Understanding the Economic Impact prior to Wells Fargo Foreclosures - Essay Example

? Understanding the Economic Impact prior to Wells Fargo Foreclosures College: Presented Understanding the Economic Impact prior to Wells Fargo Foreclosures Introduction In 2007, United States was hit by financial crisis, which emanated from a crisis in the subprime real estate loans (commonly called subprime crisis). According to Rezaee (2011), the crisis resulted from defaults on United States subprime mortgages, many of which were packaged and sold to buyers in the United States and around the world. Many Mortgage lenders and even other companies not directly involved in the business suffered huge losses and some collapsed. One of the financial institutions involved in mortgage lending that stood the crisis is Wells Fargo & company, although its rating dropped since 2007, in the light of the financial crisis. In response to the crisis, Wells Fargo & company and other companies increased foreclosure filings by 2008 to the highest record in historical. This paper provides an overview of the subprime lending industry and state the economy in Wisconsin just prior to subprime crisis and the Wells Fargo Foreclosures. Discussion Prior to 1980s, people in Wisconsin, US, had only two choices for obtaining a mortgage. According to Knapp (2010), one could obtain a home loan insured by either the Department of Veteran affairs or by the Federal Housing administration. Borrowers with good credits histories would typically obtain new loans from a bank, saving and loan or any other financial institution. Knapp (2010) elaborates that obtaining mortgage loans became much easier with the deregulation of the lending industries in the beginning of 1980. For instance, the monetary control act and the deregulation of the Depository institutions in 1980 removed the restrictions that imposed a ceiling on the interest rates charged on mortgage loans. One remarkable impact of the deregulation is that it led to the introduction of new mortgage loans, which included ‘adjustable rate mortgages that were particularly favorable to mortgage borrowers who had their credit profiles impaired. However, according to Knapp (2010), these events did not lead to an explosive growth in the mortgage industry until the securitization of mortgage loans in the late 1990s. The securitization option encouraged the majority of the existing mortgage lenders to adopt a new business model which Knapp (2010) refers to as “originate to distribute” business model. This new model required that the credit risk posed by the mortgages loans was not exclusively to be absorbed by the lending institutions. Rather, it was to be shared with other investors in the world who purchased the Mortgage-backed securities. Knapp (2010) further argues that by 2006, approximately one-fourth of all new mortgage loans in United States were made to subprime borrowers while the other ratio was securitized and sold to investors in the United States and around the world. The increased demand for high-yield mortgage-backed securities among investors, including institutions such as hedge funds institutions and large banks, led the lenders to ratchet up their marketing efforts. They then came up with new products, which were designed specifically for the sector of the mortgage market in order to persuade individuals who were deemed to be of high credit risks to obtain mortgage loans. Among the most popular of these products were the stated-income” and the “interest-only” mortgages. The stated-income loan required an applicant to simply report his or her annual income during the application process of the loan (Knapp, 2010). The lender depended on the applicant’s self reported income in the determination of the size of loan that one could afford. According to Knapp (2010), many applicants for the Stated-income loans grossly overstated their annual income so that they could purchase a larger home than was economically feasible given their actual incomes. An individual who obtained the Interest-only mortgage loan was required to pay interests on his or her loan for a fixed period of the mortgage term. The loans could then be extended over either the first five to 30 years of the mortgage term. Most of them were extended to 30 years, similar to other mortgage loans. Housing prices in the regions where subprime lending was prevalent rose rapidly during the late 1990s and afterwards and many subprime borrowers purchased homes with intentions of achieving short-term gains. For instance, according to Knapp (2010), an individual who obtained a 100% loan to purchase a $2 million home could be able to realize more than $ 400,000 profit in a period of two years if the house prices rose by 10% each year. Generally, this increased the demand for the mortgage loan and as a result, the housing prices reached peak in the United States in 2006, though had started to fall in some parts of the country a few months before. By 2007, the prices had declined by around 10% from their peak levels in most regional housing markets and by mid 2008, the fall in prices had reached 20% from the peak. Knapp (2010) argues that many mortgage borrowers started defaulting on their monthly mortgage payments, as a result of the falling prices. In fact as Knapp (2010) explains, most of them “became upside down in their homes” as the unpaid values of their mortgages grew beyond the market values of their homes. An estimated 9 million of the U.S. house owners had negative equity in their homes by early 2008. This sharp downturn in the housing market had a huge and drastic impact on mortgage lenders, especially subprime mortgage lenders (Gordon, 2011). The financial problems facing the mortgage industry spread to other sectors of the economy because of the securitization of subprime mortgage loans. Many high profile companies in the financial services industry that had no direct connection with the subprime mortgage lenders suffered huge losses as the market value for mortgage-based securities plunged. Some of these institutions collapsed while others merged to stabilize amidst the crisis. For instance, in October, 2008, Wells Fargo agreed to buy Wachovia Corporation, a bank holding company that owned a number of non-bank broker-dealer entities such as Wachovia capital markets L.C.C and Wachovia Securities L.C.C (Gordon, 2011). As the prices of the Mortgage-backed securities continued to fall, Wells Fargo, among other banks increased foreclosure fillings. In fact, McKernan (2010) argues that foreclosure record in Wisconsin rose to a record of 30,000 properties in august 2008. Generally the above factors fueled and uncovered rampant mortgage fraud that left the participants, the country, and the world economically desperate, and triggered one of the worst economic meltdown in history. Conclusion Wisconsin was hit by great economic crisis prior to the Wells Fargo Foreclosures. This was caused by a financial crisis and recession that rattled the banking world. The crisis in the mortgage lending industry stemmed from defaults on U.S. subprime mortgages, many of which were packaged and sold to buyers in the United States and around the world. As a result of the crisis, many institutions, including those that are not directly involved in lending collapsed while others merged to stabilize amidst the crisis. Further, the mortgage lending institutions increased foreclosure fillings, the prices of the Mortgage-backed securities continued to fall. The resultant crisis severely affected the participants, the US and even the world. References Gordon, G. L., (2011), Stabilizing economies through diversification, Reinventing Local and Regional Economies, N.Y: CRC Press Knapp, M. C., (2010), New century financial corporation, Contemporary Auditing: Real Issues and Cases, Mason: Cengage Learning McKernan, p., (2010), Understand the fundamentals of the US foreclosures, Fire Sale: How to Buy US Foreclosures, California: John Wiley & Sons Rezaee, Z., (2011), Core deposits as a special type of intangible asset valuation, Financial Services Firms: Governance, Regulations, Valuations, Mergers, and Acquisitions, New Jersey: John Wiley & Sons, Read More