...Moral Hazard and the Mortgage Industry Moral hazard describes behavior when the party responsible for the interests of another party has an incentive to put its interests first (Dowd, 2009). The possibility of it increases when the party does not necessarily suffer the consequences of its actions and thus becomes susceptible to taking more risk because it knows it would be protected. An example of moral hazard is the subprime mortgage crisis, which preceded and “triggered” (Bernanke, 2012) the recent recession. To a great extent it was caused by excessive risk-taking by organizations “too big to fail”, meaning that “certain businesses are so important to an economy that disastrous consequences would result if they were allowed to fail” (Federal Reserve Bank of Kansas City). Before technological improvements would make it “relatively easy and cheap” (Wright, 2013) to transform illiquid financial assets as loans and mortgages through securitization and to sell them to investors, banks would approve mortgages with a goal of holding them until maturity. They would be carefully screening out possible delinquents and would aim to minimize their own risk and a prospective subprime borrower would not be considered. According to Dowd (2009), this “incentive is seriously weakened” if the bank (or any other financial institution such as a mortgage broker) is only originating the loan and collecting fees for it. The inherited risks involved in such practice are considerably higher since...
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...Research in Higher Education Journal Centering the business capstone course on the banking crisis: concrete integrated pedagogy Khalid A. Razaki Dominican University Wayne Koprowski Dominican University Peter Alonzi Dominican University Robert Irons Dominican University Abstract The recent financial crisis offers instructors rich material for business programs regarding the relations between accounting, business law, economics, and finance, as well as ethical issues. This paper offers a concrete approach to developing a business capstone course built around the financial crisis and the lessons it offers business students. Complete pedagogical modules are offered for each discipline, including suggestions for specific assignments in each discipline. Key Words: Capstone Course, Banking Crisis, Pedagogy Centering the Business Capstone Course, Pate 1 Research in Higher Education Journal INTRODUCTION A capstone course is essential in the business school curriculum. It provides each student the time to refresh their grasp of and to hone their ability to apply the principles, tools, and methods of the fields comprising the business curriculum. Further, it gives students the opportunity to integrate the insights of the various fields. The effectiveness of the capstone course can be enhanced by centering the capstone course on the 2008 financial crisis. All students share the common experience of the 2008 crisis’s violent shaking of the economy. It immediately affected each...
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...AFTER THE BAILOUT: REGULATING SYSTEMIC MORAL HAZARD* Karl S. Okamoto ** How do we prevent excessive risk taking in the financial markets? This Essay offers a strategy for regulating financial markets to better prevent the kind of disaster we saw during the Financial Crisis of 2008. By developing a model of risk-manager decisionmaking, this Essay illustrates how even “good people” acting in utterly rational and expected ways brought us into economic turmoil. The assertion of this Essay is that the root cause of the Financial Crisis was systemic moral hazard. Systemic moral hazard poses a unique challenge in crafting a regulatory response. The challenge lies in that the best response to systemic moral hazard is “predictive prevention.” It is inherently difficult to reward individuals for producing predictive prevention. Unsurprisingly, markets fail to produce it at optimal levels and thus cannot prevent systemic moral hazard and the kind of crises that ensue. The difficulty in valuing predictive prevention is seen when we model how risk managers make decisions regarding the prevention of excessive risk. The model reveals how the balance can be tipped in favor of risk taking that leads to systemic failure and broad social harm. The model also reveals how regulation might work to reset the balance to one that is superior for society. We can achieve optimal risktaking decisionmaking in two ways: (1) by requiring all asset managers in the market to put their own money at risk in...
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...What role dir moral hazard play in the United States financial crisis? Sub-prime lending People with no credit worth background could become credits easily all of the sudden. Reinvestment Act (passed in 1977, but revised in 1995 and amended in 2005) ( REFERENCE NIGEL) wants to make Hispanics and blacks more able to get credits, however the act missed the control function Moral hazard: Crazy loans. Interest only plans Everyone knew that they were unlikely to be ever paid back. Merrill lynch $55billion worth of securities on these books. “Home mortgages were purchased from banks and other lenders by Wall Street firms that packaged and divided them into different categories – based on the ability of borrowers to repay (see Foster & Magdoff, 2009, p. 94). They then were sold as investments” the riskier they are the more yield they generate. Lenders were happy because by selling to a bank they could make new loans. Banks were happy because of high volumes. Banks increase pressure on lenders to sell more morgages. Vicious cycle. Large sectors of the American industry outsourced companys to countries were labour is cheaper -> US many people unemployed -> less disposable income. At the same time government home ownership = American dream ← Credit default swap. o Packaging mortgages into a bond which then is sold to investors. Investors did not have to understand mortgages. Since this was rated by agencies such as standard & Poors, Moody’s triple A rating ...
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...yield of 2%. The next day, market yields rise to 3%. If you now want to sell the bond, what price do you expect to receive? (10 points) (Note: You do not have to calculate any specific numbers but can answer in the form of a mathematical expression.) What is the implied yield to maturity for the buyer at that price? (5 points) 1.02/1.03 x 1000= 990 I expect a lower price because the market yield is higher than the bond yield. The implied yield for the buyer at that price is now 3%. Why is the process of turning loans into bonds called “securitization”? (15 points) The process is called securitization because something that is not originally a security, which is a stock or a bond, gets turned into one. Commonly mortgages get turned into commercial mortgages-backed securities. That process literally...
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...capitalism and government under the mantle of democracy is collusive and incestuous in their ultimate pursuit of profit and power. The film clearly captures the systemic corruption of the United States by greedy and morally unbalanced industry leaders and their cohorts who engineered a financial catastrophe in 2008 not seen since the great depression. The film’s writer and director Charles Ferguson contends that the collapse of the financial industry could have been prevented had there been more regulation of Wall Street. He clearly establishes his line of reasoning through a series of interviews with many of the major players in government and the financial industry who indirectly and in some cases directly contributed to the financial fiasco of 2008. The financial collapse was caused by three main contributing factors; first, a toxic sub-prime mortgage market engineered by the financial industry; second, government’s failure of regulatory enforcement of the financial industry and Wall Street; and third, a collusive relationship between business leaders and government officials elected to curtail the same crisis they helped create. The financial collapse of 2008 resulted from a toxic sub-prime mortgage market engineered by an out-of-control industry that led to its inevitable implosion. In September 2008, the global financial market was rocked to its core when the sub-prime market tanked. As a result, a global recession followed and the national debt doubled, millions of people...
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...Emergency Economic Stabilization Act of 2008 (EESA), in an effort to mitigate the economic repercussions of the subprime mortgage crisis (Nolen). The crisis was a result of many factors that can be categorized under the term subprime lending, which refers to higher risk loans to individuals with limited creditworthiness. The Emergency Economic Stabilization Act authorized the United States Secretary of the Treasury to spend up to $700 billion to purchase mortgage-backed securities and other troubled assets in order to prevent the collapse of the U.S. financial system (Nolen). Ultimately, the policy resulted in federal bailouts intended to strengthen consumer confidence, increase liquidity, and stabilize the credit market by protecting “too big to fail” banks from failure. Supporters of the bailouts argued that, though it may not be ideal, protecting the largest banks against failure was necessary to prevent an even larger financial crisis from devastating the entire U.S. economy (Slavov). The 2008 financial crisis highlights the dilemma created by “too big to fail” banks, a term given to financial institutions that are so intertwined in the economic system that their failure would result in economy wide repercussions and ultimately give rise to a recession. This was the argument in favor of bailouts in the subprime mortgage crisis. These major banks are so crucial to the economy that if they collapse, other institutions that are financially connected...
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...171 to 60, people nervous. Ran out of cash. But they have cash and no problems. They bought bundled subprime mortgage. - Because they thought housing can only go up. - The value of houses have gone down. - High-risk loans in the reaper market. Goldman Sachs may be deserting Stearns. - Public acknowledgement of its bad. They only had option, to raise capital. - Federal System, Tim Gygner - Morgan, The Fed found toxic assets. Billion in hidden subprime mortgage loans and credit default swaps. - Credit Swap: - I sell you insurance, if they cannot pay, we pay. - They bought so many, hundreds of billions of dollars. If they can’t pay people back, it would cause collapse - There would be systemic risk, because Stearns is so connected to the banking world. - If we allowed them to fail, they would collapse. Federal Reserve and JP Morgan payout - JP Morgan and Federal Reserve provided secure bailout. Moral Hazard If you bail someone out of a self-inflicted problem, what can they do Paulson made millions of dollars, anti-government. There is no responsibility, Bear Stearns was bought by JP Morgan. Post-Bear Stearns People took mortgages that you can’t afford. - Buying the big houses make you look rich. Brenanki and Paulson called that it was all fine. - They said it was contained. Toxic Mortgages continue to lower profits, losses are real. - Trillions of dollars of losses. Freddy Mae and Fannie Mae ...
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...transaction costs for investors. | | | | | * Question 3 0 out of 10 points | | | The free-rider problem arises: | | | | | Selected Answer: | [None Given] | Answers: | A. when people benefit from a good without paying for it. | | B. only when markets are perfectly competitive. | | C. if labor unions are strong. | | D. when a country is expanding. | | | | | * Question 4 0 out of 10 points | | | A project pays $125 with a probability of 0.75 or pays $90. What is the expected value of this project? | | | | | Selected Answer: | [None Given] | Answers: | A. $116.25 | | B. $93.75 | | C. $98.75 | | D. $161.25 | | | | | * Question 5 0 out of 10 points | | | In a home mortgage, the house serves as: | | | | | Selected Answer: | [None Given] | Answers: | A. bank capital. | | B. a bank's real asset. | | C. a down payment. | | D. collateral. | | | | | * Question 6 0 out of 10 points | | | According to the adverse...
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...Principal Agent Problems in the Financial Crisis of 2007-2009 BMI Master Thesis November 2009 Jasper Holke Klein Supervisor: Rob van der Mei [pic] Faculty of Sciences Business Mathematics and Informatics De Boelelaan 1081a 1081 HV Amsterdam Preface This paper is one of the last compulsory elements of the program Business Mathematics and Informatics at the VU University Amsterdam. The objective of this subject is to demonstrate the student's ability to describe a problem in a clear manner for the benefit of an expert manager. This is accomplished by doing a literature research and to apply this research to a practical situation. I have always had a strong interest in strategic thinking. One of the ways that this is modeled in the scientific theory is through game theory. From the broad range of subjects that are available in game theory I decided to focus on information asymmetry and, more specifically, on the principal-agent relationship as this theory is very widely applicable and has a strong explanatory power. In this way I was able to combine my interest in strategic thinking and the financial sector and able to give a clear explanation for the events that happened within the financial crisis of 2007 - 2009. Finally, I would like to thank my supervisor Rob van der Mei for his comments and suggestions. Amsterdam, November 2009, Jasper Holke Klein Summary This paper analyses the origin of the...
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...stabilize the economy and maintain price stability. 4. Based on the information you researched from Federal Reserve publications, present and justify your own economic outlook for the next 12 to 18 months. Introduction American economy is composed of financial balance of services, Agricultural, manufacturing and banking industry. In the result U.S one of the biggest global economy which comprises of foreign investments and movement of wealth in trade. From past many years the U.S economy is emerged more as service based and industrial base economy than farming based. This result the banking system to be more complex to deal with the government and currency , instituting the regulations and a centralized bank to regulate and from a policies which could limitize the negative effect on the general economic health on the country. In this paper I will analyze the Federal Reserve Banking System in U.S.A and the Federal Reserve’s assessment of the current economic activity and financial markets. its current view about increasing inflations . Current economic activity : Recently the whole USA economy is suffering from the Sub Prime Mortgage...
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...shocking news and events that were unknown to others during the time, but also to me. For example, the lack of morals and responsibility that took place during this past recession. Investors and companies bet on Mortgage-Backed-Securities and not only that, but companies tried to make more profit by ensuring them in case of default. Also the fact that AIG not only insured the claims but acted irresponsible in the sense that they did not set aside the necessary capital to pay out in case of these policies failing. Blinder talks about these types of players...
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...The Mortgage and Financial Crises: The Role of Credit Risk Management and Corporate Governance William W. Lang Federal Reserve Bank of Philadelphia Ten Independence Mall, Philadelphia, PA 19106 Phone: 215-574-7225 E-mail: William.Lang@phil.frb.org Julapa Jagtiani Federal Reserve Bank of Philadelphia Ten Independence Mall, Philadelphia, PA 19106 Phone: 215-574-7284 E-mail: Julapa.Jagtiani@phil.frb.org February 9, 2010 Abstract This paper discusses the role of risk management and corporate governance as causal factors in the onset of the financial crisis. The downturn in the housing and mortgage markets precipitated the first phase of the financial crisis in August 2007 when the solvency of a number of large financial firms was threatened by huge losses in complex structured financial securities. Why did these firms have such high concentrations in mortgage-related securities? Given the information available to firms at the time, these high concentrations in mortgage-related securities violated basic principles of modern risk management. We argue that this failure was a result of principal-agent problems internal to the firms and to breakdowns of corporate governance systems designed to overcome these principal-agent problems. Forthcoming in Atlantic Economic Journal (2010) JEL Classification Numbers: G01, G18, G21, G28 Keywords: Financial Crisis, Risk Management, Corporate Governance, Subprime Crisis _________________________ The opinions expressed in this paper...
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...Introduction Recent global financial crisis has highlighted the problems in the current financial system. Some of the analysts have even termed it as the downfall of the capitalism and interest based economy driven by ‘greed’ and has acknowledged the need of a new financial system. One interesting development in this whole scenario was the relative stability of Islamic Financial Institutions (IFIs). In the last decade, IFIs have witnessed an impressive growth and have begun to make an impact on the current financial setup. This paper aims to highlight the basic foundation of Islamic financial system and the development of different markets and institutions. It will then point out certain issues and challenges facing the Islamic Financial Institutions. HISTORY Early History: The history of Islamic Financial system goes back to 1,000 – 1,500 AD, during which the Middle Eastern tradesmen would engage in transactions based on Shariah. During that time, the Ottoman Empire Arabs had good trade relationships with the Spanish, and they established their financial systems without interest, based on profit and loss sharing basis. As time went by, Middle Eastern and Asian regions became important trading partners for European companies such as the Dutch East India Company, as a result of which European banks started to spread their branches in these countries, which typically were interest-based. Thus the conventional financial institutions became more dominant as Western countries started...
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...world as new form of contagion. In the second chapter the consequences of the subprime crisis in the Spanish banking sector will be described. The last chapter of the thesis will present an analysis of the reforms made, using legal intervention. It will be concluded with a general point of view regarding the present situation of the Spanish banking system, the potential results of the current measures and the perspectives of new reforms. Contents 1 | Introduction | | 2 | Introducing the Subprime Crisis i. The subprime crisis: origins and evolution ii. Implications of the mortgage bubble The Spanish Banking sector: Before and after i. The evolution of Spanish economy until the Subprime Crises ii. A unique model in Spain: Banks and Spanish Savings Banks iii. Spanish economy snapshotThe change in the banking sector regulation | | 3 | * Banking regulatory failure and moral...
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