Transcript Retail Financial Products

Dr Folarin Akinbami
Durham Law School
Durham University
INTRODUCTION
 INNOVATION & FINANCE
 SUBPRIME MORTGAGES:
 ORIGINS
 PROLIFERATION
 BENEFITS
 PROBLEMS
 CONCLUSION
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)
USES OF INNOVATION
 More efficient allocation of Risk
 Expanded Financial Intermediation
 Increased Liquidity
 New Diversification opportunities
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
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)
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)
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
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
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
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 middleincome borrowers
 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
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
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
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
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
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)
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