Faculty Commentary: Mortgage Crisis and the $700 Billion Bailout

Congress and President of the United State of America are deliberating a bailout of the financial institutions with a price tag of $700 billion of tax payers' money. The era of speculations fueled by greed and irresponsibility in the financial sector and Wall Street has created a profound financial crisis unlike any since the Great Depression. Aggressive lending to borrowers ,with unsound credit led to record foreclosures. These endangered investment houses and froze credit, which is the lifeblood of the economy.

Last week, Treasury Secretary, Henry Paulson and Federal Reserve Chairman, Ben Bernanke urged the Congress to quickly sign off on the bailout plan, which they contended would help prop up the economy. The bailout plan is to remove billions of dollars in risky mortgage-related assets from financial firms' balance sheets. The distrust of the financial companies that hold these assets has led to a seizing up of the credit markets. This in turn threatened the entire economy by making it difficult and expensive for businesses and consumers to borrow money.

Relevant questions here are these:

·Who are the culprits?

·Who should bear the burden of the $700 billion bailout? Main Street (i.e. Tax -payers ) or Wall Street ?

·How much free hand should government have in this kind of intervention?

·Should there be an oversight board attached to the bailout, ensure accountability, and monitoring?

For more insight into the genesis of the crisis, here is a synopsis of how the financial sector got to where it is today. The historical development that led to the current complex and fragile financial system point to the fact that the seeds of crisis were planted long ago by lax monitoring, risky innovations, and deregulation during a long period of relative economic stability. The loss of Bank reserves, known as one of the most important cushions in the financial system can be blamed on a number of regulatory failures of the Federal Reserve Bank (Fed). The Fed made no effort to curtail leverage and speculation; for example, the link between excess liquidity and debt-financed speculation. The Fed ignored asset bubbles; that is price inflation, and credit. It did not call attention to the problem of over-the-counter markets created by banks. It over looked the implications of deregulation and innovation; and changes in financial structure, such as the explosion in debt and the channeling of savings from banks to institutional investors. The Fed also disregarded the implications of foreign capital inflows into the country and the effect of such inflows on the direction of policy.

We have also seen a shift from a bank-based system to a market-based system. The market based system is naturally pro-cyclical. That means it is prone to business cycle swings. In the last 10 years, household financial and total debt grew large. Yet banks today account for less than 24 percent of total credit, compared to 56 percent in mid 1970s.

"New Economy" in the 1090s, and unprecedented real estate appreciation are the result of long-term, policy-induced, profit seeking, financial innovations. Many of today's financial problems can be traced to securitization (the "originate and distribute" financial model), leverage and the confusing array of extremely complex instruments that only a few understand. This array of financial instruments played a major role in the recent market crisis. The shift away from direct borrowing by the government required alternate sources of funding through sales to private investors. That is, the creation of mortgage-backed securities. These structures were the basis for the development of the new and complex financial instruments, which included the ''no income'; 'no job'; and 'no asset' loans; plus the adjustable rate mortgages.

The mortgages funded by securitization shifted the risks from the originators of the Real Estate Mortgage Investment Conduit (REMIC) to the buyers of the collaterized securities, and the revenue did not require regulatory capital. The requirement for mortgages to conform to Government-Sponsored Enterprise (GSE), such as Fannie Mae and Freddie Mac, conditions created mis-pricing between Prime and Sub-Prime mortgages. The sub-prime market was stable as long as the number of new mortgage originations increased and the house prices rose under conditions of falling interest rate (a la Greenspan). When the Fed reversed its accommodative monetary policy, (after all, there is no free lunch), delinquency rates increased in 2005. The number of foreclosures rose and is still rising; placing pressure on house prices.

Mortgages used to collaterize the structural mortgage obligations were returned to the banks. Many of the banks had insufficient capital adequacy ratios and were subsequently required to report additional losses when the market for Collaterized Mortgage Obligations (CMO) collapsed. When the banks and single-line insurers were unable to meet their credit default swap and guarantee commitments (which they went into, in order to attract buyers); the credit rating agencies down graded the single-line insurers. This led to further down grading of the CMOs, and more selling pressures. In order to calm the markets, major U.S. and European banks borrowed at above-market rate.

THE REST OF THIS HISTORY IS UNFOLDING EVEN AS YOU READ !!!!!