it a reality for people who really had no business realizing it. Yet there were several other problems and issues that led to the crisis. This paper will look at the causes of the subprime crisis, the ethical issues that underlay the crisis, and what can be done to prevent a similar crisis from occurring in the future.

The Causes

The major root causes of the recent subprime financial crisis were numerous. The dotcom bubble at the end of the 1990s-early 2000s led to a collapse in the Fed Funds rate, which brought interest rates down to between 1 and 2% from 2002 to 2005. The low rates made borrowing more attractive to consumers, which meant there was more demand for things like houses—which made sellers jack up the prices of their homes. Sellers of homes wanted to get rich by collecting a 30% return on their purchase of a few years prior: with housing heating up, and everyone who applied for a loan getting one (thanks to lenders like Countrywide Financial), homes were going like hotcakes and prices were soaring. Mortgage lenders were encouraged to hand out loans to subprime borrowers because restrictions had been eased and during the 1990s the Clinton Administration had wanted to see to it that everyone should have the opportunity to own a home and live the American Dream (McLean, Nocera). Thus the housing bubble was created by way of artificial demand made possible through risky lending practices, with the risk being sold off to investors who were starved for yield. Personal greed was an ethical issue at every level: the owners of Countrywide wanted to get rich off the subprime market. Home owners wanted to get rich by selling into the bubble. Mortgagees wanted to feel rich by becoming “home owners” of multiple homes that they could not normally have been able to afford under traditional lending standards (which would be restored following the bursting of the bubble). The problem was epic, however—and the dotcom bubble that burst at the start of the 21st century also played a part, as it caused big fund managers to have to find a place to obtain yield (ROI) for their vast funds (such as those responsible for paying pensions). The MBS market looked attractive. In other words, a global savings glut had occurred following the bursting of the dotcom bubble, with developing nations reversing course; they stopped running deficits and starting saving more. Subprime borrowing began to rise and the banks and financial industry were happy to let it because there was a demand for fixed yield in the international market at the selling of these mortgages as fixed yield was a way to satisfy that crowd (McLean, Nocera). The shoddy mortgages were thus bundled into securities and sold to third parties who would chop them up and bundle the different tranches together and sell them again. But these financial instruments were problematic on the face of it because they really were not what they were made to seem—because the ratings agencies were getting paid a pretty penny to overlook the junk subprime mortgages piling up in the bundles. Only people like Michael Burry, who actually bothered to look at what was inside the MBSs, knew they were ticking time bombs (Lewis). Yet even his impulse was to bet against them—not to warn the world. Thus, personal greed was everywhere a problem in this fiasco.

One of the biggest contributors to the problem, however, was the ratings agencies, which were supposed to put a rating on these securities based on the underlying likelihood of default. The ratings agencies like Moody’s failed to rate them appropriately, and so investors thought they were…

… middle part …

…of interest, but the government was not interested in ethics at the time—just in friendship—so it put the burden on taxpayers (as always).

The regulatory agencies have not done much to address the situation. Leveraging is still the name of the game and moral hazard continues to be an issue. The same cycle is about to start again with the Fed Funds rate rising once more—this time under Chair Powell. Already the markets are responding and the rate is only at 2%. If the Fed takes it higher, as it intends on doing, it is quite likely that a flight from equities will lead to more volatility the world over. Will another bailout help to wash clean the hands of the major players once more?

Preventing another Crisis like This in the Future

The way to prevent another crisis like this one from happening in the future is to recognize that the system itself is highly flawed. There are too many ways in which it can be gamed. The banks should not be allowed to have their own people (former workers or top level executives) working in government. Paulson and today Mnuchin are just two examples of former Goldmanites directing the U.S. Treasury (in case something bad happens, they have one of their own in there to make sure they are protected).

AIG should have been forced to liquidate—like Lehman—to cover its costs. Instead, it was allowed to keep going because of the special relationship Goldman had with the Treasury. Lehman collapsed along with Bear Stearns. But AIG was too big to fail? Ethics matter and the government has to be mindful of that. If the system is going to permit unethical practices, the system has to be dismantled. The reality is that when Lehman collapsed and Wells-Fargo bought it up, Wells-Fargo was pulling strings to make a play that it thought it could benefit from, while when AIG was set to fail, Goldman made a play that it thought it would benefit from. Both were running different plays but both were essentially using the same playbook.

In the future, the guilty parties have to be made to suffer the consequences of their actions and that means forcing them to shut down, selling off their assets to cover their expenses, and letting them fail if necessary. Actions have to have consequences. The idea that any one organization or institution is too big to let fail is absurd. AIG should have been let to fail and the government should have gone after the credit ratings agencies that were giving the bundles of loans high credit ratings, too. They were in on the take as well. All of them were acting recklessly and criminally. Even the little people, who were profiting off the bubble by selling into it, and the people seeking home mortgages at a time when banks were handing them out like candy—they should have known to be more responsible. But who was there to tell…

Sources Used in Document:

Works Cited

Lewis, Michael. The Big Short. NY: W. W. Norton, 2010.

McLean, Bethany and Joe Nocera. All the Devils are Here: the Hidden History of the Financial Crisis. Penguin, 2011.

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