Financial crisis Lehman brother
In August 2007, the Federal Reserve Chief placed financial stability above inflation as his main concerned. The action marked the official start of the economic recession. The recession gained intensity in 2008 and by 2009, the financial sector in America and most of the world seemed to be locked downward spiral. All financial analysts and experts had to put their efforts together to prevent the situation from becoming another great depression. Many analysts attribute the recession to the subprime crisis that occurred in the America in the middle of 2007. The rest of the financial markets crumbled due to the widespread exposure of subprime assets. The situation was by the panic that gripped the financial market with many investors withdrawing their investments in an attempt to salvage their hard-earned capital. The withdrawal of investors led to drying up of the asset classes and serious damage to the financial markets. The imbalances caused by the financial market were mainly caused by the overreliance of using funding from other sectors of the economy that were prone to ballooned valuations. By 2009, there was still no agreement among financial analysts as to what the main cause of the financial imbalances, but many of them believed that the accommodative monetary policy of 2001 bore the largest blame. The accommodative monetary policy is since there was no adequate regulation after its enactment and many financial institutions took advantage of this lace of regulation in order to make investments that were ethically incorrect . The paper looks at the 2007 to 2010 financial recession to understand the causes while looking at Lehman Brothers as a case study as to how financial organizations conducted themselves.
Understanding Subprime mortgages and the connection to financial institutions
Subprime is a term that refers to lending that is offered to a borrower with a low credit qualification. The subprime loans are with higher interest rate as compared to similar loans given to individuals who are eligible for prime loans. In the financial sector, the interest rates are offered based on the indirectly proportionate relationship between revenue and risk. When a financial asset has a high risk, the expected returns are also higher .
Subprime lending is risky not only to the borrower but also to the lender. The lender charges high interest rates because the likelihood of default is a lot higher and the borrower is with high monthly repayments. Financial institutions also employ loans with adjustable interest rates, which initially have a low interest rate then it is increased later in order to accommodate the high risk involved in subprime lending. Borrowers are as subprime borrowers if they have certain characteristics that deem them credit risks in the financial sector. One of these characteristics is more than one loan payment paid past the 30 day due date or having any loan paid over 90 days past the due date within a three-year period. Another situation that highlights someone as a subprime borrower is having any judgment, repossession, foreclosure or non-payment of a loan in the last four years. Apart from that, any person who has filed for bankruptcy in the past 7 years is also deemed a high-risk borrower. Furthermore, any person who has a credit score of less than 620 is considered to have a high probability of default (Gad, 2007).
Despite many people attributing the financial crisis to the mortgage sector, the main culprits were the financial institutions that introduced subprime mortgages in the housing sector. Initially, the main players in the housing sector were companies such as Freddie Mac that were government sponsored. These companies only gave mortgages to people considered as prime borrowers. The entry of the private sector in the housing market allowed financial institutions to introduce mortgages to subprime borrowers. Initially, subprime lending was limited to the financial sector with amounts available for subprime lending to be between 58,000 to 85,000 dollars. The entry in the mortgage market meant that the average amount offered to subprime borrowers rose to 130,000 dollars. The subprime loans offered also came with faster repayment periods. The faster repayment period made the rate of default higher .
The financial sector then introduced practices that seem to go against the ethics of lending. One of these is the lending without regard of the ability of a person to repay. Some of the borrowers were so in deb that they could not service the loan and the banking institutions took advantage of this to offer them loans even though they would not be able to repay the loan. Financial institutions were also accused of loan flipping where borrowers had to refinance a loan repeatedly within short periods. Many borrowers were also not given full information of the nature of the loans such as adjustable interest rates as well as exorbitant interest rates that went beyond common practice subprime loan repayment . Commercial banks took advantage of the lack of regulation to increase market share in the housing sector by targeting subprime borrowers. The commercial banks then use the subprime loans in financial transactions that exposed the rest of the financial industry to the risk that these subprime loans posed. Ultimately during the financial crisis the transactions made by these commercial banks led to an imbalance in the financial markets.
The role of mortgage brokers and underwriters in the financial crisis
The mortgage brokers also bore a large blame for the financial crisis. Mortgage brokers do not offer any of their own money as mortgages and they only seek to earn commission by convincing unsuspecting borrowers to obtain mortgages from financial institutions that they represent. A study done in 2004 showed that over 68 percent of all the mortgages originated from mortgage brokers. Out of these mortgages, 42 percent of these loans were subprime in nature. Many borrowers have accused mortgage brokers of failing to give full information of the nature of the loans offered by the financial institutions they represented. Mortgage brokers also pushed most borrowers to obtain loans with adjustable interest rates. They used unruly practices such as lack of full disclosure of the nature of the loans.
The financial institutions also circumvented the underwriting process by using automated underwriting software. Such software was used for the majority of the subprime loans offered because it took a short period as compared to using traditional underwriters. The automated underwriting process reduced documentation that is important when dealing with loans. The lack of documentation is one of the reasons why transactions using these loans were not fully scrutinized and the risk was then carried forward. The lax control of mortgage lending because of the push for a commission by many mortgage brokers is as one of the reasons why risky subprime loans exceeded the limit that could be handled by financial institutions. Experts revealed that the automated system of underwriting allowed loaning to individuals who would have been denied in the traditional underwriting practices.
Securitization and the role of credit rating agencies in the financial crisis
Securitization is referred to a structured finance practice where receivables, assets and financial instruments are as into pools that are then offered as collateral in third party investment. Securitization involves collection of financial assets such as account receivables that are then transferred to a special purpose vehicle or an insurer. The assets are then sold to investors who then receive the cash flows generated by the asset. Asset securitization began in the 1970 with the structured financing of housing loan pools. In the financial sector, a commercial bank can securitize its mortgage financing and offer it to a third party investor who will then collect the loan repayments. The stability of mortgage securities led to increasing investor appetite when it comes to mortgage backed securities.
Credit rating agencies played an important role in the propagation of the financial crisis. Subprime loans carry a high risk of investment and the rating given to subprime mortgages need to mirror the risk. Credit rating agencies found themselves experiencing a conflict of interest when they had to rate the securities of investment banks that paid these credit rating agencies. The higher rating led to an influx of subprime mortgage securities in the market. Statistics show that, in 2004, less than 54 percent of the mortgage securities sold to third party investors were subprime in nature. By 2006, the number had grown to slightly over 75 percent. The increase shows that regardless of the risk of default subprime securities were still easily transferable to unsuspecting third party investors. Commercial banks brought the financial risk in the mortgage industry to other sectors of the economy through securitization.
Government’s financial regulation that led to the financial crisis
Commercial banks may have been responsible for the direct development of high-risk loans in the economy, but this was only because the government had regulations that were not stringent enough in the financial industry. In particular, the community reinvestment act was used by financial institutions to justify the increase in subprime loans offered to high-risk borrowers. The lack of regulation of the underwriting and mortgage brokering business also falls on the government.
The government also gave a bail out in the savings and loan crisis particularly relating to mortgages. The action encouraged lenders to take part in the high-risk financial brokerage that was going on in the economy. The government also reduced the Federal Reserve fund rate to 1.24 percent from an initial 6 percent. The rate is by most commercial banks to set the adjustable interest rates on loans. The low rate created the low initial interest rate on subprime adjustable mortgages. This increased demand for housing that led to the housing boom that eventually
Financial crisis Lehman brother