Half a decade on, and have we learned from the subprime mortgage crisis? Are mortgage derivatives now secure, and can investors purchase mortgage backed securities with confidence? There were lessons to be learned, but have we all learned them?

There is no definitive answer to these questions. Even now, analysts disagree on the root causes of the subprime mortgage derivative crisis and its resultant effect on the world’s economy. This did not just affect Wall Street, but ordinary men and women through the USA and beyond.

In fact, some say that the subprime mortgage crisis was responsible for the worldwide recession that followed – at least in the developed nations. This is likely going a bit too far, but it certainly did not help to bolster confidence in the derivatives markets.

What are Mortgage Derivatives?

Mortgage derivatives are also referred to as mortgage-backed securities or mortgage-backed bonds. They have been explained in earlier posts. Fundamentally, banks bundle similar mortgages together and offer the bundle for sale to investors. The titles to the properties themselves are not sold, only the mortgage cash flow (interest + principal repayments), and the investor takes the hit if the mortgages are not paid.

They are attractive investment opportunities, since a $400,000 mortgage loan at 4 % can yield 440,000 over 30 years.  The 1968 Charter Act created Fannie Mae, and made it possible for banks to create mortgage-backed securities.

The theory was that by passing mortgages onto investors, banks would have more funds to offer potential homeowners, and enable them to purchase their own homes. It seemed a good idea at the time – but it only seemed that way. In fact, with more responsible lending and borrowing it may have worked perfectly, although there were more flaws than just that in the Act.

Factors Involved in the Subprime Mortgage Crisis

The 1968 Charter Act passed the loss on defaulted mortgages to the investor. This meant that the body responsible for offering mortgage loans and gaining from them were not punished for bad lending decisions.This led directly to the subprime mortgage crisis.

Irresponsible Lending Practices
Imagine if you were able to lend cash to a stranger and were then empowered to sell the loan to a third party. Not just that, but if the borrower then failed to repay you lost nothing – the third party did!  You could lend as much as possible to anybody that wanted it with no possibility of losing!

That is partially what ultimately happened. The banks and their agents were paid to lend money with little come-back for non-payment. Mortgages were allocated to applicants without zealous credit checks. Banks offered mortgages to people they would have considered prior to the introduction of mortgage backed securities.

However, not all banks were involved in this, and it was the following group that was more responsible – or irresponsible

Irresponsible Mortgage Lenders
Prior to the introduction of mortgage backed securities, only banks had the cash reserves to offer mortgages.  With the introduction of MBS, any firm could offer them because they would be paid back immediately by selling them derivatives investments. This led to the creation of irresponsible companies who cared little about the credit-worthiness of their applicants. They offered the mortgages and sold them off to investors.

Poor Regulation
Mortgage backed bonds or derivatives were not properly regulated. The Act did not provide for regulation of these new mortgage lenders in the same was as banks had been. This led to some shady practices and mortgages being offered to people who obviously would never be able to repay them.

The desire to own one’s own home is a powerful one, but good intentions to pay do not infer that the borrower has the income to pay – month in, month out, for 30 years.

Conclusions

The Charter Act was flawed, and rising unemployment and irresponsible lending were likely the cause for masses of homeowners being unable to meet their monthly payments.  The banks did not suffer nearly as much as the investors did, but the result was a financial crisis. The resultant subprime mortgage crisis hit Wall Street, and many believe it sparked the worldwide recession that was to follow.

Others say that the recession was already underway, and this was no more than a symptom.  Whatever the arguments, it appears that the subprime mortgage crisis that hit the mortgage derivatives market was caused by poor lending decisions. Let’s hope the lesson has been learned, or are these ‘famous last words?’