Mini-Case #2
Financial crisis, Home Mortgages, Credit Markets,Financial Institutions, Moral Hazard, Adverseselections,
CONCEPTS IN THIS CASE:
Mortgage defaults
sub-prime mortgages
mortgage-backed security
defaults
write off
wealth effect
moral hazard
adverse selection
You have been hired to manage a depository institution, such asa bank. The top management team is very concerned to avoid thesimilar massive defaults on home mortgages as in 2007. You arebeing asked to explain factors behind the financial crisis andexplain the role of government in minimizing the adverse impact ofthe crisis on the financial system.
You start with some background information on how a wave ofdefaults on home mortgages threatened the health of any financialinstitutions that had invested in home mortgages either directly orindirectly through investment in mortgage-backed securities.Mortgage-backed securities were perceived to be sound investmentsas they were rated by legitimate rating agencies. Before the crisishappened, banks had mistakenly believed that an innovation andsecuritization of their long-term assets could eliminate theirexposure to mortgage defaults and minimize their interest rate riskand even make them more profitable. When the mortgages started togo bad, many investment funds âblew upâ and couldnât repay theloans they had taken from the banks. The banks had to âwrite offâthe loans they had made to the investors. Doing so reduced theirreserves and lending powers. This was a major factor affectingprofitability and soundness of depository institutions.
To the management team, the lending standard was a crucialfactor to see if asymmetric information was a factor. You explainedthat a relaxed standard on mortgage lending was anothercontributing factor. According to the Federal Housing FinanceBoard, the average fee on a mortgage loan fell from around 1% ofthe amount of the loan in 1998 to less than .5% from 2002 to 2007.Mortgage lenders who were willing to lower their standards gainedmarket share. Other mortgage lenders either had to lower theirstandards or lose market share.
The bursting of any housing bubble would be expected to have anegative effect on the economy for two reasons. First, homeconstruction is an important economic activity and the decline inhome construction would reduce GDP. Second, the decrease in homeprices would also reduce household consumption due to the wealtheffect. But the bursting of this housing bubble caused more severeand widespread harm than would be predicted from just these tworeasons. As mentioned previously, most of the losses were sufferedby the financial system, not by the homeowners. The bursting of thehousing bubble sent a shock through the entire financial system,increasing the perceived credit risk throughout the economy.
Due to government interventions and a Federal Reserve increasein the money supply, the economy stabilized gradually.
How can financial innovations lead to financial crisis? Explainspecifically the role of securitization of the mortgage market.
How were adverse selection and moral hazard contributing factorsin this crisis?
Did the unprecedented level of government intervention in theeconomy prevent an even more severe economic downturn than whatactually occurred? Is this affecting a moral hazard problem in thefuture?
What will be the long-term impact of the governmentâsintervention, particularly the ballooning of the national debt?
Please make it minimum of 2 pages thanks.
