Financial crisis, Home Mortgages, Credit Markets, Financial Institutions, Moral Hazard, Adverse selections,

You have been hired to manage a depository institution, such as a bank. The top management team is very concerned to avoid the similar massive defaults on home mortgages as in 2007. You are being asked to explain factors behind the financial crisis and explain the role of government in minimizing the adverse impact of the crisis on the financial system.

You start with some background information on how a wave of defaults on home mortgages threatened the health of any financial institutions that had invested in home mortgages either directly or indirectly through investment in mortgage-backed securities. Mortgage-backed securities were perceived to be sound investments as they were rated by legitimate rating agencies. Before the crisis happened, banks had mistakenly believed that an innovation and securitization of their long-term assets could eliminate their exposure to mortgage defaults and minimize their interest rate risk and even make them more profitable. When the mortgages started to go bad, many investment funds ‘blew up” and couldn’t repay the loans they had taken from the banks. The banks had to “write off” the loans they had made to the investors. Doing so reduced their reserves and lending powers. This was a major factor affecting profitability and soundness of depository institutions.

To the management team, the lending standard was a crucial factor to see if asymmetric information was a factor. You explained that a relaxed standard on mortgage lending was another contributing factor. According to the Federal Housing Finance Board, the average fee on a mortgage loan fell from around 1% of the amount of the loan in 1998 to less than .5% from 2002 to 2007. Mortgage lenders who were willing to lower their standards gained market share. Other mortgage lenders either had to lower their standards or lose market share.

The bursting of any housing bubble would be expected to have a negative effect on the economy for two reasons. First, home construction is an important economic activity and the decline in home construction would reduce GDP. Second, the decrease in home prices would also reduce household consumption due to the wealth effect. But the bursting of this housing bubble caused more severe and widespread harm than would be predicted from just these two reasons. As mentioned previously, most of the losses were suffered by the financial system, not by the homeowners. The bursting of the housing 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 increase in the money supply, the economy stabilized gradually.

1) How can financial innovations lead to financial crisis? Explain specifically the role of securitization of the mortgage market.

2) How were adverse selection and moral hazard contributing factors in this crisis?

3) Did the unprecedented level of government intervention in the economy prevent an even more severe economic downturn than what actually occurred? Is this affecting a moral hazard problem in the future?

4) What will be the long-term impact of the government’s intervention, particularly the ballooning of the national debt?