Us Home Ownership Rates

Published Date: 02 Nov 2017

This system encourages banks to take risk recklessly which run-up the crisis said Simon Johnson (cited in Richman 2012), a professor of global economics and entrepreneurship. This is because the federal government make implicit guarantee that they would not be allowed to fail since they were crucial for providing stability global financial system. Thus, those big banks felt that if just one of them failed, it would have affect others financial system down with it. They believed worked with implicit government support, they able to take risks without further consideration. Banks increased their power as they able to underwrite, sell insurance and securities and make risky investments with their depositors' money. Consequently, they made fraudulent loans and sold them to their customers in the form of securities caused the bubble peaked in 2007 and collapsed in 2008 (Rickards 2012).

"Commercial banks are not supposed to be high-risk ventures", said Joseph Stiglitz (cited in Roosevelt Institute n.d.). In fact, commercial banks are responsible to manage people’s money conservatively. On other hand, investment banks are accountable in managing investors’ money to earn higher return. Banks should not have the thoughts of they are too big to fail without concerning consumers’ money and the consequences. Of course, Clinton administration helped them grow even larger. According to Lenzner (2011), if Clinton remained the regulation of Glass-Steagall Act, banks would not have only care about their own interest in the first place. They would be not having operated with implicit federal backing and so they would not able to take high risk. The financial crisis could have been avoided if the Clinton administration thinks prudently the effect that agreed to deep-six the discipline of the Glass-Steagall Act, which in 1933 wisely that prevented banks with consumer deposits from engaging in risky investment banking activities. With this, it would ensure relative stability on Wall Street for over half a century (Lenzner 2011).

Besides, the combination of easy money and low interest rates that engineered by the Federal Reserve complementing the easy housing policies created by a variety of government agencies such as GSEs (Fannie Mae and Freddie Mac) play main role in this financial crisis (Richman 2012). They convinced unqualified home-buyers with poor credit histories to make housing mortgages and does not take into account whether repay can be made. Easily borrowed money result the demand for houses increased thereby the housing prices skyrocketed since anyone can get the mortgages. People began obsessed with home-buying and led to an explosion of sub-prime mortgages.

Thus, housing boom existed broadly due the widespread usage of CDOs where banks and GSEs sold them as mortgage-backed securities to financial investors who had lot of money to lend (Ismail 2009). Diagram 1 below illustrated that the dramatic rise in home ownership rates. During credit crisis of 2007, the housing bubble began to burst. Both Fannie Mae and Freddie Mac started experiencing financial distress because they have guaranteed many securities based on subprime loans and they were overleveraged (Spaulding n.d.). Consequently, their guaranteed failed since many of the subprime borrowers started to default. The government regulators that should have been protecting the consumers’ money had done nothing during the crisis.

Diagram 1: U.S. Home Ownership Rates (Hancock n.d.)

The crisis would never have occurred if the government housing and monetary policies did not implement by those government agencies. From Inside Job, it stated that GSEs should tighten their rule by lending money to the potential homebuyers rather than to those who unable to afford or repay the loan. Without the excess demand from securitizes, subprime mortgage originations would have been far lower to led huge financial crisis. According to Lenzner (2011), the financial tsunami could be avoided if the chairman of Federal Reserve Bank, Alan Greenspan willing to accept others people advice instead of using his power to deregulation the housing policies. He should not ignore the warned from Loews Cop. Laurence Tisch and John Whitehead, who are the investors and economist of Wall Street that wish Federal Reserve to calling off the easy money policy and low interest rates. Moreover, the other banking regulators should not resisted the appeal for strictly ruling of subprime mortgages and other high-risk unusual mortgages that allowed people to make loan far more they could repay them (Andrews 2008).

The self-interest of the most influential credit rating agencies (CRAs), Moody’s, Standard & Poor’s and Fitch are responsible for contributing to the worst recession. In order to gain more business, they gave high investment grades for the banks that issued them. They were paid by the investment banks to evaluate the CDOs in a highest possible investment grade (AAA rating) but also do not suffer any losses if their ratings are inaccurate. In fact, high ratings from the three agencies allowed banks to sell trillions in risky investments (Wagner & Rexrode 2013). The higher the CDOs sold, the higher their profits. Yet, when the housing prices began decline and sub-prime mortgages began to default, it clearly showed that the assessment of the agencies was totally a faulty rating.

The executives of CRAs who explained that they were underestimated for the sharp drop in home prices by using historical data were just their own wishful thinking saying (Woellert & Kopecki 2008). Most ironically, they argued that the assessment was just their merely opinion, public should not fully trust it. According to Woellert & Kopecki (2008), the fact that caused this crisis is the three big credit rating agencies who are more likely to care about own interest for earning higher profit and violated internal procedures in granting top ratings to mortgage bonds. They made billions of dollars in giving high ratings to risky securities. Diagram 2 below has shown the revenue of the CRAs increased every year from rating asset-backed securities (ABS).

Diagram 2: Revenue of the three credit rating agencies (Barnett-Hart 2009)

The crisis could be avoided if credit rating agencies leaving aside their personal interests and followed a tightly standard rating rule. They should not loosen their standards in order to get business since the originators of structured securities generally choose the rating agency with the lowest standards of credit assessment. CRAs should consider that their reputation is the major criteria as it will influence the trust of the public. Information that provided by CRAs must be appropriate, legitimately, accurate (Bahena 2010). The 2008 SEC report indicated that the policies and procedures for rating CDOs and MBSs could be better documented if CRAs disclose the substantial aspects of the rating process. Indeed, if more information is presented evidently, market participants will be able to make more informed decisions regarding the rated instrument (Bahena 2010). On other hand, the investors should also perceive the information given by CRA regardless the investment grade is high or low instead of paid to those agencies who able to create the high grade rating results.

Question 2

Diagram 3: Growth in CDO and CDS markets (Yellen 2013)

Diagram 3 above showed that the growth of CDO and CDS from 2000 to 2010. CDO is one of the financial instruments that led financial crisis. Since the banks sold mortgages to investment banks, investments banks will combine thousands of individual housing mortgages to create complex derivatives, which known as CDOs. Then, CDOs will sell to investors worldwide. CDOs was getting popular day by day due to it rated highly (AAA) by rating agencies. Therefore, most of the people thought it is a high quality investment. Furthermore, this system also allowed banks that lend mortgages to their customers would not have to worry about whether their customers are able to repay or cover their loans. In fact, those banks just keep making risky loans. For investment banks, their target is only to maximize their profits by selling more CDOs. In the early 2000s, there was a huge increase in the riskiest loans (subprime) that were combined to create CDOs. Until 2008, the increase of loan defaults began since households stopped making payment on their mortgages and thus CDOs became worthless as shown in diagram above (Barnett-Hart 2009). Overall, the reason that CDO led the stock market crash was probably caused by the agencies that gave high rating to risky securities and claimed CDOs as "safe" investments (Saporito 2008).

Moreover, Credit Default Swap (CDS) was the key point in turning the market into the worst crisis. CDS worked like an insurance policy. It is a private insurance agreement between the buyers of CDS who makes payments to the seller who give them credit protection. In fact, buyers will receive a payoff if a security goes into default. Therefore, CDS became a popular financial instrument because it created the safest way to insure investors against the risk of default (Philips 2008). However, this system has been misused. AIG, the world’s largest insurance company almost collapsed due to selling CDS (Saporito 2008). For investors who owned CDOs will paid AIG to purchase CDS as a protection which mean if the CDOs went bad, AIG promised to pay the investors for their losses. Since CDS was unregulated, AIG did not have to bring in any money to cover the potential losses. Instead, AIG would be on the hook if CDOs went bad. Indeed, the problem happened. Followed by the CDOs began to junk, AIG had payouts billions of dollars to investors who purchased CDSs now. CDS lost its value during 2008 as shown in diagram above. Hence, there’s a reason Warren Buffett called these instruments as "financial weapons of mass destruction" (Philips 2008).

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