Subprime Mortgage Crisis Origin And Term Paper

Length: 12 pages Sources: 10 Subject: Economics Type: Term Paper Paper: #90267783 Related Topics: Financial Crisis, Trade Deficit, Investment Banking, Economists
Excerpt from Term Paper :



Why Did Mortgage Lenders Lend to Subprime Customers?

The growth of the subprime market owes itself to an influx of international and hedge fund investors who were increasingly separated from the final mortgagees. Banks and savings and loan institutions generally knew their borrowers, because they lived and worked in the same communities. When banks and S&L's held the mortgages, they were making a bet on the creditworthiness of people they knew well. This started to break down in the late 1980's, when the federal government stepped in to the "S&L Crisis" and created the RFC -- Reconstruction Finance Corporation -- to buy assets and close down S&L's which had made imprudent loans.

Loan securitization was thus slowed down by the S&L crisis, but was built slowly over the 1990's as money center investment banks developed ways to evaluate and package the mortgages into understandable assets which could be judged as being of investment grade. The ratings agencies, primarily Fitch, S&P and Moody's, evaluated the quality of these mortgages and issued an opinion to the investors which assured them of the likelihood of repayment.

Around 2001, the nation emerged from a short economic downturn and started to invest in houses. The reasons were primarily secular: increasing numbers of households (i.e. empty-nester baby-boomers, smaller family sizes -- therefore more households, a reduction to 0 in capital gains rates up to $500,000 for a couple with housing capital gains) contributed to make investments in housing significantly better than it had been in the past. Housing prices had been rising at a modest level for the previous five years, so housing prices were rising but still regarded as reasonable as compared to other asset prices.

The resulting increase in demand for housing was fueled by the above-mentioned decrease in interest rates which caused a lower barrier for prospective home buyers, which made homes more affordable even as housing prices were rising. Those who 'originated' mortgages -- builders, bankers and mortgage brokers -- were transaction-driven. The more mortgages that they 'sold' to mortgagees, then 'passed on' to securitizing investment bankers, the more money they made on each transaction. Thus the faster homes were built, the more homes were sold, and the more money came in to the packagers. Investment bankers were similarly mortgage quantity-, not quality-driven. This means that they were compensated on the total value of the mortgages that they packaged and sold to investors. Sales of existing homes rose dramatically from 2000 to 2005, as shown by the following graph:

Existing Home Sales

These sales peaked in 2005, however, and started to decline. This led to the opposite of the home sales expansion, with a subsequent decline in revenues for mortgage brokers, bankers and investment bankers.

Since the brokers and bankers made their money on the transaction, they held no responsibility longer-term to assure the continued quality of the underlying assets -- the homes and the mortgage payments -- would remain high.

What about the Ratings Agencies?

The three major ratings agencies, Fitch, Moody's and S&P, were competing for a share of the credit rating business. These firms had chiefly made their money in the past by rating municipal bonds. This was a lucrative but low-margin, low-growth business. Each of the credit rating agencies saw mortgages -- particularly subprime mortgage aggregates -- as a way to earn increased margins in a growing industry. These are private institutions, however, which generate revenue by the number of ratings that they issue. Their bills are paid as a part of the issuance of the collateralized mortgage securities: i.e. The more securities they rated, the more money they made. Since the investment bankers (who had an incentive to increase their number of transactions) rewarded the ratings agency contracts, they would not go to a ratings agency that gave relatively few "investment grade" ratings to their securities. If any of the three were to suddenly grow more conservative, that ratings group would quickly lose market share and revenues.

That these ratings agencies were too lax is evident in their recent statements that they did not cause the 'mortgage mess.' They are under fire from Congress for their inability to give objective ratings of their securities:

Democratic and Republican senators said they were particularly concerned with a key aspect of the agencies' business models: they get paid by the companies whose bonds they rate. That's like a film production company paying a critic to review a movie, and then...

...

Jim Bunning, R-Ky., said. (AP, 2007)

At the same hearing, Michael Kanef, a managing director at Moody's, agreed with the senators that their employees should not be allowed to go directly to mortgage investment banking houses. This is a clear statement that conflicts of interest have existed for some period of time.

Buyers of the Securities -- why did they do it?

The buyers also changed over time. In the days when banks and S&L have held the 'paper,' they knew their customers. The mortgage-backed securities were generally sold to U.S. investment houses which understood the risks and were able to judge the quality of the loan packages. In this decade, a decided increase in foreign buyers changed the ability of the buyers to judge the quality of what they were buying. Relative interest rates and returns on investment were low in Europe and Far East Asia; subprime mortgages in the U.S. seemed to offer a higher premium for a low perceived risk. Splitting the mortgages into discreet elements -- some higher-risk interest-related securities and some cash-flow oriented securities, seemed to give those foreign investors an even better return. The world was awash in dollars as the U.S. continued to run a significant balance-of-trade deficit, which meant that a lot of governments and foreign individuals held dollar assets. The combination of readily-available dollars and a relatively low perception of risk for high-return subprime securities in the U.S. combined with a lack of knowledge of the marketplace and the quality of the underlying assets to create an opportunity for fraud or incompetence.

Conclusion

Was the present subprime mortgage crisis a one-time 'perfect storm,' which will never occur again? Part of the answer relies on what structural changes will be made to the U.S. And international markets for housing mortgages. One can make a pessimistic scenario:

Moral hazard' has not hit this market in the way that it would if the U.S. And other sovereign treasuries had not intervened to pour in liquidity. Thus many investors who should have learned their lessons were bailed out by government action.

Packaging of mortgages has not abated, although it has fallen back with the current skittishness of global markets related to subprime and other mortgage prices. Once housing prices start to rise again, there is no assurance that mortgage packages won't again flood the market.

The world is still awash in cash -- and the U.S. still offers outsize returns as compared to other areas in the world.

On the other hand, there may be some cause for a rethinking of the mortgage crisis. If politicians in the U.S. decide to impose conditions on rating agencies, or instill SEC-like oversight, they could create a fairer judgment of the underlying credit quality of the mortgage-backed securities.

One could argue that mortgages and housing prices are cyclical, and each new generation must learn the lessons of valuing assets. If the U.S. And other governments step in to 'clean up' the market that does not mean that the enterprising global markets won't find another way to hit a depressive period in the future.

Works Cited

AP. (2007, September 26). Credit rating agencies defend track record. AP, p. n.p.

Collins, M.C. (1997). Thrift viability and traditional mortgage lending: A Simultaneous equations analysis of the risk-return trade-off. Journal of Real Estate Research, n.p.

Economist. (2003, December 30). Cracks in the Brickwork. Economist, p. n.p.

Economist. (2005, June' 16). The Global Housing Boom. Economist, p. n.p.

Friedman, M. a. (1961). Capitalism and Freedom. New York: Simon & Schuster.

Froot, K.C. (1995). The Global Financial System. Boston: Harvard Business School Press.

Greenspan, a. (2007, December 12). The Roots of the Mortgage Crisis. Wall Street Journal, p. n.p.

Hewitt, M. (2007, July 17). Who Do We Owe and How Much. Retrieved February 5, 2008, from DollarDaze: http://images.google.com/imgres?imgurl=http://www.dollardaze.org/blog/posts/2007/July/17/1/FedFundsRate.gif&imgrefurl=http://www.dollardaze.org/blog/%3Fpost_id%3D00211&h=383&w=470&sz=10&hl=en&start=1&sig2=jFunzJiUxJMw48lPwjO0DQ&um=1&tbnid=PudWaTiu4wOyIM:&

Kaarlgard, R. (2007, August 27). Liquidity Crisis or Credit Crunch. Forbes, p. n.p.

Lehnert, a. (2005). Averview of the U.S. Mortgage Markets. Washington: BIS.

Louis, B. (2007, March 9). Rising Subprime Mortgage Defaults Add to Unsold Homes Inventory. Bloomberg.com, p. n.p.

MRL. (2007). Mortgage Default. Retrieved November 18, 2007, from Mortgage Reference Library: http://www.brokeroutpost.com/reference/10996.htm

Sloan, a. (2007, October 16). Junk Mortgages Under the Microscope. Fortune, p. n.p.

Subprime Mortgage Crisis

Sources Used in Documents:

Works Cited

AP. (2007, September 26). Credit rating agencies defend track record. AP, p. n.p.

Collins, M.C. (1997). Thrift viability and traditional mortgage lending: A Simultaneous equations analysis of the risk-return trade-off. Journal of Real Estate Research, n.p.

Economist. (2003, December 30). Cracks in the Brickwork. Economist, p. n.p.

Economist. (2005, June' 16). The Global Housing Boom. Economist, p. n.p.


Cite this Document:

"Subprime Mortgage Crisis Origin And" (2008, February 05) Retrieved August 2, 2021, from
https://www.paperdue.com/essay/subprime-mortgage-crisis-origin-and-32441

"Subprime Mortgage Crisis Origin And" 05 February 2008. Web.2 August. 2021. <
https://www.paperdue.com/essay/subprime-mortgage-crisis-origin-and-32441>

"Subprime Mortgage Crisis Origin And", 05 February 2008, Accessed.2 August. 2021,
https://www.paperdue.com/essay/subprime-mortgage-crisis-origin-and-32441

Related Documents
Housing Market Crash Subprime Mortgage Crisis
Words: 1795 Length: 6 Pages Topic: Economics Paper #: 95942912

Subprime Mortgage Crisis A major issue for today's economy in the U.S. is the subprime mortgage crisis. The mortgage crisis has sent the U.S. economy into a recession with greater impact than the Great Depression of the 1920s. One will discover some important terms that will allow the reader to better understand this topic. Additionally, this paper will examine some background information and events that led to the housing market crash

Subprime Mortgage Crash in the
Words: 2782 Length: 10 Pages Topic: Economics Paper #: 35792130

Enter the Fed, Yet Again Unable to understand that rapid interest rate moves create shocks to the market, resulting in distortions in supply and demand, the Fed dealt with the bursting of the housing bubble by lowering interest rates rapidly, this time to next to nothing. This response was intended to stimulate the economy. In 2001, the rate decreases were also intended to stimulate the economy, but they mainly stimulated one

Influence of 2007 Economic Crisis on American Car Market
Words: 24230 Length: 88 Pages Topic: Transportation Paper #: 81822842

2007 Economic Crisis on American Car market Effect of the 2008 global economic crisis on automotive industries Crisis in the United States Crisis in Canada Crisis in Russia Crisis in European markets Crisis in Asian markets Effects by other related crisis events In this paper, we will review the effects of 2008 global automotive crisis. Our main focus will be on the American car manufacturers and the negative impact they suffered due to the crisis. We will

Organization Behavior Global Financial Crisis the Most
Words: 3459 Length: 10 Pages Topic: Economics Paper #: 31736712

Organization Behavior Global Financial Crisis The most recent financial crisis has badly affected the Global economy. Individuals, businesses, and Governments; every entity has taken its impacts in one way or another (Burger, Coelho, Karpowicz, & Tyson 2009). Since its arrival, financial crisis has posed big threats to the world markets. The countries are trying to overcome the bad impacts of this crisis but have failed to recover their positions due to severe

Financial Crisis of 2007-2009
Words: 2251 Length: 8 Pages Topic: Economics Paper #: 7342025

Financial Crisis and Its Implications: Events Occurring Between 2007 and 2009 A Critical Literature Review The Roots of the Crisis Real Estate Valuation Bubble Sub-Prime Mortgages Low Interest Rates Moral Hazard in Regard to Consumer Spending Packaging Real Estate Loans as a Commodity (Derivatives) Market Interrelatedness Future Implications The financial crisis, which seemed to be elevated to its greatest extent world-wide between the years 2007 and 2009, is difficult to unravel. The causes, interlink-ages, and effects are so intertwined that

Federal Reserve and Financial Crisis
Words: 701 Length: 2 Pages Topic: Careers Paper #: 20272170

Banking System The United States banking system has been around for quite a while. Indeed, the Bank of New York was founded in 1784, a scant eight years after the United States was created. The banking system has two major functions. First, they operate an overall payments system. Second, they facilitate and allow for financial intermediation. There was no formal financial system in the colonial states prior to the formation of