Introduction - Weebly



Spring 2010 and America slowly emerges from what is now being called the Great Recession (2007-2010), the worst financial period in U.S. history since the Great Depression. The Great Recession being precipitated by a series of bank and insurance company failures which triggered the financial crisis mid-September of 2008 and served to halt the global credit markets and required unprecedented government intervention (bailouts).

While there were a number of contributing factors that led to bank and insurance company failures, the U.S. financial crisis occurred as a result of other factors including inflated real estate values, easy credit conditions, deregulation and over leveraging. However, the main contributing factor for the financial crisis of 2008 arose as a result of the real estate and sub prime lending crisis: an inflated real estate market driven by sub prime lending which fueled the creation of mortgage back securities (innovative financial products) that were sold to meet global investor demand for securities producing higher yields and lower (dispersed) risk.

Beginning in the mid 1990s, and continuing for almost a decade, commercial and real estate property values rose by 53% higher than the rate of inflation (Pozen, 2009). At the same time as housing prices increased, there was simultaneous government deregulation within the mortgage industry which allowed unqualified borrowers to secure mortgages they could not afford and served to blur the lines between investment banks and mortgage lenders as more lenders were issuing sub prime mortgages.

As sub prime mortgages were originated, the risks associated from potential default by sub prime borrowers was spread throughout the financial system in the form of a number of innovative financial products; i.e., complex derivatives. In this instance, mortgaged backed securities, or MBS, were created, packaged and sold to investors through out the U.S. and global financial system through shell companies which promised higher yields and lower default risk.

MBS were created to meet the needs of certain investors; namely those demanding securities with high yield potential, relative low risk of default and insensitive to fluctuations in the market interest rates. MBS, unlike traditional bonds, are not as sensitive to fluctuations in market interest rates and quickly became the securities of choice for many individual global investors and other institutional investors because MBS are backed by collateral/physical assets. Therefore, MBS were deemed more secure and highly rated by credit rating agency(s). MBS were also a preferred financial product for corporations as well because it allowed corporations to raise capital without having to take out a loan, issue common/preferred stock or incur debt by issuing bonds.

With a MBS, the corporation basically sells the anticipated cash flows from an asset (net present value of the total expected cash flows, principal and interest payments, over the term of the loan) and pools them together as a mortgage portfolio and sells shares in same to investors. The corporation then receives the lump sum payment of cash immediately for use to reinvest in its operations and the investor is guaranteed a steady cash flow of interest payments and the original investment capital (similar to a bond’s par value if the investor had purchased a traditional bond).

These pools of MBS are rated for risk like corporate/treasury bonds by a credit rating agency such as Moody’s so that investors can gauge the risk of different rated MBS. Any risk of default on MBS is diversified across a number of mortgages held in the portfolio because each mortgage varies in mortgage amounts, geographical location, terms and interest rates. In theory and in practice, MBS appeared to be very attractive investments as long as home prices continued to rise and homeowners kept up with their mortgage payments.

Historically, Fannie Mae and Freddie Mac led the mortgage industry in the 1990s and were mandated to promote home ownership among lower income borrowers and/or minorities. The way these institutions achieved this was to lower the standards for their conforming loans. The commercial mortgage industry soon followed suit by lowering its standards and making even more subprime loans in the late 1990s and early to mid 2000s. However, in order to compensate for the risk associated with lending to this higher risk group of borrowers, lenders had to structure their loans with higher interest rates to make up for their increase in risk.

Thus, predatory lending practices of adjustable rate mortgages with initial teaser rates were used to trick high risk borrowers into entering into mortgages for homes they could not afford. Once the introductory period expired, the interest rate would go way up and push the monthly payment of principal and interest to a point where same exceeded the amount that these borrowers could afford to pay. Soon many of borrowers went into default on the mortgage loans and as the risk of default increased substantially, real estate prices plummeted. As this started happening, mortgage and financial experts warned of the systemic risk to the entire financial system as a result of the sub prime lending practices and the risk to the value of housing prices.

It was these sub prime and predatory lending practices that eventually led to the U.S. financial crisis of 2008 and the global financial crisis became these mortgage loans were used for the MBS; the value of the MBS was derived from the underlying value of the mortgages. As the value of home prices fell, so did the value of the portfolios of the MBS. While the real estate and sub prime lending contributed to the financial crisis of 2008, they were not the primary cause of the financial crisis. It was the securitization of the sub prime mortgage loans that were rated “triple A” by credit rating agencies that was the primary cause of the financial crisis because it spread sub prime debt through out the entire financial system….in the U.S. and globally.

In addition to contributing to the financial crisis of 2008, the real estate and sub prime lending caused a significant devaluation of commercial and residential real estate values and resulted in changes with affected supply and demand in the housing market. Housing supply has increased substantially due to the rise in foreclosures and developers and property owners have found it difficult to sell or refinance due to the fact that credit markets were frozen. Homeowners that are underwater with their mortgages are trapped in their homes and same affects demand for housing.

As of Spring 2010, the real estate market has yet to stabilized and it will take years for values to increase to the point they were before the housing bubble burst. Further, if real estate values continue their downward decline, home owner equity will be eroded even more and/or wiped out altogether as more and more Americans will have even less equity in their homes or continue to go deeper underwater because they will owe more for their mortgages than what their houses are worth in the market.

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