The intention of this essay is to provide an in depth and critical analysis of the financial crisis that took place between 2007-2009, in particular focusing on some key issues raised by the Foote, Gerardi and Willen paper ‘Why did so many people make so many Ex Post bad decisions? ’ Whilst there were many contributing factors, it is clear that a specific few played a particularly dominant role, primarily the ‘Bubble Theory’, irresponsible regulation, toxic CDO’s and $62 trillion of CDS’s. ‘That’s what bubbles are: they’re examples of mass delusions’ (Norcera, 2011).
Bubble theory’s are by no means a new school of thought, in fact they date back to the Dutch Tulip bubble in the 1630’s and it is these types of bubble that are believed, by many economists, to be the primary cause of the foreclosure crisis. The bubble theory explains the crisis as a natural progression of overly optimistic price expectations for a particular asset class, recently the US housing market. When the housing bubble began to enlarge, lenders were lulled into a false sense of security, which lead to large amounts of credit being extended to ‘sub prime’ borrowers, people who had shady or uncertified credit history.
However due to the inflating house prices the banks seemed to have little concern towards the credit being repaid. Although this credit was issued to subprime borrowers through the securitised credit market, securitisation was not necessarily the definitive cause of the crisis, but what it did was act as a catalyst allowing borrowers and investors to undertake their desired transactions. With this appetite for risk from lenders and interest rates being cut to 1% by the Fed, institutional investors were eager to chase higher returns.
The opportunity encouraged investment banks to anti up their leverage and create a higher yielding product which was directly linked to an ‘ever rising housing market’. The emergence of Special Purpose Vehicles (SPV’s) allowed banks to over leverage and buy mortgages which were then bundled together into a special purpose vehicle, proportions of these were then subsequently sold off as a Collateralised Debt obligations (CDO’s), ‘an investment-grade security backed by a pool of bonds, loans and other assets’. The theory behind this SPV was to reduce the lenders liability by pooling hundreds of supposedly ndependent mortgages, meaning that in the event of any mortgage defaults the loss would be contained rather than having a simultaneous effect on the other mortgages pooled within the CDO. Given that house prices were expected to continue along the bubble’s growth path, any losses from mortgage defaults would be naturally offset by house price inflation, or so they thought. Once the Investment banks had packaged these mortgages they then sought to diversify their liability by selling off the mutual funds to external investors, some more bullish than others and hence the segregation of tranches within the CDO packages.
The riskiness of each tranche was determined by the rating agencies, Standard and Poor/Fitch, which ranged from AAA (the lowest risk, but highest price) to CCC (the highest risk, but lowest price). In the event of any mortgage defaults, the highest rated tranche, the senior tranche, was paid out first and any subsequent losses were absorbed by the junior tranches, ie junior tranches were only paid once the other tranches had been paid. Given that the Fed had cut interest rates to 1%, the opportunity proposed by these CDO’s became increasingly more attractive.
The excessive demand chasing CDO’s forced banks to lower their credit requirement standard, which inevitably lead to subprime lending. This access to the credit markets for those who ordinarily would have been declined credit meant that CDO’s were becoming filled with comparatively high risk mortgages. This became increasingly problematic when borrowers began to default on their mortgage payments, the domino effect lead to the collapse of house prices and over 2million foreclosures.
This left worldwide investors and banks with failing CDO’s who in turn also defaulted on their payments and lead to a global ‘credit crunch’. Even the largest of investment banks such as Goldman Sachs and Morgan Stanley were so confident in their products that they too maintained large holdings of ‘super senior’ tranches on their balance sheets, thus wiping billions of dollars of their balance sheets too. However whilst it is true that the bankers over zealous nature and thirst to maximise profits lead to the breaching of standards and forfeit of reliable credit checks, they were still allowed to do it.
This leads to the plausible involvement of the credit rating agencies and the Governments lack of regulation and in some cases irresponsible regulation. A major concern surrounds the actions of US credit rating agencies, namely Standard & Poor and Fitch. Whilst they may not have anticipated the financial crisis, they, to a large extend suffered from institutional failure. The mathematical models that had been developed and used by the credit rating agencies were inadequate to deal with and provide accurate data concerning the riskiness of sub prime mortgages.
The mathematical modelling teams continued to use traditional out-dated 30 year mortgages to asses the likelihood of default. Mortgages issued after 2004 were based on a different credit rating tool, know as FICO. A FICO score takes into account 5 factors to help determine a borrowers credit risk, length of credit history and the various types of credit used, the current level of personal debt, credit history, amount of new credit and passed payment history.
These new mortgages were typically non documented adjustable rate mortgages and relied on the FICO score. It became apparent that the agencies had minimal concern towards the investors. The rating analysts within the agencies expressed their levels of apprehension towards the reliability of certain ratings, but they were cut short and dismissed. The credit rating agencies were simply concerned with maintaining or increasing their market influence by doing their job and providing the ratings that their clients employed them to generate.
In many cases these ratings were later downgraded within 6 months implying that their original job was either done with a lack of due diligence or there was an ulterior motive behind providing a flawless AAA rating. This was highlighted in the residential mortgage backed security Delphinus case study where 26 dummy loans were issued that were clearly not of AAA standard, yet sailed through as AAA. This leads us to the issue of the Government and their irresponsible lack of regulation towards preventing a financial crisis.
The neoliberalist argument suggests that the US Government was a big player in the demise of the financial sector. The Governments irresponsible regulation of banks allowed the passing of the Community Reinvestment Act from 1977, ‘the law was designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low and moderate income neighbourhoods’ (Wikipedia). The law actively encouraged low income earners to take out mortgages to buy a house, which in reality they could not afford.
To really tempt fate congress later allowed the act to be amended, allowing potential borrowers to opt out of income screening, therefore meaning that no credit worthiness was required to take out a mortgage. It is this link to the CDO market which allowed for such disaster to unravel, had this act not been so irresponsibly been amended, the banks would not have been able to bundle toxic debt and sell it as a repackaged CDO. In fact George Bush Junior actively encouraged it in 2002 when he campaigned for an additional 5. 5million low income homeowners by 2010.
By actively holding interest rates below the well-known monetary guide lines it encouraged mass risk taking, not only was money cheap but low interest rates also offered very little return in the banks so investors sought alternatives which lead them to junk CDO’s and CDO2’s. However these junk CDO’s were only half the problem, whilst they were being actively encouraged they were also being bet on and against, implying a magnitude of leveraged risk. In the 1990’s J. P. Morgan developed a strategy to hedge their loan risks know as credit default swaps (CDS’s).
Essentially a CDS is a bilateral contract between two parties that provides a level of insurance. A buyer would pay a yearly premium in order to protect the face amount of the particular bond or loan, but the CDS’s unlike a traditional insurance policy were subject to counter party risk only. This implication meant that if the counterparty was unable to pay or had gone insolvent then essentially the buyer was no longer covered. What it also allowed for was speculators to gain exposure to markets where they didn’t actually own the underlying assets or credits, which they were now betting on.
The crux of the problem arose when CDS’s were taken out on the subprime mortgage securities, which had been largely over rated by the ratings agencies, therefore providing false information upon which the investment decision and insurance policies were taken. When the defaults started to roll in the likes of AIG and Bear Stearns had billions of dollars wiped off their books. To exacerbate the problem almost all the major investment banks and investment houses had insurance underwritten by Bear Stearns, which of course was now insolvent. This domino effect lead to multi billion dollar losses across the globe.
The general belief amongst economists was that financial derivatives and their purpose was to dilute individual risk through risk sharing amid investors. In theory it should create a more efficient allocation of capital and price transparency, it is the mass trading of these derivatives that became problematic and raised a cause for concern. However whilst it is true that CDS’s, CDO’s, a vast lack of regulation and inaccurate credit ratings all facilitated the collapse in the financial sector, it is not clear that they were the actual cause of the financial crisis.
What is more evident of the actual cause is the fact that financial institutions and investors, as a whole did not foresee a collapse of housing prices. The collapse of house prices created mass negative equity and consequent defaults on subprime mortgages and also the falling face value of the subprime mortgage securitisations. Investment banks were particularly caught by surprise when the ‘super superior’ AAA rated tranches of CDO’s collapsed in value, given that they had relatively few defaults.
Another factor which points to the root cause of the financial crises was the levels of excessive leverage combined with large holdings of subprime securitisations. The rapid and unexpected losses from these large investment houses lead to the markets questioning their solvency and so a mass culture of hoarding developed along with a fire sale of assets in order to deleverage their exposure. All this combined resulted in a squeeze of cash flow due to market uncertainty and lenders became unwilling to lend. This unfolding of events lead to the CDS and CDO market getting wrapped up and associated with large losses.
It is for these reasons that the financial crisis developed and continues to develop implications for the future of the financial industry. References Nocera, Joe. 2011. “Inquiry is Missing Bottom Line. ” New York Times, page B1. January 29 Journal of Economic Perspectives—Volume 24, Number 1—Winter 2010—Pages 73–92 Credit Default Swaps and the Credit Crisis Rene M. Stulz Cordell, Larry, Yilin Huang, and Meredith Williams. 2011. “Collateral Damage: Siz- ing and Assessing the Subprime CDO Crisis. ” Federal Reserve Bank of Philadelphia Working Paper Money morning
Financial Crisis Inquiry Commission. 2010. “Credit Ratings And the Financial Crisis. ” Pre- liminary Staff Report, June 2, 2010 The Credit Rating Agencies and TheirContribution to the Financial Crisis MAUR ICE MULLARD http://www. investopedia. com/terms/c/cdo. asp#ixzz2BqfZ28TI Brunnermeier, Markus K. 2008. “Bubbles. ” In The New Palgrave Dictionary of Eco- nomics, eds. Steven N. Durlauf and Lawrence E. Blume, second edition Foote, Christopher L. , Kristopher Gerardi, and Paul S. Willen. 2008. “Negative Equity and Foreclosure: Theory and Evidence. ”
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