The Chartered Accountant

GLOBAL PERSPECTIVE
The Role of the Run-Up and the Eventual Crash in Real Estate Prices, The
Unsustainable Euphoria that Accompanies Bubble Markets, the Securitization
of Home Mortgages, and the Low Interest Rate Environment were Factors
that Set the Stage for the Financial Meltdown. Nearly Every Entity that was
Involved in the Subprime Crisis Bears Some Blame.
crisis spread from the subprime market to engulf the
broader mortgage industry and the entire banking industry
in the United States, while simultaneously affecting
financial institutions in several industries and
governments, and threatening to bankrupt the small
country of Iceland. To explain why a relatively small
sector (subprime mortgages) of the US economy was
able to infect the entire globe, we need to first understand
what happens to a home mortgage in the
United States after a consumer borrows money from
a local bank to finance a home purchase.
The us mortgage Industry
The US mortgage industry has two sub-markets, the
primary market (loans between the home buyer and
the lender) and the secondary market (loans sold as
investments). There are four types of players in the
secondary mortgage market, and many companies
perform more than one function10 :
l Originators: local, regional, and national banks
and thrifts, mortgage banks, and mortgage brokers
l Aggregators: large mortgage banks, financial
firms, investment banks, and government
sponsored entities (GSEs)
l Securities dealers: broker/dealers in financial
firms and investment banks that specialize in
mortgages
l Investors: foreign governments, pension funds,
investment banks, banks, hedge funds, GSEs
Prior to the 1990s, originators sold some of their
mortgages to Government Sponsored Entities, such
as Fannie Mae and Freddie Mac, at a higher price than
the loan amount. Because banks were constrained as
to the level of debt they carry on their balance sheets,
selling mortgages to GSEs allowed them to originate
more mortgages to home owners, thereby earning
more fees and interest. Fannie and Freddie, because
they were implicitly backed by the US Government,
could borrow money through the bond market at
rates lower than those generally available to commercial
banks and thrifts. 11 Fannie was chartered by the
US Congress in 1938 after the Great Depression as
a way to create a secondary mortgage market, acting
as an intermediary between loan originators and investors,
thereby injecting liquidity and stability into
the home mortgage market. Both Fannie and Freddie,
also known as agencies, were further directed by
Congress to focus mortgage buying efforts in underserved
urban areas and low and middle income buyers.
12 The monthly payments from the homeowners
to service their loans were passed on by the local bank
to the GSEs. The GSEs would, in turn, aggregate and
package mortgages into Mortgage Backed Securities
(MBS), guarantee them, and sell them to investors
through securities brokers in a process called securitization.
These MBS were considered low risk and were rated
highly. Investors, such as foreign governments and
other institutions, bought the agency issued securities
from brokers under the implicit assumption that
these securities were guaranteed by the US government
through the GSEs that issued them. This process
of securitization allowed investors from all over
the world to safely lend money to help finance home
purchases in the United States and to earn a modest
rate of return for their fixed-income portfolio of investments.
Innovation in secondary market
Investment banks that handled the bond sales for the
GSEs noticed that there was an enormous appetite
for MBS from investors all over the world. Moreover,
some investors were willing to take on more risk but
demanded higher yields than were available from the
MBS issued by GSEs. Investment banks and larger
mortgage financing companies looked for ways to
enter this growing market and started replicating the
role of GSEs, aggregating the loans in addition to
simply passing them through their pipelines. They
10 Barry Nielson, CFA, “Behind The Scenes Of Your Mortgage,” Investopedia, A Forbes Digital Company, http://www.investopedia.com/articles/pf/07/secondary_mortgage.asp,
accessed November 12, 2008.
11 Kevin Cole, p. 5.
12 The charter specifically states that Fannie should “provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on
housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity
of mortgage investments and improving the distribution of investment capital available for residential mortgage financing,” Federal National Mortgage Association Charter
Act, p.1, http://www.ofheo.gov/media/pdf/FNMcharter406.pdf, accessed November 12, 2008.
THE CHARTERED ACCOUNTANT 1009 DECEMBER 2008