Academic journal article Academy of Accounting and Financial Studies Journal

Communication Failures, Synthetic CDOS, and the 2008 Financial Crisis

Academic journal article Academy of Accounting and Financial Studies Journal

Communication Failures, Synthetic CDOS, and the 2008 Financial Crisis

Article excerpt

INTRODUCTION AND BACKGROUND OF THE FINANCIAL CRISIS

The global savings glut, cuts in interest rates by the Federal Reserve Bank in response to Y2K in 2000, and the terrorist attack in 2001 kept interest rates low in the U.S. stimulating demand for mortgage loans. The glut of the loan-able funds also meant that there was a thirst for high yield securities. Furthermore, the passage of the Gramm-Leach-Bliley Act (1) in l999 which deregulated financial markets and removed the firewall between banking and trading activities enabled banks, insurance companies, securities firms and other financial institutions to affiliate under common ownership and to offer their customers a complete range of financial services which intensified competition and innovation of financial securities in the industry. The rise in demand for mortgage loans on one hand and the rise in demand for high yield securities by investors on the other hand escalated the securitization of home mortgages. This meant that banks could originate mortgage loans and quickly sell them to others who pooled them into mortgage backed securities. As this phenomenon became a wide spread practice, the due diligence required in screening creditworthy borrowers was relaxed. The resultant mortgage payment delinquencies from subprime borrowers triggered the financial crisis.

The following examples highlight some of the major events mortgage companies and some other financial institutions experienced as a result of the mortgage crisis. By February 2007, the situation for mortgages and mortgage related securities had deteriorated enough to cause the Federal Home Loan Mortgage Corporation (Freddie Mac) to announce that it would no longer buy the most risky subprime mortgages and mortgage-backed securities. By April, 2007, New Century Financial Corporation, a leading subprime mortgage lender, filed for bankruptcy protection; and by July 31, 2007, Bear Stearns liquidated two of its hedge funds that had invested in mortgage-backed securities (2). Thus, Bear Stearns became the first investment bank to fail. The next section explains how its investments in CDO led to its failure.

Bear Sterns had made substantial investments in CDOs it had created and insured them with credit default swaps (CDS) from AIG. Unfortunately, the unraveling sub-prime mortgage delinquencies drove the credit ratings of AIG down which subsequently reduced the value of the CDOs Bear Stearns had insured with AIG. Therefore, as the value of insurance Bear Stearns held with AIG decreased, it became insufficient to cover its losses on CDOs. Thus by July 2007, Bear Stearns' two subprime hedge funds, which were heavily invested in CDOs, reportedly lost all of their value. This situation was made worse by creditors who closed Bear Stearns' line of credits and increasingly demanded cash on outstanding loans. Under these conditions, if Bear Stearns had been a commercial bank, it could have turned to the Federal Reserve Bank as a lender of last resort. However, since Bear Stearns was an investment bank and not a commercial bank, it was unable to go directly to the Federal Reserve Bank for help. The loss of confidence in Bear Stearns' capacity to withstand its liquidity problems forced many of its counterparties to cut off their business ties with the company. Eventually, the exodus of investors, creditors, and other clients caused its share value to plummet driving it into bankruptcy. Fearful that Bear Stearns' collapse would severely damage the entire financial system, in March, 2008, the Federal Reserve Bank of New York announced that it would provide financing opportunities to facilitate the acquisition of Bear Stearns by JPMorgan (3). Eventually, in March 2008, Bear Sterns was sold to JPMorgan Chase.

In 2008, Fannie Mae and Freddie Mac were on the verge of bankruptcy as a result of rising mortgage delinquencies and foreclosures. Consequently, on September 7, 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac in government conservatorship thus saving them from bankruptcy. …

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