Thesis on "Mortgage Crisis"

Thesis 7 pages (2036 words) Sources: 10

[EXCERPT] . . . .

Mortgage Crisis

FACTORS RESPONSIBLE for the MORTGAGE BANKING CRISIS Financial Deregulation, Misguided Public Policy and the U.S. Mortgage Crisis:

The significance of the homer mortgage is the American economy goes back to the first efforts of the Roosevelt administration to reestablish economic security in the immediate wake of the Great Depression. At that time, the long-term, self-amortizing home loan was a novel concept, especially on such a large scale. In principle, it facilitated economic recovery by allowing borrowers to pay off both debt and interest in fixed payments (Kuttner, 2008).

Subsequent economic reforms and legislation followed, all intended to help

Americans become homeowners. Congress insured mortgages, created the Federal

National Mortgage Association (FNMA), and helped mortgage and lending institutions finance extensive lending practices. To further strengthen self-amortizing home mortgages, the Federal Home Loan Banks System provided oversight in conjunction with the federal deposit insurance to insulate homeowners from catastrophic events affecting banks and other lending institutions reminiscent of those attributed to the events precipitating the stock market crash of 1929 (Halbert & Ingulli, 2005; Kuttner, 2008).

One of the main problems within the American system of financial regulation and oversight is that restrictions on mortgage loan companies are significantly less stringent than those applicable to the loan portfolios of banks. However, the largest mortgage companies in the U.S. are actually subsidiaries owned by banks. In principle, the distinction was originally predicated on the fact that the mortgage loans of bank subsidiaries do not remain on their ledgers, but in the age where the biggest mortgage companies are actually bank subsidiaries, that undermines any value of banking regulation, at least in so far as it pertains to mortgage lending (Halbert & Ingulli, 2005).

In the last quarter of the 20th century, the something in the way of the so-called perfect storm" evolved that would eventually lead to the collapse of the mortgage banking industry and the widespread wave of home mortgage defaults in 2007. Shortly thereafter, the tremendous instability and vulnerabilities of the U.S. economy manifested itself in the near-overnight transition from immense profitability to insolvency for some of the biggest investment banking firms, banks, and lending institutions in the country, with even wider effects to domestic and worldwide financial interests.

Asymmetric Information, Fiscal Policy, and Risk Management:

In principle, that perfect storm began to form with the gradual deregulation of the savings and loan, mortgage lending and securities trading industries roughly simultaneous to the invention of a new form of mortgage-back securities on Wall Street.

The situation worsened when those new types of mortgage securities transferred the risks traditionally associated with mortgage lending from lending entities to the bulk third- party purchasers of those instruments (Reinhart & Rogoff, 2008).

Beginning in the late 1970s at Salomon Brothers, investment bankers began combining the computational power of microprocessors with the futures markets and also developed mechanisms for converting non-liquid debt obligations like home mortgages into complicated securities that combined hundreds or thousands of individual mortgage obligations into collective securities that could be traded at a profit. In and of itself, such practice need not necessarily have resulted in the eventual collapse of the mortgage loan industry (Gallegati, Greenwald, et al., 2008; Kuttner, 2008).

However, what Wall Street computers never attempted to model within their portfolio risk analyses was the effect that the transfer of mortgage obligations would have on lending practices, specifically, at the level of the initial credit approval process upon which the integrity of the entire capital markets depends. Mortgage-backed tradable securities became lucrative investments, largely because the traditional wisdom regarded home mortgage obligations to be among the safest type of investments.

The rational is that homeowners have a vested interest in maintaining their homes, making fulfilling their mortgage obligations a high priority. Therefore, once individual mortgage obligations became the basis of the new form of tradable mortgage-backed securities, they generated the highest rating from the credit rating agencies, by virtue of the traditional way of thinking about mortgages in relation to risk management.

Consequently, the largest pension funds invested heavily in many of those mortgage- backed securities based strictly on the traditional measures of their security and on the underlying factors that had always guaranteed their security in the past (Halbert & (Ingulli, 2005; Stiglitz, 2004).

Unfortunately, transferring the risk of default to third parties essentially eliminated the natural incentive on the part of mortgage lenders to limit their credit extension to well-qualified borrowers, since all the inherent risks associated with each mortgage transferred in its entirety upon the sale of the mortgage security to third parties.

Compounding the problem tremendously was the fact that on Wall Street, the mortgage banking industry had begun to rely on predictive modeling based on mathematical formulae so complex that even the most fundamental elements of risks and benefits became completely incomprehensible, even to the highest levels of management and corporate administrators (Gallegati, Greenwald, et al., 2008; Mishkin, 1999).

The revenue produced by securities structuring and trading programs devised by the mathematicians and physicists recruited by firms to lead their investment operations was tremendous. However, the asymmetric information available to the architects of those computer problems and those responsible for oversight and risk management within the firms exploiting them was tremendous as well. Conceptually, the entire system was also predicated on the fundamental informational asymmetry between the sellers and traders of mortgage-backed securities who knew or should have known of the inherent instability and the thousands of customers and those whose fixed incomes depended directly on the accuracy of the official credit ratings of those mortgage securities.

Furthermore, the operational culture that evolved on Wall Street was diametrically opposite to what would have been required to discover the inherent instabilities of such a system. Specifically, at most investment firms and mortgage banks, managers (including risk managers) were discouraged from any analyses that threatened profitability. Meanwhile, successes (in terms of profits generated) were rarely questioned or scrutinized, simply because they resulted in earnings (Halbert & Ingulli, 2005).

Likewise, in addition to the natural incentive not to disrupt such profitable practices on the part of those in position to examine the risks associated with the perpetual restructuring and sale of mortgage-backed securities, they were too out of the loop in terms of their technical understanding to recognize the inherent vulnerabilities in the system. In combination, the asymmetric information available to institutional managers by virtue of their lack of technical expertise and of the information actively sought by those responsible for exercising risk control resulted in a situation where tremendous amounts of money were being transferred and leveraged with virtually no appreciation for the risks that were, or should have been obvious, at least in retrospect.

The potential damage of the risks associated with the housing market were further exacerbated by the extensive reliance of pension funds in the very investments whose security was vastly overrated by the credit rating agencies who were still using traditional criteria of mortgage risk management long after the conceptual basis for the reliability of those criteria had evaporated (Gallegati, Greenwald, et al., 2008).

Capital market deregulation inspired increasing implementation of so-called "off- balance sheet activities" (Kuttner, 2008; Stiglitz, 2004), such as in connection with the traditional profits associated with the difference between the interest rates charged by banks to their customers and the rates paid by banks to their depositors. As deregulation and the securitization of mortgage obligations into tradable securities began to generate lucrative profits, the commissions and fees, associated with their trade provided substantial increases in the percentage of bank profits for which they were responsible.

Because those profits are subject to subjective criteria and fluctuate with the strength of the market, their interrelationship increases uncertainty and risk while decreasing transparency and the effectiveness of oversight and risk management (Gallegati, (Greenwald, et al., 2008).

The Housing Bubble:

The traditional criteria for rating the security of mortgage loans evaporated when banks and other mortgage lenders began encouraging widespread abuse of the system in the form of "no-doc" loans, (sometimes called "liar loans") within the mortgage lending industry. While the risks associated with mortgage lending would no longer be a concern of the lending institution, the profits and commissions remained profitable and became even more profitable by virtue of federal policies designed to help as many Americans as possible achieve the dream of private home ownership.

Real estate values increased steadily throughout the decade preceding the mortgage industry's collapse in 2007, allowing many homeowners to continually refinance, often borrowing on the increased equity of their appreciating property.

Likewise, many "flipped" their property at substantial profit. Within the real estate industry, practices evolved to entice short-term home ownership for profit with very low initial rates that increased sharply after their initial term of one or two years according to the variable interest rates in their mortgage documents (Kuttner, 2008).

Real estate developers secured favorable financing under deregulated federal policies and thousands of savvy homeowners purchased homes with very low initial fixed-rate mortgage loans, hoping to sell at a profit before the… READ MORE

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