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The Roots of Financial Crisis


We can trace back credit crisis to another notable boom-and-bust: the Internet bubble of the late 1990?. When the stock market began a steep decline in 2000 and the nation slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage.

Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. Moreover, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down.

And turn sour they did, when home buyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks ?or so they thought.

Subprime Lending
Subprime lending (providing loans to borrowers with low credit ratings or poor loan repayment histories) was very popular in the 1990s to promote home ownership amongst lower income borrowers. For decades banks found themselves defending their lending standards to the public, many of which believed they unfairly discouraged home ownership for low income citizens. The passage and subsequent revision of the Community Reinvestment Act (which required banks to offer credit to their entire market area — not just the affluent parts) was instrumental in prompting bank lending reform. To account for lending to this higher risk group, lenders structured loans with higher interest rates to make up for the risk increase. Approximately 80% of these loans have adjustable-rate mortgages that started out with a teaser interest rate, which would increase significantly after an introductory period. From 2004 to 2006, 21% of all mortgage originations were subprime, up from 9% from 1996 through 2004. As of December 2007, subprime ARMs represented 43% of all mortgage foreclosures in the U.S., and there was still an estimated $1.3 trillion in subprime mortgages outstanding.

Deregulation in the banking industry
The Gramm-Leach-Bliley Act enacted in In 1999 and it repealed the Glass-Steagall Act of 1933, which had previously enforced the separation of investment and commercial banking activities. For example, under Glass-Steagall, a bank could not offer investment services and originate loans. Repealing Glass-Steagall allowed banks to get into the lending business. Banks could work with mortgage loan origination companies to write loans to people without proper collateral and then sell the loans to investors. The loans were pooled together to create mortgage-backed securities and collateralized debt obligations . The repeal of the Glass-Steagall Act was lobbied for by banks like Citigroup for two decades. The groups spent more than $200 million in 1998 alone lobbying to this end.

Credit Rating Agencies mis-rate mortgage securities
The flaws in both the credit rating procedures and the incentives model for credit rating agencies have been exposed in the 2008 financial crisis. Credit rating agencies assign ratings to bonds and other debt instruments (such as the pooled subprime loans that were at the root of mortgage-backed securities). Credit rating agencies like Moody

©2008 International Financial Management Association (IFMA)