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Financial Shock – A 360⁰ look at subprime mortgage implosion, and how to avoid the next financial crisis – authored by Mark Zandi has successfully captured the essence of Subprime Mortgage Crisis and created description of every significant area of crisis with special attention to mortgage, financial instruments and speculation in real estate market.

The book has tried to capture the shock even before its inception and with its triggering causes and detailed description of the events that lead to the burst. A chapter on risk mitigation technique and policy decisions has been provided at the end smartly.

Book describes the triggering event after the terrorist attach of September 11, 2001 when Americans perceived staying at home was safer than travelling. At this point FED lowered the interest rate to put the liquidity in the economy so that the economy could be revitalized. Inflation was not considered a problem at that point because due to shift of manufacturing to China, Deflation was at the corner.

It describes the Tech-Stock-Bubble-Burst and low returns on saving accounts as a major catalyst for Citizens to get allured towards investing in their homes, as they had prioritize staying at home so they wanted it to be better and beautiful. Government policies and Tax Codes promoted home ownership. Guidelines from Bush administration clearly promoted Lending for house ownership and perceived it as a good macroeconomic policy that would boost economy.

After the trigger when people started seeing owning home as a good investment, they started speculating on the prices and understood it as a safe investment tool. Government was happy watching the rising ownership. Lending organization saw it as an opportunity and started lending to weak financial households called Sub-Prime Borrowers, having less perfect credit history or no credit history.

As the book describes, the Lending spectrum caught hold of securitization and started developing innovative financial instruments like Alt-A, CDO, ABS, CPDOs etc. The regulating bodies were also happy because they thought that risk is being diversified due to securitization.

Figure- Borrowing and Lending Mechanism followed during the subprime-lending period.

The Book describes the lending Process in following steps :

  1. Borrower obtains loan from lender with/without help of mortgage broker.
  2. Lender sells loan to Issuer, and borrower begins making monthly payment to servicer.
  3. Issuer makes the mortgage backed securities and sells it to investors, with assistance of underwriter, rated by Credit rating agencies.
  4. The servicer collects monthly payment from borrower and remits payment to issuer.

As described the above mechanism of lending, this mechanism was looked by global investors and they also took interest in the financial instruments created by the issuers, as the interest rates were low so they preferred high yielding mortgage based investments.

Flowing with the flow lending organizations wanted to take out the most of it and started lending in non-prudent manner as they had to pass the loan to others and they were safe from the risk of non-payment. Issuers also were glad as the prices of the houses were going high so borrowers were almost sure to pay back.

One important point that author highlights is that everyone involved in the system was of the opinion that someone else was in control of system and since the mechanism is diversified all over the world so it was too big to fail.

Towards the end of 2006 the housing market started feeling the heat of lowering of housing prices, default in loan payment, but instead of seeing this as a signal builders over-optimistically argued that people were migrating to USA in large numbers, and they would require homes to live and the housing market would never go down. Point to be noted at this point is that Regulators were sleeping at this moment.

Shutting down of two hedge funds by Bear Stern it clearly signaled the something wrong flag, the default of borrowers had rose from 775000 in 2005 to 1 million in the year end 2006. Houses prices were down by 20-30%, default and foreclosure were significantly visible.

The catalyst for default and foreclosure were due to negative equity, as the borrowers of home loan owed more in loans then the present value of the houses they had bought. It was no point in paying back the loan.

Figure- Subprime Mortgage Crisis: “Vicious Cycles” of Foreclosure and Bank Instability.

The author has also gave some recommendations to avoid another sub-prime crisis:

  • The lending rules should be clear and regulators must watch the prudent lending.
  • Data collection on lender, location, income, ethnicity of borrower etc. should be done.
  • Investment on financial literacy should be done so that people take informed financial decisions.
  • Mark to Market accounting standard should be adjusted as it creates un-necessary pressure on financial institutions to quickly adjust the book value of their assets to reflect market price.

My personal opinion is that the author did a magnificent job in unveiling the sub-prime mortgage chain and discovered the loopholes that had led to the crisis. While reading the book I did not find that the author is doing Monday morning quarterbacking. The flow of the novel was coherent but derailed from the rhythm sometimes.

On a critical note I felt the content sometimes were repetitive in nature and did not cover much of the rating agencies failure issue, just indicating few times that rating agencies misjudged the risk.

Mark Zandi’s critical remarks on Alan Greenspan’s monetary policy in my opinion was a bit too harsh as in that particular situation I don’t find better way of stabilizing the economy when you have been hit by terrorist attack, S&L crisis, having wars at one end along with the threat of deflation.

Zandi should be applauded for the easy way of writing the book that even a financial illiterate person can understand and comprehend. He has also been able to throw the ball in the right court by exposing the actual culprit for the crisis i.e, ‘Human Greed’ instead of blaming certain class of investors, bankers or regulators.

Overall ‘The Book Is A Masterpiece’.

 

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Economics

Posted: April 28, 2010 in Economics

I would be blogging on Micro & Macro Economics topics here !!