The financial crisis in the United States was triggered by many factors but the largest impact came from the mistakes and erroneous policies in financing the housing sector. The largest mess in the housing sector is the Subprime Lending Fiasco. In this crisis, loan outfits Fannie Mae and Freddie Mac lost their grip in lending subprime mortgages. These mortgages are the specially designed for people who fall short of the prime rate thus disqualifying them for mortgages offered to creditors with better credit score. They are for the creditors whose rates and dependability in paying the loans is lower and these people are generally a credit risk because it indicates that they are bound to struggle to meet the mortgage standards. The legislation at the time made provisions that would allow these people own houses and therefore the law made it possible for creditors to get subprime mortgages (Brett & Brett, 2019). Basically the creditors with a FICO score of 640 and below are grouped as subprime for bigger loans such as mortgages due to their perceived inability to handle debts. The historical low credit scores and their debt problems led to the subprime lending fiasco because these people could not afford to pay these debts and their financiers became cash strapped and were left with repossessed houses with no buyers.
Causes of the Subprime Lending Fiasco
Hedge Fund’s Key Role in the Crisis
In the USA, hedge funds are better placed in the economy because of the need to outperform the market. In USA, the demand for the mortgage-backed securities made hedge funds to go all out in giving Americans mortgages in the popular plan called the credit default swaps. The law required these hedge funds to be well insured and most of them were insured by AIG (American Insurance Group). AIG is the world’s largest multinational insurance corporation. The large insurer fiasco revolved involved committing a grave accounting fraud whose total was close to a whopping $3.9 billion which came about when the company was trying to balance out the effects of losses from the hedge funds (Baranoff, 2019). In their massive accounting fixes, they perpetrated fraud by manipulating the prices of their stock in order to entice more investors to buy them (Fiorillo, 2018). The plan also entailed illegally counting loans as part of the revenue so that they company could appear to be competitive financially. The scandal continued with the organization sending clients to the various insurers that come into payoff agreement with AIG and then telling traders to illegally hike the AIG stock price as a way of ‘boosting’ the company’s financial strength in the eyes of the investors. The whole fiasco was brought to the public’s attention by the SEC regulator investigations, which were triggered by possible tip off by a whistleblower. The settled with the SEC for that mess amounted to $10 million in 2003 and a further $1.64 billion in 2006. The 2006 one was due to the impropriety that arose as a result of the dealings with the hedge funds like the Louisiana pension fund for that stood at $115 million, as well as three Ohio pension funds for $725 million each (Amadeo, 2019). The losses were huge and many people lost their homes due to the decisions and financial decisions made by the hedge funds and the consequent errors of their biggest insurer, AIG.
Delegate your assignment to our experts and they will do the rest.
Derived spinoffs driving the Subprime Crisis
The banks and the hedge funds initially profited from the mortgage business and they ended up making the business very popular and home ownership was a big thing at the time. The money from the sale of mortgages funded more advertising and the demand for homes and hence mortgages was on the rise. The subsequent demand led to the hedge funds introducing new underlying mortgage plans that covered even the prospective customers with low FICO scores (Fiorillo, 2018). That move altered the course and meaning of the mortgage plan and as more lenders joined in the hedge funds and banks continually lowered rates and standards for new borrowers. On the other hand, AIG continued offering insurance on each of these loans because if was one of the firms in corporate America that would afford and was big enough to offer backing for the many mortgages (Watkins et al., 2019). The size of AIG and the scope of the insured mortgages through hedge funds and banks triggered the equilibrium greatly resulting to the 2006/7 economic depression. The market went on and developed some variations of products that harder to insure, called the mortgage-backed securities. The mortgage-backed securities allowed the lenders bundle their loans and develop new packages and later resell them for a profit (Brett & Brett, 2019). The changes made it possible for conventional loans allowing them have more funds for lending to the market. In the advent of the interest-only loans the new change was that the risk was now shifted to the lender and a default was pegged on the interest rates reset. The whole idea was glued on the expectation that the housing market continues to grow and that way, the risk for the hedge funds and banks would be small (Amadeo, 2019). Tragically, the interest-only idea loans were pooled with mortgage-backed securities and the increased liquidity generated in the market resulted into a boom in the housing sector.
The firm slid into bankruptcy and as a result the situation demanded that it required a bailout especially due to the negative publicity that it received following the negativity that arose from the news of the negative press that arose from the news of collapse and bankruptcy (Brett & Brett, 2019). Nonetheless, the Risk Radar Report, indicated that there were some strange underlying issues in the firm’s books of account. Ironically, the issuer of risk management solutions had itself grossly failed in exercising a prudent risk management of its own and had invested in very risky investment portfolios that messed up its balance sheets (Brett & Brett, 2019). The risk management failed to assess the derived spinoffs correctly and continued to insure mortgage loans at the same terms even in the times of the housing boom The government and most particularly the exchequer noted that the personnel managing the firm defied all ethics and oversaw one of the biggest corporate scandals of all time. Amadeo (2019) agrees that the ethical issues that arose from this fiasco forms the basis with which future corporate management and oversight ought to be conducted because with benefit of hindsight, stringent measures that must have been put in place as a way of preventing such future scandals from recurring.
Adhering to myths
The financial sector at the time chose to follow and stick to some few myths in law and this also caused the crisis. For instance, the role of Fannie Mae and Freddie Mac two of the main government-sponsored organizations was misunderstood (Amadeo, 2019). The two were said to have taken part in the crisis and the but indeed they just caught up. The two organizations were not responsible for the massive mistakes that took place (Amadeo, 2019). In the industry, the two were accused of falsifying business records, securities fraud, grand larceny and conspiracy. In truth, the two were not in charge of the persons that did so but their role was offering the necessary environment for the other firms to carry out their roles in the mortgages business. In the famous law that every erring organization during the crisis blamed, the Community Reinvestment Act had no input at all (Amadeo, 2019). The law only proposed a responsible approach whereby the banks and hedge funds were required to go out their way and make efforts to lend more funds and support the poor in the lower-income regions and the inner cities. The act led to the formation of the Fannie Mae and Freddie Mac and the two were only pushing that requirement but they were not mandate in the 1977 to push the banks and hedge funds beyond their responsible limits (Amadeo, 2019).
The banks and the hedge funds also blamed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 as the reason why they gave loans and mortgages leading to the 2006 and 2007 economic crisis. The act was established with the goal of strengthening the Community Reinvestment Act (CRA) which required it to publicize the banks' and hedge fuds lending records as a way of offering information to the public on their operations (Amadeo, 2019). The act also prohibited the banks and funds from expansion should they fall to adhere and comply with standards set by the CRA requirements. In 1995, more regulations were put in place that demanded more investment into the public through loans and other befitting community services and the CRA became much stronger. Regardless of the pressure that the CRA put on the banks, it did not have any provision that allowed the banks fund the subprime and give loans to people with the low FICO points. The banks made this mistake out of greed by expecting that the housing boom would last long and they would make lots of profits (Watkins et al., 2019). The banks blamed false blame on the CRA and it is clear that it did not ask them to revise and lower the lending standards. It is clear that they only wanted to develop loan products for an additional but profitable derivatives and spinoffs as a way of benefitting from the housing boom.
Ways to avoid and deal with the crisis
The Subprime Lending Fiasco was purely something that would have been avoided if greed and unethical behavior was avoided. The failure to adhere to the law, the principles and of finance and personal ethics led to the devastating crisis. First, the ethical issues that triggered the fruition of the scandals at the various banks and ultimately at AIG were based on the concerted efforts in firm cover ups. The audit reports by Price Water House Coopers LLP, which was tasked with carrying out audits for the firm even before the audit queries started realizing that there were deliberate efforts in withholding documents. Audit queries arose and the management would not explain them convincingly. However, the reporting did not indicate these problems in the audit reports and hence the huge losses triggering a crisis (Fiorillo, 2018). Thus, it shows that the auditors were working closely with the management to cover up the scandal. It is difficult to imagine that the AIG Board's Audit Committee responsible in ensuring that the firm's accounting standards are upheld did not have any knowledge about any audit mishaps (Baranoff, 2019). Further, the banks and the hedge funds would have also admitted that the subprime loans existed because this would have protected AIG as an insurer from big losses. The collusion between the technocrats at AIG, auditors, banks and hedge funds means that this mess was covered up deliberately (Brett & Brett, 2019). The whole thing indicates that the professional ethics of all the accountants involved in the whole cover up was wanting and that they all teamed up to loot their firms. If that was not the case, then the possible explanation here would be that the accountants did not adhere to the accountants’ code of conduct and they did not carry thorough audits and hence went against their professional contracts in doing so. Proper conduct would have made it possible for early detection and the crisis would have been avoided.
The crisis would have been avoided if the laws and regulations understood the kind of erosion of morality, values and ethics in corporate America. The individuals running the economy are well educated and they possess the necessary skills required in understanding the corporate firms in such a way that they can virtually orchestrate a successful heist and cover it up pretty well (Baranoff, 2019). The economic and the moral problems that face the modern day business firms cannot be curbed by the modern set of laws and legal solutions. The nation requires a new approach in dealing with corporate America because the modern laws overseeing the multi-billion entities are no longer able to prevent fiasco such as the one leading to the Economic Crisis in 2006 – 2007 (Brett & Brett, 2019). The laws must take into account the fact that the laws at the time were based on the major flaws and the fail safes are not strong enough to keep modern day corporatism in check. The modern capitalists are now able to collude with the people working in the regulatory bodies and that means that collusion occurs and that encapsulates the need for better laws and regulations. The modern suggestions in solving these problems include the use of the blockchain technology that will allow the citizens crosscheck transactions involving the government and private entities. The blockchain technology is the solution because today’s corporations are no longer there to serve the society but instead they are purely in existence for profits. The thinking behind the notion of profits at all costs is pushed by the persons running and managing the corporations. A summary of the events culminating to the collapse of AIG indicate that unethical behavior is now a common language among today's professional and that multimillion deals can easily be struck with little or no regard to the persons or ethics (Watkins et al., 2019). The blockchain technologies would have made detection of fraud and collusion very early because the people manning the blockchain are enough public security against fraud.
Conclusion
In conclusion, with the benefit of hindsight, it is very clear that the firms (banks and hedge funds or even the insurers) would have done a lot more to prevent the subprime lending fiasco that arose. The firm would have taken some specific measures that would ensure the firm does not make huge losses as it were in the case. The businesses could have taken a thorough ethical and financial audit of their staff as the first line of defense because that was the only way that they would detect that the employees were defrauding the firms and that they did have some assets and bank balances that did not add up. The firm must have detected that the company staff detested the AIG audit and that ought to have raised the alarm about the fiasco that was cooking behind the scenes. The other failsafe, measure that the firm ought to have taken was to ensure that they had a third-party review and consultant looking into the business practices of the firm.
References
Amadeo, K. (2019). The Causes of the Subprime Mortgage Crisis . The Balance. https://www.thebalance.com/what-caused-the-subprime-mortgage-crisis-3305696
Baranoff, E. G. (2019). An Analysis of the Aig Case - Understanding Systemic Risk and its Relation to Insurance. SSRN Electronic Journal . https://doi.org/10.2139/ssrn.1899047
Brett, E. A., & Brett, E. A. (2019). International Economic Theory and Policy. In International Money and Capitalist Crisis . https://doi.org/10.4324/9780429046322-3
Fiorillo, S. (2018). What Was the Subprime Mortgage Crisis and How Did it Happen? The Street. https://www.thestreet.com/personal-finance/mortgages/subprime-mortgage-crisis-14704400
Watkins, T., Valley, S., & Alley, T. (2019). The nature and the origin of the subprime mortgage crisis . San Jose State University Department of Economics. https://www.sjsu.edu/faculty/watkins/subprime.htm
