The Us Economic Meltdown In 2008 Finance Essay
The financial crisis in the United States that began in 2008 can be considered an economic meltdown because it has led to a prolonged period of recession. While many factors contributed to the economic meltdown, excessive reliance on residential mortgaged-back securities (MBS) was one of the primary causes of the financial crisis. Banks and other financial institutions experienced a liquidity crisis when the asset value of the MBS rapidly collapsed and they were unable to dispose of the MBS assets. Because banks also carried MBS as part of their assets to meet reserve requirements, they were forced to curtail lending. In many cases, banks did not have sufficient reserve assets to remain solvent, which led to Federal Reserve Board closing these banks. The long term effect of the economic meltdown 2008 has been a dramatic slowing of the economy, extremely expansive fiscal policy to stimulate the economy, and an increase of government oversight over financial institutions the effect of which remains undetermined.
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Role of Mortgage-Backed Securities
Residential MBS are derivative instruments developed over the past decade in the banking and financial services sector that are a form of collateralized debt obligation (CDO). In general, a CDO is a derivative security that is supported by a fixed income asset producing a revenue stream (Tavakoli, 14). An organization such as a bank can create a CDO by pooling several loans and selling the rights to the cash flow from the repayment of the loan principal and interest to another party. Because the CDO represents an asset pool, it theoretically provides diversification. The derivative instrument retains some of its value even if one of the loans in the underlying asset pool defaults. A MBS is a CDO in which the underlying asset is a residential or commercial mortgage. More exotic forms of the MBS sever the principal payment on the underlying asset from the interest payment, creating two separate derivative instruments from the same mortgage loans. The instrument receiving the principal payment continues to be backed by the underlying mortgage asset while the instrument based only on the instrument payment is not backed by the mortgage asset. The CDOs including the MBS were issued in tranches that were based on the level of risk involved with the underlying assets. In the case of the MBS type of CDOs, the subprime residential mortgage represented the tranch with the greatest amount of risk and with the highest potential for return (Brunnermeier, 78).
The residential MBS provided significant advantages for banks because they allow the bank to spread the risk of mortgage default and reduce liquidity risk while obtaining funds from the sale of the instrument to support creation of new loans. By creating and selling the MBS, the bank transfers some of the risk of default to a third party (Murphy, 16). The bank receives an immediate payment from the sale of the instrument that is less than the value of the face amount of the mortgage and its cash flows, with the third party assuming the risk that the cash flow will continue in the future. The bank also reduces liquidity risk, which is the possibility that the bank will not be able to sell fixed assets such as a mortgage if it should need cash to cover other obligations. The funds the bank receives from the sale of the MBS contribute to its ability to meet the fractional reserve requirements established by the Federal Reserve Board, which allows the bank to make new loans. The fractional reserve requirement is the amount of assets the bank has to hold in reserve to compensate for the risk of loan default. It is intended to ensure that the bank will remain solvent if it is faced with a substantial number of defaults in its loan portfolio.
The use of CDOs and particularly MBS led banks and other financial institutions to gradually shift their business model towards a greater focus on fee based income for loan origination. In the traditional banking business model, the institution makes loans and receives cash flow from loan origination fees, interest payments and principal payments. By using the CDO and MBS, the bank could receive the loan origination fee, but immediately sell the interest and principal cash flows. As a result, banks became increasingly focused on short term profit and less concerned with the actual risk associated with the mortgage because the risk was passed on to a third party, which increased the moral hazard in residential mortgages. The market for residential MBS grew substantially because of the perception of low risk and high returns, with residential MBS securing over $1 trillion in cash flows in 2007 (Ferguson, et al., 18).
Banks not only created MBS instruments, but also accumulated the securities to hold as part of their reserve asset base, with the valuation of derivatives supported by the strong market for residential MBS. The Federal Reserve Board permitted banks to hold derivates as part of their fractional reserve with the risk of the derivatives a factor taken in to consideration when determining the necessary size of the reserve for the banks. Because of the significant profit opportunity represented by subprime residential MBS, many banks and financial institutions purchased these instruments to increase the profitability of their reserve assets. Because the subprime residential MBS involved high risk loans, the interest payments were relatively high, generating higher returns for the owners of the securities. At the same time, the instruments were perceived as representing lower risk because each RMS aggregated many loans. If one of the loans underlying the instrument defaulted, it would impair the value of the instrument but it would retain some value because of the continued principal and interest payments by the other loans.
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Credit default swaps also contributed to the perception of lower risk associated with subprime residential MBS. A credit default swap is a derivative that involves an agreement between a seller and a buyer for the seller to pay a certain amount to the buyer if a certain credit event occurs such as the default in the payment of a loan (Tapiero, 367). Banks and other financial institutions that had retained some risk exposure from any guarantees associated with the residential MBS for principal payment used the credit default swaps to mitigate the risk. In the event of a loan default, the counterparty to the swap would be obliged to pay an amount approximately equal to the value of the underlying asset. One of the difficulties with relying on a credit default swap, however, is the ability of the counterparty to meet the obligation in the event of a default. The swap is a contractual agreement, which depends on the solvency of the counterparty at the time the default event occurs that triggers the payment. If the counterparty has a large number of credit default swaps and multiple defaults occur simultaneously, it is possible that the counterparty will be unable to meet the payment obligation under the terms of the swap.
Government policies contributed to the increased use of residential MBS over the past decade. Since 1999, the government increasingly used the provisions of the Community Reinvestment Act of 1977 and its amendments enacted during the Clinton administration to pressure banks to make loans to the subprime market. The Act required banks to meet community needs, with the amendments establishing objective numerical criteria to ensure that banks were making loans to individuals and businesses that the bank would not normally deem to be creditworthy (Wallison, 3). In 1992, Congress also added an affordable housing mandate to the charter of the government sponsored entities of the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). As a result, these quasi-public entities increasingly participated in the sub-prime market by securitizing the loans made by banks. Because of the government securitization, banks were more willing to make mortgage loans to customers with poor credit histories and high risk of default. The policy led these two government sponsored entities to accumulate a large amount of mortgage backed securities particularly in the subprime sector of the market. In addition, the entities created residential MBS for sale to third parties, theoretically distributing their risk.
An additional governmental policy contributing to the economic meltdown was the mark-to-market rules for the valuation of derivative instruments such as the residential MBS. The mark-to-market policy is found in the accounting rules of the Financial Accounting Oversight Board, to which the SEC has delegated authority to establish GAAP accounting rules for publicly traded companies. The rule requires firms holding derivative securities to use the market price of the security as the fair value of the asset for reporting its value on financial statements (Jickling, 6). As a result, the value of the derivative is dependent on the amount it can be sold for in an arm's length market transaction at the time the accounting report is prepared. The approach does not consider the intrinsic value of the security such as the value of the future cash flows it may generate in the case of MBS derivatives.
Both government policies and the liberal use of residential MBS may have also contributed to the formation of an asset price bubble in the real estate market over the past decade (Brunnermeier, 82). The Federal Reserve Board has kept interest rates relatively low, which allowed individuals to purchase homes at higher because of lower costs of servicing the debt. Banks and other lending institutions also developed mortgage products such as the adjustable rate balloon mortgages designed to allow individuals to purchase homes that may otherwise find the mortgage unaffordable. The increased demand for housing drove prices upwards, particularly in more desirable locations. By early 2007, the residential real estate market had the characteristics of an asset price bubble (Jickling, 5).
The factors of increased numbers of subprime residential MBS securities created by financial institutions, the accumulation of the securities as reserve assets. and government policies gradually produced greater vulnerability in the financial sector to vulnerability in the housing market. The vulnerability began to appear in late 2007 and early 2008, with the gradual collapse of the housing market, and an increased number of defaults among mortgagees in the subprime segment of the market. Credit rating agencies downgraded the subprime residential MBS, but the downgrades extended to other tranches of MBS, suggesting that the problem of defaults affected all levels of the housing market (Brunnermeier, 83). At the Federal Open Market Committee (FOMC) meeting in October 2007, the problem of defaults was viewed as affecting only a small number of banks that had invested heavily in subprime residential MBS (FOMC, October, 3). By March 2008, however, the FOMC acknowledged that the problem caused by the weakening of the real estate market had become widespread in the financial industry, and was affecting the use of MBS securities as collateral for overnight borrowing from the Federal Reserve (FOMC, March, 4). The problem with defaults in the subprime market continued to accelerate, leading to the financial crisis of August and September 2008.
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By September 2008, the majority of the subprime residential MBS had become worthless assets based on the mark-to-market accounting system because the financial market for these securities had collapsed. A high rate of default in the underlying assets impaired the value of the MBS, with no buyers willing to purchase the securities because of the high risk. At the same time, credit default swaps were no longer available for the residential MBS because the counterparties believed that the risk of default was so high that the premium for swap could not sufficiently compensate for the risk. With no buyers for the securities, the banks that held the residential MBS as assets were forced to value them at or close to zero. The zero valuation, however, did not mean that all the mortgages in the MBS bundles had defaulted, but that the instrument could not be sold in a secondary market. In effect, the subprime residential MBS had lost all book value although they continued to supply some cash flow to the banks. The collapse of the subprime residential MBS security market occurred relatively quickly, reducing the ability of financial institutions to divest these assets. At the same time, it resulted in the inability of major firms such as Lehman Brothers that were counterparties to credit default swaps to meet their contractual obligations and pay the stipulated amounts required when the default occurred (Brunnermeier, 90).
Short-Term and Long Term Implications
A significant short-term implication of the collapse of the residential MBS market was the negative effect on the money market. Many lending institutions were unable to continue making loans of any type because of the losses in their fractional reserve assets. This led to a liquidity crisis in the economy because banks and other financial institutions were unwilling to make short-term loans to each other because of uncertainty of the worth of the assets pledged as collateral. In effect, many financial institutions were unwilling to participate in the money market, which had a ripple effect in the capital markets from securities dealers unable to obtain short-term loans necessary to conduct transactions. In addition, banks that relied heavily on short-term loans from other institutions were unable to roll over their debt, contributing to their liquidity problems (Brunnermeier, 91).
The financial crisis also had short-term implications for the economy as a whole because economic activity depends on liquidity provided by the financial sector. When credit becomes difficult to obtain, businesses and consumers are unable to maintain the same level of economic activity. As a result, a recession occurred following the financial crises, with GDP at negative growth rates for four quarters. A relatively short-term effect was the reduction of interest rates and other measures by the FOMC to stimulate the economy and liquidity such as providing special credit facilities to restore liquidity. These measures, however, have a substantial lag time before they have a major effect on the economy.
The financial crisis had a large number of long-term implications for the financial industry and for the economy. More than 100 banks became insolvent and were places into receivership by the Federal Reserve, with bank failures continuing in 2010. While the immediate liquidity problem created by the financial crises has been resolved, credit remains scarce when compared to levels in 2007. Banks and other financial institutions are reluctant to use MBS securities to collateralize debt, which reduces their ability to extend credit even to highly creditworthy customers. In addition, the government has increased its regulatory oversight of the financial industry with the Wall Street Reform and Consumer Protection Act of 2010, the full effect of which on the banking and financial services industry remains uncertain. It is likely that the caution of financial managers to avoid future market liquidity risks and regulatory oversight will substantially reduce the use of all types of CDOs in the future, including residential MBS (Brunnermeier, 92). This would lead to lower availability of credit in the economy because financial institutions would not be able to pass loan risk on to third parties.
The financial crisis also had long term implications for fiscal policy with the federal government engaged in extraordinarily high deficit spending to stimulate economic growth and to reduce unemployment. The deficit spending threatens is likely to result in higher taxation that will slow economic growth. It could also reduce the ability of the government to use fiscal policy for interventions in future economic downturns.
The financial crisis of 2008 was caused by poor risk management practices among banks and other financial institutions, which was implicitly encouraged by various government policies to increase affordability of home ownership. The excessive reliance on subprime residential MBS to obtain short-term liquidity and the belief that pooling and credit default swaps reduced the risks of these instruments left financial institutions vulnerable when the price of real estate collapsed and defaults increased. The financial crisis has significantly weakened the American economy by reducing access to credit.
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