RETAIL FINANCIAL PRODUCTS AND THE GLOBAL FINANCIAL CRISIS

1. RETAIL FINANCIAL PRODUCTS AND THE GLOBAL FINANCIAL CRISIS Dr FolarinAkinbami Durham Law School Durham University

2. INTRODUCTION • INNOVATION & FINANCE • SUBPRIME MORTGAGES: • ORIGINS • PROLIFERATION • BENEFITS • PROBLEMS • CONCLUSION

3. INNOVATION & FINANCE • INNOVATION: Implementation and taking to market of new inventions... finding new and more efficient ways of doing things. (Chesbrough, 2003) • FINANCIAL INNOVATION: implementation of new products, processes or services in the financial industry • Being able to innovate is essential for survival in most industries and this is particularly the case in the financial industry (Bernanke, 2009)

4. USES OF INNOVATION • More efficient allocation of Risk • Expanded Financial Intermediation • Increased Liquidity • New Diversification opportunities

5. Explaining Subprime Mortgages • Subprime Mortgage: A mortgage loan advanced to a borrower who would not qualify for a prime (market rate) loan because they are regarded as posing a greater risk of default • Why: Impaired credit or unable to provide documentary evidence of their income • The lender charges a higher interest rate than the market rate in order to compensate for the greater risk involved in making the loan

6. SUBPRIME: ORIGINS • Not often discussed • Beneficial Loan Society: a US no-bank lender • Intimate knowledge of borrowers, which allowed it to lend to even troubled borrowers (Lowenstein, 2009)

7. SUBPRIME: PROLIFERATION • Deregulatory measures • Securitization • Public Policy (of promoting homeownership) • Credit to the poor • Market forces • Subprime mortgage origination: $65 billion in 1995 to $332 billion in 2003 (around 13% of all home mortgages by end of 2006)

8. DEREGULATION • Depository Institutions Deregulation and Monetary Control Act 1980: prevented the individual states from enforcing interest rate caps • Alternative Mortgage Transaction Parity Act 1982: allowed lenders to offer adjustable-rate mortgages and balloon payments • Tax Reform Act 1986: made interest payments on mortgages and home equity loans tax deductible

9. SECURITIZATION • The process where illiquid assets (e.g mortgage receivables) are converted into liquid securities whose value is derived from the value of the underlying mortgage receivable or other assets • Proportion of subprime that were securitised: 50.% in 2001 to 80.5% in 2006. • Value of subprime mortgages that were securitised: $56 billion in 2000 to $508 billion in 2005 • Effect of securitization: made lenders reduce their underwriting standards

10. PUBLIC POLICY (homeownership) • US housing policy promotes homeownership (Homeownership is a key part of the American Dream) • Government-Sponsored Enterprises (GSE): • Federal National Mortgage Association (Fannie Mae) • Federal Home Loan Mortgage Corporation (Freddie Mac) • created to purchase prime mortgages from lenders. This replenishes the lenders’ capital and allows them to make even more loans • Pressured into lowering their standards and purchasing subprime mortgages

11. CREDIT TO THE POOR • Helps to address issues of Distributional Justice, Social Justice, Fairness and Equality • Equal Credit Opportunity Act 1974 (revised 1976): enacted to discourage race and gender discrimination in mortgage markets • Community Reinvestment Act 1977: enacted to encourage lenders to lend to all segments of their communities, including low-income and middle-income borrowers

12. Home ownership for low income and minority households • “I believe that those on welfare, what they really want is a piece of the American dream: homeownership, a good job, opportunities for their children” (President G H W Bush (July 27,1992)) • Belief that increased rates of homeownership for those on low incomes would bring with it a wide range of social, behavioural, political, economic and neighbourhood improvements due to the economic investment that homeownership represents

13. Market Forces • Borrowers: borrowers with impaired credit could now enter the housing market • Lenders: higher interest rates, fees and charges; potential to lend to a whole new group of borrowers • Investment banks: fees for packaging the pools mortgages into residential mortgage-backed securities • Global capital market investors: sought AAA rated investments and the CRAs had given AAA ratings to the residential mortgage-backed securities

14. BENEFITS ASSOCIATED WITH SUBPRIME • Homeownership for the poor and the credit impaired • Minority households showed the largest rates of increase in homeownership between 1994 and 2003 (Gramlich, 2004) • Minority households who own their homes are approximately 36 times wealthier than those that rent (Xiao Di, 2003) • More business opportunities for lenders • Helps with housing policy • Helps with economic policy

15. PROBLEMS ASSOCIATED WITH SUBPRIME • Neo-classical economics criticisms • Reduce allocative efficiency • Costs • Externalities • Behavioural economics criticisms • Exploit borrowers’ imperfect information and imperfect rationality • Cost deferral • Complexity

16. NEO-CLASSICICAL ECONOMICS CRITICISM • Reduce Allocative Efficiency • complexity prevents effective comparison shopping thus hindering competition • Bubbles • Costs • Imposes costs on borrowers and lenders • Externalities • Foreclosures impose significant costs on other stakeholders such as neighbours, the community, taxpayers and local authorities

17. BEHAVIOURAL ECONOMICS CRITICISMS • Imperfect information and imperfect rationality: lenders exploit consumers’ cognitive limitations and cognitive biases such as myopia, over-optimism and framing effects • Cost deferral: multiple pricing structures that allow borrowers to postpone the bulk of the costs associated with credit till a future time e.g. ARMs • Complexity: allows lenders to conceal the true cost of the loan by using a “multi-dimensional pricing maze” (Bar-Gill, 2009)

18. CONCLUSION • Difficult to make an argument for an outright ban of subprime mortgages or any other financial innovation • Nevertheless, the problems associated with subprime mortgages suggest that rather than welcome all financial innovation unquestioningly, they need to be viewed with a healthy degree of scepticism • Scrutinise them more closely • Regulators should take a more robust approach toward carrying out their duties as regulators