Several factors account for the run-up in house prices. Banks and other lenders practically tossed money at prospective new homeowners and existing homeowners who wished to refinance at lower rates p.
Meanwhile, as will also be discussed below, mortgage securitization permitted the lender to sell mortgage loans to investment companies, which in turn pooled them into mortgage-backed securities they sold to other investors. The securitization of mortgages moved the mortgage loan off the books of the lender and freed capital to make additional mortgage loans pp. According to Blinder , a bond bubble accompanied the housing bubble pp. Unlike the housing bubble, in which the misperception was the conviction the value of houses would increase forever, the mistaken belief in the bond bubble was that the historic low rate of defaults on mortgages during the period — would continue evermore pp.
Because mortgage-backed bonds provided a higher return than U. The key ingredient to the — financial crisis was excessive leverage throughout the entire financial system. Leverage began with home owners. Overall mortgage indebtedness in the U. Banks were also dangerously overleveraged. The former were unsecured, short-term loans that, until the crisis, were invariably renewed by the lender. The latter were agreements to sell securities initially Treasury bonds and later mortgage-backed securities and collateralized debt obligations to the lender and then repurchase them at a slightly higher price.
Repo loans too were invariably renewed by the lender. Because these were generally private transactions, there was little transparency in either market, and the extent to which the banks expanded their leverage through the commercial paper and repo markets was generally unknown by other banks. That would become a major issue as the financial crisis unfolded, because lenders began to question the value of the assets the borrower posted as collateral and disclosed on the balance sheet FCI Report , p.
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Another vehicle banks used to achieve higher leverage was off-balance-sheet entities, such as structured investment vehicles SIV Blinder , p. The bank, in turn, loaned the money it received from the SIV, converting the cash into loans without affecting the amount of its reported assets. When the value of the loans in the SIV sour—as they did with gusto in the financial crisis—the thin layer of equity in the SIV is wiped out and the losses are attributable to the bank pp.
For some banks, leverage remained roughly constant. Other banks upped their leverage.
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More than the other banks, Citigroup held assets off its balance sheet, in part to hold down capital requirements. Large investment banks were even more successful in achieving significant leverage. Investment banks were not subject to the same capital requirements as commercial and retail banks. Rather, investment banks were permitted to rely on their internal risk models in determining capital requirements.
This enabled them to achieve higher leverage. If the bank is unable to roll over its short-term borrowing, the modern version of the run on the bank ensues p. Synthetic leverage in the form of derivatives augmented the leverage in the financial system. Two common derivatives are exchange-traded futures and options and over-the-counter credit default swaps p. Credit default swaps are agreements between a buyer and a seller in which the seller agrees to pay a debt obligation, such as a bond or a loan, if there is a default, and the buyer agrees to pay premiums to the seller for the debt protection p.
The drastically high risks they imposed on the parties to the derivatives, however, were sufficient to trigger the financial crisis. Because the derivative mimics the returns received by someone actually owning the security, traders could achieve the same profit or incur the same loss without buying the security. Unfortunately, the banking regulators seemed not to notice despite warnings that matters were getting out of hand p. One particular type of derivative—the credit default swap CDS —emerged in the year and went on to play a major role in the financial crisis.
The CDS is like an insurance policy. If a default occurs on the underlying debt, the seller is obligated to pay the buyer the face value of the debt FCI Report , p. The CDS plays a crucial role in permitting investors to hedge against non-payment. For example, an investor who is fearful the debtor on a bond will not be able to pay can purchase a CDS on the bond and have assurance the face value will be paid when due.
If the debtor pays the bond when due, the CDS expires and the premiums paid by the purchaser for the CDS reduce the profit realized on the bond. If the debtor fails to pay the bond when due, the seller of the CDS pays the face value to the buyer of the CDS, much like an insurance policy covers insured losses. Like an insurance company, the seller of the CDS incurs a large loss, but hopefully one that occurs only rarely Blinder , p. They simply placed a bet with each other on whether or not a default event will take place.
In this scenario, risk is created not extinguished p. These loans took multiple forms, including interest only the borrower pays interest only for a stated period and a final principal payment in one large installment at the end of the term , balloon mortgages the borrower pays lower, regular payments for a specific term and then must pay the remaining balance in higher payments within a relatively short time FCI Report , p. Mortgage brokers played a crucial role in pushing borrowers into subprime loans. By more than half of all subprime loans were being originated by mortgage brokers rather than by banks p.
Because many mortgage borrowers are financially unsophisticated, they were particularly ill equipped to understand the transaction, compare terms of financial contracts, and shop around before being pushed into the subprime mortgage terms p.
Fannie Mae and Freddie Mac led the way. Possessing a near monopoly on prime, fixed rate mortgages within their loan limits, they purchased those mortgages from banks, thrifts, and mortgage companies, assembled them into mortgage pools, issued securities backed by the mortgage pools called mortgage-backed securities or MBS , and implicitly guaranteed the payment of the mortgages through their GSE status pp.
Following their example, investment banks would later bundle a wider variety of loans into securities and sell them to investors, who received investment returns funded by principal and interest payments made by the debtors on the underlying loans pp. Those loans, however, extended beyond prime mortgages to include subprime and adjustable-rate mortgages, equipment leases, credit card debt, auto loans, student loans, and manufactured housing loans pp. The benefits derived from assembling these loan-backed investment packages were significant: lenders moved the loans off their books, reducing the amount of capital they were required to hold against losses and improving their earnings; banks earned fees for assembling the investment packages, raised funds from selling the asset-backed securities generating new funds for additional loans, and had the option of retaining parts of the securities on their books as collateral for borrowing p.
These benefits aside, securitization also introduced an enormous level of complexity into the securitization products, and separated the lender from the risk of default, which was transferred to investors downstream p. The earliest MBS created by Fannie and Freddie were relatively simple mortgage pools containing a few thousand mortgages Blinder , p. The average value of the mortgages multiplied by the number of mortgages generated the par value for the security; the average interest rate of the mortgages, less anticipated losses from defaults, constituted the interest rate of the securities sold to investors.
Because the mortgages were pooled, the risk from defaults was spread throughout the pool, much like investors are advised to diversify their portfolios. Because prime mortgages had very low default rates and were implicitly guaranteed by the GSEs, investors believed the MBS were safe investments. The risk profile of the security they purchased was inherited directly from the underlying mortgages in the mortgage pool, much like investors purchasing mutual funds p. In short order, things quickly became far more complex.
The mortgage pools, sometimes combined with other types of loans, were divided into multiple tranches which would absorb in ascending order the losses stemming from the mortgage or loan defaults. The lowest tranches sometimes called the residual or equity tranches would absorb the first wave of loan defaults e. The equity tranches, having the highest level of risk, paid the highest interest rates; the mezzanine tranches paid lower interest rates; and the senior tranches, possessing the least risk, paid the lowest interest rates Blinder p.
These tranches permitted investors to choose the level of risk and rate of return they were most comfortable with. Because loan defaults on mortgages were quite low, no one expected losses to reach the upper tranches. Inevitably, the equity tranches received no rating; the mezzanine tranches received lower investment grade ratings e.
With ready buyers for their own product, mortgage securitizers continued to demand loans for their pools, and hundreds of billions of dollars flooded the mortgage world.
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In effect, the CDO became the engine that powered the mortgage supply chain pp. Only a small percentage of mortgage defaults was required to ultimately trigger the collapse, akin to mad cow disease: while the disease may infect only a small portion of the beef on the market, the infection is so frightening that consumers shun all beef. Traders assumed the worst and tried to dump their now-unwanted securities into falling markets.
Prices plummeted and panic ensued pp. Moreover, the practice in the rating business was to negotiate the desired ranking. For example, the securitizer might ask the rating agency what tweaking was needed to get the AAA rating. Because security ratings are statements of opinion, not fact, and because their agreements to provide ratings disclaim liability for erroneous ratings, rating agencies are typically not liable for their misstatements p. Lastly, giant asset managers, regulators, and market professionals too often relied exclusively on the opinions of the rating agencies rather than undertaking their own due diligence.
Senior executives and key employees received enormous compensation packages for the financial success of their companies, and golden parachutes in the event of financial losses p. They earned even bigger commissions if they pushed the borrowers into dodgier mortgages, but lost nothing if the loans defaulted. In early , the housing bubble burst. Home prices fell. Home sales declined.mitwiz.com/kuj-idrossiclorochina-vs.php
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Mortgage delinquencies increased and continued to do so as went on, particularly in subprime adjustable-rate mortgages FCI Report , p. Rating agencies downgraded their ratings of mortgage-backed securities and collateralized debt obligations. Alarmed investors sold, and sales prices plummeted.
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