Imprudent Mortgage Lending, Poor Risk Management - Essay Example

Student name: Course: Professor: Institutional affiliation: Date: Introduction The global financial crisis of 2008 was situation characterized by massive collapse of stock prices worldwide mainly in the major stock markets of the US and Euro zone. There was also a lot of bailing out of large investment banks by the government in the US and Europe. There was also failure of businesses and decline in the buying power of consumers. The economies slowed as well triggering another crisis in the Euro zone (The Economist, 2009). The crisis did not happen instantly; it was an accumulated multiplicity of factors over several years before the crisis really emerged in 2008. There are conflicting contention as to the cause of the crisis but one common denominator in all arguments is that the crisis stemmed from the real estate sector of the United States. It would be wrong to isolate single factor as the sole causative factor to the crisis since there are many players involved in the sector who all did play or didn’t play a role in allowing the crisis to grow into unmanageable levels (BBC, 2009). Some of the common factors that led to the crisis are analyzed below under respective headings. Imprudent mortgage lending By the turn of the millennium, competition by players in the mortgage financing had grown considerably. As the competition grew the banks and mortgage financiers lowered their interest rates to keep abreast with the competition. There was also the abundance of cheap short term credit that mortgage buyers could take advantage of to buy the mortgages created by the mortgage financiers (Merrouche, 2010). The implication of the high demand for housing and the growing competition led to a relaxing of the mortgage laws. It was now possible for somebody to buy a house which he would have otherwise not afforded in the first place. High risk borrowers like people who had recently left jail or don’t have good credit ratings could also borrow. This raised the level of subprime loans in the market. It was no big deal if a borrower had no down payment for a mortgage loan facility, the banks were willing to offer credit to enable them buy a home. This was around the years 2001 and 2006; the default rate in the mortgage sector began to rise and thus affecting even the prices of the houses which started to slowly go down. In 2008 for instance the default rate was at 5.2% from 2% in 2001 (Chan, 2011). The imprudent lending led to an accumulation of high risk mortgages that were growing the default rate. The mortgages had however been sold to investors who bought them without knowing the risky nature of the mortgages. The mortgage facilitators unfairly passed a high risk liability to the investors who were now suffering the effects of defaulted loans creating a situation in the market where the investors were loosing their money and confidence in the system (Bernanke, 2010). Poor risk management After mortgages were securitized they were then sold to unsuspecting investors including investments banks. The banks either did not take due diligence in analyzing the risky nature of the loans. They relied heavily on credit ratings which had consistently failed to give the real picture of the loans being created in the real estate sector. The banks proceeded to buy high risk mortgages from the real estate sector believing they were making prudent investments but in real sense the loans had very poor credit rating and would not return their investments. The investors can however not be entirely blamed for buying the securities since they totally relied on rating agencies who had access to information that they could not access. The inadequacy in risk information or knowledge in relation to the securities from the real estate meant that the investment banks and companies did not do effective risk distribution in their capital and financing structures and thus exposing themselves to vulnerability incase of unfortunate turn of events in the market (Bernanke, 2010). Excessive leveraging Leveraging is simply using borrowed money to spend and return it later. If used wisely, leveraging is a smart way of seizing opportunities in the market especially when time is a big factor. It is imprudent to have a leveraging level where your assets are far much lower than your leveraged amount. This may result in a big financial crisis in case payment of the debt is made impossible by certain factors in the market and the capital cannot be able to absorb the losses (Bernanke, 2010). In the 2008 crisis, the securities being created from mortgages in the real estate were very attractive but unknown to the investment banks and financial firms they carried with them very high risk. The investors borrowed more than what they held in capital to be able to buy the securities. These highly leveraged financial firms also had a very high dependency on short term debts to enable their operations. These two factors raised their vulnerability too high such that incase of lack of confidence in them then they will be without funds to run their activities (Ritholtz, 2011). Earlier in 2004, Securities and Exchange Commission reviewed the leverage rules for five banks including Lehman Brothers and JP Morgan in Wall Street allowing limitless leveraging from the initial position of 12-to-1 leverage capitalization limit. Soon leverage hit 40-to-1 a very vulnerable position. By 2008 three of the banks had gone down leaving two to be bailed out (Denning, 2011). As can be seen from the graph below the level of defaulting on loans and mortgages in America had been growing slowly as the crisis neared. Source: The Economist.com Weak regulations and ineffective authorities The fact that bad mortgages could be created points to a situation whereby the authorities had not acted proactively to ensure there are stringent rules to be adhered to when mortgages are created. The situation was different since high risk mortgages could be created by lending to high risk individuals. The mortgages were then securitized and sold to unsuspecting investors who actually bought bad securities from non performing loans (Jickling, 2010). When the default rate begins to rise, it is when the investors discovered the risky nature of the loans. They however relied on rating agencies who either slept on their job or had vested interests. In either scenario, it points to a relaxed approach to dealing with the rating agencies since they were entrusted with the duty of ensuring the investors buy securities that were safe for them but not high risk loan products packaged as attractive securities by greedy dealers to investors (CNN Money). The situation directly points to a form of fraud involving the sector players especially the during the securitization of the mortgage, the end loser is the investor and the authorities had a duty of protecting them but they didn’t either because the government wanted to ensure people have decent housing or the government failed in supervising the sector. The misinformed ratings given by the agencies such as Moody’s, S&P and Fitch can be blamed on poor economic models that don’t reflect the reality on the ground. They may also be blamed on conflicts of interest whereby it is not clear whose interests the agencies serve. It goes without saying that there are some people who made huge profits from the crisis; they are the greedy people who tricked investors into buying securities rated as triple A while they were not even close to AA status. The markets reliance on ratings as inevitable as it may have been also made the fraud have a far-reaching impact as far as the crisis is concerned (Denning, 2011). Panic in the sector The financial firms were also very highly leveraged than expected; they also had a very high debt dependence arrangement. The institutions debts were by far greater than the capital that could be used to absorb the loss. It points to a relaxed supervisory role by the authorities since the institutions capital structure should be analyzed from time to time by the authorities (BBC, 2009) . After the failure of a few financial firms in the market which was attributed to the high default rate of the subprime mortgage products, there was widespread panic in the market; subsequently the investors and lenders didn’t at all want to risk their money anymore in the market. This resulted in a growing credit crunch made even worse by the fact that the loans ere not performing so that investors can recover their money. The panic in the market and the fact that the government intervened to bail out some financial firms created a situation whereby confidence in the mortgages weaned and there was areal credit crunch in the real economy since nobody wanted to risk their money out there with so much uncertainties and widespread defaulting of existing debts (Thomas & Holtz, 2011). Conclusion From the analysis of various factors leading to the financial crisis it is evident that there was a rush for money or greed for lack of a better term that was either going unnoticed or ignored by authorities in the mortgage market. a lot of mortgages were given to people who belonged to the high risk category, the mortgages were securitized and sold to unsuspecting investors and fund managers who had leveraged heavily against the rules relying on inaccurate ratings of the mortgages. When default rate starts to rise and the property house begin to fall, there is widespread panic and everybody is holding on to their money and the result is an economic crisis, the biggest since the 1930s depression. References BBC. (2009, August 7). BBC NEWS | Business | Timeline: Credit crunch to downturn. Retrieved August 19, 2013, from BBC Website: http://news.bbc.co.uk/2/hi/7521250.stm Bernanke, B. S. (2010, September 2). FRB: Testimony--Chairman Ben S. Bernanke-Causes of the Recent Financial and Economic Crisis. Retrieved August 19, 2013, from Federal Reserve Bureau Website: http://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm Chan, S. (2011, January 25). Financial Crisis Was Avoidable, Inquiry Finds, The New York Times. Retrieved from HYPERLINK "http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=1&" http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=1& CNN Money. (n.d.). The crisis: A timeline. Retrieved August 19, 2013, from CNN Website: http://money.cnn.com/galleries/2008/news/0809/gallery.week_that_broke_wall_street/ Denning, S. (2011, September 22). Lest We Forget: Why We Had A Financial Crisis: Forbes. Retrieved August 19, 2013, from Forbes Website: http://www.forbes.com/sites/stevedenning/2011/11/22/5086/ Jickling, M. (2010). Causes of the Financial crisis. Congressional Research Service. Merrouche, O. (2010). What Caused the Global Financial Crisis? International Monetary Fund. Ritholtz, B. (2011, November 05). What caused the financial crisis? The Big Lie goes viral. Washington Post. Retreived from HYPERLINK "http://articles.washingtonpost.com/2011-11-05/business/35283739_1_credit-crisis-financial-crisis-wall-street" http://articles.washingtonpost.com/2011-11-05/business/35283739_1_credit-crisis-financial-crisis-wall-street The Economist. (2008, October 23). Into the storm. Retrieved August 19, 2013, from Economist website: http://www.economist.com/node/12471135 Thomas, B., Holtz, D. (2011, January 27). What Caused the Financial Crisis?, The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB10001424052748704698004576104500524998280.html Read More