Tuesday, January 29, 2013

"The Origins of the Financial Crisis"

Miami Personal Bankruptcy Lawyer Jordan E. Bublick has over 25 years of experience in filing chapter 13 and chapter 7 bankruptcy cases. His office is in Miami at 1221 Brickell Ave., 9th Fl., Miami and may be reached at (305) 891-4055. www.bublicklaw.com  

In 2009, the article "The Origins of the Financial Crisis" was released by the Brookings Institution. In this article the authors explained that the then present financial crisis had its origins in an asset price bubble that interacted with financial innovations that hid risks, with companies that failed to follow their own risk management procedures, and with regulators who failed to restrain excessiveness. The housing market asset bubble developed as prices increased yearly from the mid-1990's to 2006 out of line with fundamentals such as household income and with an unrealistic expectation of future price increases. The financial innovations with rapidly increasing subprime lending, masked the inherent risk included Adjustable Rate Mortgages with low "teaser rates", no down-payments, and negative amortization predicated on the expectation of future increases of housing prices.

The development of private sector mortgage-backed securities backed by "non-conforming" loans with other means of "credit enhancements" allowed the growth in subprime lending. This technique of "securitizing" mortgages was developed in the 1970's by the government-sponsored entities Fannie Mae and Freddie Mac for "conforming" loans or loans below a certain dollar amount and for borrowers with good credit scores. The private sector mortgage-backed securities market remained small until the late 1990's until the investment banks developed new ways of securitizing subprime mortgages, including dividing cash flows from the mortgage-backed securities into various "tranches" with different levels of risk, high credit rating agency ratings for the highest "tranches", and "monoline" bond insurance that would pay off in the event of loan defaults. The increase in homeownership due to the availability of subprime lending increased housing demand and inflated home prices.

The article notes that during this period of new mortgage financial innovations there was an environment of easy monetary policy by the Federal Reserve and poor regulatory oversight. Financial institutions borrowed to finance their increased purchases of mortgage-related securities and created "off-balance sheet" entities that were not subject to regulatory capital requirements. The authors relate taht financial institutions turned to and relied on short-term collateralized borrowing such as repurchase agreements, so much that by 2006 investment banks were rolling over a quarter of their balance sheets every night. Once panic hit in 2007, the uncertainty over asset values caused lenders to abruptly refuse to rollover their debts and overleveraged banks found themselves undercapitalized and with assets with falling values.

The authors are shocked to find that institutions along the mortgage securitization chain grossly failed to perform adequate risk assessment with respect to the mortgage-related assets they held and traded. These institutions along the chain include the mortgage originator, the loan servicer, the mortgage-backed security issuer, and the credit rating agencies. There was a lack of due diligence in each link in the securitization chain and instead there was a reliance on computer models.

The article finds that due to the nature of the securitization model, financial institutions had little concern about the risks in the mortgage-related assets as they were able to pass the risk down the chain -- the so called "originate to sell" model. The authors question why the ultimate buyers of the mortgage-backed securities failed to understand the involved risk. They suggest that factors were that the ultimate buyers were caught up in the "bubble mentality" as were the others, the complexity of the securitization system, reliance on rating agencies, and complex flawed computer models.