Government Policy, Moral Hazard And The Endless Financial Crisis

1962 words - 8 pages

The story begins in 1938 when Roosevelt establishes Fannie Mae to purchase mortgages from lenders and sell them to investors as mortgaged backed securities. Loan originators are no longer exposed to mortgage default risks, and they have a continuous supply of money to lend as they sell each loan to Fannie. In 1970, congress creates Freddie Mac to buy and securitize private loans not guaranteed by Fannie Mae. Because Freddie Mac and Fannie Mae are government sponsored enterprises (GSE), investors believe the securities are backed by the US Government and thus very low risk. Later, the Community Reinvestment Act gives Fannie Mae an affordable housing credit for buying subprime loans, and ...view middle of the document...

Investors believe large institutions are intrinsically safer than small ones since they are implicitly guaranteed by government.
Fast forward. The Dot-com bubble swells and pops, the World Trade Center is attacked, and the Fed responds by lowering the federal funds rate from 6.5% to a 45 year low of 1% to stimulate economic growth. Acquiring dept is now inexpensive. Treasury bond yields fall forcing investors to look elsewhere for safe investments.
Zoom out, rewind, and press play. As interest rates and lending standards fall, Americans are borrowing to buy homes and taking out equity loans to finance consumer spending. Household debt swells from $705 billion in 1975 to $7.4 trillion in 2001, and finally to $14.5 trillion in 2008. With mortgage rates at a record low, home demand skyrockets, and home prices follow. The housing bubble is born. Consumers borrow to speculate in real estate which is appreciating at 10% per year in most areas. In 2005, 40% of all home purchases will be non-principle residences. The supply of good mortgages are soon exhausted, and lending standards continue to decline as little risk is perceived in issuing a note backed by appreciating real estate. During the bubble years, $3.2 trillion will be loaned to homeowners with bad credit, undocumented income, and little or no down payment. Despite the reduced standards, there still aren’t enough loans to satisfy investor demand. The financial industry will develop derivatives to take their place.
Zoom in, way in. A credit default swap (CDS) ensures a collateralized debt obligation (CDO, a complex type of mortgage backed security, MBS) against default allowing the seller to take the same risk as if they held the CDO. A synthetic CDO consists of a portfolio of CDS’s and essentially allows investment banks to sell the same package of sub-prime loans over and over again as long as investors will buy them. The Federal Reserve requires that financial securities be rated by at least two of the three major credit agencies (Fitch, Moody's, and Standard and Poor’s). However the creators of the securities are paying the agencies to rate them while the agencies compete with each other for this lucrative business. During 2000-2006, credit rating agencies will earn 40% of their revenue giving mortgage backed securities AAA ratings, the same rating given a government guaranteed bond. The Securities and Exchange Commission will allow banks holding these presumably very safe AAA rated securities to take higher leverage, and they do. Investment and depository banks will borrow heavily, driving their debt to equity ratios as high as 40:1 to buy “AAA” rated CDO’s and synthetic CDO’s. By 2008, these contracts will total 33 to 47 trillion dollars.
Zoom out and fast forward to 2006. Median home prices nationwide have declined 3.3%. Because many homeowners purchased with little or no down payment, this small decrease in price leaves them with negative equity and an...

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