The Global Financial Crisis according to Isaac Gradman

Global Financial Crisis Survey

Isaac Gradman is Managing Partner of Gradman Law and Managing Member of IMG Enterprises, a leading expert in mortgage-backed securities litigation and other legal issues stemming from the mortgage crisis. Gradman is the editor of Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System (written by Bill Frey of Greenwich Financial Services). He blogs at The Subprime Shakeout.

1. Which FCIC View best represents the causes of the Financial Crisis?

Majority Conclusions

2. Which narrative presented by Douglas Elliott and Martin Baily of the Brookings Institute in Telling the Narrative of the Financial Crisis: Not Just a Housing Bubble best represents the causes of the Financial Crisis?

"Everyone" was at fault: Wall Street, the government, and our wider society.

3. The Global Financial Crisis is ongoing and will end in the year

2013 or beyond.

4. What were the primary causes of the Global Financial Crisis?

Hard to boil it down to one paragraph, so here's two:
  • The roots of the mortgage crisis took hold after the collapse of high-tech stocks in 2000. When the stock market crashed that year, the Federal Reserve reacted by cutting short-term interest rates. Sharply lower federal funds rates caused a corresponding decrease in mortgage rates. Even after the economy had recovered, the Fed held interest rates at rock-bottom levels for an extended period. Home prices appreciated because the economy was growing while the cost of financing a home was dropping. Many new home buyers, for whom the dream of homeownership was suddenly within reach, entered the market, while others traded up from modest to pricier homes. Soon, the protracted period of home price appreciation and low mortgage rates attracted speculators who saw the opportunity to turn a quick profit by flipping properties. Even homeowners who stayed in their houses enjoyed the boom. In 2002 to 2003, the mortgage refinancing index hit levels impossible to imagine, as the entire home-owning population had the opportunity to refinance whenever interest rates dropped.
  • During this unprecedented period of low interest rates, institutional investors became starved for investments that would provide greater returns than Treasuries or corporate debt. At the same time, low interest rates caused a prepayment wave in the early 2000s that allowed subordinate mortgage backed securities investors to make massive profits—profits that fueled an insatiable appetite for additional mortgage credit risk. Wall Street responded by expanding its capacity to meet the oversized demand for housing, both by encouraging existing borrowers to refinance and by making loans to borrowers who previously could not qualify. While home prices continued to appreciate for a few years longer, common sense began to take hold as many realized that the housing market had become a bubble supported by easy subprime financing. Eventually, rationality returned to the housing market, as investors and home buyers began to doubt that home prices would continue upward forever. When this unprecedented run of home price appreciation came to end and home prices finally leveled off, many borrowers found they could not make their mortgage payments, refinance at lower rates, or recoup the unpaid principal balances of their loans by selling their homes. Those who had enough equity in their homes to try to sell rushed to do so, causing a flood of houses on the market. Soon, the supply of houses for sale exceeded the number of potential buyers. House prices that had leveled off now began to fall, and millions of people who could pay their mortgages stopped paying them because they were “underwater,” meaning that the mortgage exceeded the current value of the house, resulting in negative equity. Once it was clear that millions of mortgages would not be paid off, panic gripped the financial markets, and the mortgage crisis of 2007 was in full swing.

5. What still should change as a result of the crisis?

The changes fall into two categories: changes to the structure of the conventional fixed-rate mortgage and changes to the structure of mortgage backed securities transactions.
  • With respect to the first category, we need to do away with fixed-rate loans without prepayment penalties, as they impose significant systemic risk on the U.S. economy. Because interest rates are historically volatile and because homeowners tend to respond rationally to interest rates in exercising their free prepayment option, the U.S. financial system is subject to the havoc caused by frequent prepayment waves. Controlling interest rates is impractical if not impossible, so we must control the incentives to refinance by adding a prepayment premium when interest rates fall below the fixed rate on the mortgage, and a prepayment discount when interest rates rise above the mortgage's fixed rate. This premium or discount would vary directly with prevailing interest rates. Not only would this reduce the systemic risk caused by volatile interest rates, but making refinancing more expensive or difficult in lower interest rate environments would also discourage borrowers from taking out mortgages they cannot afford with an eye toward refinancing within a few years if the rates drop. In sum, the beloved conventional fixed-rate mortgage has outlived its usefulness and should be consigned to the scrap heap of financial history.
  • As to the second category, the goal is to create a system where the economic interests of participants are properly aligned, and remain aligned throughout the life of the deal, whatever the market conditions. Only by doing so can we attract the private capital back to the U.S. housing market (as most would agree that we no longer wish to have a mortgage market financed entirely by the government). One major area of concern with the current model is the prevalence of conflicts between the servicers and the investors they are charged with protecting. Recent servicer performance has made it clear that servicers will not adhere to their contractual obligations from the PSAs when it is not in their immediate economic interests to do so. In this regard, we should consider restricting the firms that originate and sell loans from later servicing them. This would remove the primary conflicts of interest for the servicer, as that entity would have no other affiliation with the borrower other than maximizing the borrower’s payments on the mortgage. The relationship between the trustee of a securitization and the investors is another major area of concern from the perspective of conflicts of interest in future transactions. If investors were properly informed, no clear-thinking investor would allow a fully indemnified and passive trustee to be the fiduciary on any transaction in which it invests. In this capacity, investors should demand that the trustee be unambiguously independent and provided with economic incentives to protect investor interests. To encourage this reform, rating agencies should refuse to rate a transaction that does not feature an active and independent trustee. In addition, given the profound public policy implications of alienating investors, the federal government should consider abolishing the practice of allowing trustees to be indemnified by those they are responsible for monitoring. Finally, we should standardize MBS trusts and the agreements governing them, as well as create a new entity that serves, much like ISDA, as the standard-bearer for private label securitization. Additional reforms and details regarding the above proposals can be found in Way Too Big to Fail, authored by Bill Frey and edited by Isaac Gradman.

Compiled by Gary Karz, CFA
Host of InvestorHome

Global Financial Crisis Survey

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