Mini-Case #2
Financial crisis, Home Mortgages, Credit Markets, Financial Institutions, Moral Hazard, Adverse selections,
CONCEPTS IN THIS CASE:
Mortgage defaults sub-prime mortgages mortgage-backed security defaults write off wealth effect moral hazard adverse selection
You have been hired to manage a depository institution, such as a bank. The top management team is very concerned to avoid the similar massive defaults on home mortgages as in 2007. You are being asked to explain factors behind the financial crisis and explain the role of government in minimizing the adverse impact of the crisis on the financial system.
You start with some background information on how a wave of defaults on home mortgages threatened the health of any financial institutions that had invested in home mortgages either directly or indirectly through investment in mortgage-backed securities. Mortgage-backed securities were perceived to be sound investments as they were rated by legitimate rating agencies. Before the crisis happened, banks had mistakenly believed that an innovation and securitization of their long-term assets could eliminate their exposure to mortgage defaults and minimize their interest rate risk and even make them more profitable. When the mortgages started to go bad, many investment funds ‘blew up” and couldn’t repay the loans they had taken from the banks. The banks had to “write off” the loans they had made to the investors. Doing so reduced their reserves and lending powers. This was a major factor affecting profitability and soundness of depository institutions.
To the management team, the lending standard was a crucial factor to see if asymmetric information was a factor. You explained that a relaxed standard on mortgage lending was another contributing factor. According to the Federal Housing Finance Board, the average fee on a mortgage loan fell from