Financial Institution of Lending - Assignment Example

RUNNING HEAD: Financial of Lending Financial of Lending of Discuss predatory lending (housing) and outline its strengths and weaknesses and the risks to the wider economy and finance sector. Predatory lending affects the borrowers in the sense that they are being made to suffer because of the combination of unfair terms of loans and the pressure which limit the information and choices available to them (Goldstein, 2000. These borrowers normally include a certain group given their vulnerabilities like the blacks and the Latinos (Goldstein, 2000). The lending practice then disturbs the efficient operation of the market and in turn affects efficiency of the economy and the finance sector. The strengths of the predatory lending may be taken from the similarly characterized subprime lending where there is an opportunity to extend home ownership in the mortgage market for those who cannot afford in the prime market. The barriers created by the prime segment of the mortgage markets from the use of lending standards like income, wealth, employment history to accept or reject loan applicants. Rejected applicants from the prime segment can still have the hope of having homes from the more expensive subprime market (Chinloy and MacDonald, 2005). In other words, the strength comes with the chance to avail a housing loan from other sources what could not be obtained from the normal way or prime market. Because of higher risks faced by creditors in subprime market, the prices are normally higher in relation to the higher risk faced. Thus the chance to engage in predatory lending becomes more understandable. The weakness of the predatory lending however comes with the necessary consequences when the values of underlying assets used in mortgage would surface by the working to the law of supply and demand. Predatory lending could eventually contribute or lead to the creation of bubbles that would burst. The effect of course would be bad for the economy as a whole and it could affect the finance sectors which are directly linked with the economy. Predatory lending prevents the market to operate effectively by not providing the necessary or correct information for decision borrowed and this would cause to create bubbles that would eventually burst. Since the financial sector is necessary part of the global economy it would necessarily be affected if the economy is not doing well. No wonder this was what happen of Lehman Brothers, Fannie Mae, AIG and all other institutions under the financial sector which were affected by financial crisis 2007 to 2009. The connection of the economy and the finance sectors should be easy to understand because prices of goods and services as well as credit related thereto will require the participation of banks and/or financial institutions. It is argued that all cases of blatant fraud in subprime lending are predatory or greedy lending. Included also are the loan terms which are out of line of the standard prices. These latter particularly refer to loans that are characterized by corrupt or unprincipled practices that compel borrowers to accept the loan (Goldstein, 1999). Thus, this will imply that not all subprime lending to be predatory if borrowers are sufficiently informed or aware of the risks that they are having and they have freedom to decide before they accept the loan. They key characteristics of what makes lending predatory is the lack of the rational decision making which is a requirement for the efficient operation of any market in capitalism or market economy. When borrower are duped into accepting things which they should have not accepted in the first place, their freedom of choice is affected necessarily and most of the times this is illegal. This eventually would create a bubble that would burst. Since housing and the related property need to be acquired with mortgages by making the property as collateral, these mortgages are necessarily inflated or overpriced and hence they do not have correct values. Since the financial institutions would eventually securitize theses mortgages to transfer the risks associated with bloated-price mortgages in their balance sheet, the banks are necessarily conduits of fraudulent practices as they are being made part to large-scale fraud in the economy. The securitization of mortgages or the creation of asset-backed securities is something that motivates banks as they earn from the practice and they believe that risks related to assets from their balance sheet would be reduced (Fabozzi, and Kothari,2008). To understand the asset bubble that may have been partly created by predatory pricing there is need to go back in time a little. It is normal in the economy to expect prices of goods and services including housing to at least go with overall rate of inflation and this was observed before 1995 and after the end of the Second World War. The period that followed between 1995 and the summer of 2007, it was found that US house prices were generally no longer with overall rate of inflation as prices by 70% even after reducing inflation factors. This essentially represented about not less $8 trillion seeming increased housing wealth or demand but was essentially inflated with the effect of creating a housing wealth of 40 percent or $20 trillion total (Baker, 2007). As to what caused the rapid rise in house prices was explainable due to a range of factors. One cannot discount the growing demand for homes and government and private sector promotion of home ownership as a result of demand to be part of the causes. The supply of credit would have to grow as well as mortgages were made available at very low interest rates. Profiteers would have to take their part also as these investors would go for financial speculation hoping to profit as a result of rising house prices. For fear that, they would be unable permanently to have their houses as induced by unscrupulous or lender or brokers said first-time buyers because victims of predatory lending as they would later be found out that they could not pay when interest increased (Beitel, 2008). The practice of predatory lending should not be difficult to see as one of the causes. They were duped into believing that the time then was ripe to purchase a house with the mortgage. But since these borrowers were not thoroughly screened as they were even helped into making false documents just to avail of the housing mortgage, which makes the loan fraudulent therefore predatory lending, they would find themselves of be actually big part of a big fraud where greedy business practices came to play. 2. The government puts a lot of money into banks who over-lent funds. So why are the banks still lending out money for mortgages? Discuss Banks have to lend money to debtors to run and lending out money for mortgages is just one of the choices that can be made. Loans are the main asset in banks’ portfolios that could reach an average 50 to 75 percent of banks’ total assets. The composition of loan depends significantly on size, lending expertise, location and trade area of these banks. Despite the reality that lending practices cannot be the same for similar-sized commercial banks, several characteristics were noticeable. Commercial banks with $100 million to $1 billion assets were found to have the greatest ratio of net loans to asset is 70.4 percent. Commercial banks in the $1 billion to $10 billion asset category came closely where the ratio of loans to assets is about 70% (Koch and MacDonald, 2009). Although the largest banks were found to have reduced lower dependence on loans relative to smaller banks. This would mean that many of the largest institutions use more their resources or assets in on non-credit products and services that generate non-interest income or loans to primarily source their revenue because they have more standardized transactions that could provide them economies of scale (Koch and MacDonald, 2009). The fact the banks must have to do loan to survive is basic reality since such is the nature banks. Another noticeable finding by researcher was that real estate loans characterize the largest simple loan category and the fasters-growing category for all the banks. That banks are considerably using mortgages as source of income was the third noticeable thing from research whereby residential family loans which are mostly mortgage products constitute largest amount of loans for extended by almost all banks under the real estate category (Koch and MacDonald, 2009). In whatever words needed to describe this reality is that almost all banks cannot avoid this reality in the mortgage business. When banks give focus to certain activities, profitability objective cannot be avoided; hence it can be argued that mortgage loans contribute much to the profitability of the banks. Another reason on why banks go into mortgage loan is that it allows the banks to create securitized asset (Global Economics Crisis Resource Center, 2009) whose main purpose is to remove risky assets from their balance sheet. In so doing they would make another institution to assume the credit risk while allowing these banks to receive cash in return. This allows banks to invest more of their capital in new loans or other assets to their capital. The increase of assets from securitized assets could also mean have lower capital requirement because of the reduced risk from securitization. The practice of mortgage loan has produced multiplied benefits for banks. The idea of more profit and reduced risks is a case of hitting two targets with one stone. Banks are private owned and the shareholder of these institutions has the right to earn also above cost of capital. If they do now find way of earn above cost of capital then what they do would be unfair to the shareholders who may just as well look for another business. Normally when ordinary companies expand there is increased risk with uncertainty. It would seem that in the case of banks, the expansion by offering more mortgage loans would afford them better flexibility as long as they can securitize these mortgage loans. When the capacity to securitize with view of some being allowed to engage in investment making would seem to allow more banks to become bigger which of course can be considered as growth by shareholders or investors. The multi-tiered commercial banking system as participated in by super-regional banks, community banks and global banks make more the idea of mortgage loans more significant. When banks can offer a wide array of products and services for different customers including government, business and individual and yet they have mortgage loans as major sources, these banks could just be creating business bubbles without actually producing the normal economy would allow. The mortgage loans which motivated banks to create further business by securitization became part of the game. This was of course closely related to what happened in the 2007 to 2009 financial crisis where the cause was traced to the faults committed in the subprime lending. The United States has its biggest firms in the banking industry including Bank of America, J.P. Morgan Chase, and Citigroup. There are global institutions offering a wide array of products and services for their various customers. The laws then of the US effectively allowed the combination of commercial and investment banking which could encompass insurance and other financial services. Before World War II, the US had its glass-Steagall act of 1933 which separated commercial banking from investment banking (Koch and MacDonald, 2009). The law however allowed an exception under Section 20 for banks to possibly engage in the investment banking business long with the condition that banks were not predominantly engaged in these activities. Subsequent amendments were mad to the law; thus starting 1998, a number of banks operated under Section 20 companies exemptions. When the US congress passed the Gramm-Leach Bliley Act, which for the first time in November 1999, US banks became more free to totally compete with the global diversified financial companies around the world by as they were not allowed to offer broad range of products comparably. The repeal of sections 20 and 32 of Glass-Steagall by Gramm-Leach-Bliley also modified portions of Bank Holding Company Act (Koch and MacDonald, 2009) which further allowed banks to grow bigger. But not all that is big is safe or better a risk for less control comes with big companies. The capacity to do mortgage was expanded along with laws passed by the US Congress but the incentive that it had for banks may have blinded the banks decision-makers since eventually the values of mortgages loans were downgraded when it was time to realize that the bubble created by securitization and other causes, would have to burst. However, after the crisis, banks would continue to do mortgage lending since the housing needs would always be there and mortgage lending is the necessarily associated way to making banking business. 3. With liquidity rationing, (credit crunch) does offering covered bonds hold the answer. Discuss. It is argued that during a credit crunch there is reduced general accessibility of loans or a there is abrupt tightening of the conditions required to obtain a loan from banks (Burdekin & Siklos, 2004). Under such situation, there is therefore a higher demand than supply loans by banks. Now to see the picture or role played by covered bonds, it must be realized that banks need to generate funds also other than deposits. Covered bond issuance is therefore an alternative source to finance mortgages lending requirements of banks. If there is no sufficient source of funds, the problem of tight conditions for lending could be worse. However, it may be argued that covered bonds issuance may have contributed to the financial crisis of 2008. The argument may be true in the sense that although covered bond is different from securitization because in the former the banks issuing the covered bonds retain the risk, the fact the banks suffered declined in their values, it follows that covered bonds value must also have to fall, because the underlying assets which is present in securitizations have fallen. The only difference is that it is the banks values that are falling, which is caused by crisis created by the subprime mortgage. In terms of law of supply and demand, there is greater demand for loan than supply whether there is credit crunch or credit rationing. Although covered bond is a less favorable option than asset backed securities (MBS) by banks, it could be an act of survival on the part of banks as borrowers would be more than willing to invest in covered bonds than MBS given the cause of the credit crunch. It is further argued that banks have the incentive to create securitized asset since they intend to remove risky assets from their balance sheet. This is of course transferring to another institution to assume the credit risk and this would allow these banks to receive cash in return. This practice therefore allows said financial institutions to invest more of their capital as generated from securitization to be available for new loans or make their balance sheets to look better and would imply banks to have lower capital requirement by regulators. Although banks can engage in MBS or securitization as a way of reducing credit risk, doing such thing was not encouraging and would be self-defeating if the cause of the credit crunch is partly caused by MBS. A typical covered bond is a corporate bond or a debt security which is still back-up by cash flows from mortgages which allows recourse to a pool of assets that secures or if the originator banks become insolvent. In effect since covered bonds are secured the banks, the fall in value of banks because of the fall in the value of the loans entered would have the effect of bringing down the value of covered bonds issued by said banks. This could be observed empirically. Before the outbreak of the 2007 to 2009 financial crises, covered bonds were assigned AAA credit ratings (Standard and Poors Corporation, 2008). When investors realized that that many loans backing these bonds were a low quality credit ratings which were made high earlier because of lower risk than MBS had still to decline sharply. It is in this sense that the lessened demand for all types covered bonds or MBS had contributed to the financial crisis. To generate funds from investor during credit crunch investor must perceived some advantage. One advantage is reduced risk and this could be found as one major advantage to a covered bond since the debt and the underlying assets pool would remain on the issuer’s financials. As such is the duty of and issuers must ensure that the pool consistently backs the covered bonds. This assures and attracts the investor who may have the recourse to both pool and the issuer in the event of default. It is also argued that true covered bonds so have a strong structure from their being usually overcollaterelized as investors essentially can claim on both the pool and issuing the bank. Being over collateralized investors would feel its greater advantage than MBS and should assure them that they are more protected. As an investment option when investors are cautions in finding places where the place their money covered bonds must indeed be serving a purpose a giving an alternative. Without the alternative the investors cannot be possibly move investors would not make any more that would cause to increase the uncertainty. Thinking that banks would not allow themselves to go down given the recourse given to investors, the latter would be more of help in alleviating the credit crunch than becoming factors or elements to aggravate the credit crunch. Since there are several causes of the credit crunch solving the same should the same should be solving the causes. The covered bond was used as an alternative to asset-back securities in the US as a way for banks to generate funds to solve problems in credit crunch. Theoretically it was believed to be better than asset back securities in terms of better security for investors. Although it may not directly solve the issue of credit crunch because of the borrowing initiated by the bank when the bank should be lending more, there must also be way to attract people or institutions to put their money in the banks. Tight credit crunch is an issue that must be addressed by the government and the latter could not allow getting worse. If government could prevent the same into becoming a financial crisis, it must do so by allowing the issuing of covered bonds as alternative source of funds for banks. It could be a better way to make banks to take the responsibility for their issuance by not allowing the banks to transfer the risks as could normally be done in MBS. However sometimes the slow lending activity or credit crunch is caused by government or monetary authorities (Gray & Dilyard, 2005). One possibility is a projected decline in the value of the collateral required by banks to secure the loans where the change in value was caused by regulation. Another thing that could cause credit crunch is monetary conditions cause change as when the central banks unpredictably raises reserve requirements or imposes new regulatory constraints on lending as of way of directing the course of the economy. Given this and other causes banks could actually be running out of options to survive and operate profitability or above cost of capital. The issuance of covered bond which is actually more risky to them than MBS would have to be done although it is not the direct solution to the problem as the causes are external to them and the solution would be for the monetary authorities to eventually relax regulation or reserve requirements for banks when deemed appropriate. References: Baker (2007). Baker, D. (2007) Midsummer meltdown: Prospects for the stock and housing markets, Centre for Economic and Policy Research, Washington, DC. Retrieved 13 June 2011 from < http://www.cepr.net/index.php/publications/reports/midsummer-meltdown-prospects-for-the-stock-and-housing-markets> Beitel, K. (2008) The subprime debacle, Monthly Review, Vol. 60, No. 1, pp. 27-44. Burdekin & Siklos (2004) Deflation: current and historical perspectives. Cambridge University Press Chinloy and MacDonald (2005). Subprime lenders and mortgage market completion Journal of Real Estate Finance and Economics 30 (2), pp153–165. Fabozzi, and Kothari (2008).Introduction to securitization. John Wiley and Son Global Economics Crisis Resource Center (2009).Global Economic Watch: Impact on Business, Ethics and Society. Cengage Learning Goldstein (1999). Understanding Predatory Lending: Moving Towards a Common Definition and Workable Solutions. Retrieved 13 June 2011 < http://www.jchs.harvard.edu/publications/finance/goldstein_w99-11.pdf > Goldstein (2000), Note, Protecting Consumers from Predators Lenders: Defining the Problem and Moving Toward Workable Solutions, 35 Harv. C.R.L. REV, 225, 255 Gray & Dilyard (2005). Globalization and economic and financial instability. Edward Elgar Publishing Koch and MacDonald (2009), Bank management, Cengage Learning. , p. 543 Standard and Poors Corporation (2008). Standard & Poors creditweek, Volume 28, Issues 37-48. Read More