Retail Financial Products - Folarin Akinbami - Durham University by hcj

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									         RETAIL FINANCIAL
 PRODUCTS AND THE GLOBAL
          FINANCIAL CRISIS
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 middle-
  income 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

								
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