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RETAIL FINANCIAL PRODUCTS AND THE GLOBAL FINANCIAL CRISIS. Dr Folarin Akinbami Durham Law School Durham University . INTRODUCTION. INNOVATION & FINANCE SUBPRIME MORTGAGES: ORIGINS PROLIFERATION BENEFITS PROBLEMS CONCLUSION. INNOVATION & FINANCE.

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retail financial products and the global financial crisis

RETAIL FINANCIAL PRODUCTS AND THE GLOBAL FINANCIAL CRISIS

Dr FolarinAkinbami

Durham Law School

Durham University

introduction
INTRODUCTION
  • INNOVATION & FINANCE
  • SUBPRIME MORTGAGES:
    • ORIGINS
    • PROLIFERATION
    • BENEFITS
    • PROBLEMS
  • CONCLUSION
innovation finance
INNOVATION & FINANCE
  • INNOVATION: Implementation and taking to market of new inventions... finding new and more efficient ways of doing things. (Chesbrough, 2003)
  • FINANCIAL INNOVATION: implementation of new products, processes or services in the financial industry
  • Being able to innovate is essential for survival in most industries and this is particularly the case in the financial industry (Bernanke, 2009)
uses of innovation
USES OF INNOVATION
  • More efficient allocation of Risk
  • Expanded Financial Intermediation
  • Increased Liquidity
  • New Diversification opportunities
explaining subprime mortgages
Explaining Subprime Mortgages
  • Subprime Mortgage: A mortgage loan advanced to a borrower who would not qualify for a prime (market rate) loan because they are regarded as posing a greater risk of default
  • Why: Impaired credit or unable to provide documentary evidence of their income
  • The lender charges a higher interest rate than the market rate in order to compensate for the greater risk involved in making the loan
subprime origins
SUBPRIME: ORIGINS
  • Not often discussed
  • Beneficial Loan Society: a US no-bank lender
    • Intimate knowledge of borrowers, which allowed it to lend to even troubled borrowers (Lowenstein, 2009)
subprime proliferation
SUBPRIME: PROLIFERATION
  • Deregulatory measures
  • Securitization
  • Public Policy (of promoting homeownership)
  • Credit to the poor
  • Market forces
  • Subprime mortgage origination: $65 billion in 1995 to $332 billion in 2003 (around 13% of all home mortgages by end of 2006)
deregulation
DEREGULATION
  • Depository Institutions Deregulation and Monetary Control Act 1980: prevented the individual states from enforcing interest rate caps
  • Alternative Mortgage Transaction Parity Act 1982: allowed lenders to offer adjustable-rate mortgages and balloon payments
  • Tax Reform Act 1986: made interest payments on mortgages and home equity loans tax deductible
securitization
SECURITIZATION
  • The process where illiquid assets (e.g mortgage receivables) are converted into liquid securities whose value is derived from the value of the underlying mortgage receivable or other assets
  • Proportion of subprime that were securitised: 50.% in 2001 to 80.5% in 2006.
  • Value of subprime mortgages that were securitised: $56 billion in 2000 to $508 billion in 2005
  • Effect of securitization: made lenders reduce their underwriting standards
public policy homeownership
PUBLIC POLICY (homeownership)
  • US housing policy promotes homeownership (Homeownership is a key part of the American Dream)
  • Government-Sponsored Enterprises (GSE):
    • Federal National Mortgage Association (Fannie Mae)
    • Federal Home Loan Mortgage Corporation (Freddie Mac)
  • created to purchase prime mortgages from lenders. This replenishes the lenders’ capital and allows them to make even more loans
  • Pressured into lowering their standards and purchasing subprime mortgages
credit to the poor
CREDIT TO THE POOR
  • Helps to address issues of Distributional Justice, Social Justice, Fairness and Equality
  • Equal Credit Opportunity Act 1974 (revised 1976): enacted to discourage race and gender discrimination in mortgage markets
  • Community Reinvestment Act 1977: enacted to encourage lenders to lend to all segments of their communities, including low-income and middle-income borrowers
slide12

Home ownership for low income and minority households

    • “I believe that those on welfare, what they really want is a piece of the American dream: homeownership, a good job, opportunities for their children” (President G H W Bush (July 27,1992))
  • Belief that increased rates of homeownership for those on low incomes would bring with it a wide range of social, behavioural, political, economic and neighbourhood improvements due to the economic investment that homeownership represents
market forces
Market Forces
  • Borrowers: borrowers with impaired credit could now enter the housing market
  • Lenders: higher interest rates, fees and charges; potential to lend to a whole new group of borrowers
  • Investment banks: fees for packaging the pools mortgages into residential mortgage-backed securities
  • Global capital market investors: sought AAA rated investments and the CRAs had given AAA ratings to the residential mortgage-backed securities
benefits associated with subprime
BENEFITS ASSOCIATED WITH SUBPRIME
  • Homeownership for the poor and the credit impaired
    • Minority households showed the largest rates of increase in homeownership between 1994 and 2003 (Gramlich, 2004)
    • Minority households who own their homes are approximately 36 times wealthier than those that rent (Xiao Di, 2003)
  • More business opportunities for lenders
  • Helps with housing policy
  • Helps with economic policy
problems associated with subprime
PROBLEMS ASSOCIATED WITH SUBPRIME
  • Neo-classical economics criticisms
    • Reduce allocative efficiency
    • Costs
    • Externalities
  • Behavioural economics criticisms
    • Exploit borrowers’ imperfect information and imperfect rationality
    • Cost deferral
    • Complexity
neo classicical economics criticism
NEO-CLASSICICAL ECONOMICS CRITICISM
  • Reduce Allocative Efficiency
    • complexity prevents effective comparison shopping thus hindering competition
    • Bubbles
  • Costs
    • Imposes costs on borrowers and lenders
  • Externalities
    • Foreclosures impose significant costs on other stakeholders such as neighbours, the community, taxpayers and local authorities
behavioural economics criticisms
BEHAVIOURAL ECONOMICS CRITICISMS
  • Imperfect information and imperfect rationality: lenders exploit consumers’ cognitive limitations and cognitive biases such as myopia, over-optimism and framing effects
  • Cost deferral: multiple pricing structures that allow borrowers to postpone the bulk of the costs associated with credit till a future time e.g. ARMs
  • Complexity: allows lenders to conceal the true cost of the loan by using a “multi-dimensional pricing maze” (Bar-Gill, 2009)
conclusion
CONCLUSION
  • Difficult to make an argument for an outright ban of subprime mortgages or any other financial innovation
  • Nevertheless, the problems associated with subprime mortgages suggest that rather than welcome all financial innovation unquestioningly, they need to be viewed with a healthy degree of scepticism
  • Scrutinise them more closely
  • Regulators should take a more robust approach toward carrying out their duties as regulators