The Breakdown in Prudent Credit Practices, Free Essay in Finance

Financial institutions are essential for the stability of an economy's financial system. An important aspect of sound financial management is effective risk management. For lending institutions, the underwriting process requires an accurate estimation of the default risk. It reduces the risk of losses to the lender and the entire financial system. The 2008 financial crisis resulted from the subprime mortgage crisis. A breakdown in prudent credit practices contributed to poor underwriting practices that contributed to the crisis.

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According to Dwyer (2010), subprime mortgages advanced to borrowers with less creditworthiness than prime mortgages. The crisis began with the increased securitization of mortgages. The pooling of subprime mortgages into collateralized debt obligations as well as mortgage-backed securities violated the prudent credit management practices (Durguner, 2012). These mortgages were lucrative to investors since they offered higher yields than asset-backed securities. Lenders, especially private lenders, pooled subprime mortgages and sold tranches to gullible investors. Private lenders provided 80% of the subprime mortgages in 2006 (Dwyer, 2010). They also introduced adjustable-rate mortgages, whose interest rates varied over the term of the mortgage depending on the market interest rates (Durguner, 2012). It encouraged subprime lending. Most lenders of mortgage securities relaxed the standards for lending due to the stiff competition and the desire to maximize returns (Dwyer, 2010). The result was that mortgages were advanced to borrowers who did not meet credit standards. Such borrowers would ordinarily not be granted any loans due to the high default risk.

Sensible risk management requires reasonable assessment of default risk. Lending institutions rely on credit ratings provided by rating agencies to assess the default risk of a security or issuer of a security (Mullard, 2012). Accurate and reasonable credit ratings are essential for efficient management of the financial system. Despite the high risk associated with mortgage-backed securities and their issuers, rating agencies gave higher ratings on these securities. The high grades encouraged investors to purchase the risky mortgage-backed securities (Dwyer, 2010). Credit rating agencies gave inaccurate grades thus leading to inappropriate risk management and financial decisions by investors. Some agencies even violated their standards in the run-up to the subprime mortgage crisis and resultant financial crisis (Mullard, 2012). For instance, Standard & Poor's gave both AIG and Lehman Brothers a rating of 'A' until six days to their collapse. Moody's did not downgrade the credit ration of Lehman Brothers until a day to its collapse (Frydman & Goldberg, 2013). These inaccurate ratings were due to lack of transparency in the rating process. Besides, there were conflicts of interest among the rating agencies since they provided other financial services to the lenders and other financial institutions (Frydman & Goldberg, 2013).

Lenders and borrowers were not prudent in the determination of risk associated with mortgage-backed securities. Most lenders increased subprime lending due to the rising house prices. They believed that the values of real estates were impervious to downturns and focused on the high returns but ignored risk. In the early years of increased subprime lending, borrowers who could not continue paying mortgages simply refinanced the loans based on the high house prices or sold the houses at a profit (Durguner, 2012). They never considered that house prices could fall. When the real estate prices finally fell, there was a rapid increase in defaults leading to losses to lenders and investors in mortgage-backed securities.

In conclusion, the subprime mortgage crisis and the resultant global financial crisis could have been avoided through prudent credit practices by lenders, borrowers and investors in mortgages.

Recommendation on Proper Risk and Assessment

Accurate credit ratings could have avoided the subprime mortgage crisis. The misleading ratings by agencies led to unsound financial and credit management by lenders and other financial institutions (Mullard, 2012). Rating agencies should be transparent and publish their assumptions and methodologies of their credit ratings. If rating agencies were transparent, players in the financial system could have assessed the actual risk associated with mortgage-backed securities. Besides, additional regulation of agencies could have prevented conflicts of interest that resulted in inaccurate credit ratings.

Improved mortgage origination could have prevented the financial crisis. High underwriting standards could have reduced subprime lending. Lenders could have only approved applications from those who indicated a great ability to repay. Besides, improved oversight by the state and federal authorities, including private lenders was necessary to avoid the crisis. Private lenders contributed more than 80% of the subprime mortgages and did not have to follow some of the regulations other financial institutions had to comply with (Durguner, 2012). The Fed could have also protected the consumers by requiring lenders to disclose how mortgages are affected in several scenarios. Lenders gave adjustable-rate mortgages to borrowers without revealing or explaining how an increase in market interest rates could have impacted their affordability. Such disclosures could have helped borrowers make sound decisions and avoided some mortgages.

Finally, it could have been prevented by better risk management practices by financial institutions. Financial institutions were affected since they were unable to assess the actual risk involved in mortgage-backed securities they invested in. Regulations requiring improved governance, risk management practices, and efficient information systems could have enabled the institutions to assess the risk of these securities accurately.

References

Durguner, S. (2012). The 2007 Subprime Mortgage Crisis: Changing Characteristics of Lending to Subprime Households. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2023826

Dwyer, G. (2010). Financial Crisis of 2008 in Fixed Income Markets. DIANE Publishing.

Frydman, R., & Goldberg, M. (2013). Lehman Brothers collapse: was capitalism to blame?. the Guardian. Retrieved 28 March 2018, from https://www.theguardian.com/business/2013/sep/13/lehman-brothers-was-capitalism-to-blame

Mullard, M. (2012). The Credit Rating Agencies and Their Contribution to the Financial Crisis. The Political Quarterly, 83(1), 77-95. http://dx.doi.org/10.1111/j.1467-923x.2012.02268.x