Causes of the Financial Crisis of 2008-2009 Essay
Causes of The Financial Crisis of 2007-2009 According to our financial textbook “ Financial crises are major disruptions in financial markets characterized by sharp declines in asset prices and firm failures” (Mishkin and Eakins 2012). In August 2007, defaults in mortgage market for subprime borrowers sent a shudder through the financial markets, leading to the worst U. S financial crisis since the Great Depression.
Alan Greenspan, chairman of the Fed, described the financial crisis as a “once-in-a-century credit tsunami”. (Mishkin and Eakins 2012). Furthermore, Wall Street firms and commercial banks suffered losses mounting to billions of dollars. Households and businesses found they had to pay higher interest rates on their borrowings, and harder to obtain credit. World Stock markets, investment firms and banks went bell up. A recession began by December 2007. (Mishkin and Eakins 2012).
The 2007-2009 Financial Crisis was caused by multiple interrelated causes including: subprime mortgages, unregulated mortgage originators, originate to distribute model which led to the securitization of loans, mortgage backed securities purchased by investors, and flawed credit ratings in behalf of credit rating agencies. The financial crisis was initiated by a bust and boom of mortgages due to low interest rates.. According to (New York Times 2011) The roots of the credit crisis stretched to another notable boom and bust: the tech bubble of the late 1990s.
When the stock market declined in 2000, the Federal Reserve sharply lowered interest rates to limit economic damage. As a result, lower interest rates make mortgage payments cheaper and demand for homes began to rise, sending prices up. In addition millions of homeowners took advantage of the rate drop to refinance their existing mortgages. These created the quality of mortgages to go down. (New York Times 2011); With its easy money policies, the Federal Reserve allowed housing prices to raise to unsustainable levels (Jickling 2010).
As a result of the Federal Reserve lowering interest rates and sudsidizing the housing market, the supply and demand for subprime lending and mortgage backed securities increased dramatically (Banking Law Committee 2009). According to Jickling (2010) it is difficult to identify a bubble until it bursts, and the Fed actions to suppress the bubble did more damage to the economy than waiting and responding to the effects of the bubble bursting. One of the most mportant factors, which caused the Financial Crisis in 2007-2009, is the subprime mortgages or subprime lending. “ Many Loans were made to borrowers with subprime credit or without appropriate credit analysis or documentation to support the loan (Banking Law Committee 2009). Furthermore, mortgage loans were made to borrowers for the first-time purchases. Some of these mortgages were structured so that they would require financing after a few years and could not realistically be repaid (Banking Law Committee 2009).
The ability to refinance loans, incentivized households to borrow money from the bank they could not necessarily afford, hence most defaulted on their loans. Moreover, a third factor which caused the Financial Crisis is unregulated mortgage originators. The mortgage brokers that originated the loans often did not make a strong effort to evaluate whether the borrower could pay off the loan, since they would quickly sell off the loans to investors in the form of a security, which is called securitization. (Mishkin and Eakins 2012).
This particular scenario will be discussed further in the paper, where securitization of mortgages will be discussed. The mortgage companies that originated subprime loans operated free of federal oversight and engaged in practices generally not permitted for federally regulated lenders. For these originators, little was done to prevent abusive or unsound lending practices (Bank Law Committee 2009). Many banks bought loans from unregulated originators, mainly for the purpose of packaging and securitizing them, but also for investment and trading purposes (Bank Law Committee 2009).
Moreover, many participants contributed to the creation of bad mortgages and the selling of bad securities, feeling secure they would not be held accountable for their actions. The unregulated mortgage originators had no personal responsibility if those contracts failed. And so it was for brokers, realtors, individuals in rating agencies, and other market participants, each maximizing his or her own gain and passing problems on down the line until the system itself collapsed. (Jinkling 2010).
In the end, these unregulated originators were concerned on their commission fee, for personal gains, not if any of the loans were going to default. The Originate to Distribute model plays an essential role, on the unregulated mortgage originators perspective and agenda. Many mortgage brokers and lenders operated under the “originate to distribute” model whereby they originated loans solely for the purpose of selling them. This model allowed them to earn loan origination fees without incurring any type of credit risk.
Many times this model, allowed the unregulated originators to take additional fees for collecting loan payments, escrowing and making payments for property taxes and insurance premiums. Additionally, unregulated mortgage originators can charge a fee just by receiving customer inquiries. (Bank Law Committee 2009). According to Mishkin and Eakins, the originate-to-distribute business modal was exposed to principal-agent problems, in which the mortgage brokers acted as agents for investors(principals) but did not often have the investor’s best interests at heart.
Once the unregulated mortgage originator earned their fees, why would they care if the borrower makes good on their payment. The more value the originator makes the more the commission fee (Mishkin and Eakins 2012). Another essential factor to have caused the Financial Crisis of 2007-2009 is the securitization of mortgages. The originate-to-distribute model made possible for the securitization of loans. The securitization process transferred most of the risk of mortgage lending from loan originators to investors who bought securities backed by the loans.
Investors thought that by purchasing these securities they were hedging some risk with these loans. However these loans were shifted back into the financial system because both banks and investment firms were also purchasing these mortgage backed securities (Bank Law Committee 2009). Securitization essential is transferring the risk of mortgage lending from banks to investors. Banks however also earned fees on securitization by origination, selling, securitization, underwriting, servicing to investors. (Jickling 2010). Securitization, led to the demand of mortgage-backed securities by risky investors.
In addition, mortgage-backed securities really fueled the collapse of the banking and financial system. Mortgage-backed securities were in demand by investors because these types of securities yield higher returns. These type of mortgage-backed securities promised higher yield based on higher interest rates and cash flows (Bank Law Committee 2009). This actually means that the higher the interest, the higher the return. One can say that investors who are risk lovers and to even lose it all were willing to invest in mortgage-backed securities.
Furthermore, investor demand for these securities became aggressive and stimulated mortgage originations, particularly for subprime loans that were easy to produce. Investors believed American households would not risk losing their homes by defaulting on their mortgages. Investors were convinced that mortgage backed securities were high yield and safe finance products (Bank Law Committee 2009). According to Mishkin and Eakins, commercial and investment banks, who were earning large fees by underwriting mortgage-backed securities had weak incentives to make sure that the ultimate holders of the securities would be paid off.
All these products, including CDO’s, mortgage-backed securities and subprime mortgages are so complex that most investors could not even determine who owned the assets, or even the value of the cash flows on these underlying assets (Mishkin and Eakins 2012). Ultimately, the credit rating agencies contributed significantly to the financial crisis by issuing flawed investment grade ratings to subprime mortgage-backed securities that declined in value when the housing market collapsed. The ratings provided by the agencies were erroneous or inaccurate.
Most ratings wre based on risk models which provided inadequate consideration on liquidity and in many cases were paid for by the issuers of the securities. The ratings were relied by a wide range of investors and were one of the main causes in the spread of “toxic assets” throughout the financial system. (Bank Law Committee 2009). If the credit agencies would have been more deligent about providing accurate ratings and the risks on the mortgage-backed securities, investors would have been more cautious about investing in these types of financial instruments. (Bank Law Committee).
According to Jickling, many credit rating agencies gave AAA ratings to numerous issues of subprime mortgage-backed securities many which were subsequently downgraded to “junk” status. Furthermore, Critics cite poor economic models, conflicts of interest, and lack of effective regulation as reasons’ for the rating agencies’ failures. (Jickling 2010). A recent SEC report based on an examination of the credit rating agencies found numerous deficiencies (Bank Law Committee 2009). These agencies should have looked closely at the specific written procedures and policies on etermining ratings based from the models and methodologies (Bank Law Committee). A significant reason, why credit rating agencies were subject to conflicts of interest is because the large fees they earned from advising clients on how to structure products that they were rating meant that they did not have sufficient incentives to make sure their ratings were accurate (Mishkin and Eakins 2012). The result was wildly inflated ratings that enabled the sale of complex financial instruments that were far riskier than investors thought (Mishkin and Eakins 2012).
In conclusion, many factors contributed significantly to the Financial Crisis of 2007-2009 including subprime mortgages, unregulated mortgage originators, originate to distribute model which led to the securitization of loans, mortgage backed securities purchased by investors, and flawed credit ratings in behalf credit rating agencies. Also investors trying to earn higher yield on mortgage-backed securities while at the same time hedging risk triggered The Financial Crisis of 2007-2009. Workscited Jickling, Mark, (April 9, 2010). www. fas. org. Causes of The Financial Crisis.
Retrieved April 11, 2012, from www. fas. org/sgp/misc/R40713. pdf. Bank Law Committee: Bleier, Michael E. , Bondehagen Kay E. , Brewster Donald P. , Collins Kathleen. , Eager Robert. , Fein Michael L. … Ziskind, Martha. (September 2009). The Financial Crisis of 2007-2009, Causes and Contributing Circumstances, 8-19. Retrieved from: http://apps. americanbar. org/buslaw/committees/CL130055pub/materials/201001/causes-report. pdf Mishkin, Frederic S. , and Eakins Stanley G. , (2012). Financial Markets and Institutions. Boston, MA: Pearson Education.