Role of US Mortgage Market Securitisation in the Credit Crunch and Global Financial Crisis

Housing Markets and Policy
Student Name
Institutional Affiliation
Date
Executive Summary
For the years leading to the financial crisis, the US housing market was rife with cheap and easy credit to home owners who had poor credit histories. This was the first domino because more people could now afford homes rushed to secure mortgages. This drove the prices of homes high which came with higher repayment costs and saddled the borrowers with hefty premiums. On the other hand, the market securitization built on this risky market other securities that were tied to the housing market. The US housing market was the root of the financial crisis. The crisis was exacerbated by securitization mainly by the banking industry and other players like hedge funds. However, there are several ways in which the US mortgage market created the perfect fodder for the other industries to securitize the market.
The US mortgage market securitisation played a key role in causing the financial crisis through heavy securitization of the subprime mortgages. The market also relied on ratings were based on faulty assumptions and inadequate analysis, which resulted in a mispricing of risk CITATION Van10 \l 1033 (Gupta, Mittal, & Bhalla, 2010). Finally, the market was heavily interconnected and the contagion effect of the plummeting securities brought down the entire industry. This article also highlights that the financial crisis would still have happened even if the housing market was not securitized. There had been deregulation in the decades before the credit crunch and it created room for risky financial innovation that led to risky financial instruments within the framework of the law yet they could destabilize the markets. The financial system was weakened, making it vulnerable to a financial shock.
Introduction
In 2008, there was a severe economic downturn that started in the US and quickly spread to the rest of the world. The crisis had its roots in the US housing market where years of speculative property values coupled with easy credit and low interest rates eventually led to default and foreclosures CITATION Jos22 \l 1033 (Ryan-Collins, Llyod, & Macfarlane, 2022). Subprime mortgages were given to high-risk borrowers. The market also securitized these subprime mortgages using complex financial instruments and sold to investors. When the housing bubble burst, the complex financial derivatives faced massive losses and led to a credit freeze and liquidity crisis in the US financial system which led to a credit crunch all over the world.
The financial crisis would still have happened if the markets were not securitized. The issues that surrounded the financial crisis were beyond the housing market. There had been systemic deregulation of the industry in the decades and years following the crisis. This left room for financial instrument engineering and it is the main cause of the crisis CITATION Wat141 \l 1033 (Watcher, 2014). Housing market only served as the source of securities but an entire industry of securities was built on it. Therefore, while housing market caused the crisis, the banking industry would still have created complex financial instruments that would have found other products to securitize. The financial crisis would have unfolded elsewhere. Secondly, had the housing market not have been securitized, it would have less far reaching consequences and probably it could have been contained before it spilled into other markets.
What was the role of US mortgage market securitisation in the Credit Crunch (2007/8) and subsequent Global Financial Crisis?
How the Financial Crisis Unfolded
In the years before the 2008 economic recession, the US financial market had been systemically deregulated. The government believed in the nature of markets to regulate and correct themselves and this faith in the system eventually failed. One of laws that had been repealed was the Glass-Steagall Act of 1933. This law separated investment banking from commercial banking. In 1999, the law was repealed under President Clinton which open the door for commercial banks to invest in investment banking activities such as trading and underwriting securities. In a deregulated environment, the banking regulators were denied powers to control the industry CITATION Jam09 \l 1033 (Crotty J. , 2009). Banks had lobbied for the repeal of the act as it compelled banks to be more accountable and transparent in their operations. The banking industry had spent more than $300 million in lobbying efforts in the 25 years leading to the repeal CITATION Den09 \l 1033 (Igan, Mishra, & Tressel, 2009). Repealing the act create a loophole in the regulatory framework that allowed banks to legally be opaque and removed the requirement for banks to declare and explain their operations mainly to the regulators. Secondly, repealing the Glass-Steagall Act allowed consolidation in the banking sector. More banks merged and smaller banks were acquired by bigger banks which created the famous ‘too big to fail’ titans in the industry. JP Morgan and Chase Manhattan merged in 2000 and during the unfolding of the crisis it allowed Bank of America to acquire Countrywide Financial Services and Merrill Lynch. When the legal framework changed, there was a shift in the approach to risk and regulation of the banking industry. New financial instruments were fashioned in a weak regulatory environment CITATION Cro09 \l 1033 (Crotty J. , 2009). There was expansion of subprime lending and mortgage securitization. Mortgage securitization had been existing for a long time and it had largely operated as safe investment bets for the investors. The credit rating agencies mostly gave them clean bill of health based on historical data on mortgage securities. However, the new mortgage market had morphed into a vicious cycle of predatory lending that exposed investors and led to subprime lending CITATION Bai08 \l 1033 (Baily, Litan, & Johnson, 2008). Historically, mortgage loans were safe since banks offered mortgages to credit worth individuals who repaid it in full hence led to the believe that mortgages were secure investments. Secondly, when the lender defaulted, the banks could foreclose and relist the property into the market. Thus, it was a safe investment for the banks.
The crash was caused when the financial market players created other products and services pegged on the mortgages. A vibrant market of mortgage securitization emerged and it was supported by many financial institutions that created new financial products pegged on the mortgages CITATION Wat141 \l 1033 (Watcher, 2014). The new financial instruments were created under a weak regulatory authority. Studies have shown that those countries that have undergone the greatest degree of financial liberalization are more likely to experience strong macro-economic fluctuations. These financial instruments were highly profitable but relied on risky practises. Following the repeal of the Glass-Steagall Act, the congress passed the Commodity Futures Modernization Act of 2000. This act further deregulated the financial market by allowing the derivatives market to exempt Over-The-Counter (OTC) derivatives from regulation by the Commodity Futures and Trading Commission (CFTC). This allowed for unregulated financial innovation that developed a new product dabbed Credit Default Swaps (CDS). These CDSs were structured in a way that they could be traded without oversight by the regulatory bodies. CFMA allowed some certain derivative contracts to be exempted from scrutiny by the Securities and Exchange Commission and the CFTC. Secondly, they created other instruments like Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDOs). The financial market players structured their securities and derivatives in a manner that was galvanized from scrutiny and oversight by the regulatory bodies. These instruments were predatory and while they were legal, they had been structured to be complex and pegged on a poorly regulated environment and compromised or incompetent credit rating system. They were also very opaque and difficult to understand to the public and the investors. With these products promising high yields in a largely unregulated environment, it was a matter of time before predatory and unsafe speculative trades emerged CITATION Wat141 \l 1033 (Watcher, 2014). Banks could take on large amounts of leverage and engaged in speculative and riskier trading practices.
However, when the banks deregulated and diluted the requirements to access mortgage, people flocked to take advantage of this new trend to own a home. The financial market created more MBSs which, investors swarmed to buy. They offered good returns to investors and they were insured in another complex web of CDSs CITATION Bai08 \l 1033 (Baily, Litan, & Johnson, 2008). There were several products being traded in the market that were hinged on the mortgages. As market for mortgage securities grew, mortgage financiers sought to create more mortgages. They relaxed the rules on who qualified for mortgages. More people hopped into the chance to get and own a home also seized the opportunity as they looked affordable. However, as time progressed, the mortgage repayment rates increased because the value of the property kept increasing. The financial market had inflated the supply of credit to get mortgage and the public’s appetite for mortgage grew. The demand for homes increased because of the profitability of mortgage securitization CITATION Bai08 \l 1033 (Baily, Litan, & Johnson, 2008). Some banks even engaged in predatory lending to continue issuing mortgages to support the mortgage security market. There was an increase in risky lending practices, such as adjustable-rate mortgages and no-documentation loans, which were packaged into mortgage-backed securities and sold to investors
Eventually, the people could not keep up with the repayment of their mortgages because of their ballooning payments. However, since the price of the houses had been inflated and when the houses were foreclosed, they could not find new buyers in the market. Relisting the products in the market led oversupply of houses and led to the mortgage bubble bust. In 2007, some big lenders started declaring bankruptcy which foreshadowed the financial market crash. The system had become unsustainable and it was a matter of time before everything came crushing down.
This set off a chain of events in the market that eventually led to the crash. The steady and healthy income stream the investors had enjoyed dried up. Additionally, the derivatives market which had engineered the Credit Default Swaps (CDS) was reeled in. The CDS were insurance of the mortgage securities. Hence as market securities lost value, the insurers were forced to pay. AIG had gone all in in this market and it suffered catastrophically. Additionally, the CDS had also been securitized and were being speculatively being traded, the traders had been better in on whether the value of securities would go up and down and this created a new layer of securities that cascaded from the mortgage industry. When things went down, this complicated interrelated system is subprime mortgages, mortgage backed securities (MBSs), CDOs, CDSs and CDSs-backed securities had to come down. Investors suffered huge losses as the market declined and securities plummeted. since most of the big financial institutions had leveraged their positions largely, there was a cascading effect throughout the system. However, the financial crisis had its roots in the deregulation of the US financial market created an environment that was conducive to excessive risk-taking and speculative activities.
What was the role of US mortgage market securitisation in the Credit Crunch (2007/8) and subsequent Global Financial Crisis?
Securitization of subprime mortgages: Lenders issued mortgages to borrowers with poor credit history and a high risk of default. The housing market bubble, which was driven by a combination of low interest rates, lax lending standards, and speculation, eventually burst, causing housing prices to decline sharply CITATION Bai08 \l 1033 (Baily, Litan, & Johnson, 2008). These subprime mortgages were bundled together with other types of mortgages and sold as mortgage-backed securities (MBS).
As housing prices fell, borrowers began to default on their mortgages, causing the value of the MBS and CDOs to plummet. The demand for these securities was high, as investors believed that they would provide a steady stream of income. The MBS were then further packaged into complex financial products called collateralized debt obligations (CDOs), which were sold to investors around the world CITATION Cro09 \l 1033 (Crotty J. , 2009).
The CDOs were highly leveraged, meaning that they relied heavily on borrowed money to purchase the underlying assets. This increased the risk associated with the securities. Therefore, the securitization that was enabled by deregulation and financial engineering played a key role in causing the credit crunch CITATION Wat141 \l 1033 (Watcher, 2014). It is likely that the financial instruments would have been based on other products and still led to the credit crunch. The housing market created the perfect fodder for the players in the market securitization and it is largely to blame for the credit crunch.
The widespread use of MBS and CDOs meant that the losses from the mortgage market spread throughout the financial system. Banks and other financial institutions that had invested in these securities suffered significant losses, causing them to become highly leveraged and undercapitalized. This, in turn, led to a credit crunch as banks became more hesitant to lend to each other and to other borrowers, causing liquidity to dry up and exacerbating the crisis.
Credit rating agencies: The securities market is highly depended on the credit rating agencies to determine the risky nature of any product in the market. These credit rating agencies erred in rating the products and gave risky products a ‘AAA” (triple A) rating despite their high-risk value CITATION Utz10 \l 1033 (Utzig, 2010). The rest of the securities market is depended on product rating and the credit rating industry inflated the value of securities. The MBS and CDOs were given high credit ratings by credit rating agencies, which led investors to believe that they were low-risk investments. However, the ratings were based on faulty assumptions and inadequate analysis, which resulted in a mispricing of risk CITATION Van10 \l 1033 (Gupta, Mittal, & Bhalla, 2010).
Contagion: The interconnectedness of financial institutions through securitized products created a contagion effect when the crisis hit. Many financial institutions held significant amounts of MBS and CDOs on their balance sheets or had exposure to them through complex financial instruments, leading to a severe disruption in the global financial system when the value of these securities collapsed. The complex web of interdependencies among financial institutions, as they held or had exposure to these securities on their balance sheets or through complex financial instruments such as derivatives CITATION Sco201 \l 1033 (Scott, 2020).
For example, if Bank A had purchased MBS or CDOS from Bank B using short-term borrowing in form of repurchase agreements and the value of those securities declined, the lending bank may require additional collateral to reduce its exposure. It may r...