The financial crisis showed its first signs in the first quarter of 2006 when the housing market turned. A number of subprime mortgages, that were designed with a high interest payment began to default. Many of the loans were highly risky and only possible due to the clever creation of products like “2/28” and “3/27” adjustable rate mortgages (ARMs). These loans offered a fixed rate for the first two or three years, and then adjustable rates for the remaining twenty- eight or twenty-seven years, respectively. After the first two or three years, the adjustment of rates would be substantial enough as to be unaffordable for the subprime borrowers; thus, the mortgages were designed to be refinanced. But for the most part, this would be possible for subprime borrowers only if the collateral on the loan had increased in value, otherwise, they would default.
Because these mortgages were all originated around the same time, mortgage lenders had inadvertently created an environment that could lead to a systemic wave of defaults if the price of housing had declined two or three years later, when the mortgages reset. Alas, in 2006 when Ownit Mortgage Solution’s went bankrupt and later on April 2, 2007 with the failure of the second largest subprime lender, New Century Financial, it was clear that the subprime mortgage boom had ended.
The next wave of the crisis began on August 9, 2007, BNP Paribas which is a large, complex financial institutions (LCFI), could not assess the mark-to-market values of their securitized investments backed by subprime mortgages. This led to a suspension of redemption’s by Paribas, which, in turn, caused the asset-backed commercial paper market for OBSEs to “freeze”: Purchasers of ABCP suddenly realized that assets backing the conduits were of such dubious quality that they might have little to no resale value, especially if they were all hit at once with delinquencies and defaults and given there was little to distinguish between BNP Paribas conduits and those of other financial institutions, the lack of transparency on what financial institutions were holding and how much of the conduit loss would get passed back to the sponsoring institutions caused the entire market to shut down. All short-term markets, such as commercial paper, began to freeze, only to open again once the central banks injected liquidity into the system.
The Role of Asset Securitization in Financial Crisis
The Large and complex financial institutions or LCFIs (the universal banks, investment banks, insurance companies, and even hedge funds) that dominate the financial industry, did not follow their mode of operation in terms of securitization and chose not to transfer the credit risk to other investors. They became the major purchasers of these securities, instead of acting as intermediaries between borrowers and investors by transferring the risk from mortgage lenders to the capital market, the banks became primary investors, and this was one of their undoings.
Securitization allowed for lenders to make loans available to riskier borrowers, simply by generally expanding the supply of credit. When originators could securitize their loans, they had a new source of finance for loan origination. The result could have been a reduction in the cost of credit that led to a credit expansion. With lower borrowing costs, households will on average borrow more. Moreover, the lower cost of credit may have made lending to riskier borrowers profitable, resulting in more subprime lending
Mortgages were granted to people with little ability to pay them back, and was also designed to systemically default or refinance in just a few years, depending on the path of house prices. There was the securitization of these mortgages, which allowed credit markets to grow rapidly, but at the cost of some lenders having little, contributing to the deterioration in loan quality. Some securitized mortgages were rubber-stamped as “AAA” by credit rating agencies due to modelling failures and, possibly, conflicts of interest, as the rating agencies may have been more interested in generating fees than doing careful risk assessment.
The fact that there was conflict of interest as regards the rating of the assets by the rating agencies allowed room for default, by allowing investors to buy inapproiately rated asset.
Asset securitization were divided into mortgage pools into “tranches” according to the predicted riskiness of the loans. Holders of shares in the riskier tranches received higher premium payments, but in exchange, they were subject to losses before the holders of shares in the less-risky tranches. Thus, the holders of the least-risky tranches, as determined by the rating agencies got a lower risk payment, but they would feel any effect of non performance in the structured security only after its “subordinated tranches” had stopped performing through delinquency or default.
Asset securitization allowed for assets to be placed in off-balance-sheet entities, therefore banks did not have to hold significant capital reserves against them. The regulations also allowed banks to reduce the amount of capital they held against assets that remained on their balance sheet, if those assets took the form of AAA-rated tranches of securitized mortgages. Thus, by repackaging mortgages into mortgage-backed securities, whether held on or off their balance sheets, banks reduced the amount of capital required against their loans, increasing their ability to make loans many fold.
All this loop holes allowed for the failure of the likes of Fannie Mae, Freddie Mac, and Lehman Brothers, which invested in the securities created out of these mortgages, which had its toll on the capital markets and thus caused the worldwide recession. Standing behind the collapse of the investment banks and the GSEs was the systemic failure of the securitization market, which had been triggered by the popping of the overall housing bubble, which in turn had been fuelled by the ability of these firms, as well as commercial banks, to finance so many mortgages in the first place. The severity of the resulting recession and its worldwide scope has been magnified by the huge decline in lending by commercial banks, including not just BNP Paribas, Citibank, Royal Bank of Scotland, and UBS, Bank of America, J. P. Morgan Chase, and others, such as Wachovia, IndyMac, CITI Group, that no longer exist. All these banks had been huge buyers of subprime mortgages.