Housing Slump Credit Crunch And Role Of Government Finance Essay - Free Essay Example

The financial landscape of the United States has considerably changed since the Great Depression slowing moving towards less regulated platform where free market is desired and encouraged. What at first was labeled as a minute weakness in the mortgage/housing market has developed into a full blown financial crisis which has led the United States and the rest of the world into a recession. The American unemployment rate has jumped to 8.5%, its highest since 1984 while the US economy shrunk at a rate of 6.3% in the last the quarter of 2008[1]. The consensus on the main cause of the crisis is the housing market and the mortgage backed securities that it produced. The current financial crisis brought back talks on regulation and yellow tapes for entities engaging in the financial market. The role of the government has also been put into question; theres a debate on whether or not the government should just be a passive bystander or play a more aggressive role in regulating and intervening in the financial market. II Financial Markets Securitization is a process in finance that allows banks or other financial institutions to pool similar financial assets together and sell them to a separate entity that would issue securities based on the cash flow coming in from those pooled assets. The U.S Securities and Exchange Commission defines Mortgage-backed securities (MBS) as debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property[2]. When banks or mortgage companies issued mortgages to borrowers, they would turn back and sell those mortgages to entities such Fannie Mae, Freddie Mac or other private companies. These entities would then bundle the mortgages together and issue securities on them so that whoever bought those securities would have a claim on the principal and the interests of the original mortg` ages. This means that when the borrowers would make a payment on his/her mortgage to the bank, the bank would send the payment to the entities that would redistribute the income as interest payments to the securities holder. It is worth noting that the entities issuing the securities back them up; even if the borrower fails to make its monthly payment, Freddie Mac for example would still pay to the investor who holds the mortgage-backed securities his/her interests accrued. Most MBSs are issued by government sponsored agencies such Freddie Mac and Fannie Mae; there is a common belief that they implicitly have the backing of the U.S government which supposedly makes them safer and more attractive to investors. Subprime Loans Subprime loans were mortgages offered to individuals with low credits score; there was high a probability that they were going to pay the loan late or not pay it at all. Banks will tend to loan to the individuals at higher interest rates than it would have had the people been more credit worthy. It is undeniable that problems in the subprime mortgages sector triggered the financial crisis that started in 2007; as people couldnt pay their mortgages due to either high interest rates or low income (or both), the country began to see foreclosure which spread to subprime lenders and eventually cause the commercial paper meltdown. Nobody was willing to lend as there was a fear that loans couldnt be repaid. Lending standards were more than relaxed when it came to offering mortgages as borrowers either had no or low income and documentation was often not required. Lenders relied too much on high prices in the housing sectors and didnt factor in decline in prices which they should have in ord er for them to have been able to avoid much of the downside of the crisis. It is important to note that subprime loans only constitute a small part of the mortgage sector. The problem is that they were bundled up and sold as securities to investors everywhere who didnt have the knowledge necessary to make informed decisions on what they were buying. There was an issue of imperfect information in the distribution of risk that might have been avoided had all the actors in the financial arena known what they were getting into. Lending standards are in place for a reason, they allow for a safe flow of credit throughout the market. Mortgages offered to people who are credit-worthy easily translate into timely payments and pay down of debt. Out of all the possible culprits, subprime loans are highly ranked on the guilty list. Mortgage Brokers The subprime loans were not issued by commercial banks who have much tighter lending standards; mortgage brokers were the ones making those loans. Mortgage brokers didnt have to follow the rules and lent money to people who couldnt really afford it. Mortgage brokers were paid on the number of loans they could get out to companies that could bundle it up and sell it as securities. There was no incentive for quality but a strong push for quantity. Little efforts were put into explaining to borrowers how the mortgages worked and what the details were. Not only brokers can be blamed but also investment banks. The high demand for mortgage-backed securities (fueled by high housing prices), brought investment banks to accept questionable loans into their pool to create securities based on uncertain flow of capital. Government in this case could have done a better job regulating non-bank entities engaging in financial activities. Rating Agencies The role of credit agencies was to rate securities and other financial instrument based on their ability to pay their investors on a timely basis; the higher that ability (high creditworthiness) the higher the credit rating. The agencies rate the ability of a security to pay based on securities past behavior; especially they expected securities to still pay investors as they had been doing up until that point and didnt factor in financial shocks such a decline in housing prices, devaluation of securities and lack of liquidity in the market. The model used by rating agencies to assess those financial instruments were obsolete because they only took into account events such interest rates shocks but failed to evaluate risk and the level of leverage of each companies. In the case of mortgage backed securities they failed to see that those securities had a direct relationship with the mortgages underlying them, their models were too optimistic; people not paying their mortgages, difficul ties in the housing markets were unforeseen and not taken into account. Also, when assessing and rating the mortgage-backed securities, the agencies had little to no information on the people who were given the mortgages; their creditworthiness was never examined when the ratings were issued. The credit rating industry is dominated by 3 companies who share about 95% of the credit rating market: Standard and Poors (SP), Moodys and Fitch Ratings, the remaining 5% is shared by rating agencies who do not have as much influence and connections in the market to make a considerable impact. The market share, the power, the influence enjoyed by the three companies makes them monopolies that have developed over the years. With the government always trying to go after monopolies[3]because it discourages competition, the big 3 have had some impunity in operating as monopolies. This discouraged innovation because there was no incentive to do so, had there been more competition among the rating a gencies, models would have been updated, new and more accurate rating instruments could have been invented. Even though there are over 100 credit rating agencies besides those 3, the fact they owned such a big market share allowed them to rest on their laurels and not do the job as accurately as they should have. Credit rating agencies were hired by the companies issuing those instruments which in itself could create a conflict of interest on the part of the agencies. Having close ties with the private market did not allow for objective ratings as they were influenced by the money incentive and were telling the companies how to structure the securities in order to get a higher rating. Government should definitely have stepped up and not tolerate those relationships to get in the way of objective and accurate rating. It is only now that the SEC (Security and Exchange Commission) is thinking of way of dealing with the problem of conflict of interest, disclosure of information; however nothing seems to be done about the monopolies Standard and Poors (SP), Moodys and Fitch have enjoyed over the years. Even though commercial banks are still very much regulated, other players in the financial sector (such as mortgage brokers) are not and this is the area where lack of regulation played a role. Private financial markets where complex investment tools are developed are hard to regulate because those tools are hard to understand. Participants in those markets tend to be investments savvy individuals who have learned how to take advantage of loopholes in regulations and are not the average investor. Private rather than public interests are what fueled those investors allowing for the taking of irresponsible amount of risk. Investors created collateralized debt obligation backed by securities (such as mortgage-backed securities) and thought of themselves as protected against risk because they bought insurance against market downturn in the form of credit default swap[4]. Companies were not required by law to have the necessary capital to back up those swaps; this allow for high leverage and lack of protection for investors who actually thought they had some cushions against market downturn. Had there been some type of regulation private companies would been required to have enough money to back up the insurance claims that people had purchased. There is little doubt that more sophisticated investors took advantage of the system by designing financial instruments that were not easy to understand to the average investors and that went through loopholes created by regulations or lack of. III Role of the Government Community Reinvestment Act Government actions such as the Community Reinvestment Act, regulations or lack of have been accused of playing some part in the crisis. The government has been particularly active in trying to stop or slow down the current downward spiral and some are questioning if this is actually making things worse or better. It would be hard to know the full result of government intervention for quite some time but it is worth exploring what role, if any, had the government in the current economic state of the world. The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate.[5]This was to insure that banks met the needs of the population they were servicing, especially in middle-class to low income neighborhoods. Although law makers would rate banks on how well they were meeting those needs, they would make sure that banks still adhere to and enforced lending standards. To be in compliance with the CRA, banks didnt have to offer subprime loans, they could just invest in the community. So, although at first it might seem as if the Act shares some responsibility, it is hard to find a positive correlation that proves so Glass-Steagall Act The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation and separated banks according to the type of business they were engaging in (commercial vs. investment banks). According to law makers of the era, commercial banks engaged in risky behavior before the Great Depression; they argue that is was those risky behavior, or speculation, that caused banks commercial failure after the stock market crash of 1929. Banks could not pursue both activities and had to decide on one and stick to it; the end goal being eliminating those risky actions that could cause a bank to run into financial trouble. The act was in effect for most of the 20th century with some loosening over the years (especially in the 1980s) and some credited it in giving the banking system a sound financial platform for running bank activities while others argued that the act restricted banks to realize their full potential and not being able to compete in the international arena. Financial Modernization Act The Financial Modernization Act became law in 2000, officially repealing the Glass-Steagall Act. Commercial banks were allowed to dive into unchartered water such as investment banking and insurance. The act allowed commercial banks such Bank of America and Morgan Chase to assume a higher level of risk in the hopes of getting a higher return by exploring investment opportunities (such as securitization) that were not available to them before. The Act allowed banks to merge with each other; this allowed mega banks such Citigroup and Bank of America to surface. By doing so though, the Act might have indirectly contributed to the doctrine of Too Big Fail. Large banks (commercial and investment) were not allowed to merge with each other; the Act created those entities that became vital to the economy as they facilitate the flow of funds, and were intermediaries between those who deposit money as part of their saving and those in need of funds. By allowing banks to significantly increase their size and their market share, the government put itself in a position where letting those banks fail, should a problem arise, would not be option. The financial bailouts are evidence of this; a substantial portion of the Trouble Assets Relief Program (TARP) funds went to the biggest banks in the country.[6]The increase in the amount of risk that commercial banks were allowed to take on thanks to the Act was a contributory factor in the financial crisis but commercial banks are still well regulated. Deregulation is not what caused the crisis, peoples actions did. Fannie Mae and Freddie Mac The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation Freddie Mac are US-government sponsored enterprises (GSEs) created by Congress to cater to the needs of Americans desiring to own a home. Fannie Mae and Freddie Mac are part public and private meaning that while following a social agenda to insure that individuals who want a home could buy one, they also are stockholder-owned, profit seeking corporations[7]. Fannie Mae was created to buy loans, as investments, from the Federal Housing Administration in 1938 and resell them to interested parties. Freddie Mac was created by Congress in 1970 to purchase loans made institutions that were part of the Federal Home Loan Bank System3. Both entities were created to allow the flow of credit between suppliers and demanders of mortgages, it is worth mentioning that they do not directly lend to home buyers. By selling their mortgages to Freddie and Fannie Mae, banks are allowed to get more capita l in order for them to supply more mortgages to the population. Before the financial crisis, the two GSEs enjoyed benefits as they experienced the best of both world; although created by Congress, they did not answer to the Federal government but to their board of directors. The GSEs are independent of any government political agenda and are not subject to the federal laws and regulations that are applied to other government agencies, they ,also, are tax-exempt. The two entities enjoyed all the advantages of public and privates companies but experienced none of the disadvantages. For the most part the two companies have done the job they were supposed to do; furthering the social agenda of home ownership, especially among less financially well-off individuals. Together, Fannie Mae and Freddie Mac own about 50% ($11 trillion worth) of all mortgages in the United States. The securities issued out of those mortgages are considered safe investment as they are implicitly guaranteed by th e American government. Without the two entities mortgage rates would have been much higher than what they were at the time of the crisis because by dealing with large amount of mortgages they were able to keep their costs low. Although at first it might seem easy to place part of the blame on the shoulders of the two entities its worth exploring why they might not be as guilty as one might think. The vast majority of mortgages held by the two GSEs are the safe, conventional ones. Those are the mortgages that people still pay on time without defaulting (not subprime). What really got the two companies in trouble was that when the crisis was raging nobody was willing to buy the securities issued by them even though they were pool of safe mortgages, coupling that with few bad mortgages where people werent paying, allowed for losses that were not foreseeable. This forced the U.S Treasury to put the two companies under conservatorship of the U.S government to send a signal to outside inv estors that it would be safe to buy securities as they were officially backed by the U.S government. Government backed securities send a strong to the rest of the world that it is safe to now start buying American (in our case) securities because they are pretty much riskless; this allows for funds to start flowing in the country and there is a dire need for that. The government had to step in and reassure the rest of the world that America is still the best place to invest in because we know that it is very unlikely that the U.S government does not honor its debt. In the case of Fannie Mae and Freddie Mac during expansionary time, the implicit backing of the government allow mortgage-backed securities to be sold to investors looking for a safe return and it also allowed banks to offer more mortgage to those who were looking to buy a house. What Fannie Mae and Freddie Mac were guilty of was to fall under political pressure to allow themselves to relax the standards on what type of m ortgages they were willing to buy from banks. By accepting some subprime assets and taking more risk, they exposed themselves to greater loss should the economy take a downturn. The two companies would have reduced their losses had they not been exposed to the risk they decide to take on. The Federal Reserve (Fed) Theres an argument to be made as to the role of the Federal Reserve[8]in the housing crisis. By being able to influence the money supply in the United States the Federal has the power to influence interest rates which in turn influences the rate at which loans are given out. By increasing the money supply (which happens when the Federal Reserve buy Treasury Bonds from banks), it lowers the interest rates because now that banks have more spend they will tend to lower their lending rates to attract borrowers. One can argue that this is one of the reasons why there was a housing boom in the first place; more money to be lent at low rates meant more borrowers (such as housing contractors, individuals willing to own a home, mortgage brokers) were lining up to take advantage of the opportunity. Starting in the year 2000 and ending in around 2004, the Fed continuously pursued to lower interest rates by slowing increasing the money supply in the country. Interest rates levels where the lowes t they had been in a really long time and lower than what the Fed had been setting for awhile. It wouldnt be a stretch to conclude that a relationship can especially be found between the amount of credit available in the market and housing starts. Contractors were willing to build more houses because, first the money was there to do so and second they knew that people would be able to borrow money at a lower rate to buy a house. As the economy was overheating and housing prices were going up substantially, the Fed wanted to slow it down by lowering the money supply thus increasing interest rates and slowing down the amount of lending. As rates rose, the housing bubble started to burst and some borrowers were left with lower house values and huge mortgages. It is important to note that borrowers of subprime mortgages had adjustable rate mortgages; when interest rates were low they had more ease making their payments but as rates started going up, so did their monthly payments that th ey could no longer afford. As mentioned earlier, when borrowers stop paying, it starts a chain reaction where mortgage brokers do not get money and cannot send funds to the entity that bought the mortgages from them and the companies do not have the funds to redistribute to its investors. Privates firms and governments-sponsored agencies found themselves with troubled assets on their balance sheet because money is not flowing. In the midst of the crisis, the Fed decided to drastically reduce interest rates to reduce the size of the debt on the balance sheet. Sometimes it is better to let the market work itself out in terms of interest rates determination. The blame is definitely not on Fed in terms of who started the crisis, but it more than plausible that the Fed tight control over the money supply and supervision of the inflation rate were contributing factors in making a bad situation worse. IV Conclusion The American economy is a free market economy where government should try to stay out of it as much as possible. While following a political and social agenda, the government has to put in place safeguards to allow for a safe and responsible course of business. It is clear that the government failed to regulate blurry areas of our financial system and allowed individuals to take on huge risk without the capital to back it up. The goal is not to mingle with the business of banks but to put boundaries separating what is allowed and what is not. The American regulatory system tends to always come up with regulations after the fact which sometimes makes them ineffective and obsolete. The government should be stricter with the financial entities like it has been with other sectors. It is one of the only sectors where monopolies are not only allowed but encouraged. By allowing those mega banks to exist, the government put itself and the people that it represents into a difficult position w hen theres a market downturn; letting those companies fail will have disastrous consequences for the economy because there are the reason why credit flow through the economy. At the same time shouldnt the government send a stronger message saying that risky behavior that will send the country into a recession, behavior that would cause people to lose their jobs and their homes is not acceptable and would not be tolerated? But it seems as of the government and the financial markets never learn as the country goes trough some type of financial disaster every 10 years or so.