Introduction
The 2008 financial crisis in United States of America caused the government to take several steps to ease the situation in the economy. The government through the federal and treasury institutions bailed out the insurance giant AIG. There was also the takeover of the Bear Sterns Bank by the government.
The American Recovery and Reinvestment Act were passed which authorised the injection of $787 Billion in the economy to stimulate demand and employment. The stimulus package was also offered with the aim of mitigating the mortgage foreclosures. There were the homeowners Affordability and Stability Plan that assisted the struggling people to refinance their mortgages.
The government purchased mortgage-backed securities and treasury bills to improve the credit conditions. The treasury also injected capital into the troubled financial institutions in exchange of common equity and preferred stocks in certain cases. Financial institutions were temporarily suspended from short-selling by the Securities and Exchange Commission.
The government continued to lower the interest rates in order to increase security. What caused the financial crisis and what was the role of mortgage backed securities and collateralized debt obligations in the financial crisis? These financial instruments contributed substantially to the financial crisis.
The Role of the MBS and CDO in the financial Crisis
The financial crisis has its origin in the housing sector. There was a surge in the subprime borrowers in the mortgage sector. The subprime borrowers have certain characteristics. They have low credit scores. Additionally they have high debt service to income ratio that may be as high as 40%.
They take small loans in the range of $100,000. They also have a high loan to value ratio of over 80%. House prices had been increasing from the 1990’s to 2005. In fact in the period 1998 to 2005, the housing prices doubled increasing the investor’s confidence in the market.
The home owners were therefore at an advantage since the value of their houses kept increasing (Weaver, 2008). When they were financially distressed they could sell the house. The mortgage rates were also relatively low in the period 2000 to 2005 so the people could refinance for another product that also had low rates.
At this time the adjustable rate mortgages (ARM) became highly attractive to the home owners. This kind of loans also increased during this period. The subprime owners were either getting ARM or other hybrid loans. There was an increase in the amount of loans in this sector that was contributed by a number of factors.
First of all, there had been lax underwriting standards over that period. Annual surveys that were conducted by the Office of the Comptroller of the Currency (OCC) showed that banks had lowered their credit standards in the period 2004 to 2006. The percentage of loans that had been given with full documentation also declined during this period.
There was also increased indebtedness of the subprime owners. In the period 2000 to 2006, the homeowners had been taking higher value loans against their house with the expectation that the prices would rise. The opposite trends in the cost of mortgage credit and the housing prices also made the home owners participate more in the market since the risk of default was much lower (Baily, Litan, and Johnson, 2008).
In 2004 however the mortgage rates started to rise and the house prices started declining. The home owners found themselves in a fix.
The consequences were high rates of delinquencies and foreclosures on the homes. In 2007, it was evident that the subprime borrowers were not the only ones affected by the financial crisis. The crisis had spread to the Alt-A and the prime mortgage products as well.
This turn of events in turn affected the mortgage backed securities. The financial market had turned the pool of financial obligations into a source of liquidity for the lenders and capital for several consumers. These repackaged products caused the housing crisis to affect the markets even more since the products were being sold in the global financial markets (Bullard, Neely and Wheelock, 2005).
The securitization process was a procedural process followed by the financial institutions. A customer would approach the bank for a loan to finance his purchase of a residential or commercial property. The rate of interest would be agreed on based on the credit features of the individual. The higher the risk the higher the interest rates would be.
The mortgage lender would then approach the mortgage banker to be relieved of the risk of default of the customer. The mortgage bankers in the past would issue bonds in the market to sell the loans in the market however now there was an innovative system where the mortgage banker would sell the loan to an investment banker.
The investment banker would get a large group of mortgage based financial products, underwrite it and then sell it to investors. These mortgage backed products would be pooled together into a mortgage backed security. The risk of total default was therefore lower however the returns remained the same. If the customers defaulted, the investors
could still sell the houses and recover their money. The MBSs varied in their form or composition however they gave the investors certain yields either as cash flows over a period of time or the market value of the MBS.
There was also the creation of the CDOs. A collateralized debt obligation refers to an entity that holds the debt as the collateral in order to issue liabilities in the market. These liabilities are issued in the form of tranched securities. The CDO comprises of securities that are rated differently in terms of the timing of the repayment and the risk or seniority in bankruptcy. CDOs have different purposes.
They are those which are issued for the company to be able to hedge the credit risk and minimise the exposure in regulatory risk when it comes to the balance sheet balances. A company may also issue them in order to collect interest on the high yield products while others are issued in order to earn high management fees and exploit the management expertise. The product had existed in the market since the 1980’s however during this period the amount of CDO’s increased immensely.
There were credit agencies that would rate the risk of the MBS and CDOs. These ratings would influence the price of the security in the market and also inform the investment bankers on the risk-weighted capital treatment of these securities according to the Basel II framework.
The credit agencies were rating 80% of the subprime products at the highest credit rating (Jo, Lee, Munguia and Nguyen, 2009). The securities were therefore highly attractive. Banks, hedge funds and pension funds purchased the securities as part of their market portfolio.
The investment banks needed to also seek protection on the low credit rating securities in accordance to Basel II requirements. This came in the form of the credit default swap (CDS) which is a financial derivative. This would assist the holder of the MBS or CDO by insuring him against the risk of default.
There was the creation of naked CDS which refers to contracts where neither party was in possession of the security or asset. This would create an avenue for high speculation and loopholes in risk management. The insurance company, AIG, was able to take up a high amount of CDS as the market was highly unregulated.
This was because the product had not been placed in the securities, insurance or futures contract in the financial market. If the insurer was rated highly in the industry, there was no need to provide any collateral. Furthermore the CDSs were put in the financial statements as profits based on the default probabilities the company had calculated based on the experience of the former years.
The securitization of mortgage securities had gained high popularity through the years due to the low interest rates and the rising house prices. The home owners gained immensely form speculation. There were high origination fees earned by the mortgage brokers.
The rating agencies experienced high demand for their services and earned high profits while the investment bankers were earning high amounts in securitization fees. All the relevant stakeholders were gaining and happy with the process. The investment bankers got even more involved in the process after April 2004, where the Securities and Exchange Commission allowed the investment bankers to borrow even
more money. They now took on more securitization of mortgage loans. Companies such as the Lehman Brothers now adopted generous lending standards. In the year 2007, the MBS market was now valued at $2Trillion while the CDO market was valued at $521Billion. This was despite the fact that between 85-95% of the CDS products were based on speculative circumstances.
The housing crash therefore affected investors and halted their cash flows. The lower house prices saw the prices of the MBOs and CDOs depreciate even further. The risk of default increased and the foreclosures and delinquencies thrust the country and the world into a financial crisis.
wThe CDO and MBOs started receiving adverse credit ratings as most of the products were subprime or non-agency categories. The Moody Company downgraded 30% of the products they had rated. Some of the products that had been graded highly were also downgraded. There had been an assumption that the housing prices would just continue increasing however it turned out not to be so.
The credit rating companies did not put into consideration the risk of defaulting en masse or the relaxed rating standards that were in place at that time. Insurance companies like AIG found itself facing high insurance payouts due to the massive defaulting the banks were experiencing (Roger and Stacey, 2001). They had to increase their capital in order to adequately deal with the change of circumstances. There was suspicion from the public towards the financial institutions that further aggravated the situation.
Depositors now wanted their money from the banks and the hedge funds. The interbank lending rates soared as banks were now reluctant to lend to each other. They were not
sure or certain of their value in the financial statements after the crisis and were also reluctant to lend to banks which they could not correctly affirm their credit worthiness. The firms that had specialised in the use of MBO and CDO in order to get funding could no longer receive any money due to the increase in the interest rates.
When the Lehman Brothers and AIG started facing great pressures, the money market became even more restrictive in their lending practices. The consequence was a credit crunch which affected firms adversely as they needed loans for liquidity.
Conclusion
The financial crisis in 2008 was therefore caused by a myriad of factors. There was the lending to subprime borrowers to the financial institutions. There was greed in the sector with the brokers focused on the high rewards. There were also the credit rating agencies that were not prudent in considering several risk factors in grading the subprime mortgages.
However, the biggest cause of the crisis was the innovative financial products that had been introduced in the market in the recent years. The MBS and CDO involved huge companies such as banks, hedge funds and pension funds. When the housing prices fell and the mortgage rates went up, these big institutions magnified the impact of the defaults, the foreclosures and the delinquencies of the home owners. There was a credit crunch, firms collapsed and the government had to step in order to save some of the companies.
There was a need to minimise the impact that would be felt in the market. A stimulus package had to be injected into the market by the American government. There have been steps in the regulatory environment to streamline the risk management process as a result of the financial crisis.
References
Baily, M., Litan, R. and Johnson, M. (2008). The Origins of the Financial Crisis. Fixing Finance Series, 3, pp. 1-47.
Bullard, J., Neely, C. and Wheelock, D. (2005). Systemic Risk and the Financial Crisis: A Primer. Federal Reserve Bank of St. Louis Review, 91(5), pp. 403-17.
Jo, H., Lee, C., Munguia, A. and Nguyen, C. (2009) Unethical misuse of derivatives and market volatility around the global financial crisis. Cambridge Journal of Academic and Business Ethics, 33, pp. 563-580.
Roger, L. and Stacey, L. (2001) A Model of Financial Fragility. Journal of Economic Theory, 99(1-2), pp. 220-64.
Weaver, K. (2008). The sub-prime mortgage crisis: a synopsis. Global Securitization and Structured Finance, 4, pp. 22- 31.