Patrick Christensen
Econ2020
Sub-prime Mortgage Crisis
Sub-Prime mortgage lending became an issue when mortgage lenders
would sell mortgages to investment banks. Investment banks created complex
derivatives called collateralized debt obligations (CDO’s), by combining
commercial mortgages, corporate buy-out debt, home mortgages, car loans,
student loans, and credit card debt (Ferguson, 2010). These derivatives are
then sold to investors, Mortgage borrowers are now paying mortgage payments
to investors, and this creates a system without risk for the mortgage lender and
the investment banks.
There is no risk to the mortgage lender because they sold the mortgages
to the investment banks. The investment banks created CDO derivatives and
sold them to investors leaving the investment banks with no risk. Investors
purchased the CDO’s because the received a “AAA” (Wikipedia, 2011) rating by
rating agencies, who also won’t be held accountable because the rating is only
their opinion.
The product of this is the more mortgages lenders furnished the more
profit mortgage lenders and investment banks realized. The highest risk
mortgage loan is a sub-prime mortgage loan. Sub-prime mortgage loans went
from 8% of all loans in 2002 to 20% of all loans in 2006 (Philips, 2008).
Investment banks preferred sub-prime mortgage loans because they carry a
higher interest rate. Mortgage lenders preferred them for the same reason and
also because investment banks wanted them. This led to a massive increase in
predatory lending (Ferguson, 2010). Mortgage lenders were needlessly placing
borrowers in expensive sub-prime mortgage loans, and many of those loans
were given to people who could not repay them.
This caused home prices to sky-rocket, from 1996 to 2006 prices
doubled 194% (Ferguson, 2010). Sub-prime mortgage lending went from $30
billion a year to over $600 billion a year in 10 years (Ferguson, 2010). Country
wide financial, the largest sub-prime mortgage lender issued $97,202,850,000
worth of loans and made over $11 billion in profit between 2000 and 2006
(Ferguson, 2010). Cash bonuses for traders and CEO’s spiked from around $10
billion in 2002 to $30 billion in 2007. Lehman Brothers, Top underwriter of
sub-prime mortgage loans wrote $106,444,600,000 in 2005 and 2006. The
CEO Richard Fold took home $485 million (Ferguson, 2010).
As you can see because of the profits being realized there was a big push
for sub-prime mortgage lending, despite the economic effect it may have. Our
government didn’t help either. The Securities and Exchange Commission never
conducted a major investigation of the investment banks during the bubble.
Investment banks began to borrow money to issue more mortgages. In 2004
Hennery Paulson the CEO of Goldman Sachs helped lobby the Securities and
Exchange Commission to relax limits on leverage ratio (Wright, 2011), allowing
banks to increase their borrowing. In 2003 investment bank leverage was
between 15:1 and 25:1 by 2007 it was between 25:1 and 33:1 (Wright, 2011).
Another factor of the crisis came from the insurance sector. AIG the
world’s largest insurance company was selling huge quantities of derivatives,
called credit default swaps. Basically this was a policy that investors could buy
to insure their CDO’s (Davidson, 2008). So for a quarterly premium if investor
CDO’s defaulted AIG would pay the investor for their losses. Speculators could
buy credit default swaps from AIG to bet against CDO’s they didn’t own
(Davidson, 2008). Investment banks would buy an insurance policy on a CDO
they sold to an investor so if it went bad they would get paid by AIG (Ferguson,
2010). AIG paid bonuses of $3.5 billion between 2000 and 2007 (Davidson,
2008). Credit default swaps weren’t regulated, so AIG didn’t have to set aside
any money to cover the policies if a claim was made (Davidson, 2008). AIG’s
financial division in London issued $500 billion worth of credit default swaps
during the bubble. Many of them for CDO’s backed by sub-prime mortgage
loans. Joseph Cssano CEO of AIG made $315 million (Davidson, 2008).
In 2005 Rajaun delivered a paper at the annual Jackson Hole
symposium, the most elite banking conference in the world (Ferguson, 2010).
His paper titled “Is Financial Development Making the World More Risky?”
Conclusion “Yes”, because investment banks were allocating huge cash
bonuses for short-term profits and no penalties for losses (Ferguson, 2010).
This creates a greater incentive to take risk. Rajaun stated “it may lead to a full
blown financial crisis, a catastrophic meltdown.” Well he was right!
Goldman Sachs sold $3.1 billion worth of CDO’s backed by sub-prime
mortgages in the first half of 2006 (Philips, 2008). The CEO of Goldman Sachs
was Hennery Paulsen the highest paid CEO on Wall Street (Ferguson, 2010). In
May 2006 President Bush made Hennery Paulsen the secretary of the treasury.
Paulsen had to sell his $485 million of Goldman Sachs stock to become an
employee of the government and because of a law passed by the first president
Bush he didn’t have to pay any taxes; it saved him $50 million (Ferguson,
2010). Goldman Sachs was purchased $22 billion worth of credit default swaps
from AIG for CDO’s they didn’t own, so they could get paid when the CDO’s
failed (Davidson, 2008). Goldman Sachs would sell CDO’s to investors then
insure against them, Morgan Stanly did the same (Ferguson, 2010). This
sounds highly unethical to me; they were eventually both sued for fraud.
Foreclosures went from 300,000 in the first quarter of 2007 to 1,000,000
in the third quarter of 2009 (Ferguson, 2010). When mortgages began to
default CDO’s started going bad son investment bands had tons of CDO’s they
couldn’t sell to investors, mortgage lenders had tons of sub-prime mortgage
loans that investment banks wouldn’t buy, and AIG had $13 billion owed to
holders of credit default swaps (Davidson, 2008). This crash caused the
government to take over of AIG, the bankruptcy of Lehman Brothers, and the
acquisition of Merrill Lynch by Bank of America (Ferguson, 2010). Let’s not
forget the $700 billion from the government to bail out the investment banks.
This crash caused the great recession. Foreclosures in the U.S. reached 6
million by early 2010 (Ferguson, 2010). The top five executives at Lehman
Brothers made over a billion dollars between 2000 and 2007, when the
company went bankrupt they got to keep all their money. Country Wide CEO
made $470 million between 2003 and 2008 (Philips, 2008). It’s no wonder that
the people behind the sub-prime mortgage crisis didn’t consider the effects of
their actions, they were driven by greed. Huge profits with no consequences for
their unethical decisions. Millions of people’s jobs and retirements were lost so
that a few people could become incredibly wealthy.
Bibliography
Davidson, A. (2008, September 18). How AIG Fell Apart. Retrieved November 06, 2012, from The Big
Money: http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apartidUSMAR85972720080918
Ferguson, C. H. (Director). (2010). Inside Job [Motion Picture].
Philips, M. (2008, September 26). The Monster That Ate Wall Street. Retrieved 11 06, 2012, from The
Daily Beast: http://www.thedailybeast.com/newsweek/2008/09/26/the-monster-that-ate-wallstreet.html
Wikipedia. (2011, November 11). Moody's Investor Services. Retrieved November 06, 2012, from
Wikipedia: http://en.wikipedia.org/wiki/Moody%27s_Investors_Service
Wright, W. (2011, April 26). Investment Banks and The Death of Leverage. Retrieved 11 06, 2012, from
efinancial news: http://www.efinancialnews.com/story/2011-04-26/investment-banks-and-thedeath-of-leverage