This paper seeks to summarize a stream of research that has delved into the major causes of the financial crisis in 2008. More precisely, we will be looking at a combination of causes such as the sub-prime mortgage crisis, the mortgage backed security, the collateralized debt obligation as well as how the Incidental credit-default swap contributed to the Incident. This paper will begin from analyzing the past, when it happened and how it built up and resulted in the financial crisis. The financial crisis of 2008 and will be useful for the people unversed in economics or insane but wish to have a basic understanding of its causes and history.
During the early 2000, numerous companies and individuals bought new operating systems that were YAK-ready in fear that the mike” problem would cause computer systems to malfunction. This had allowed technology companies to generate obscene amounts of revenue. At one point, the telecommunications giant, Nortek, owned one third of the stock markets in Canada (Wahl 2009). As a result, stock prices of these companies started to increase rapidly and this led to investors investing in all sorts of high tech companies, spawning the “Tech Bubble”.
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The bubble eventually burst, and as stock prices began to decline, so did the value of these tech companies and many were forced to declare bankruptcy. The American Stock Exchange Index, Nasdaq, dropped from 5048. 62 to 3649 (Trading Charts 2013). Along with the disruption and uncertainty after the 9/1 1 bombing of the World Trade Centre, the US economy took a serious hit and was plunged into recession. In an effort to improve the situation, the Federal Reserve attempted to reduce the American interest rate drastically. Interest rates were lowered 13 times from 2001 to 2003, from 6. To 1. 0%, causing the interest rates to be at their lowest level since 1958 Cones, Swoon and Frank 2003). Table 1: Federal Reserve Interest Rates from 03/01/2001 to 25/06/2003 Indeed, the primary effect of a low interest rate is that it stimulates economic activity. With lowered interest rates, the cost of borrowing becomes much lower as borrowers do need not pay as much interest as before thus are willing to borrow more money. Mortgages, car loans and other credit products can now be obtained relatively cheaper than in the past.
This results in an increase of individual household expenditures on consumer products such as houses or cars. Furthermore, the lowered rates would allow large corporations to incur less operation cost and spend more on business expenditures which in turn, allowing them to achieve a better profit margin on their balance sheets.. In addition, that an increase spending in capital goods can also indirectly lift the long-term performance of the economy (Killeen 2010). Another benefit of the low interest rates is that it helps to recapitulate the industry banking system, allowing the net interest margin (MIN).
The net interest margin is a reference measure of how rewarding a firm’s investment decisions when compared to its debt situations. A positive interest margin would indicate that the firm has made an optimal decision, as interest income are higher than the amount of interest expense incurred by investments. (Killeen 2010) exuberant about finding something to do with their newly borrowed cheap money. However, as investors were still traumatized from the stock market’s dotcom bust, the next best option was to put their money in real estate given that it does not go bankrupt like how a company would (Kenton 2013).
Table 2: Housing Prices vs.. Inflation (National Association of Realtors) Table 3: Median and Average Sales Prices of New Homes Sold in the U. S. 1963-2010 Monthly Data (U. S. Census Bureau New Sales) The above graph from the #1 source for US population data and economic indicators, Census Gob, shows that housing prices has consistently increased at an alarming rate since 2001-2006. A closer look at the data suggests that the average housing price in the year 2000 is $207,000 and shot up to $246,300 in 2003 before peaking again at $274,500 during 2004. Evidently, people were taking advantage of the low interest rates for purchase of homes.
With an interest rate of 1. 0%, this could mean that anyone could make a mortgage loan and sell off the mortgage loan a few months after and make a hefty profit. However, it does raise suspicion as to whether the grossly inflated housing price might lead to yet another bubble. A bubble can be said to be a situation in when there is an excess of public expectation for future prices which causes price to be impertinently raised (Case and Sheller 2003) A closer examination reveals that home prices during this period had raised nominally by 129% in San Francisco, 94% in Los Angels and 126% in Boston, even thou inflation.
In 2003, large samples were drawn from a few areas: Orange County, California; Alameda County; Middlesex County, Boston; Milwaukee County and Wisconsin were given surveys about their future price expectations of the home prices. It was shown that about 90% have expected an increase over the next several years. In addition, when asked about the result of the average rate of price increase per year over the next ten years, Orange County’s and Boson’s reckoned a rate of 13. 1% and 14. 6% respectively (Douglas 2011). The most optimistic speculation came from San Francisco, at 15. While the least optimistic was 1 1 . 7% from Milwaukee (Karl and Robert 2003). Furthermore, even with the lowest rate of 1 1 . 7%, the price of the property would be tripled in a span of 10 years. As the home prices rose beyond household incomes, numerous prospective home buyers were no longer able to afford the house payments under the traditional fixed rate mortgages. However, the low interest-rate was able to allow such buyers to afford house payments under the use of the adjustable-rate mortgage (ARM) (Investigated 2013). Interest rate changes to reflect market conditions . There are 2 examples of adjustable rate mortgages; the 2/28 mortgage rate is where an initial interest rate is fixed for 2 years before resetting to an adjustable rate for the last 28 years of the mortgage; the 3/27 mortgage rate is the same as the 2/28 rate except that interest rates are fixed for the initial 3 years before resetting to an adjustable rate for the last 27 years of the mortgage(limestone 2013).
Unlike the traditional fixed rate mortgage, the ARM could provide the buyer with lower monthly payment initially as the short term interest rates can be said to be lower than the long term interest rates. To illustrate with an example, interest and principal monthly payment $400,000 30 year fixed mortgage rate with 6% interest rate would be $2400 while for the same $400,000 30 year ARM with an initial 4% would come up to be about $1900. Taking advantage of the growing housing market, the mortgage lenders begin creating a different form of ARM, called the Payment Option ARM.
With this option, the borrower may decide to make fixed payments of interest and principal payments as a whole and this in turn would reduce the outstanding balance on the mortgage loan every month. Alternatively, the borrower may also decide to make payments of only interest or could choose to make part of the interest payments. Essentially, this option made it temporarily affordable for a greater majority of home buyers and this contributed to rising home price(Holt 2009) . The ARMS was able to provide the home buyers with a lower monthly payment because short-term interest rates were generally smaller than long-term interest rates.
An economist, Alan Greenshank, who is also the chairman for the US Federal Reserve since 1987 to 2006 was accused of to have orchestrated the financial crisis that resulted by promoting the usage of adjustable rates mortgage due to the low interest attest that were being regulated by financial institutes (Neaten 2012). The Supreme Mortgage Crisis Among the majority of home buyers who are now able to purchase a mortgage loan are the supreme mortgage buyers. A supreme mortgage is one that is usually handed out to borrowers with lower credit ratings.
As the mortgage lender views the borrower as having a higher-than-average risk on defaulting, these lending institutions usually charge interest at a rate that is significantly higher than a conventional mortgage in order to remunerate themselves for the additional risk undertaken (Supreme Mortgage Loan 2013) . Historically, supreme mortgage loans has the foreclosure rates of ten times than of a normal prime rate (Elaborated and Toreros 2007). It was particularly difficult for the low-income families to own a house as there were major barriers for them to do so.
A responded an average of 4. 6 major barriers in owning a home. These barriers are insufficient savings, insufficient hourly wages, poor credit ratings, high incurred of debt and even discrimination by mortgage lenders (Santiago and Galatea 2004). In recent years however, political measures has been taken to improve homeownership amongst low-income families. One of them is the Section 8 Housing Choice Voucher Program, which is the federal government’s extensive program for assisting the low- income families to afford housing in the private market (HUT GOB 2013).
In 1995, there was a modification towards the Community Reinvestment Act that forced financial institutions to increase their mortgage lending to the low-income families (Gather 2008). The Federal Home Loan Mortgage Corporation (Freddie Mac) and Federal National Mortgage Association (Fannies Mae) are public government sponsored corporations who increases the funding available in the market by buying mortgages on the secondary market. It buys from the loan originators, securities them, and finally selling them as mortgage backed securities to investors on the open market (Financial web 2013).
Freddie Mac and Fannies Mae would only choose to buy mortgages that complied with strict standards of down payment and income requirements. Unfortunately, mortgages that belonged to low-income families often did not comply with those standards. However, in 1996, the Department of Housing and Urban Development passed on a regulation that required Freddie Mac and Fannies Mae to increase the percentages of mortgage loans held by low-income household in their portfolio. As a exult, strict standards that were once absolute had then been relaxed.
Housing prices were soaring since the lowering of interest rates in 2001 and these increase in housing prices directly affected the prices of the mortgage backed securities as well, causing it to increase at a rapid rate as well. People do not have a financially rational mindset and they do not care if the performance of any single loan were good or not hence they simply bought the security because they were under the impression that the housing market was good (Candid 2009). The increased serialization of the home mortgage debt also led to the diminished housing tankards.
Azans (2013) explains how the serialization of these mortgage debt severely impaired the mortgage market. Taking advantage of the low interest rates, mortgage lenders in the U. S. Started marketing to lower income households. They were encouraged to do so by the introduction of “serialization” of mortgages – instead of keeping mortgages on their books and relying on homeowners to pay them down, large numbers of mortgages were bundled by investment firms and sold to banks and other investors. Two types of these bundles sold are mortgage backed securities and collateralized debt obligation. Empires of the similar nature, by the banks and financial institutes to the third party financial institutes or investors as investment opportunities (Buckley 2011, 3). In a mortgage backed security, a bank or mortgage company first makes a home loan. The bank then sells that loan to some investment bank or a governmental enterprise like Freddie Mac and Fannies Mae. These financial institutes then bundle hundreds of such loans and place it into a pool to be sold as securities to investors on the secondary market.
Investors who have purchased these bundles will be paid from the interest and ironical payments flowing into the pool from the mortgages. These securities or bonds are ordinarily packaged into trenches that have different categories in terms of risk and return. For example, the least risky trance would usually contain only about 1-3 years of payments as the assumption is that borrowers would make payments for the first 3 years. The riskier trance may contain the next 5-7 years of payments (Forbes 2013).
The mortgage backed security is packaged in such a way that investors are able to choose their preferred expected rate of return with a riskier rancher. The least risky trance, or commonly known as the senior trance, held about 80% of a bond issuance and received a AAA rating from the credits ratings (Allies and Halverson 2013). An AAA rating meant that the security had the same security rating as the US Treasury Bond, a security that could assumed to be risk- free. However, a large fraction of this “AAA” rating had belonged to supreme borrowers, the low credit ratings borrowers with an alarming rate of defaulting.
This was made possible through the use of a “non-documented” loan whereby both the loaner and he borrower were not statutorily required to provide any information about themselves (Clark 2013). The supreme-mortgage loans were packaged in such a way that the keen investors merely understood the security through its risk and return model, without actually realizing that the mortgage backed security was actually derived from the pool of supreme-mortgages. Additionally, investors were relying on the AAA rating that were given by the three credit ratings agencies: Standard and Poor’s, Moody’s and Fitch (Kinsley 2012).
The ratings that are given by credit rating agencies has always been strictly based on he ability of the debtor’s ability in making his debt payments and his risk of defaulting (Standards and Poor 2013). There has been criticism about subjective credit ratings that were given by the 3 ratings watchdogs after the bursting of the housing bubble. As the investment banks and financial institutions are the ones who provide the fees to these ratings agencies therefore this may create a conflict of interest between the agencies and the financial institutes.
While the purpose of these credit ratings agencies are made for the benefits of the investors, the real linens of these credit ratings agencies are the investment banks and financial the agencies have an incentive to accede to the ratings that they want, for fear of losing them to the other competitors. It has been revealed that the employees at these three credit ratings agencies knew about the dangers of the supreme mortgages, but had given their approval anyway(Ellis 2010).
The subcommittee of these credit ratings agencies mentioned that in 2006, an arrangement was initially made to revamp their flawed risk models but was eventually overturned as they were worried that the new risk models would amen the ratings of these supreme mortgages, leading to unhappy customers (Ellis 2010). The subcommittee further revealed that despite the credit rating agencies being mindful of the high risks in the housing market, the rating models that were being applied still awarded grossly inflated grades to the securities.
The financial executives from Standards and Poor’s had acknowledged that the financial institutions generally shop around for the best preferential ratings. The former vice president of Moody’s had also admitted that he was constantly pressured to accept risky deals as he was fearful of losing the customers to the other monitors (Bolton, Freesias and Shapiro 2009). Clearly, the AAA ratings that were given to these sub-prime mortgage backed securities were not a fair representation of the real underlying risks.
The once highly esteemed reliability, independence and Judgment of these credit agencies were severely impaired by these investment banks. However, because the security is based on a tripartite setting, there can be other risks involved in the mortgage-backed security. A great risk is that the borrowers may end up not paying at all. When the borrower prepays the mortgage for the purpose f refinancing, then the investor gets his initial investment back. However, refinancing often occurs when interest rates are low, hence, not leaving much room for other alternatives for the investor.
The worst risk is when the borrower is forced to default, that is when the investor takes a drastic loss (Madame 2013) and this was one of the major reasons of what it had led on to the 2008 financial crisis. Furthermore, these trenches can be further repackaged and sold off as collateralized debt obligation. Collateralized debt obligation, or COD, can be defined as the selling of a combination f mortgages and debts of various fields, such as housing mortgages and vehicle loans, by a financial institution (Buckley 2011, 3).
It is similar to mortgage backed securities with the difference being COD is a mixture of non-similar loans whereas MBPS consists of loans with a similar nature. COD is one of the crucial factor that led to the collapse of the housing bubble and ultimately resulting in the infamous financial crisis of 2008. As middlemen by selling off repackaged MBPS and COD to outside third parties hence due to this, the banks and sellers are not shouldering the debt on their balance whets personally, but instead was treating the MBPS and COD as a commodity that can be sold off and increase revenue (Buckley 2011, 3).
Although not visible plainly on the balance sheets, the increasing sale of MBPS and COD gradually increased the leverage of capital on these banks and financial institutes. Karl and Robert also commented that in a housing bubble, because home buyers are under the impression that they would be significantly compensated from the future price increase, a house that would normally be considered overpriced for them would now be an acceptable purchase.
Also, it could be said that in a bubble, these home buyers would portray irrational behavior such as not saving as much as they normally would, since they believe that the increased worth of their home would affect the savings for them. What had been merely a speculative theory of Karl and Robert turned out to be prophesied a few years later. Table 4: Housing prices consistently increased and reached their peak in the 2nd quarter of 2006 before finally falling by less than 2% in the second quarter of 2006.
Speculators who purchased homes with no down payments simply defaulted as soon as the home prices fall. A large number of them did not even pay the first monthly payment. Supreme homeowners who exercised the adjustable rates mortgage found it difficult to refinance as the reduction in home prices simply meant that they had zero equity in their homes. Eventually, when the adjustable rates spiraled upwards, these supreme homeowners simply could not cope with their monthly payments.
As a result, foreclosure rates begin to increase by 43% over these two quarters and grew drastically to 75% from 2006 to 2007. (Patrick 2013) Fixed rate mortgages had increased foreclosure rates for about 55 percent for prime homeowners while prime homeowners had an alarming foreclosure rate of about 80 percent. Similarly, adjustable rates mortgage had increased foreclosure rates for about 400 percent(prime) and around 200 percent(supreme). (Alex 2008) Much like how the increment of housing prices has a continuum effect, falling housing prices reinforced the continuing fall in home prices.
The rapid increase of foreclosure rates meant that there was a great increase in the inventory of homes that were available for sale. The spiraling effect of this is that home prices sinks even deeper and more homeowners re being forced into a negative equity position, leading to even more foreclosures. Correspondingly, the sudden decrease in foreclosure had a detrimental effect on the value of mortgage-backed securities. The investment banks had great difficulty in trying to issue new mortgage-backed securities and this in turn stamped out a great had simply burst.
It turns out, Karl and Robert were not the only economic analysts who classified the housing boom at that time, to be a housing bubble. Several other economic analysts including influential economists like Robert James Sheller, Professor of Economics at Yale University (Sheller 2005), Dean Baker, American macroeconomics and co-founder of the Centre for Economic and Policy Research (Baker 2002) , Michael Hudson, former Wall street analyst (Hudson 2006), and many others. Credit Default Swaps (CDC) Credit Default Swaps, or CDC for short, is another major cause of failure that resulted in the Financial Crisis of 2008.
CDC is comprised of a contract between two parties in which the one party will pay an amount of premium to the other party for assurance on a bond or loan in case it defaults, hence this acts as a form of insurance as the iris party would be able to claim a capital sum from the ‘insurer’, which is the latter party (How does a Credit 2007). Hull and White (2000, 3) defines credit default swap as a financial instrument that provides insurance against the risk of a default by a particular company, which is referred to as the reference entity whereas a default by this company is known as a credit event.
In the case of a credit event occurring, the buyer of the insurance is entitled to sell bonds issued by the company for their face value to the seller of the insurance whom had agreed to buy the bonds. The total face value of the bonds that can be sold is known as the credit default swap’s national principal. The buyer of the CDC makes periodic payments to the seller until the end of the life of the CDC or until a credit event occurs. These payments are typically made in arrears every quarter, every half year, or every year.
The settlement in the event of a default involves either physical delivery of the bonds or a cash payment. During the period of the Financial Crisis, CDC dealt the finishing blow when the numerous defaults occurred, with a staggering amount of SUDSY trillion outstanding (Hull and White 2000, 5). The increasing number of defaults on these insured loans ensured that the buyer of the CDC will be refunded with their principal. Consequently, this building up forced the bank, Lehman Brothers, to declare bankruptcy and governments to intervene by putting in funds for a bailout of other banks (Hull and White 2000, 5).
A simple illustration on how CDC works during financial crisis: Above is a simple diagram of how CDC worked during the financial crisis. For example, Lehman Brothers wants to raise $1 billion and issues bond in exchange for funding. On the other hand, an investment manager has a pension fund of $1 billion o invest and wants to create some decent return. He could invest in Lehman Brothers which will give him 10% interest after 10 years. However, the credit agencies in the market I. E.
Moody’s, Standard and Poor’s only gave Lehman Brothers a EBB allowed as other securities pose a higher risk. Hence, he could not invest in Lehman Brothers which is only rated EBB. On the other hand, there is Alga insurance company which came into the picture. Alga was considered by credit agencies as a company with AAA credit rating. Since there is credit approval from the insurance company that the bond was 100% safe and that he full value of the bond would be covered if Lehman Brothers default, the EBB bond from Lehman Brothers would now be considered as an AAA bond.
The credit default swap was then used and given to the pension fund investment managers by Alga in exchange of 1% (I. E. 100 basis points) of the interest the investment managers get from lending money to Lehman Brothers. Alga is said to give protection for that debt against Lehman Brothers and in return get a yearly insurance premium of 1%. If for any reason Lehman Brothers default on their debt and is unable to repay it, Alga will have to compensate $1 billion. The pension fund then receives a net 9% of the interest and is protected no matter what happens.
However, we realize that Alga did not have to do anything to get its yearly interest. Although CDC is similar to an insurance policy, there is a slight difference in that CDC is unregulated unlike insurance. People in Walters did not want to call it as insurance because if they did, it would be subjected to federal and state laws (Buckley 2011, 76). Mortgage back security or collateralized debt obligations could also use CDC to protect investors in those debt or bond issued. As CDC is unregulated, Alga id not need to set aside reserves like what normal insurance companies do.
They could Just be taking premiums from many all sorts of sources taking up more liability as they thought it was not possible for banks like Lehman Brothers to default on their payment. Furthermore, Alga may not only insured Lehman Brother’s debt. It was possible for them to give CDC to other pension funds to insure them against another corporation’s debt Fee 2008, 31). Thus, as Alga had an excellent rating from Moody’s etc, they could continue insuring many companies’ debt without the need to set any none aside.
As long as Moody’s does not get suspicious and realize Alga is insuring $1 trillion of other companies’ debt although it only had $100 billion in assets, Alga could continue to keep insuring to get an excellent income stream (Buckley 2011, 82). As CDC is also unregulated, a company taking on a CDC do not need to own the underlying instrument that CDC covers (Credit Default Swaps Intro 2011). This means that companies could buy insurance without even owning the bond or debt. In the real world, we cannot buy insurance against a neighbor’s house in the event it urns down.