Default Risk And The Housing Market Meltdown

The United States of America housing sector faced a downpour recently. There were malpractices or misinformed practices by financial sector that lead to the fall in the housing sector. Many banks and insurance companies were using Mortgage-based securities and CDO’s against their increase leverage ratio (Blackwell, Griffiths, & Winters, 2007). Regions like Arizona, Nevada, and California became prone to the meltdown. With poor regulations and an increase in malpractices in those regions, most citizens were losing their homes. It is important to discuss the events that lead to the failure of the entire financial sector of the world. In addition, the explanation of ways that would prevent a repeat of the same learning from the past events is necessary. This paper majors in the discussions of the housing meltdown and the foreclosures of selected regions within the United States.

It would be proper to understand the underlying factors that lead to the meltdown of the housing sector in the United States and the entire world with a bias on countries like Arizona and California. This will assist to understand the ongoing crisis and come up with a proper remedy for it. Part of the problem that might have lead to the failure of the housing sector in states such as San Diego, Phoenix, and Miami is lack of proper origination practices. It is obvious that newer products will always present stakeholders including buyers with fresh curves (Taff, 2002). Per se, the process that both the lender and the borrower in the market used in the determination whether the products they intended to transact were in good condition was improper. Borrowers did not understand the products that they intended to buy or the terms of such contracts.

In the said states and all over the United States of America there was crisis within the rating agencies. There was a shift of the entire real estate industry towards its ability to sell securities referred to as mortgage-backed securities, which depended heavily on the rating of securities. Unfortunately, insurers made payment packages to the same rating agencies hence most would receive a rating of AAA to date (Blackwell, Griffiths, & Winters, 2007). Most scholars could not understand the reasoning behind $1.2 trillion worth of subprime mortgage would end up causing a financial crisis on a global scale. The secret was hidden leverage practices, regulators allowed investment companies to grow with little capital. This meant that most of them opted for leverage of 10:1 and other in states such as Nevada opting for 20:1 leverage. Once such institutions failed, they sunk into insolvency.

Various default risks do exist in mortgage financing. One of them is the credit default risks. Investors that are eying the mortgage-backed securities biasing on those lacking some backing by entities have to have extra care on the characteristics of these securities. CMO’s are prone to greater magnitude of risks when there are rises in interest rates. This given the fact that a CMO rises steadily with decline in the interest rates while on the other hand, the rate of dropping when the reverse is true increases. Prepayment is also a risk and is the likelihood that borrowers increase their rate of payment if there is a decrease in the interest rates. Due to such shortening of the life of the debt, the principal that the bonds retain declines considerably.

There are a number of strategies considered in a bid to decrease the risk involved in the process of investing in mortgage. Currently, the banking sector especially financial institutions have ineffective regulations (Taff, 2002). Initially, there were efforts in place to minimize or eliminate the inconsistency that lead to hiccups such as fluctuating interest rates. Consolidation was not successful to the desired levels and the indications are that there is need for the streamlining of the banking regulations in the country. Lack of proper mix between the government and the private sector is the other cause of elevating uncertainties within the industry. There were, and they still are in existence, efforts to ensure that there was an appropriate mix between government and the private sector. This is assisting in the reduction of the said risks by ensuring that there are effective responses from the two bodies on crucial issues.

During the crisis on the housing sector in the United States of America, there was a realization that in deed some cities or states were immune to the crisis. This could be because of different belief systems, better legislation, or better lending and borrowing practices. The crisis was widespread affecting regions outside the United States but some areas in the country were prone relative to others (Kothari, 2006). According to this realization, it would be prudent to hold loan portfolio from various regions within the country. This will mean that in the instances that the country is facing such crises the loss of investors is not collective, which will be the case with those that have portfolio in a single location. Hence, it is recommendable to have loan portfolio from various locations that will ultimately reduce the level of risk considerably.

Banking practices from various locations is another factor that would favor having portfolios from a variety of locations. Organizations respond to the regulations and the factors that government and other governing bodies have in place in making of decisions. Given that different states will have varying regulations, it has the meaning that financial institutions from different regions operate fundamentally different regardless of their affiliations. This means that it is not possible to have a blanket failure of the entire United States financial institutions but rather this will happen on certain regions. Having loan portfolio from different regions has the meaning that there is a reduction in the level of risk.

As earlier stated, the United States proved vulnerable under some conditions. There is then the need of reforming some of the sections after learning from the financial crises. Regulators will have to tighten the rules on leverage. This is possible through enacting debt-equity swaps, which will in turn reduce the level of rebuilding capital. It is also evident that the country responds more to solutions after crises, which is leading to massive losses on the part of Americans. Per se, after reforming the regulation sector there should be a focus on the means of preventing crises (Blackwell, Griffiths, & Winters, 2007). Scholars in the finances sector have been for a long period been recommending there be covered bonds that will be an alternative for the securitizing mortgages. However, they should not be substitute for the same but should be complement of the securities. This indicates that there should have been improvements made in the view of modifying mortgage loans, which will be a provider of greater resource for the stakeholders.

Lack of transparency is the other lesson culminating from the housing sector crises that rocked the country. This call for the founding of an exchange mandated credit swaps that is formal that will ensure that the level of transparency does improve considerably. Evidently, the existing home ownership solutions are not effective and soon more Americans will be homeless (Kothari, 2006). To avoid such instances, there is a need for the government to come up better options. Innovative options include, down payment assistance, equity programs of a shared basis, and the trusts on community lands. However, there is need for proper and informative research to decide on the best option. Additionally, to avoid foreclosures it would be accurate and adequate to have reforms within the Real Estate Mortgage Investment (REMICs).

It is evident from the discussions contained herein that there are factors that lead to the failure of the real estate sector. Financial institutions were not keen on the introductory practices. This had the meaning that borrowers did not understand the terms of their contract, which lead to them taking more risks. Investors were also taking more risks and were did not ensure that borrowers had the capability of paying the loans back. The consequence of this is an increase in the number of defaults. To this effect, the government has to come up with legislation that will streamline the regulatory bodies this will tighten borrowing rules and the leverage of financial institutions. Increasing the transparency of the regulatory bodies and the rating agencies will also assist in improving home ownership.

References

Blackwell, D. W., Griffiths, M. D., & Winters, D. B. (2007). Modern financial markets: Prices, yields, and risk analysis. Hoboken: John Wiley & Sons.

Kothari, V. (2006). Securitization: The financial Instrument of the future. Hoboken: John Wiley &Sons.

Walter, V. (2010). Risk Management: Foundations for a changing financial world. California: SAGE.

Taff, G. (2002). Investing in Mortgage Securities. London: Taylor and Francis Publishers.