Mortgage Securitization - Report Example

Mortgage Securitization Affiliation Mortgage securitization Executive Summary This report provides an in-depth review about mortgage securitization as well the role it played during the 2008 global financial crisis. It also provides examples of some of the states and countries that got affected by the crisis. In addition, the report offers some advantages of mortgage securitization as well as its disadvantages and the risks associated. Introduction A mortgage is a loan acquired to fund the procurement of real estate. The purchaser, thereafter, is indebted to the lender the entire amount borrowed, in addition to the agreed interest and any other fees. As warranty or assurance of payment, the financier holds the deed or possession of alleged property, until the purchaser compensates the mortgage off. Nonetheless, the buyer resides in the said property as if it were already his/her own. Aside from interests and other fees, there is usually an agreed payment period that the buyer is expected to clear up the entire debt. On the other hand, mortgage securitization is a process that involves merging of different mortgages that bear related characteristics in a pool and trading debt securities that lure interest on primary payments from the mortgages pool. Securitization turns non-liquid resources of single mortgage loans into vendible securities that can be purchased, traded and sold on the secondary markets. The securitization process enables mortgage inventors to trade mortgage loans from their records and use the acquired money to make further loans. The lenders are able to continue in recycling loan money to home possessors without holding the loan assets on their records. Additionally, mortgage securitization enables the initiators of the mortgages to diversify their risk aside from enabling them to secure instant liquidity for the properties, which would, if not so, have encountered some struggle in trading. The mortgage process involves the pooling of various mortgage loans after which they are moved to a trust or a Special Purpose Vehicle (SPV). The SPV, then, gives out the securities backed by this mortgage loans pool soon after getting them graded from a credit rating agency. The money produced by the pooled assets is, hence, used to settle the principal and the interest on the mortgage backed securities. Money is produced by the payment or repayment of mortgages and the monthly mortgage. Mortgage-backed securities are an example of securitization. It bears a resemblance to bonds, mechanisms dispensed by governments and organizations that guarantee to pay a fixed amount of interest for a specific period of time. Mortgage-backed securities are formed when a firm purchases a certain number of mortgages from a basic lender that is, from the firm one got his /her mortgage from. Afterwards, one uses his/her monthly costs, and those of thousands of others, as the income stream to pay off shareholders who have purchased masses of the offering (Ashcraft & Schuermann, 2006). They let mortgagees to sell the mortgages they form, hence restocking their resources, and letting them to lend over. For their part, purchasers of mortgage-backed securities acquire security in the understanding that the rate of the bond does not just lie on the affluence of one borrower, rather, it is on the combined creditworthiness of a bunch of borrowers. The financial catastrophe of 2007 to 2008, also referred to as the Global Financial Crisis and 2008 financial crisis, is thought by various economists to have been the nastiest financial disaster since the Great Depression of the 1930s. It imperilled the entire downfall of large commercial institutions, which was stopped by the bailout of banks by state governments, though stock markets continued to drop globally (Schwartz, 2009). One of these financial tragedy main facilitators was the outbreak of defaults and foreclosures, which also created a substantial dead weight expenses in their own right. Two huge causes for the foreclosures and the defaults were the recession in house values and an intense reduction in the worth of mortgage loans. In lots of areas, the crisis, subsequently causing evictions, extended lack of jobs as well as foreclosures, also affected the housing market. The crisis played a substantial part in the letdown of crucial companies, failures in consumer capital valued in trillions of U.S. monies, and a recession in fiscal activity. Consequently, this led to the 2008–2012 worldwide depression and also participated in the European sovereign-debt crisis (Erkens, Hung, & Matos, 2012). The effects of the worst financial recession since the Great Depression forced changes onto national governments and the U.S. economy and its effects are bound to be felt for decades to come. According to the Federal Reserve approximation, the country lost nearly an entire years value of economic activity, which is approximately $14 trillion, during the downturn from 2007 to 2009. Moreover, according to Census Bureau data, homeownership proportions among individuals with youngsters under the age of 18 dropped severely during the recession, decreasing 15% between 2005 and 2011. The situation was typically worse in some states like Michigan, where the reduction in homeownership was 23%, and in Arizona and California, the rate was at 22%. Moreover, the recession mandated states to reduce their expenditures across the board, a blow from a common trend of 1.6% progression yearly, following the National Association of State Budget Officers. Therefore, States cut expenses by 3.8% in financial year 2009 and by another 5.7% in the 2010 financial year (Murphy, 2008). The direct resource or prompt of the disaster was the bursting of the U.S housing bubble that had started to rapidly peak by around 2005 to 2006. Afterwards, the adjustable-rate mortgages and the already rising payment rates on subprime started to increase fast. Also, the housing prices started to increase as banks started to issue out more loans to the prospective homeowners. Enormous inflows of external funds followed by the Asian fiscal disaster and the Russian debt crisis of the 1997 to 1998 time enabled easy obtainability of credit in the United States (Klagge, Fromhold-Eisebith, & Fuchs, 2010). As a result, this led to a house building boom as well as eased the debt-financed consumer expenditure. In addition, careless lending principles and escalating real estate prices participate in the formation of the real estate bubble. As a contribution to the credit and housing booms, the amount of fiscal contracts known as collateralized debt obligations and mortgage-backed securities, which drew their worth from the housing prices and mortgage payments, increased tremendously. Financial innovations like these allowed organizations and financiers around the globe to invest in the United States housing market (Friedrichs, 2010). As a result, when the housing prices went down, key worldwide organizations that had invested greatly in subprime mortgage-backed securities as well as borrowed, reported major losses. Also, dropping prices caused homes to be valued less than the mortgage loan, offering a financial motivation to enter foreclosure (Lehnert, Passmore, & Sherlund, 2008). The soring profits resulting from securitization lured many into the market. Banks now borrowed extra money so as to loan out in order to make more securitization (Singh & Bruning, 2011). Also, various banks gave loans more to have a justification to securitize those loans. While on running out of who to lend to, the banks resulted to lending out to the poor, that is the subprime, the uncertain loans. Increasing housing prices contributed into lender’s thinking that it was not too risky. To them, bad loans translated to reclaiming high-valued property; hence, self-certified and subprime loans became quite renowned, mostly in the United States. In addition, a number of banks even began to purchase securities from others. More compound kinds or securitization like Collateralized Debt Obligations extended the risk, although they were complex and frequently concealed the bad loans. It was maybe to ensure that no one received bad news in the midst of the ongoing good things. Additionally, high street banking institutions ventured into some kind of investment banking, trading, selling and buying risk. Consequently they resulted into investing on home loans and mortgages, while they lacked the right management and controls (Mian, Sufi, & Trebbi, 2010). As a result of numerous banks taking on great risks, they raised their vulnerability to problems. However, several investment banks had less in deposits, that is, lacked secure retail funding, so several of them failed intensely and fast. The issue was very big such that, even those banks with huge capital assets ran out and, therefore, had to seek the governments to be helped out. And although fresh capital was added into the banks to, as a consequent, enable them to lose further money but without going smashed, it proved not to be enough to restore the dwindled confidence. A number of factors in the mortgage industry contributed to this financial crisis. The loan value dropped in great part due to one unplanned aftermath of securitization, which is, that mortgage lenders did not accept the costs of these drops in loan worth, and so, they did not pay any attention to them. Another probable reason for the drop in loan quality was the lack of lenders to comprehend precisely the terms of the loans they were being presented with. As a result, it caused them not to totally adopt the costs of foreclosure and default either. Another factor is that the predominance of the loans in the subprime segment was cross adjustable rate mortgages with non- amendable rates for 2-3 years and amendable rates subsequently. Since the 2/28 and the 3/27 adjustable rate mortgages were being issued at around the same period, it unintentionally, might have formed a complete surge of defaults or refinancing (Simkovic, 2013). The main aim for mortgage securitization was to increase the source of mortgage loans in a large scale and by it aid more people into achieving homeownership. It also provided a way to diversify risks such that no individual organization would have to suffer the loss alone, rather, they would share. It, therefore, made many banks to need lesser collateral, especially for subprime loans. Based on the American historical point of view, it is evident that there has been a notably low association in housing value movements in the past. As a matter of fact, lowest price growth correspondence in a U.S. cities shot from 60% - 17% and the highest shot from 94% - 96% (Demyanyk & Van Hemert, 2011). Established on these low correlations, the risks were therefore low, and the entire architecture industry made sense. The academics and the press view is that gluttonous real estate agents as well as the bankers afflicted the structure of securitization. Actually, a lot of mud was found beneath their carpet. It can be considered that the catastrophic problem was a consequence of organized poor pricing. Although the system of securitizing developed grounded on assumptions of low historical correlation, the system itself builds correlation, hence it was a major problem. The process and the subprime led to a relationship that would end up making the system susceptible to small shocks (Singh & Bruning, 2011). Consequently, felony rates on subprime mortgages increased same as the foreclosures. The reduced housing prices also extended to the prime mortgages. Advantages and Disadvantages Some disadvantages of mortgage securitization include, increased risk taking, whereby, the purchasers can be passed down the risks in case the mortgage goes bad. Also, it increases occurrence of fraudulent cases due to its nature of involving numerous participants. The buyer can end up not knowing the exact prize of the loan, while still repaying. Advantages include, for the loan issuers, they spread their overall risks by including many participants. It also reduces interest rates due to spreading of risks and increased market liquidity. Conclusion In conclusion, questions like how predatory banking can be recognized and regulated or can the set regulation do away with the generalization nature of various mortgage products, usually arise. Also, what capacity of standardization of mortgage loan is necessary and its limitation as well as the securitization regulatory limits, is another question that begs. The availability of innovation and choice is noble and non-standard agreements can be valuable, since various households opt for different contracts. Also, standardization is viable because it endorses liquidity in the mortgage based securities market since it makes the securities easier to value. It also restricts predatory lending. Recommendation Loan inventors and mortgage agents need to be incentivized to adopt the externalities formed by the dead-weight expenditures related to foreclosures and defaults. Ensuring that mortgage customers comprehend completely the terms of all loan products presented to them will help in internalizing the costs that they hold in case default or foreclosure. Availability of provisions for effective restructuring and renegotiation of a loan in case of default can minimize the foreclosure dead- weight costs and also make it much hard to securitize the loan. In addition, a trade-off and the precise nature of every encompassed provision are necessary. Bibliography Ashcraft, A. B., & Schuermann, T. (2006). Understanding the Securitization of Subprime Mortgage Credit. Foundations and Trends® in Finance. doi:10.1561/0500000024 Demyanyk, Y., & Van Hemert, O. (2011). Understanding the subprime mortgage crisis. Review of Financial Studies, 24, 1848–1880. doi:10.1093/rfs/hhp033 Erkens, D. H., Hung, M., & Matos, P. (2012). Corporate governance in the 2007-2008 financial crisis: Evidence from financial institutions worldwide. Journal of Corporate Finance, 18, 389–411. doi:10.1016/j.jcorpfin.2012.01.005 Friedrichs, D. O. (2010). Mortgage origination fraud and the global economic crisis. Criminology & Public Policy, 9, 627–632. doi:10.1111/j.1745-9133.2010.00656.x Klagge, B., Fromhold-Eisebith, M., & Fuchs, M. (2010). The Return of Depression Economics and the Crisis of 2008. Regional Studies. doi:10.1080/00343401003707367 Lehnert, A., Passmore, W., & Sherlund, S. M. (2008). GSEs, mortgage rates, and secondary market activities. Journal of Real Estate Finance and Economics, 36, 343–363. doi:10.1007/s11146-007-9047-5 Mian, A., Sufi, A., & Trebbi, F. (2010). The political economy of the US mortgage default crisis. American Economic Review, 100, 1967–1998. doi:10.1257/aer.100.5.1967 Murphy, A. (2008). An analysis of the financial crisis of 2008: causes and solutions. Social Science Research Network, 4493, 27. Schwartz, A. J. (2009). Origins of the financial market crisis of 2008. Cato Journal, 29, 19–23. Simkovic, M. (2013). Competition and Crisis in Mortgage Securitization. Indiana Law Journal, 88, 212–71. Singh, G., & Bruning, K. (2011). THE MORTGAGE CRISIS. Academy of Banking Studies Journal, 10, 23–44. Read More