2007-2008 Subprime Mortgage Crisis Research Paper

Pages: 11 (3418 words)  ·  Style: Does not matter  ·  Bibliography Sources: 14  ·  File: .docx  ·  Level: College Junior  ·  Topic: Finance  ·  Written: December 17, 2018

$100 million was underwrote by the Treasury in their mortgages, then returning them to be owned by the government (Sorkin, 2010; Frame et al., 2015). In case Freddie and Fannie had signed up for bankruptcy, it would have caused a collapse in housing market. This was government guarantees were required for banks to lend.

AIG Insurance Company

AIG is among the world’s largest insurers. Its business mostly entailed traditional insurance products. When it engaged into default swaps for credit, trouble was brewed up. These swaps made the assets which were in support of mortgages and corporate debt get insured. If AIG ran bankrupt, the financial institutions which brought these swaps would fail.

The swaps of AIG against subprime mortgages was propelled to verge of bankruptcy. AIG was compelled to bring up millions of capital as the mortgages connected to these swaps became default. As stockholders got to know about the situation, they put up their shares for sale ,creating a challenge for the AIG to cover the swaps (Moran, 2009).AIG could not sell the swaps before they were due despite that they had enough assets to cover the swaps.

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AIG received an $85billion loan for two years from the Federal Reserve to increase their emphasis on the global economy. The government was given 79.9 % of AIG’s equity and they were given the right to management replacement. It was also given veto power above all vital decisions like payment of dividends and asset sales. In October 2008, Edward Liddy was hired by the Fed as the CEO and chairman to oversee the company’s management (Moran, 2009).

Research Paper on 2007-2008 Subprime Mortgage Crisis Assignment

Fed’s plan was to break up AIG and sell the pieces to refund the loan. However, the stock market plunge which happened in October made that difficult. The potential buyers required any extra cash to be included in their balance sheets. The treasury department bought $40 billion from AIG’s Capital Repurchase Plan. $52.5 billion in securities backed by mortgage was bought by the Fed. The money enabled AIG to retrieve its credit swaps saving a large percentage of the financial industry from collapsing. The bailout of AIG was identified as one of the biggest financial rescues in the US history.

What ethical misconduct did these individuals and/or entities engage in that caused the subprime mortgage crisis?

Hedge funds are ever trying to perform better than the market. They made demand for mortgage-backed securities by joining them with credit default swaps guarantees. What would be the negative effect? Nothing, until fed began to increase their interest rates. Those with mortgages whose rates could be adjusted couldn't make these larger payment. Demand and housing prices decreased. They defaulted when they were not in a position to sell their homes. AIG almost ran bankrupt in their attempt to cover the insurance (Mishkin, 2011).

Deregulation was also another major cause for subprime mortgage crisis. In the year 1999, banks were given permission to work as Hedge funds. They as well put depositor’s funds into investment. That is what resulted to Savings and Loans Crisis in 1989 (Davidson, 2008). A couple of lenders used millions of dollars to influence state legislatures to freeze laws. Those laws would have prevented borrowers from having unaffordable mortgages.

Hedge funds and banks got so much money from selling securities which were mortgage-backed resulting to a high demand for the latent mortgages. That is what made mortgage lenders reduce standards and rates for their borrowers continually (Davidson, 2008). The mortgage-backed securities gave lenders permission to package loans into bundles and sell them. Banks were permitted to have extra funds for lending in the time of conventional loans. Availability of advent of interest-only loans made it possible to transfer the lender’s risk to defaulting upon the interest rates resetting. The risk was small as long as there was continuous rise in the housing markets.

The advent of interest-only loans together with mortgage-backed securities led to another problem. Access to the market was highly improved that it led to a boom in housing (Davidson, 2008; Mishkin, 2011). The advent of interest-only loans assisted in bringing down monthly payments in order to make it affordable for the subprime borrowers. However, it increased the lender’s risk because the primary rates always reset after one, three or five years. But, the increasing housing markets gave comfort to lenders, who made an assumption that borrowers could sell the house again at a higher price than the default.

The risk was not limited to mortgages. All forms of debts were put together and sold parallel to debt obligations. As housing prices went down, multiple home owners who were using their homes as ATMs discovered that they could support their lifestyle no more. Non-payments in all types of debts started creeping up slowly (Mishkin, 2011). CDO holders were inclusive of both hedge funds and lenders. They also entailed pension funds, mutual funds, and corporations. That increased the individual investors’ risk (Mishkin, 2011; Davidson, 2008). The main issue with CDOs was the buyers’ ignorance in pricing them because they were so new and complicated.

Stock market booming was another reason. Everyone had a lot of pressure to create money that they frequently bought the products depending on only word of mouth. CDOs were majorly purchased by banks. As non-payments began to increase, banks were not in a position to sell the CDOs and they also had less money to lend (Davidson, 2008). Those who could get funds did not want to lend banks which could not pay. By the time 2007 ended, Fed was forced to come in as a last resort lender. The crisis arrived in full circle. The banks resolved in lending too little rather than too freely causing further decline in housing market.

How could the subprime mortgage crisis have been prevented and how can a similar catastrophe be prevented in the future?

Regulation of hedge funds and mortgage brokers who bargained too much and made bad loans respectively, could have halted the crisis. Early recognition of the credibility problem could have helped too. The only available solution was the government to purchase the bad loans. The crisis was also as a result of outstripped human intellect and financial innovation. The prospective effect of new products like derivatives and MBS were not clear even to those who created them. Regulation could have toned down the downtime by decreasing a bit of the leverage. It couldn’t have made it possible to prevent new financial products creation. Fear and greed will always result to an illusion.

The following strategies should be put in place to prevent a similar crisis

Improved Credit Ratings

Agencies for credit rating are to boost the method in which they “grade” securities. Presently, both structured credit products and traditional securities have the same grade (Adrian and Shin, 2010; John, 2008). Structured credit products are advanced and often more complex packages inclusive of elements like tranches of mortgages representing a certain level of risk for repayment. They are made to meet specific need for investors.

Credit rating agencies are recommended to make their procedures more clear. This entails publishing enough information about the assumptions for latent credit rating models and methodologies and distinctively differentiating complex products ratings from traditional instruments (John, 2008).

Improving Mortgage Origination

This paper suggests better standards for underwriting by mortgage originators. An important recommendation oversees mortgage brokers better by federal and state regulators inclusive of state licensing of mortgage brokers who are not being supervised (John, 2008). This important step would ensure a continuous weakness in mortgage originations. Requirements for licensing are well enforced to aid in improving mortgages quality created by brokers

Moreover, the paper suggests a more consistent oversight or meet the least of standards, inclusive of enforcement mechanisms which are effective. This would boost the current regulation rather than bring a new item that would make matters more complicated (John, 2008).

Ultimately, Federal Reserve issue is recommended to create consumer-protection rules which are inclusive of affordability of various mortgages types and better disclosure to make it possible for customers to make a comparison between different products before making a purchase (Adrian and Shin, 2010). Federal and state regulators will ensure that the rules are enforced in all types of mortgages.

Improved Risk Management and Regulation

In subprime crisis, major financial institutions are not able to approximate their real exposure to losses coming up as a result of these securities. The range from poor understanding of the true risk related to individual investments to the inability to collect the different holdings’ investments properly in all business lines for all firms (John, 2008). Consequently, financial institutions have been more exposed to risks and prospective problems in liquidity than they expected, because credit conditions have gone down.


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