The definition of Asymmetric Information involves two parties, and which one party has more superior information and normally will not disclose the truth or harmful situation of a transaction to another party. The asymmetric information provided by the banks on the Collateral Debts Obligations is one of the causes that led to the sub-prime crisis in 2008 & 2009. Collateral Debts Obligations are financial instruments that are pooled by many sub-prime mortgages and sold to investors with attractive higher promised yields than normal bonds.
Defaults and foreclosure increased and losses impacted the financial institutions that contribute to the crisis. A financial institution is an institutions concerning finance, which is defined as managing money among individuals, businesses and governments. Some examples for financial institutions are mainly banks; retail or investment bank, insurance company, stockbroking, asset management and finance company. They are the intermediaries of financial markets. In the past, things were simpler and banks were only making loans and taking in deposit or withdrawal from individuals and businesses.
Bankers were more discipline and manage their risk carefully. However, due to the fast paced technology change and The Agency Theory, agents want to take risk to show results and good performance. In order to deliver better profit, they bring in a diverse range of products and activities. The government normally regulates these financial institutions and today we have banks selling insurance products and insurance company selling banks products. Adding to the advanced technology today, just one click consumers can move their money quick and effectively. Banking has changed: What does it mean for consumer? Investopedia) The role of a rating agency is to assess the financial strength & creditworthiness of companies and governmental entities, and their ability to meet the interest and principal payments on their bonds and other debt. Rating agency normally studies the specific debt issue and thus high rating will increase the investors’ confidence. The few examples of rating agency are Moody’s, Fitch Ratings and Standard & Poor.
However, not all ratings from the agency are accurate, in the ratings for Collateral Debts Obligations the initial ratings were excessively high (AAA) or top management grade quality ratings. This resulted in a failure to incorporate the high risk inherent in non-creditworthy customers in the underlying mortgage. Thus, rating agency fallen after the crisis and some being sued for giving misleading ratings. This is supported by article from The Business Times (2007) “Investors have begun to sue Moody’s and others because of Bear Stearns credit debacle”.
This sub-prime mortgages collapsed and created chaos in the global financial system. Bear Stearns investors around the world begun to approach lawyers to sue the company for the losses incurred. Both raters from Moody’s & Fitch’s admitted and acknowledged responsibilities that they did not expect the housing market in US to deteriorate in such a quick time. However this was all too late when the sub-prime crisis happened. (Gretchen Morgenson, The New York Times). What is sub-prime crisis?
What are the major causes of the sub-prime crisis and how does all this banks, rating agency, investors and even the government contributes to the sub-prime crisis of 2008-2009? In the article from The Business Times Singapore on “A quick guide to the sub-prime issues”, it stated that HSBC, the world’s third largest bank had their 50 percent earning wiped out by sub-prime losses from it US branch. Mortgages companies either go bankrupt or put themselves up for sale, same for Bear Stearns brokerage house and BNP Paribas announced the suspension of their funds due to the US mortgages.
Fannie Mae and Freddie Mac, two US government-sponsored giants have been bailed out and the bankruptcy of the Lehman Brothers. The nation was swept with a series of panicky withdrawals, AIG, insurance giant was frantically being rescued by regulators. How did it all happen? Firstly, “sub-prime mortgages” refer to housing loans extended to borrowers with poor credit track records. Risky borrowers hold about 15 percent of all outstanding mortgages.
The “sub” derives from the Latin Sub and meaning “under, close to” which also indicate a secondary action and as for “prime” derives from the Latin prima which means “first”. Adding the two words together it also refer to “first” borrower. The financial industry manage to hide the fact that sub-prime turns out to be way below prime. (Sub-prime: Words that hid a crisis, The Straits Time). Mortgage lenders that are dominated by government-sponsored agencies, such as Freddie Mac and Fannie Mae allow a rapid growth to extend credit to borrowers with weak credit histories and high risk of default.
Banks on the other hand did not manage their risk and homebuyers were not even required to produce any proof of income. They provided additional perks and offers to homebuyers, with the attractive initial low interest on the fixed-rate mortgage payment and the touting loans to individuals with poor credit ratings allows homebuyers in US to live the American dream with big house. Ensuring the homebuyers that property prices will rise even if interest rate were going higher for the remaining life of the mortgage.
These businesses also allow banks to earn a fee every time a mortgage was sold and making it extremely profitable. The government extended a safety net to new activities and this led to increasing incentives for risk taking which also plays a part in the sub-prime crisis. (Who is to blame for the sub-prime crisis? Investopedia) Secondly, the extending credits to risky borrowers were already a ticking time bomb and to worsen it, the sub-prime loans were re-packaged with safer loans to create instruments known as the Collateral Debts Obligations.
These derivatives, which were artificially created, are pooled mortgages which investment bank bought were then securitize into bonds that were sold to investors. And some investors were retirees; old people with no knowledge about investing. It was attractive to the investors as it was issued by government agencies and investors pursue higher yields and invested in these instruments for higher return as compared to other bonds with same ratings. (A quick guide to sub-prime issues, The Business Times Singapore) Lastly, Chairman of oversight committee said, “self-interest was at the root of the crisis”. Corporate excess and greed enriched company executives at enormous cost to shareholders and our economy,” (MarketWatch, The Wall Street Journal 2008). I agree that the main cause was Wall Street greed and how borrower was tempted to take mortgages they could not afford and investors to buying mortgage backed securities that were combined, blended, sliced and stripped to produce high ratings bonds. Another main cause is the self-interest of banks to gain better profits by relaxing their lending criteria and not managing risk well. The people involved were all tantalized.
US economy began slowing down and interest rates rose, house prices tumbled and sub-prime mortgage default which creates losses on the mortgage of Collateral Debt Obligations. Foreclosures doubled during the time of falling property prices and banks could not re-sell the property as times are bad and nobody could afford even prices are cheap. Investors started to pull back investments in CDOs and hedge funds. This affected the financial system worldwide and resulted in liquidity as uncertainty grew and financial institutions were unwilling to lend to each other. Who is to blame for the sub-prime crisis? Investopedia). Investors all around the word were hit with recession and suffered huge losses in the investment during the sub-prime crisis. As part of personal financial planning, individual can actually avoid if they had actually plan and analyze ahead before undertaking investment. Some factors which make investment risky and uncertain is because of the volatility of stock prices, the explosion of information technology and the complex calculation of derivative.
The advice to investors is using the Efficient Market Hypothesis to assess the fundamentals of the share or bonds they are going to invest. Technical Analysis can also helps in the assessing of fundamentals. The most important is to diversify, spread investment to reduce risk. However, risk can never be eliminated completely no matter how diversify the investor’s portfolio is. Diversification do not guaranteed that investor would not make a loss but at least reduce the impact. Risk is inseparable and every investment will involve risk.
It is best to identify risk and manage liquidity and plan cash management. Investors in the sub-prime crisis should analyze and read the prospectus for the bond issue before making a choice based solely on its rating. (The importance of Diversification, Efficient Market Hypothesis, Investopedia). Make key decision on investment goals and based on risk tolerance whether if investments are worth investing. However, when investors suffered huge losses in the crisis, there is one that gains profit during the crisis. In the article from The Telegraph, it stated, “John Paulson becomes $3. billion hedge fund king betting against sub-prime” John Paulson, who did not make any losses but instead gain profit during the recession had displayed financial planning by studying the fundamentals and he had predicted that the sub-prime loan would not make money and thus he short sell those sub-prime mortgages. In conclusion, the crisis would not have happened if US homebuyers adjust their lifestyle to reality and start making tough choices like cutting down expenses in order for the crisis to not resurface.
They should start managing their personal finance and identify the assets and liabilities before going down to the bank for credit loan as this will led to debts that they could not repay. In a nutshell, many were responsible for the sub-prime crisis of 2008-2009. However, it could be prevented if the financial institution & mortgage lenders practice adequate lending standard and borrowers exercise personal financial planning. And investors on the other hand are more risk averse.