...stock indices of the G7 and BRICs losing nearly half of their value since the beginning of the year. This has seriously damaged banks’ balance sheets and restricted their lending capacity. With the cost of short-term credit rising dramatically and liquidity drying up, these events have been dubbed the worst financial meltdown since the Great Depression in 1930s. More importantly, the shock waves from the US financial market have spread throughout the globe, with many countries on the brink of recession (see Figure 1, Appendix). How did a “house fire” in America turn into a global banking crisis? Sub-prime mortgages are a financial innovation designed to provide home ownership opportunities to borrowers in the U.S. with a higher risk profile (such as borrowers with low incomes, bad credit histories or limited disposable income). Most of the sub-prime mortgages were given out on a variable interest-rate basis, with the risk of potentially large adjustments to monthly payments if interest rates rose. Instruments of this nature increase the probability of foreclosure. Institutions (lenders) were “easy” with credit regarding these mortgages under the assumption that housing prices would continue to appreciate in value. Even if some of...
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...labeled the world financial crisis since the Great Depression of 1920-30. The initial indication of a severe financial melt-down appeared in October 9, 2007 when the Dow Jones Industrial Average set a record by closing at 14,047. One year later, the Dow was just above 8,000, after dropping 21% in the first nine days of October 2008. Major stock markets in other countries had plunged alongside the Dow. Credit markets were nearing paralysis. Companies began to lay off workers in droves and were forced to put off capital investments. Individual consumers were being denied loans for mortgages and college tuition. After the nine-day U.S. stock market plunge, the head of the International Monetary Fund (IMF) had some sobering words: “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” It has been maintained that huge economy inequalities coupled with low rate of profit in the US economy contributed to an increased capital flow to the financial sector and the increasing provision of credit to US workers whose real incomes had declined. Under auspices of financial innovations, debt was sold in complex new financial products to investors. Cheap and apparently riskless lending drove the rising leverage of investments. ‘Securitization’ helped to spread the risks to global financial markets and deficient government regulation facilitated these developments. A huge...
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...businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to a global recession and contributing to the European sovereign-debt crisis. Most experts agree that one of the most important contributors to the recession was the collapse of the housing bubble. This led to an extremely high rate of loan defaults for people who probably should not have been given those loans in the first place. Due to the practice of predatory lending, many unsuspecting people were offered mortgages that they could not afford; however these people were convinced by lenders and realtors that they would be able to refinance those properties in a year or two and make tons of money. Since, the housing market was strong at the time, many people jumped on this opportunity, knowing that the property they were signing for was more than their budget could handle. Another part of the problem was the relationship between mortgages, the housing crisis and Wall Street. When Wall Street giants such as Bear Stearns, Lehman Brothers and Merrill Lynch jumped into the void left open by the collapse of the Government Sponsored Enterprises (GSE) Fannie Mae and Freddie Mac;...
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...CDS market and states the regulation reform after the crisis. Part I is background, generally introduces the Wall Street crisis. How it happened? What consequence it has? Part II is mainly about AIG’s CDS business: how AIG got involved in the crisis and why the biggest world insurance company suddenly collapsed. Part III is about credit default swaps: definition, construction, and problems. Part IV is concerned on the regulation reform after AIG’s failure. Wall Street Crisis Speaking of the Wall Street crisis, people all know it proceed from subprime crisis. The relatively low interest rate prompts banks to issue large amount of housing loans. To transfer default risk embedded in those loans, investment banks package those loans and mortgages into student loans, car loans and credit card debt, which form the so-called collateralized debt obligation (CDOs). All these derivatives depend on the housing loans. In the era of low interest rates, house prices rise rapidly and promote the rapid development of the housing loans business. With steady stream of housing loans into financial derivatives products, different ranks of products are packaged to sale out. The good view of economy makes those potentially risky CDOs popular with retirement funds. Lenders didn’t care anymore about whether a borrower could repay; the investment banks earned more money on selling more CDOs; the rating agencies had no liability if their ratings of CDOs prove wrong. Everyone in this securitization food...
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...banks failing by the day…definitely, these are uncertain times for the financial services industry. While many people who have lost their jobs, are faced with permanent shrinkage of their lifestyle, others in the industry are going through the trauma of not knowing if and when their turn would come. Who is to blame? Flashback to year 2003: Rohit (name changed to protect identity), a good friend of mine and someone who was officially considered to be a genius with an IQ of 150+, graduated from one of the leading IIM’s. Rohit managed to make it into the New York Headquarters of the most sought after firm that had arrived on campus for the first time – Lehman Brothers – a top U.S. Investment Bank (then). On joining, he was assigned to Lehman’s mortgage securities desk that dealt with Collateralized Debt obligations (or CDO’s). Following is an extracted transcript of a chat session I had with Rohit back in 2004: Me: So man, you must feel like you are on top of the world. Rohit: Yes dude, the job here is amazing, I get to interact with people around the world, investment managers – who want to invest millions of dollars Me: great…so tell me something interesting. What’s your job all about? Rohit: You know there is a great demand for American home loans, which we buy from the U.S. banks. We then convert these into what is called as CDO’s (Collateralized Debt Obligations). In plain English – this refers to buying home loans that banks had already issued to customers, cutting them into smaller...
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...and its collapse in the U.S. to everyone from home buyers, Wall Street, mortgage brokers, mortgage underwriters, investment banks, rating agencies, investors, low mortgage interest rates, low short-term interest rates, and relaxed standards for mortgage loans. Predatory lending was just one of many factors along this transaction chain. Predatory lending consists of loaning money to consumers in the hope and expectation that they will default and the lender will be able to take the collateral (homes.) We will discuss if the government failed to protect its citizens thru public policy and what role (if any) investments in mortgage backed securities played in the market crash of 2008 as well. While economist continue to debate who or what is at fault. The market crash clearly devastated the U.S. economy. We will also discuss how such devastation is considered to be one of the worst market failures in history. The events leading up to the crash are easier to identify after a crash, the signs were in the forefront and ignored by most people, firms, banks, and the government. Together we will embark on a journey to discover what role predatory lending, mortgage backed securities, and relaxed regulations played in the housing market crash of 2008 and to clarify if one or more of these events or a combination of them all can be considered Market Failure. Keywords: Market Failure, Predatory Lending; Mortgage Backed Securities; Housing Crisis; Public Policy ABSTRACT Six...
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...SUBPRIME MORTGAGE CRISIS The U.S. subprime mortgage crisis was a set of events and conditions that led to the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages. What is a subprime mortgage? A subprime mortgage is a type of loan granted to individuals with poor credit histories, who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate. There are several different kinds of subprime mortgage structures available. The most common is the adjustable rate mortgage (ARM), which initially charges a fixed interest rate, and then converts to a floating rate based on an index, plus a margin. The better known types of ARMs include 3/27 and 2/28 ARMs. What lead to the US subprime mortgage crisis? ARMs are somewhat misleading to subprime borrowers in that the borrowers initially pay a lower interest rate. When their mortgages reset to the higher, variable rate, mortgage payments increase significantly. This is one of the factors that lead to the sharp increase in the number of subprime mortgage foreclosures in August of 2006, and the subprime mortgage meltdown that ensued. Many lenders were more liberal in granting these loans from 2004...
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...What Needs to be Done – The Follow Through Plan Momentum is a beautiful force, especially if moving in the desired direction. However, economic momentum can be lost quickly if the inertia that mobilized it dissipates with waning enthusiasm. This article is about the continuation of what needs to be done to maintain positive economic inertia and provide a kinetic boost that will charge the US economy successfully into the foreseeable future. Although time is of the essence in any equation dealing with momentum, some of the “Follow Through Plan’s” planks discussed below have greater priority versus the remaining. But let us not pretend that if some of the plan is sacrificed due to the “feel good” inspirations fostered by the beginnings of proactive economic stimulus, it will not be sustainable if the core retains the properties of risk-tails that can demolish the forward curve permanently … and swiftly. Black Swan events, or those considered to be Gaussian anomalies or 9th degree standard deviation eclipses do not, and have not, occurred at the interval statistical quants have modeled. In fact the anomaly is to believe that Black Swan events are anything but a force of nature and occur about as common, as frequent and as necessary as the changing of the seasons. The “Follow Through Plan”, needed to retain economic leadership of the United States well into the 21st century, should include all of the following critical levels of change and direction. The order...
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...The Great Recession and the Great Depression John Maynard Keynes wrote in the depths of the Great Depression that, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”1 This acute observation is applicable to our current Great Recession as well. In fact, the newly discredited ideas are not too different from the old, suggesting that Keynes may have overestimated the ability of people to learn from their mistakes. I discuss the parallels between these two watersheds in recent economic history in three steps. The first and most important step is the causes of the crises and their relation to economic theory. The second step is the spread of the crises as they affected the whole world. I close with the final step, recovery—at least as far as we can see it at this point. Marx said famously that history repeats itself, “the first time as tragedy, the second as farce.”2 I argue that this observation also fits our current condition. Both of these dramatic and costly economic crises came from the interaction of economic imbalances in the world economy and the ruling ideology of financial decision makers who confronted these imbalances. The first imbalance came from the First World War. This paroxysm of violence brought the long economic expansion of the nineteenth century to a sudden end. Britain, the workshop of the prewar world, was exhausted by the struggle. America, the rising...
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...Entrepreneurship, MIT Sloan School of Management, Former Chief Economist, IMF On October 9, 2007 the Dow Jones Industrial Average set a record by closing at 14,047. One year later, the Dow was just above 8,000, after dropping 21% in the first nine days of October 2008. Major stock markets in other countries had plunged alongside the Dow. Credit markets were nearing paralysis. Companies began to lay off workers in droves and were forced to put off capital investments. Individual consumers were being denied loans for mortgages and college tuitions. After the nine day U.S. stock market plunge, the head of the International Monetary Fund had some sobering words: “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” 3 1 2 3 Interview with the case writer, April 10, 2009. Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009. “IMF in Global ‘Meltdown’ Warning,” BBC News, October 12, 2008. This case was prepared by Cate Reavis under the supervision of Deputy Dean JoAnne Yates. Copyright © 2009, Massachusetts Institute of Technology. This work is licensed under the Creative Commons AttributionNoncommercial-No Derivative Works 3.0 Unported...
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...1) Throughout this class we have discussed the conduct of the major players at financial institutions and their role in leading their companies to the brink of failure, and in some cases have been successful (Bear Stearns, Lehman & AIG). With that as a starting point how important is character and ethics? What role(s) do you think boards of directors should play and did they exercise their fiduciary responsibilities to the shareholders and employees? Money is an important character in various financial institutions, but by itself is not necessarily evil. Rather, it is something that is used to trade goods and services. We call it "currency", and it allows us to do business between organizations. Unfortunately, that is the sterile dictionary-type definition but it does not capture all the issues that are involved with finances. In corporate life, just like in many other realms, money causes all sorts of problems. People make incredibly bad decisions because of money, and plenty of people have gone to prison because of their money-related behavior. This is why people always approach money with a certain amount of uneasiness. Here are a few thoughts on why financial management ethics are important. The numbers do not have a soul, so they cannot govern themselves. They must be managed by people. Ethics are important because finances make people do some strange things. The spreadsheet does not have a conscience, and the goal of working with spreadsheets is to make numbers add...
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...Detroit’s Perfect Storm sets Sales up for Bailout By Jeffrey Adik Copyright © November 2008 Jeffrey Adik Intraduce, LLC | All Rights Reserved The domestic automotive crisis embodies the perfect storm. The gale-forces our economy now faces are the result of a lengthy series of events that have effectively frozen consumer lending and generated an extraordinary global lack of trust across all investor categories. Attempts by the international market to hedge the crisis, through US currency devaluation, have only accelerated problems. The doubling of fuel prices had an immediate impact on the US consumer goods market, perhaps most visible in the automotive industry. This dramatically affected consumer buying habits, whose interest has shifted away from operationally expensive SUVs and resulted in substantially devalued new and used gas guzzlers. Automotive demand has now fallen to the lowest levels in 20 years, and had irreplaceable impact on the largest profit category of the industry. While we have seen a huge direct impact on the market’s perception of the auto industry’s viability, an even deeper crisis looms: Leased vehicles, a large proportion of which fall into the SUV & lower fuel-economy categories, are still on the industry books. These vehicles will be entering a redefined market with substantially lowered demand, and therefore require significant price discounts. Auto Inventory and Demand: Vehicle production has been cut, of course, yet the length...
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... A L R E P O R T Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future Clifford V. Rossi Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future Clifford V. Rossi Robert H. Smith School of Business University of Maryland May 2010 2 9946 Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future © Research Institute for Housing America May 2010. All rights reserved. Research Institute for Housing America Board of Trustees Chair Teresa Bryce, Esq. Radian Group Inc. Michael W. Young Cenlar FSB Nancee Mueller Wells Fargo Edward L. Hurley Avanath Capital Partners LLC Steve Graves Principal Real Estate Investors Dena Yocom IMortgage Staff Jay Brinkmann, Ph.D. Senior Vice President, Research and Business Development Chief Economist Mortgage Bankers Association Michael Fratantoni, Ph.D. Vice President, Research and Economics Mortgage Bankers Association Anatomy of Risk Management Practices in the Mortgage Industry: Lessons for the Future © Research Institute for Housing America May 2010. All rights reserved. 3 Table of Contents Executive Summary 1. Introduction: Findings and Recommendations 2. A Model for Mortgage Risk Taking: Growth, P / E and the Fallacy of ROE 3. Data and Model Limitations Data Integrity Economic Environment Mortgage Products and Risk Layering Borrower and Counterparty Behavior 4. Governance, Corporate...
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...This article was downloaded by: [Loughborough University] On: 26 March 2015, At: 11:27 Publisher: Routledge Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK Public Money & Management Publication details, including instructions for authors and subscription information: http://www.tandfonline.com/loi/rpmm20 How the UK government responded to the fiscal crisis: an outsider's view Walter Kickert Published online: 23 Mar 2012. To cite this article: Walter Kickert (2012) How the UK government responded to the fiscal crisis: an outsider's view, Public Money & Management, 32:3, 169-176, DOI: 10.1080/09540962.2012.676273 To link to this article: http://dx.doi.org/10.1080/09540962.2012.676273 PLEASE SCROLL DOWN FOR ARTICLE Taylor & Francis makes every effort to ensure the accuracy of all the information (the “Content”) contained in the publications on our platform. However, Taylor & Francis, our agents, and our licensors make no representations or warranties whatsoever as to the accuracy, completeness, or suitability for any purpose of the Content. Any opinions and views expressed in this publication are the opinions and views of the authors, and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content should not be relied upon and should be independently verified with primary sources of information. Taylor and Francis shall not be liable...
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...and Fall of Lehman Brothers. Loose regulations, deception, and greed were the root of all evil for one of the largest investment banks in the world. Lehman Brother’s was founded in 1850. Lehman Brother’s survived the Great Depression, WWI and WWII. In 1969 Lehman Brother’s hired Richard “Dick” S. Fuld Jr. as an intern who in 1994 became CEO of the Company. During Bill Clinton’s Presidency government started to support middle and lower class people to own their own houses. During this time a XX”Fair Housing Act” was created which was supposed to stop mortgage banks from discriminating lower income people from owning their own houses. The 911 attacks from 2001 created the greatest loss in Wall Street since The Great Depression. George Bush and the government encouraged Americans to buy more property. Mortgage companies started to take advantage of all these factors and lured low income uneducated people to buy mortgages with introductory rates. They never warned these buyers that these were just introductory rates that would later increase. This in turn created a larger problem for the new uneducated homeowners. These new loans created havoc for the homeowners that were struggling to make payments, and then came the massive layoffs. The economy nearly came to a standstill, and the housing market was one of the hardest hit sectors in the global economy. With the perfect situations created by loose regulations, and the perceived opportunities to make massive profits, Lehman...
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