Question

1. How do mortgage backed securities work? Why did banks think that selling mortgage backed securities would relieve them of the risks involved with mortgage lending? How did the banks indirectly come to once again be exposed to mortgage lending risk? What happened to bank reserves during the mortgage debt crisis? How did the Federal Reserve respond; and, in hindsight, do you consider the Fed's response to be appropriate and corrective? Explain why or why not?

Answer 1

Introduction

The Mortgage financing risk was primarily highlighted across the United States and the world around 2009, When the United States went into recession during the housing crisis.

The basis for the existence of Financial Institutions is that they earn interest, using the money which is collected through borrowers. Banks only need to maintain their minimum cash reserve requirements and the remaining part can be used for financing activities.

As such, banks grant these loans based on the credit profiling of individuals and factors such as the amount of collateral security that is available with the creditor.

Case Specifics

How do mortgage-based Securities work? Why did banks think that selling mortgage based securities would relieve them of the risks involved with mortgage lending?

Mortgage based securities basically refer to an asset being pledged by the person seeking a loan which then becomes the banks property unless the loan is repaid in full.

Usually this is used as a measure of guarantee that in the advent of a default by the borrower, the bank would then have the right to sell off the property and avail benefits of the same.

Banks collectively thought prior to the 2009 Recession that since land was a scarce resource, once pledged the price of land would definitely increase over a period of time. Thus the overall risk of operation was thought to be minimal.

The Basis of a mortgage based lending is exercise for a bank is that it is more convenient and risk free for banks to give out such loans because the risk would get mitigated by a pledged asset thus making it safer in the eyes of the banker.

How did the banks indirectly come to once again being exposed to mortgage lending risk? What happened to the bank reserves during mortgage debt crisis ?

The mortgage crisis was the resultant of over valuation of the price of properties in the market by banks and bodies respectively.

People did not in reality have the purchasing power, to buy a property for the price as indicated by banks the resultant was that the price of land as a resource fell down rapidly since buyers were no longer available.

Since the price of an asset being lent fell rapidly, the risk associated with lending increased. People began defaulting on loans since the price of the asset mortgaged was lesser than even the loan amount provided by the banks. Further banks were unable to sell these houses since the demand for these fell rapidly.

As a result of such financial activity in which banks previously were extremely careless in giving away loans which, later resulted in defaults the reserves of the banks fell rapidly.

Banks were left with huge problems in terms of unpaid loans which led to a decline of their capacity to generate revenue and a recession which was extremely difficult to correct for the government.

How did the Federal Reserve Respond ? do you consider the feds response to be appropriate ?

The Federal Reserve responded to the situation with a decrease in the actual interest rates charged by them for commercial banks until it did not impact inflation rates.

Reduced interest rates meant banks could lend to asset creating businesses at a lesser rate which would generate employment opportunities in the country and a rise in overall demand was expected.

Further the Federal Bank engaged in quantitative measures such as maintaining future interest rates and communicating the same in advance to avoid speculation.

The also pumped back money into the economy by directly printing notes to a particular extent. All these measures were helpful in my opinion to ease of the situation since, the market and demand at that time were not sufficient enough to correct themselves without intervention respectively.

Please feel free to ask your doubts in the comments section if any