Cause of Problems for Financial Institutions During the Credit Crisis

Cause of Problems for Financial Institutions during the Credit Crisis

Lindenwold University

The purpose of this research paper is to discuss issues and problems that generated the last Credit Crisis of 2007-2009. To begin, the term Credit Crisis is a worldwide financial impact regarding subprime mortgages, collateralized debt obligations, frozen credit markets and credit default swaps. I suspect you may wonder “How might a Credit Crisis happen?”, or “Who is affected by the crisis?” If we explore the answers to these proposed questions, you will find that the Credit Crisis affects everyone. So for example, let’s group these people into home owners and investors.  Home owners represent their mortgages and investors represent their money. These mortgages represent houses and the money represents large institutions like pension funds, insurance companies, mutual funds and etc. These groups make up a financial system network of a bunch of banks and brokers commonly known as Wall Street. These investors were looking for a good investment that will for sure turn into more money. This introduces the beginning of the Cause of Problems for Financial Institutions during the last Credit Crisis of 2008.

In the 2000’s, U.S. investors began seeking for low risk, high return investments and started investing their money in the housing market. The logic behind this was to receive a better return from interest rates homeowners paid on mortgages rather than investing in U.S. treasury bonds paying very low interest. Lenders figured that mortgage backed securities were safe investments with Triple A ratings. Triple A ratings meant that it’s fully trustworthy and is expected to make their financial commitment.  Mortgage backed securities are created when large financial institutions securitize mortgages.

Investors were desperate to buy up more and more of these securities and sale shares of the pool to investors so lenders began to loosen their standards. The worst case for these investments, the houses could be sold for more money. Investors trusted these ratings and began to invest more and more. The prices of homes were on the rise with low interest rates, easy lending requirements made the mortgage backed securities appear to be an even better investment. Worst case scenario, if borrowers defaulted, the bank would still have the houses as collateral.

Let’s take a minute to discuss the causes and effects so far. Prior to 2007, the equity in house prices were increasing and more and more households wanted to take advantage of these price gains and were interested in buying a home. Our U.S. government encouraged homeownership and provided incentives. Many laws were passed to encourage banks to make loans with these incentives. People wanting loans, banks lending loans created a circulation of money for the economy.  As you will see, the housing market was a stimulated effect and demand.

With high mortgage loans, equity began to decrease as people were not able to make the payments. Foreclosures were on the rise as the value of the houses became less than the total loans. This circulation that was once a positive outcome, turned around to negative economic loss of spending in the economy. This led to a freeze in bank lending. Another name is a liquidity crisis. This period was said to be the worst recession since the Great Depression in the 1930’s.

This excessive habit for investing in mortgages can be categorized as the housing bubble. A bubble which simply filled as much as it could until it burst. The original term Economic bubble is when asset prices increase to levels above fundamental values driven by irrational decisions and this are exactly what happened. Supply was up, demand was down and home prices started to collapse.

Borrowers started defaulting on their mortgages. Some borrows just stopped paying because they could not afford the ballooning payments. Home prices dropped way below the loan amount and value. In return, borrowers had mortgages more than their home was worth. Financial institutions stopped buying sub-prime mortgages and sub-prime lenders were stuck with bad loans. Subprime is credit issued to borrowers with poor credit history and high interest rates. Subprime lenders were issuing loans with unreasonable rates that had a likelihood of defaulting on the loan. “The Housing Market Crash of 2007 was the cause of the financial crisis. This nearly caused the U.S. to experience another depression like the Great Depression. There are a number of things we can look at to determine how the housing bubble occurred and what happened to cause the bubble to collapse (Degrace).”

        In 2007, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) announced they would no longer purchase these risky sub-primes. These are government sponsored businesses whose purpose is to expand the secondary mortgage markets by securing mortgages with mortgage backed securities. This increases the money supply available for mortgage lending and new home purchases. There were many red flags that indicated problems in the future. To begin, Freddie and Fannie accumulated too much debt. The total debt was equal to all publicly held debt in the U.S. by private investors and the Federal Reserve. Freddie and Fannie held the monopoly in traditional fixed rate mortgages while Wall Street only had a small share. Wall Street wanted to increase their investing and decided to stop buying from Fannie and Freddie market and buy in the riskier markets to increase the number of mortgages it could buy. So they purchased more and more of these mortgage backed securities and Fannie and Freddie market share began to decline. They started to experience huge losses and the regulator of FHFA placed them into conservatorship which is government equivalent to Chapter 11 bankruptcy.

By 2007, some big lenders declared bankruptcy. The problem spread to the big investors who invested money into these mortgage backed securities and CDO’s started losing money on their investments. Collateralized Debt Obligation is a collection of all debt products that does not include mortgages. CDO’s had many types of financial products such as loans, credit card debt, and bonds to name a few. Investors were interested in these types of CDO’s because they offered a diverse variety of risk. The assumption of investors was that mixing safe, risky investments in the right proportion will aide into relatively stable financial products.