Student Writing on the Housing Market Bubble
Let's make this a better country by learning from the past.
REA 281 - Principles of Real Estate Law & REA 282 - Real Estate Finance
Final Exam: Economic Meltdown History

After studying your textbook and these laws, explain how deregulation in the lending and secondary mortgage markets caused the economic meltdown of 2008. For extra credit, explain credit default swaps and how they added to the meltdown. Please write one or two pages only.

1999: Gramm-Leach-Bliley Act - read more about this law
2000: Commodity Futures Modernization Act - read more about this law
2004: SEC further deregulates financial institutions - read more about this law
The writing was so good, I asked a few students for permission to post their work.
- Nori Muster, Adjunct Professor in Real Estate, Mesa Community College, Mesa, Arizona

Read great answers from students:
D.B. * F.G. * T.M. * J.R. * C.P.M. * T.S. * R.B. * E.R. * D.R.

D.B., Spring 2019

Economic meltdown history. The history of banks is the history of bank failure. When immigrants come to America they trust our institutions but they rarely trust banks because banks in less developed countries are less successful. Take for example the inflation in South America, the currency issues in the common market, Greek debt.

In the USA banks failed on a regular and predictable basis up and until the great depression. The Federal reserve, FDIC guarantees, banking commissions and supervision all try to promote the safety of banks as an institution. In 1873 and 1907 and in 1893 the failures of industry triggered regular banking crisis and in 1907 a nationwide panic resulted in mass withdrawals of principle from banks causing a failure.

The overextension of loans in the real estate industry caused a banking crisis in 2008. The causes of this this were complex and many people and processes were to blame

Financial products called derivatives were created to provide investors partial and incongruous access to the lucrative mortgage backed securities. These derivatives were used to invest in mortgages that did not have the conservative underwriting and scrutiny of loans that had preceded them. This "end around" traditional underwriting criteria gave the impression to international and local investors that they could own a piece of the American dream. Before 2018 many would argue that there are few investments as secure as a mortgage on a house in the United states. Dumb money chased after the dream and a seemingly unlimited supply of capital was created by the derivatives. This money wan injected into an already booming cyclical real estate market and the effect was to drive up prices and to invite unqualified mortgagors to own properties with little or no concern for their ability to pay the mortgage loans.

Reasons for the market bubble crash.

While the traditional mortgage regulatory systems were in place the new players in the market did an end around to create business. They worked outside of established credit standards for borrowers, They invited creative and often illegal schemes for false documentation into the business to create loans because there was so much capital available to fund mortgages that was looking for a home. People who were bartenders last week were mortgage loan officers this week making hundreds of thousands of dollars in commission. To the new players this gold rush would never end.

At the same time the historical real mortgage market continued coexisting with the new players. Traditional mortgage bankers turned down bad risks, conducted stringent appraisals of homes and followed all of the rules for sound lending. Countrywide was accused of turning down qualified buyers and then suggesting that their full spectrum lending division could approve the buyers. This made lots more money for Countrywide when they diverted business. The new competitors backed by derivatives drove up prices with 0% down payments loans, no escrows, pre-payment penalties and they overlooked the most reasonable rules for credit such as income to payment ratios and credit history. The two competing structures could not coexist and in fact the new players selling to derivative rich investors would take both houses down in the end.

The worst of the bubbles burst in 2005 and 2006. The lenders were the first to recognize the problems when their capitol dried up. Mortgages were left unfunded at the table and mortgage companies closed their doors to try to figure out what happened and where all of this was going. Surprising numbers of defaults were appearing on the marketplace. So many defaults that the small departments dedicated to loss reduction (bad loans) were quickly overwhelmed. Sellers could not sell their homes because there were too many overpriced homes on the market already. The term jingle mail was introduced to the real estate community. It was coined by loan servicers who would open up envelopes to find keys to the house instead of mortgage payments.

When the defaults began they were met by a loss mitigation industry that was used to .0007% defaults on mortgages usually due to serious health issues with individuals who could not pay their mortgages. Now they were being overwhelmed with hundred of thousands of mortgagors who wanted to speak with them, negotiate with them. They could not pay their mortgage and they could not sell their houses.

The lenders met this challenge with abject failure. Bank of America established a 1 800 number to discuss problematic loans with their clients that was immediately transferred to India. Call centers with no power to help or to understand the problems were frustrating American homeowners to a new level of confusion. Borrowers had nobody to talk to and nobody to work out their issues with.

The concepts of strategic default, walk away, Jingle mail, short sale, foreclosure once only whispered in America was now part of the daily discourse. A new industry of short sales was developed mainly by bank employees who had the direct phone numbers of the people who could make decisions in the banks. These contacts were only available to the short sale experts. It was impossible for borrowers to get help or to get sound advice.

New industries were invented. Some investors bought the notes from banks directly. Some wall street firms decided to buy entire portfolios from banks for rentals. Places like Phoenix and Las Vegas received infusions of cash and new investments seeing the tide of valuation find a balance and then a few years later some appreciation. While this was good news for neighborhoods and cities it did little to help the owner who had lost their home.

The banks hit new bottoms as well. Large mortgage servicing companies disappeared, Lenders after a very close scrutiny of mortgage portfolios bought into each other for balance. Huge players in the investment banking world simply closed their doors sending people onto New York streets with a box and a mysterious future. Bank of America in a politically influenced move bought Countrywide mortgage swallowing a poison pill and "taking one for the country" to help to find a bottom to the crisis. Mortgage lenders were out of work along with processors and underwriters , appraisers and real estate agents. It was a crazy time for the industry.

Although many would disagree with me I would say that a panic mentality was created by the reaction of lenders and servicers to the problems. Instead of continuing to appraise homes for what buyers were willing to pay appraisers cut appraisals at the behest of the lenders unwilling to take on additional risk.

When lenders offered no help to seller seeking short sales neighborhoods took huge hits in value deepening the crisis. Lenders took advantage of the gains collected from MIP and PMI insurance by foreclosing on as many properties as they could ignoring the attempts of the mortgagors to work out the loans. If there was less panic and more thought given to the situation much of the damage could have been avoided. Municipalities too, instead of recognizing the crisis went along with archaic foreclosure procedures putting up stickers on houses, stigmatizing properties, conduction foreclosure sales in the most inconvenient and confusing ways making opportunities for investors to buy the properties for 10 cents on the dollar. They could have upheld values by changing the procedures and participating in sales that would represent market values. This would have saved communities from billions of dollars in losses. Nobody was thinking out of the box, There was simply panic and a universal attempt to find a safe place. It was like overcrowding the debtor's prisons. Nobody benefits.

The derivatives gave channels for money to enter the housing markets but with no rules or intelligent borders to protect the investors' money. All that was learned about what makes a good loan was tossed out the window. These unregulated investments created mortgage backed securities. Investors identified tranches or aspects of loans that could be invested in. For example an investor could invest specifically in the third year of a mortgage product. There was no connection to the fico scores of the mortgagors, the appraisal of the properties or other sound qualifying controls. These investments were not only speculative they were easily influenced negatively by movements in value, interest rates or the market. When an investor is in a derivative they do not have the direct rights to foreclose or to protect their position. Lenders from all over the world invested in derivatives as if they were investing in regulated mortgage backed securities. In fact they were in a much riskier position. But because the derivative investors failed they failed dramatically enough to bring down their counterpart the traditional controlled regulated markets. Nobody was going to invest in mortgages until the problems were solved and the reassurance of normal market dynamics came back into he sector.

An interesting group of investors bet against the market as it is portrayed by the movie the big short. Usually people who short the market are considered to be betting on bad things to happen and the marketplace looks at them as a bad thing. In this case there was so much enthusiasm for the newfound commissions and profits in selling derivatives that the market members were happy to sell short positions they could not believe that anyone would bet against American mortgages. This was like betting against Fort Knox. The market was glad to take this crazy money. However the investors , like me from my seat as a real estate broker, saw events and situations that signaled that the market had gone too far too fast. I saw that nobody was being turned down for a mortgage. Just call this guy . . . He will get you a mortgage and you can settle in two weeks. Just prove you make deposits into a checking account. Just prove that you have an income or some cash the rest will work itself out. Along with these mortgages in the market place was incredible appreciation well beyond what made any sense and well beyond what people could afford to pay for houses. While I did not see the effect of derivatives precisely my gut told me that this was a house of cards.

For mortgage brokers these were heady times I remember a settlement for $100,000. The settlement originator drove from New York to Philadelphia for the settlement. This was very unusual. When I saw the settlement sheet and did the math I saw that he made $15,000 in fees and commissions from the $100,000 loan. I thought about what they were making on the $400,000 loans and the bigger loans. They were creating 15 -20 loans a month and pocketing a fortune. The borrowers were left with loans representing 105% of the inflated value of the property. With no way to pay taxes (no escrow) and a pre payment penalty that will guaranty that they would not be able to sell the property for years if ever at all.

The federal reserve and the treasury department pulled us out of the economic recession by guarantying the mortgage money to the market until the help was not needed. Keeping rates low was helpful as well. Huge systems for HUD and Fannie Mae disposed of properties and brought back markets and interest. Large financial purchases of housing for rent and for sale saved individual cities like Phoenix and Las Vegas. Real estate tax laws benefiting renting like depreciation, deductions of interest and taxes and 1031 tax exchanges pointed the way for capitol to infuse the Real estate investors also did their share of heavy lifting.

Once the problems were discovered the federal government had to step in not only to save the real estate market but to save the entire banking industry not only at home but around the world. Massive moves by the federal reserve, political moves by the treasury department and concessions to make banks more stable were made. People asked if the banks caused the problems then why should we use taxpayer resources to prop up the banks. The phrase too big to fail was tossed around. It was understood that if the banks fail we all fail . We could conceivably be back in the dark ages because everything that civilization had developed could conceivably be destroyed. The banks were propped up. Stress tests were developed to see who could withstand the pressures that the lenders faced and mergers, reorganizations and changes were put into place to secure the financial futures. Few lenders went to jail. Fewer lenders suffered much. The crisis was averted and we all had front row seats to the show.

The partial repeal of the Glass seagull act in 1999 was pointed to as a partial cause for the crisis. Essentially the banks were allowed to use bank assets in risky investments like derivatives, stock purchases and ventures that could put hard earned savings at risk. This permission came from the Graham-Leach-Bliley act. It was said to have created a "permissive" environment for lending. Many in politics blame the Clinton administration for the easing but few could have seen the coming events that rocked the economy of the world.

The benefits and earnings were great but the risk was high. The banks were risking our money for their profits. The act separated banking from investments. Today the head of Trumps economic council wants to revisit the glass seagull act. Elizabeth Warren and Bernie Sanders are vocal supporters of the act. Elizabeth Warren is an interesting figure as she held out on a recent omnibus bill in the senate to make sure that everyone was aware that the ability of derivatives to be used again in residential mortgages was granted back to the lenders. She says she wants to put the "too big to fail genie" back in the lamp forever so we never have to face TARP 2 (another bailout of the banks) . The vehicles also known as credit default swaps are potentially back in the marketplace.

As part of the Graham Leach Bliley act many parts of the glass seagull act of 1933 were repealed as part of a larger reaching consumer protection initiative. Glass seagull was a law that was born in the depression in 1933 and it was created in reaction to banks lending borrowers and investing themselves in speculative investments primarily in the stock market.

There was a great optimism at the time and it was thought that if you had any money at all you should have it in the market. Beg borrow and steal to buy shares of stock and the largest problem borrow on margin to purchase a lot of stock to leverage investments. When the stock market crashed the investors found that they had lost everything and the banks realized that they had made bad loans. When the margins were called the banks and the savings of many Americans was in jeopardy. Banks used bank assets and savings to create profits in investments to the possible detriment of the banks financial security. The same issues that dragged the country into a banking/mortgage crisis are looming again at least within the constraints of the laws. The major political action committees of the Banking mortgage and real estate industries will have a lot to say about the future of Glass seagull philosophies. With 20 + Democratic presidential candidates this may get lost in the noise. There are strong lobbies in favor or allowing banks and investment bankers to participate in investments with other peoples money.

The next big crash. Are the signs present to predict the next big crash? Will it be a multi car pileup or just a fender bender? Here are the signs that I see in the marketplace that suggests to me where the crash will come from.

Inflation in in residential real estate is dramatically higher than inflation in the economy. There are many hot spots in the most populated parts of the country that are way out in front of the country in appreciation. However there are signs in the statistics that suggest the brakes are being put on in places.

"Annual home price appreciation nationwide has now slowed for five consecutive quarters following a post-election spike to double-digit appreciation in the first quarter of 2017," said Daren Blomquist, senior vice president at ATTOM Data Solutions. "Although home sellers are still in the driver's seat of this housing market, moderating home price appreciation is good news for prospective homebuyers and signals that rising mortgage rates and other housing headwinds are cooling red-hot home price appreciation in some areas."

Here are some headlines that can complicate the happy picture for the US housing market.

The executive branch of the government is taking on China, the European Common Market, Canada, Mexico and just about every trading partner that the United states does business with in a high stakes attempt to renegotiate trade.

Rates are low encouraging refinances as much as purchases

Lots of building is catching up to rising demand

Tax loopholes and millennial preferences for renting are fueling the growth of more new rental units.

RAM Mortgages being crippled by HUD

Banks are back to making high risk loans again including no doc and 100% LTV farmers loans in increasing numbers.

Why crash may not happen

Few adjustable rate mortgages and much fewer interest only loans

Stricter underwriting standards for many mortgage programs and no prepayment penalties in standard loans

A wariness of much of the public not to overextend themselves in real estate. Millions lost houses and they won't repeat the mistakes.

Real estate viewed as less of an investment and more of a housing.

Building is limited by finite things like number of builders, long term process of developing land to market, regional planning, highway traffic and heightened planning and environmental restrictions on overdevelopment

Economic Cycles

Econimic cycles in real estate are inevitable but reaction to a crash is controllable, I would propose the following changes in the real estate finance and in the government to make sure that a fiscal downturn does not turn into a real estate crash that brings the entire economy down like a house of cards. I believe that the process that we use to treat people who are behind in their payments is the problem. By the time a property with an outstanding $200,000 principle balance is foreclosed on in the present method the property becomes devalued by as much as 75%. There is a big difference between a house that has a mortgage that is in arrears and a house that has been stigmatized, abandoned, left vacant, the owners harassed, utilities off, grass uncut and then peddled for sale as a property with problems by an uncaring system. The trick to avoid downturns that spin out of control is to control this process in a more humane and sensible way.


Lenders would typically have a small amount of delinquencies with mortgage payments and they treat these as collection issues. They use hardball tactics, recorded conversations, threats and harassment to try to get people to pay the mortgages.


If there was another crash lenders could switch gears and use the same energy to work out issues, restructure loans and to take a longer view. The best result is to keep the borrowers or another resident in the property.


Foreclosure laws and traditions create momentum towards foreclosure not workouts.

The archaic laws dictate that in a title theory state with judicial foreclosure if a lender accepts any part of the payment that is short of the full arrears amount then the foreclosure clock would be reset back to the beginning putting the lender at risk of losing their court dates. The laws could change to allow partial payments on a specific schedule for example 1/12th of the arrears for 12 months . The present laws encourage borrowers to walk away and to squirrel away the little money they have to pay for rent food and utilities. If their payments would not hold off foreclosure why feed the lenders with the little money that the borrowers have. The ticking clock creates a trap. Borrowers had no other options except to exercise a strategic default and to get on with their lives.

Additionally the first step in a judicial foreclosure state is the automatic application of 5 or 6% attorneys fees on the principle balance. This grows as the payments add up. This creates a bigger hole for borrowers to dig out of the loan.


This is the traditional way to foreclose but the attorneys fees do not have to be taken up front. Rewrite the documents. Attorneys should only get paid if there is an actual foreclosure and 6% is way too high.

Contract conversations Real estate regulations and laws governing attorneys both prohibit a licensed professional from discussing the possible option of a borrower walking away from a mortgage (break a contract).


• If the laws were changed to reflect the reality of the situation (as in business loans) practical option a lot of borrowers would not be left in the dark or wondering what their adviser won't answer their questions or give them practical options. This is a muzzle on a clients rights to fair council with their advisors.


The following suggestions are premised on the belief that the process of selling foreclosed property is the problem. It is punitive against the borrower but in the end it is a negative affect on the entire community when houses are subject to involuntary transfers for less than market values. Whatever the effect on the borrower there is no need to penalize the neighborhood and the community stripping away equity from homeowners and sending wealth to investors.


Let a buyer buy back their own houses, If a borrower lost his house to foreclosure let them buy it back at the courthouse steps or when it is listed as a REO property. They will most likely pay more money for their old house than an investor.

Separate category for fico. If a loan goes into default a borrowers fico score drops quickly and all of the other forms of credit become unavailable. The trigger is the foreclosure notice sent by the attorneys .They cannot borrow money to make up payments and they cannot get new employment (based on credit in many cases) to make more money to pay the arrears.

With cooperation the problem can be managed to the benefit of all


Condo law changes. Condo laws penalize the entire condo when a property goes into foreclosure. New financing is limited and the lawsuits created by foreclosure hurt the whole association causing prices to drop .


Let the units be treated a single legal entities and the values will remain high enough to foster a new buyer.


Realtor cooperation labels. Once a house is labeled as a bank owned property the value drops a minimum of 35%. (figure from Hudhomestore.com values compared to NARRPR AVM appraisals) This stigmatized properties and hurts local values for no reasons.


Treat all housing as housing and do not stigmatize the property.

Give new avenues that allow access to homes in trouble, When the only avenue is foreclosure or sheriff sale what is the benefit for a seller to try to sell their house. What's the point? The short sale methodology (longer wait times, legal and negotiation expense, stigma) give no appreciable help to borrowers. I suggest that licensed appraisers working for the county should be given access to these properties while the owner is still in the house. The owner benefits because three can move out like humans and not with a sheriff at the door. Give the homeowner a good reason to take this path. They can also sell their property for the appraised value established by the appraiser. The bank benefits because this amount will be greater than sheriff sale or courthouse prices. The attorney fee will be absent. The stigma will be absent. The neighbors benefit because the value does not bring down the block or neighborhood values. The banks have no carrying costs REO expenses, realtor expenses transfer taxes can be forgiven by the county and state. Contracts can be offered by HUD or state authorities to real estate companies and appraisers to manage the business. The effect would be tremendous for the lenders because the houses would sell for 30-40% more money, They would have no legal costs (typically 6 %) no marketing costs, no underperforming assets just transitioning assets that will look better on their books. It is a human sensible way out for all concerned. Purchasers can use normal mortgages to buy these houses and the price would not be limited by cash purchases only as is found at Sherriff sales.


Bankruptcy courts not foreclosure sales appraisals not cents on the dollars. The mortgage bankers and bankers lobbies have successfully kept the bankruptcy courts out of foreclosures.


I believe that it is time for this to change. Bankruptcy courts can order lower payments for a period of time for borrowers to catch up They can order the sale of properties They can negotiate a fair deal for homeowners and for lenders. The losses that would come from bankruptcy courts interventions would cost less than the foreclosure process and keep neighborhoods stable.


The secondary markets treat loans as loans and not as people with loans.


Congress should make derivative investing in residential real estate illegal. Lenders should have greater responsibility to workout issues with direct with borrowers . An individual experienced businessman can be empowered to comprehend the situation and to move the problem forward with a workout or a sale. This would work easily and quickly. (similar to a Master in a divorce)


Lenders make more money than they foreclose because they collect the PMI premiums. Therefore, they do not give the owners a fair chance to sell the property at short sale.


PMI and MIP should have an insurance to pay borrowers a fixed moving expense in the case of collection of the fee by the lenders due to a foreclosure. Bankers should have to prove that the gave the owners a chance to sell the property .

Problems Life happens

People lose jobs, have babies and get sick and when thy miss a few payments they fall into foreclosure.


In a 30 year loan not 360 payments . . . . 375 months to make 360 payments with incentives for staying on time but no penalties. Borrowers should have access to mortgages that have built in optional payment dates to match up with life's unexpected events.


Short sale negotiators part of the problem, Attorneys are allowed to put their fees on short sale settlement sheets and the lenders will pay them.


Short sale negotiators have to be paid by the buyers of the properties. Lenders should pay them as well

Problem Historical attitude

Lenders act as collection agents even though they would save money and benefit more by working the situation out with the borrowers.


No collection agencies but rather counselors. One in default lenders should change tactics offering solutions instead of collections. Anyone familiar with the collection business know that the lenders are recording conversations in order to sell the rights to collection to third parties based on the conversations with the borrowers. This stifles the opportunity for honesty and workouts.

More than any other financial the costs of these suggestions can be born by the market easily and distributed across all participants. The mortgage rate naturally fluctuates and an additional.0005 in the rate spread evenly across all residential loans would not be felt. It would counter the age-old banking mentality evidenced in It's a wonderful life by the mean old banker. I know many lenders with the same mentality. Whats yours is mine and I will try to get it from you soon . . . . Its up to the government to breath some humanity into the process. What is worse debtors prison or being thrown out of your property with bad credit scores, no money and few places to live.

Problem Investors reaping the profits that lenders and owners deserve.

Middlemen buying houses from owners rather than speculators, from my vantage point in real estate I have seen hundreds of settlement sheets that tell this story. Foreclosure. Property bought at sheriffs sale for $15,000 . . . . $10,000 in fresh paint and fix up . . . . sold in 3 months for $150,000. If not for the process homebuyers can buy the same properties thru middlemen for $135,000 and everyone wins. A corrupt self serving economy of lawyers, agents, cleanout companies, locksmiths, Sheriffs and REO brokers have profited while borrowers and neighborhoods have been burdened with the cost in erased equity and appreciation.

Solutions arms length transactions for borrowers

Must accept offer at appraisal lenders or no PMI . PMI and MIP are wonderful protections for lenders but they give the lenders a reason to foreclose. They can workout the mortgage with the borrower and create a win win or they can foreclose and called the private mortgage insurance premiums. Then in the case of FHA and VA they transfer the deeds to the government who pays to resell and carry the property as a REO. Lenders should be forced to exercise a reasonable workout with the borrowers before they can arbitrarily foreclose. They should not be the ones making this decision that affects all of us.

Allow investors with 2nd mortgages. Fannie may can underwrite third party investors who can come into a property and loan borrowers money to catch up on their mortgage with a shared first position in case of foreclosure.

Problem Vacant houses sitting in neighborhoods

Lenders need a timeline when they must sell bank owned properties. Now they can take years before selling because they don't want their assets to show as losses on their portfolios.


Shorten challenge time from homeowners. Give homeowners a chance to sell the property at a fair appraised value and give them an incentive to do it. Middlemen can buy and resell the property but a vacant house costs everyone more money.


Small issues sink big ships

Sometimes it is a septic system or a sewer line or a heater that is the straw that breaks the back of homeowners,


Lenders should be willing to jump in to correct the issue to stop borrowers from walking away. The cost is less than foreclosure and carrying the property. This can be done in financial insurance pools and financed by mortgage payments

Establish Pools of insurance and warranty.


Lenders unwilling to sell bad loans and bad properties because it looks bad on their balance sheets.


In accounting world Stop considering loans as assets before they are sold. If the are not assets they should be declared.


You have to have a medical reason or pass away before a lender will accept cash for keys or deed in lieu of foreclosure. You must feed the foreclosure system before any avenues open-up to dispose of the house without foreclosure.


Stop this crazy process. Lenders should accept homes and agree to cancel notes when all parties agree. Change the paperwork.


Can't afford to sell a house when mortgage and value is upside down


Open up Homeopath and HUDhomstor.com and Freddie Mac home steps REO selling site to homeowners. Lenders agree to take the proceeds after appraisals and sales No commission or attorney fees.


Bank owned empty homes


Transfer ownership to property managing companies to rent out properties. Lenders profit and homeowners escape with less cost and pain. Establish or use large national property management companies to make offers on the houses.


lenders rush to foreclose because real estate taxes and homeowner's insurance costs are adding up.


Provide insurance pool to cover these costs in the event of a default Add this cost (small) into pmi premium

F.G., Fall 2017

On its own, The Gramm-Leach-Bliley Act (GLBA) appears to be a good law. It allows financial institutions to merge, offering one-stop services to clients while (allegedly) ensuring clients' financial privacy. The Securities and Exchange Commission (SEC) relaxing regulations which allowed banks to carry more debt isn't really anything new. The Government in the past has done this to control lending: higher capital reserves, less money to lend; lower capital reserves, more money to lend. The economy grows and contracts with these changes. The growth of the secondary mortgage market (Fannie Mae, Freddie Mac), allows local banks to free up capital for other lending activities and allows for private investors to invest in mortgage notes. This assumes there are lending standards (credit check, employment verification, Loan-To-Values are accurate, etc.) are being met. The Commodity Futures Modernization Act (CFMA) not regulating derivatives was the spark that ignited the financial crisis. At best a derivative is an insurance policy for something someone does not have a vested interest in (which normally is not allowed) and worst case, it is pure gambling which should not be done with investors' money (this is when regulation would come in handy). I heard that for every $1 in a mortgage there were $20 in insurance.

As mortgage lenders saw higher commissions on riskier loans, with very little if any verification of an applicant, more loans were originated. These very high-risk mortgage notes were bundled together with even more high-risk notes to create Collateralized Debt Obligations (CDO) (SEC). What would normally be given a bad credit rating was receiving the highest credit rating available. On the secondary markets, investors were lured to providing funds for these CDOs since the interest rates were high and the risk of foreclosure low (based on the fake credit rating). As individuals started identifying these CDOs for what the high risk they actually were, they purchased the derivatives on the CDOs (SEC/CFMA), investing on the failure of the mortgages backing the CDO. Some of the investors in the derivatives who were gambling on the default of the mortgages were the lenders themselves. Derivatives were easily purchased since the insurance companies like AIG were confident the mortgages backing the CDOs would not go into default and wanted the premiums paid on the derivatives. Since the secondary market was freeing up funds for lenders, lenders originated more high-risk prime loans, earned their fees and then bundled the prime-loan mortgages into bundles (SEC). The lenders would go to the credit rating agency, received a high credit rating on the CDOs and then sold the bundled CDOs on the secondary market, freeing up more funds to lend. With the new CDO bundles on the market, more individuals and financial institutions then purchased derivatives gambling on the failure of the mortgage notes (and failure of the US Housing Market and the economy in general).

The situation developed to where it was theoretically more profitable for mortgages to go into default than to meet the obligation of the note, assuming the insurance company had the capital reserves needed to pay the claim (SEC). If more prime mortgages are created with greater risk, investors are paid higher interest rates for the short term and if the note defaulted, Fannie Mae and Freddie Mac would pay out if one of them guaranteed the note and if there were derivatives on the mortgage even more would be paid out by companies like AIG. The combination of the Gramm-Leach-Bliley Act, The Commodity Futures Modernization Act and the Securities and Exchange Commission relaxing regulations created an environment that when fueled with greed, collusion and ignorance of facts, led to the demise of the Real Estate and Financial markets in 2008.

D.R., Fall 2014

The market crash of 2008 was a terrible time for the real estate market in the United States. This came after a boom period in the early to mid-2000s. With any type of market crash, the reasons for its cause are numerous and complex. However, many of the factors that played into the crash came from bad policy, greed and corruption within government and the lending institutions. One of the biggest factors into the crash was the Gramm-Leach-Bliley Act that was created in 1999. Many people cite this as the primary cause for the crash because it allowed lending institutions to become too big and too powerful. This happened because the law removed any barriers that were preventing commercial banks, investment banks and securities companies from acting as a combination of any of the three. This is where the term "Too big to fail" came from. This attitude of being "too big to fail" led to these recently merged super-banks to make very risky investments. When those investments failed, the banks needed to be bailed out with tax payer money. The banks were rolling in dough and decided to play with the market like a rich kid at a casino gambling with daddy's money.

Although the Gramm-Leach-Bliley Act was probably the biggest factor in the crash, there were other factors that played into it as well. In 2000, The Commodity Futures Modernization Act was enacted and that changed regulation laws. This brought in to the picture credit default swaps which had their part in the crash as well. Companies such as Lehman Brothers and AIG met their end primarily due to the risky practice of credit default swaps. Another factor in the crash was in 2004 when the securities and exchange commissions relaxed their policy and put faith in Wall Street. It basically removed any capital restrictions that banks previously had and relied on them regulating themselves. This act was also created in response to the European Union's upcoming regulations on foreign banks.

The market crash of 2008 was a terrible thing to witness. I experienced it first hand and it was very hard to see. Many people's lives work was gone almost overnight due to greed and corruption within the government and banking. People do have their share of the responsibility as many people who should not have bought homes did. However, they were allowed to buy these homes due to bad policy, illegal activity and short sighted lending policy.

T.M., Spring 2014

Prior to 2008, the US had been enjoying a thriving economy. The interest rate was low. Homes were being bought and sold like they were going out of style. Home prices were soaring. The real estate "players" were swimming in cash. Everyone was happy. The housing bubble was growing bigger and bigger.

Unfortunately, no one was doing their job properly. The lenders were approving loans left and right, preying on the ignorant or unknowing. Properties were practically handed over to people who never should have been able to qualify for. The subprime market was flourishing. ARM's were thrown around like bait, and the "fish" didn't realize what would happen to their interest rates later on down the road. It was the popular belief that the housing values would continue to increase. No one stopped to think "what goes up, must come down."

Thanks to the Gramm-Leach-Bliley Act of 1999, there was no more separation between the banks, insurance companies or securities firms. Merging was allowed which birthed several "fat cats." Scandals and fraudulent activity was soon to follow. The banks that were assumed to be "too big to fail" ended up doing just that. The individual companies should have stayed in their own corner and minded their own business. This deregulatory law was a huge mistake. We should have remembered the Titanic. Oops, again. In 2000, the Commodity Futures Modernization Act was employed. This law allowed unregulated trading of credit default swaps.

Credit default swaps are financial agreements between sellers and buyers of CDs that, in the event of a loan default, the buyer will be compensated. Unfortunately, this law contributed to the meltdown of 2008 because no one was overseeing these CDs transactions, and while the "cats are away, the mice will play." Money makes people do bad things.

In 2004, the Securities and Exchange Commission loosened up and allowed investment banks to take on more debt. The MBS's were booming. The subprime mortgages were booming. Fannie Mae and Freddie Mac, who were not as innocent as they seemed, took on more than they could handle and buckled at their seams. These sneaky "players" eventually required millions in bailouts, and a complete government takeover.

There was much fraud, dishonesty, lack of knowledge and just plain stupidity which truly assisted in the economic meltdown of 2008. Hopefully we all learned, so that "next time" we can do things differently!

J.R., Spring 2014

Of the many and myriad causes of the 2008 mortgage crisis and subsequent economic recession, the regulatory and legal environment were certainly major contributing factors. Among the significant regulatory changes immediately preceding the crisis was the passage of the Gramm-Leach-Bliley Act in 1999. That statute permitted the merger of commercial banks with investment firms - a step that many observers have identified as creating institutions that are "too big to fail" and too interested in risky investments to properly carry out the traditional functions of a depository bank.

The following year Congress passed the Commodity Futures Modernization Act. That law clarified that derivatives would not be regulated as "futures" or "securities," although these products would remain subject to federal regulators at the Commodities Futures Trading Commission. The law lead to the proliferation of credit default swaps (CDS), in which derivative investors purchased what effectively amounted to "insurance" on mortgage instruments in exchange for payment should the loans default. CDS have also been identified as a major cause of the financial crisis because they created fear that parties to the derivative exchange would not be able to pay their obligations in the event of massive default. Finally, in 2004, the SEC relaxed the rules pertaining to the level of debt investment banks could assume. This drove the growth of mortgage backed securities, packaged mortgage loans sold to investors in the secondary mortgage market.

During this entire period, the federal government was aiding and abetting the crisis by encouraging, through the force of federal law and the financial incentives offered by the GSEs Fannie and Freddie, an increase in homeownership rates, particularly for homebuyers with little or no equity and poor credit. These government policies, emphasizing home buying over home ownership, also helped fuel the crisis.

C.P.M., Spring 2013

Although highly contested with many opinions from different parties, below is my take on the role the following Acts played in the economic meltdown of 2008:

The Gramm-Leach Bliley Act is one of the Acts that receives significant blame for the mortgage crisis. This Act partially repealed the Glass-Steagall Act of 1933, which created a "firewall" between commercial and investment banks in which commercial banks could not underwrite or deal in securities and investment banks could not accept deposits. Once GLB was in place, holding companies could own commercial banks, investment banks and insurance companies, leading to a "too big to fail" scenario.

On April 28, 2004, changes were made to the "Net Capital Rule" of 1975 in which the largest "broker-dealers" of securities with net capital over 5 billion (Bear Sterns, Lehman Bros, etc.) were allowed to apply for exemptions in the way they calculate the "haircut method" in valuing their securities. In changing this computation, it allowed these banks to take on more risk and in turn reduce the amount of liquid assets available to pay all its non subordinated liabilities and ensure payment of obligations owed if there is a delay in liquidating the assets.

The Commodity Futures Modernization Act of 2000 clarified the law so that most over the counter derivatives between "sophisticated parties" would not be regulated as futures or securities under federal securities laws. It would instead allow the major parties of those products to have their dealings supervised by federal regulators under general "safety and soundness" standards. Of these is the regulation (or lack thereof) of credit default swaps.

With only few taking note of this perfect storm at the time (that received little acknowledgment), most were not concerned, as long as housing prices continued to rise. Upon the collapse of the US housing industry after its peak in July of 2006, we watched how it all unraveled, affecting not only the housing industry, but the stock market (and in turn peoples' retirement funds) and the global economy as a whole.

Teacher's note: another clue that warned people of the crash was when big banks had run down their credit and could not borrow money from other banks to make their weekly quota of cash on hand. That was a giant red flag.

T.S., Spring 2014

The Gramm-Leach-Bliley Act of 1999 was a direct cause of the market crash. It canceled out the vital provisions in the Glass-Steagall Act that regulated the way commercial banks and lenders can interact. The Commodity Futures Modernization Act ensured Over the Counter transactions between banks and securities firms that were subject to minimal regulation by the securities exchange commission and would not be regulated under the Commodity Exchange Act of 1933. This and the credit default swaps also led to the meltdown of 2008. To me the Securities and Exchange Commission's lax in rules was the most blatant of all of these. The SEC allowed five firms. The three that have collapsed and Goldman Sachs and Morgan Stanley to more than double the level of debt they can take on. On top of that they allowed them to remove assurances that had been required to protect them from defaults. This lax by the SEC led to billions of dollars in reserve to be released to the five major banks as a cushion against losses on their investments. Over the following years the firms would take advantage of the looser rules. Examiners from the SEC were assigned and found riskiness in all the firm's investments and their heavy reliance on debt. They were all ignored. The SEC definitely played a role in letting these huge firms get away with this. They saw the writing on the wall but decided not to take any action to limit the risk.

R.B., Fall 2013

The meltdown was caused by a combination of artificially low interest rates, lenders lowering loan qualification standards, deregulation of the lending and secondary mortgage market, insidious way credit default swaps were used, and unethical practices by mortgage brokers and many others in the chain.

The Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagall Act of 1933 and made it legal for banks, insurance companies and securities agencies to integrate. That sounds like an incestuous entanglement of power. They knew they were re-creating what caused the Depression. Now they say, since the Shadow Banking System is extremely large, unregulated and operating invisibly, its importance to the credit industry during the boom went unrecognized. Really? It was probably convenient for them not to know. This contributed an enormous portion of the credit during the boom. When the bubble popped, their amount of leverage had devastating effects on the credit industry which impacted the economy.

After the dotcom crash, the Federal Reserve made credit cheap by holding interest rates very low for a long time. Lenders made credit easy when they lowered loan qualification standards. Lenders started issuing many more risky sub-prime adjustable rate mortgages. Most of these loans were issued to two groups most likely to default; low-mid income (LMI) people and speculators. Cheap and easy credit caused an increase in demand for housing, and record level price appreciation. Since, except during the Depression, prices always increased, they rejected the possibility prices could decrease. Obviously, they were wrong. When ARMs adjusted and interest rates increased, LMIs could no longer afford the payment and there were massive amounts of foreclosures. Next, prices fell, the speculators bailed and the crash had begun. Granted, the housing crash would not have been possible without these two groups' willingness to take on these sub-prime loans. However, they only made it possible; they did not cause it.

It's not surprising that people took out those loans. However, why would the lenders lower the qualification standards and make those loans? They claim it was to comply with anti-discrimination laws but, I think it was to comply with investment banks' insatiable demand for sub-prime loans. Investment banks preferred sub-prime loans, because they had figured out how to turn a pile of these crappy loans into AAA rated CDOs. Simply put, they bundled a bunch of sub-prime loans into one bond, then rearranged the cash flows in tranches of varying risk and over collateralized them to trick the ratings agencies into thinking they were investment grade. Then, with a AAA rating, those bonds were easier to sell and fetched a higher price. Investors, especially fixed income investments, favored those bonds because they were considered safe and provided higher returns than similarly rated securities. Sub-primes were a cheap resource, bonds were highly profitable and there was large market for them. Also, mortgage bonds with low ratings were repackaged into another CDO, same as before and rated AAA. Magically, the riskiest of the risky bonds was now investment grade. Evidently, the ratings agencies were easy enough to trick because, they received a fee for every bond they rated. The more they rated, the more money they made. Their methods were inadequate and indicate they did not take the time to understand the bonds. Rather than evaluating the individual mortgages in them, they rated bonds based on the overall characteristics of the aggregate. Were they stupid or afraid to question it? When investment banks pressured lenders for more sub-prime loans, lenders lowered qualification standards to comply. The lenders did not care because, they were making money selling them and lost nothing if the borrower defaulted. Mortgage brokers, under pressure to originate more sub-prime loans, used unethical tactics, lies and fraud to make it happen. There was easy money in it for them and they knew if they refused, someone else would do it. Those bonds played a major role in the meltdown because they created a huge demand for sub-prime loans.

To make matters worse, in 2004, the Securities and Exchange Commission allowed investment banks to take on much more debt. Now, they could leverage themselves even more to create which created more demand for sub-prime loans that backed them.

When they ran out of people with bad credit, willing to take out sub-prime loans, some turned to the credit default swap created by the Commodity Futures Modernization Act of 2000. A companion bill to an 11,000 page bill that was rushed thru congress without being debated and signed Clinton it on December 21, 2000. Really? Presidents must be puppets. It made it so the over-the-counter-securities like CDS, were exempt from any regulatory control, exempt from trading on established exchanges, and exempt from reserve requirements. Removing all regulation added to the culture of greed and corruption.

The CDS purchaser pays the spread (expressed in basis points) a fraction of the bond's face value, to the seller annually. If there is a credit event, the seller pays the purchaser the difference between the face value and the current lower value. The purchaser's risk was known and limited while the reward was enormous. The CDS is a big reason the crash was so severe. The purchaser was not required to hold an interest in the bonds covered CDS. Investment banks that had tricked ratings agencies into rating their doubtful bonds as AAA and sold them to investors, then purchased a CDS betting those same bonds would fail. The risky debt they had created, and sold, then rearranged and sold again was now being gambled with in extremely large amounts; unregulated. Consequently, substantially more money was tied up in derivatives than the value represented by the underlying houses. AIG was the biggest seller of CDS. To them the CDS on sub-prime bonds seemed the same as previous CDS they had profited from and they did not recognize the risk. They thought all the loans would have to default simultaneously for an event to occur. In reality, if only a small percentage of the loans defaulted it brought the whole bond with it. They were ignorantly happy to sell the CDS because, they were creating huge profits. By the time they realized they were in over their head, it was too late. In 2008, with AIG and Lehman Brothers on the hook for a large number of CDS, systemic risk was a real fear. I wonder what would have happened if we did not bail out AIG.

Capitalism is good but, the meltdown showed us pure capitalism is not. I am certain most of the participants were clueless and were only motivated by greed when they participated in the corruption. However, higher ups knew exactly what they were doing, because they rigged it from the start. Considering the timing of the changes, the disregard of prior knowledge, how players were protected, and how neatly it all created opportunity for massive profits, it is absurd to suggest that the highly intelligent people involved were innocently unaware of the consequences of the changes they were making to the laws. It looks like they combined what they learned from the depression and the S&L scandals but, got a lot more creative with the recipe this time. All the while, the higher ups even made us think it was good for us. They paid highly intelligent professors to convince us they had made debt investments safer by distributing the risk, making markets more efficient and causing unprecedented prosperity for us. Actually, they made it riskier and transferred it to unsuspecting investors betting it would fail so, they got paid to make the markets less efficient and caused unprecedented prosperity for themselves.

E.R., Spring 2014
A Recipe for Disaster

On September 7th of 2008, the US Treasury took conservatorship of both Fannie Mae and Freddie Mac, a move that was unprecedented, in order to bolster the two main players on the secondary mortgage market. The seizure was made to help stabilize both as they begun to flounder with an ever increasing amount of foreclosures. Treasury Secretary Henry Paulson announced "a failure would affect the ability of Americans to get home loans, auto loans, and other consumer credit and business finance". At the time, the two companies backed over $5 trillion dollar in home loans, and the federal Treasury was hoping that a planned $200 billion would help stop the losses that both companies were experiencing.

The seizure of Freddie Mac and Fannie Mae was the first time that most Americans realized that there was something seriously wrong with the economy, but in reality, the economy had been struggling for a better part of a year. Housing prices had been in decline since the market peak in November of 2006, dropping almost 10% during 2007 and 2008 (nationwide average; some markets, such as Phoenix and much of Florida had a much harsher drop), the collapse of investment bank Bear Stearns, fifth largest in the nation, in March of 2008, and a rise in the unemployment rate through 2008 to the highest level since 2003. However, the economy was really just beginning to show recessionary affects, and by the end up 2008, the unemployment rate was the highest in the past 14 years. The losses in home values were just beginning to start, by May of 2012 nationwide home values would drop almost 35%. How did we get to this point?

Although it may be difficult to trace cause of the recession, there are many places to point the finger; unnaturally low interest rates, deregulation of both the banking and financial/investment industries, low rate of savings, the flawed model of huge bonuses for huge profits (which prompted some companies to practice irregular accounting methods), or just plain greed (both institutional and personal). Ben Bernanke, the Fed Chairman at the time of the financial crisis, once stated that "financial innovation, plus inadequate regulation, equals a recipe for disaster". With that being said, we are going to look at some of the key changes in banking regulation and examine how they have may contributed to the Great Recession of 2008.

The crisis was born from the union of deregulation and irrational risk taking. The deregulation of the banking and financing industry during the decades that led up to the crisis resulted in a tremendous amount of bad loans written by faulty underwriting standards. Subprime mortgages drove the lending industry in the early to mid 2000s, reaping large profits and bonuses for the banking industry and setting in action the in inevitable collapse. Once the collapse was triggered, the innovative financial instruments that grew out of deregulation inflated the worldwide loss of wealth. Alan Greenspan served as Chairman of the Federal Reserve from 1987-2006, during which many deregulatory laws were passed. These include the Gramm-Leach-Bliley Act (1999), the Commodity Futures Modernization Act (2000), and the deregulatory changes by the Securities and Exchange Commission (2004). This mindset of deregulation directly counters the regulatory mindset that followed the Great Depression. In 1933, the Glass-Steagall Act and the Banking Act were both passed and formally created a barrier between commercial banks and investment banks. Commercial banks could only operate within the state that they were physically situated and made money on the interest gap between which they could borrow money and then lend it to businesses or consumers. The underlying methodology was that by regulating the largest banks, they could both protect the consumer and foster a healthy national economy. The FDIC, created by the Banking Act of 1933, insured deposits as well as monitored the financial health of member banks. It may be overly simplistic, but the financial crisis of 2008 would not have occurred in this financial environment. Banks typically lent money locally and held the loans they issued. As a result, there were few, if any, risky loans. Bankers typically knew their borrowers and a smaller percentage of the population owned homes and businesses.

From this environment of regulatory financial enforcement, deregulation began at a slow pace. Changes in financial markets in the 1960s and 1970s starting the deregulatory ball rolling, leading to passage of several deregulatory laws. By the 1980s, financial deregulation picked up and the financial landscaping was rapidly changing. The passage of the Depository Institutions Deregulation and Monetary Control Act in 1980 greatly increases the probability of bank failures. The Act allowed banks to expand their lending practices along with raising the FDIC insurance limit from $40,000 to $100,000. That was followed by the Garn-St. Germain Depository Institutions Act of 1982, which allowed S&L/thrifts to provide a greater amount of loan products, including short term loans with little collateral and alternative mortgage loans, such as adjustable-rate loans. Between 1944 and 1974, an average of 10 banks failed each year. However, after the 1980 and 1982 deregulatory passages, bank and thrift failures increased. By 1985 almost 1500 banks and thrifts were in financial trouble. The deregulation of the early 80s directly led to the Savings & Loans Crisis in the late 1980s. During this crisis, approx 25% of the thrifts failed, holding over $400 billion in loans. The government reacted with a tax payer funded bailout, setting a dangerous precedent that was repeated in 2009.

The pace of deregulation picked up in the 1990s, which culminated in the passage of the Gramm-Leach-Bliley Act in 1999. The Act repeals parts of the Glass-Steagall Act and broke down the walls between commercial and investment banks. The results included rapid consolidation of banks, insurance companies, and securities firms, creating an increasingly dangerous lending environment. The lack of regulatory structure and oversight were apparent as lenders and traders begin to drive the nation's economic growth. The increased amount of loan products, coupled with a political push by the Bush administration to increase the percentage of American homeowners - especially to lower credit and income families and individuals, resulted in an increase in sub-prime mortgages.

The more reckless lending environment was also emulated by traders in the financial markets, where an environment of increasingly risky behavior became the norm. Investment companies handed out huge bonuses, further fueling the fire of elevated risk. The rise of the derivatives market, which the Commodity Futures Modernization Act of 2000 played a part in deregulating, became oversized and over leveraged. The derivatives market was nearly $900 trillion dollars in value when real estate values began to soften in 2007. As the subprime mortgage market began to experience defaults, the highly leveraged nature of derivatives, especially credit default swaps, turned what would have been a relatively small amount of defaults in to an ever expanding ripple effect through the economy. The initial hit to the housing and financial markets continued to expand out until it was affecting the general economy. What was initially an estimate of a $500 billion dollar hit to the financial and housing markets by September 2008 (as estimated by Forbes Magazine) turned into a $13 trillion drop in the collective wealth of America and it's citizens. The large multipliers created by the derivatives market turned the bad mortgage loans into a disaster for the entire economy. The very derivatives created by the 2000 Commodity Futures Modernization Act were basically hedges against the defaulting loans, and could have been absorbed by their issuing institutions if they had been used scarcely. However, as the quality of loans being written through much of 2003-2007 were declining, more and more credit default swaps were purchased to help offset the chance of default, and the issuing institutions, particularly Bear Sterns, Morgan Stanley, and AIG, struggled with liquidity as the market began to implode. JP Morgan also was a major issuer of credit default swaps, but had the liquidity to cover their initial losses, in so much so that they purchased Bear Stearns when they failed in early 2008.

How could these companies be allowed to 'bet' so heavily in mortgage backed securities that it could endanger the economic health of the nation? The deregulation of the financial markets brought about lax or even negligent oversight, particularly in the more complicated and ever evolving derivatives market. These hedges against default were a major source of income and helped fuel ever growing corporate profits (and resulting bonuses) for companies that issued them. The derivatives and other mortgage backed securities were part of a 'shadow banking system', where the movement of money helped facilitate the hiding of risk with ever increasing leverage. The relative short-term increase of capital provided by credit default swaps and collateralized debt obligations were just a shell game, moving risk from one place to another, and significantly increasing the risk and speed by which the securities could deteriorate were a recipe for disaster. The derivatives provided liquidity and capital that was not regulated and not bound by capital reserve requirements. Basically, banks ended up having increased leverage, but at the expense of having increased risk and increased debt. The result was a financial market that was on the verge of collapse.

It is clear that deregulation played a significant part in the Great Recession. Deregulation, coupled with artificially low interest rates, and irrational expectation of real property as an investment created a blizzard of bad debt. This bad debt, coupled with deregulation in the financial markets that allowed creation of creative financial instruments, shook the economy, both nationally and worldwide. The regulation brought about in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act is the most comprehensive regulatory reform since Glass-Steagall and is intended to have widespread effect on the financial markets. Although there is criticism about what kind of effect the new regulation will actually have, the intent of the Act is secure the markets and provide some safety for the general economy. If increased regulation can reign in the complex financial instruments in the 'shadow market' and the commercial and investment banks, perhaps we can avoid future financial meltdowns in the future.

E.R., Extra Credit, Spring 2014
Credit Default Swaps

In the first part of the final, we discuss that credit default swaps played a part in the Great Recession. How do credit default swaps (CDS) work? CDS are basically an insurance policy against the potential default of a loan. Party A lends money to Party B, then takes a CDS from a third party, Party C. If Party B defaults on the loan, Party C makes a payout to Party A to help cover the loss of the default. The payout can be the full face value of the loan or a smaller portion, depending on how the CDS is structured. If they payout is made, Party C then becomes the owner of the defaulted loan. However, the purchaser of the CDS does not necessarily have to be involved in a loan. A fourth party, Party D, which has no interest in the loan between Party A and Party B can purchase a CDS against the loan. The result is that while it is commonly called insurance against default, the CDS can be more aptly viewed as a short against the loan, allowing investors to bet that a particular loan can default.

CDS were initially created in 1994, but it wasn't until 2000, when the Commodity Futures Modernization Act deregulated the financial markets that CDS begin to grow in popularity and size. In 1998, CDS were a $180 billion dollar market. However, by 2008, CDS had grown to an overwhelming $57 trillion market. The initial idea that a CDS can be purchased to help mitigate the risk of higher risk appealed to banks and companies that dealt in mortgage backed securities on the secondary market. The companies that issued CDS were paid a regular premium payment and helped inflate profits. The banks that purchased CDS were more and more willing to write loans that they knew were bad, knowing that the CDS would help mitigate the potential risk. Because the issuers of the CDS were not required to put up collateral to cover them, there seemed to be an unlimited supply to feed the increasing demand from banks that were more willing to write bad loans. This ever increasing whirlpool of creative financing created the leverage that turned a down housing market into a financial disaster that affected the entire economy.

D.Q., Fall 2014

The 1933's Glass-Steagall Act, was created and passed in order to keep commercial banking and investment banking separate, The Act was passed in reaction to the mass bank failures nationwide during the Great Depression. Under this Act a commercial bank was defined as an institution where deposits are made and through which mortgage loans and personal loans and credit cards are issued and an Investment banks were institutions that dealt primarily in stocks, bonds, debentures, notes, or other securities. On November 4, 1999, the U.S. Congress passed the Gramm-Leach-Bliley Act (GLB), the Act, is also known as the Financial Services Modernization Act of 1999. This Act now allowed previously separated "commercial banks" and "investment banks" to be owned by a single holding firm. This Act also removed conflict of interest prohibitions between investment bankers serving as officers of commercial banks. This in turn opened up a new revenue stream for financial institutions, including mortgage-backed securities (MBS), and forms of asset-based securities (ABS). MBS's were sold to investment banks, which became entitled to principal and interest payments from the pooled mortgages, and the risk of a bad mortgage was now passed from the lender onto the owner of a MBS. This later led to lenders loosening their standards so that more mortgages and more MBSs could be issued. The loosening of the standards by these lenders led to an increase in mortgage default rates. Then as if it happened all of a sudden, holders of these securities, which included a wide range of investors from major investment firms, down to the individual consumers, were left with worthless securities. ARM mortgages were pushed to the front by most lenders as the mortgage of choice to offer. These mortgages were offered and given to applicants who would not be able to pay the principal once it came due, resulting in foreclosures and bankruptcies by hundreds of thousands of borrowers, resulting in worthless secondary market securities. (The best way I could come up with to explain them)

A credit default swap is when Company "A" loans money to a borrower "B", then Company "A" insures the loan by buying a Credit Default Swap from insurer company "C", just in case borrower "B" defaults on the loan. Company "A" agrees to pay Company "C" 10% of the FV of the loan each year as a premium. And just like any other kind of insurance, if borrower "B" defaults, Insurer "C" will pay off the loan amount to company "A". Now Insurer company "C", goes and buys a CDS from insurer "D". But insurer "D" wants 15% of the FV of the loan as a premium each year. Because Insurer "C" has so many CDS's at the time, they agree to pay the 15% to insurer "D". So now borrower "B" defaults, Company "A" turns to insurer "C" and demands their money to pay off the loan. Insurer "C" turns to insurer "D" and demands their money in order to pay Company "A". If we were talking about a few hundreds of thousands of dollars, that might not be so bad, but when the meltdown started all these insures were left holding worthless bonds that they had to pay on, the dollar amounts were in the billions. So when insures "D" and "E" and "F" started claiming bankruptcy, it caused a tidal wave effect all the way back up to the original lenders.

2. Explain why a lack of ethics on the part of lenders can hurt clients, associates, and members of the public.
3. Explain why it is important to do the honest thing, as opposed to the dishonest thing in the areas you circled.
4. Explain how the burden of guilt may ruin a person's life.

A lack of ethics on the part of a lender may put a lot of people and business in jeopardy. A lender needs to be honest and straight forward with clients, associates and others he may come in contact with. The lack of ethics on the part of a lender could lead to the lender lying on an application for a loan, in order to qualify a client when that client cannot financially afford the loan, or an unethical lender could end up stealing money and trying to cover it up.

Spreading false propaganda, can hurt others if they believe what you say is true. Also someone might use false propaganda to get ahead in business by making other believe in a false risk. When someone skirts the law they show lack of concern for others in their career, and a lack of respect for law and ethics, this can cause damage to not only themselves but others around them. When someone commits fraud they are trying to get away with something they understand is wrong, and by covering it up, they risk putting someone else's career in jeopardy.

When a person is burdened with guilt, they may risk everything to try and relieve themselves of that burden. A person may begin to act unethical or even do things that are illegal. These actions could cause a chain reaction and affect others, like co-workers or family members. As this individual risks more they continues to lose more trying to rid the guilt.

L.C., Fall 2014

PART I: Economic Meltdown History

The great recession of 2008 was a perfect storm of financial disasters caused by a gradual deregulation of the mortgage and lending institutions beginning in 1999. The Gramm-Leach-Bliley Financial Modernization Act of 1999 repealed the Glass-Steagall Act and Banking Act of 1932/33. The Glass-Steagall act prohibited the affiliation of commercial and investment banking, which was put in place after the Great Depression. As this restriction was lifted, large conglomerates were formed which dealt in securities, insurance, and commercial banking. Because all of the money was held by one large organization, they were able to take greater risks in anticipation of much greater returns. Unfortunately, the losses were hidden in the big conglomerates as the accounting was not transparent.

The Commodity Futures Modernization Act is also arguably one of the biggest contributing factors to the economic crisis in 2008. This act deregulated the over-the-counter derivative transactions between "sophisticated parties" such as banks and securities firms. This allowed pension funds and other regulated institutions to make subprime loans through companies like AIG using credit default swaps. Previously, these pension funds were only allowed to lend to highly rated ( according to Moody's, S&P), low risk institutions. These companies like AIG insured these transactions so that if subprime borrower defaulted, the securities firm (AIG) would have the funds set aside to pay off the debt. Due to the massive number of defaults, these companies did not have enough funds set aside to cover all of the insurance issued. Finally, the SEC changed the Net Capital rule in 2004. This change allowed investment banks to take on higher debt ratios. That means they were able to lend significantly more money towards bad debt, without raising additional capital to be able to pay off defaulted loans. When the bad loans inevitably defaulted, banks did have the capital and went out of business, were bought out by other companies, or bailed out by the government. There were so many banks and investment firms leveraged in bad debt, that there was not enough money to go around to cover all of the defaulted loans. This perfect storm of fiscal irresponsibility led to the economic crisis of 2008-09 to which we are still recovering in 2014.

PART II: The Difference between Right and Wrong 1. Reread the statements above and circle words and phrases you recognize as dishonest. Even if you would not do these things, circle the types of breaches you see all over in the world today.

Saying that getting an education is a waste of time and effort is dishonest and ignorant. Most of the items on the list of General Categories of Unethical Behavior are dishonest: stealing, buying influence or engaging in conflict of interest, hiding important information, lying, giving/allowing false impressions, taking unfair advantage and violating rules. The other items on the list may not involve overt lying, but they still involve immoral and unethical behavior. Spreading slander is illegal ad hurtful, taking unfair advantage is immoral and might involve lies, interpersonal abuse is also wrong and hurtful. Condoning unethical actions, permitting systemic abuse, and rationalizing ethical dilemmas all perpetuate unethical behavior. The list of rationalizations are ways that unethical people are dishonest with themselves. They tell themselves lies like these to cope with their own misdeeds.

2. Explain why a lack of ethics on the part of lenders can hurt clients, associates, and members of the public.

Unethical behavior hurts everyone involved. Clients are hurt when lenders act unethically by being given loans that they are not qualified for. Just a few other examples of unethical behavior include deceptive marketing and sales, non-disclosure of important lending terms and falsifying documents to get loan approval. This people are stuck in financial obligations that they cannot meet. This puts them at risk of default and hurting their credit and being unable to borrow more money in the future. Associates are hurt when a lender acts unethically because unethical behavior by a colleague is a poor reflection on them. As the saying goes, "a rotten apple spoils the barrel," meaning that if one lender acts unethically, then people will come to assume that all lenders act in this manner. If there are loan originators who are acting unethically and end up closing a lot of improper loans, this makes their colleagues look like poor producers and puts their jobs in jeopardy as a result. Members of the public are hurt by the economical ramifications of unethical lending. Improper lending practices contributed to the recent economic meltdown, which affected a large majority of the public. Since that time, lending practices have gotten much more strict, and in some instance too strict. This punishes members of the public for the behavior of others that led to the mortgage crisis.

3. Explain why it is important to do the honest thing, as opposed to the dishonest thing in the areas you circled.

It is important to do the honest thing because it is a way to ensure helping people instead of hurting them. Being dishonest with clients can jeopardize your license and therefore your livelihood. Being dishonest will also hurt your reputation and make it less likely for people to want to work with you in the future. It will cause people to lose respect for you and you will grow to lose respect for yourself as well.

4. Explain how the burden of guilt may ruin a person's life. Please list at least four examples of how it can hurt a person to hide secrets.

One way that guilt can ruin one's life is that it can cause a person to lose trust in him or herself. Without a feeling a foundation of integrity, one would feel insecure and have a lack of confidence. Guilt can also cause anxiety and depression. Knowing that there could be consequences of what one has done that could emerge at any moment would cause unease. This person is constantly looking over his or shoulder in fear of getting found out and punished. Keeping a secret means a lifetime of covering up the improper thing that was done and having to lie constantly. Keeping up with an elaborate lie is difficult and necessarily requires telling more lies and keeping more secrets. People around this person will eventually catch on and begin to lose trust and perhaps drop out of his or her life. A guilty person would also have a fear of abandonment. This person would worry that others would find out and leave him or her. Family members would lose touch and friends would no longer reach out.

Short Answers The workbook for REA 281 asks students to write one paragraph on why the market crashed. Here are some of the student's answers:

15g. What happened to the housing market in the 00s and why did it crash? A:

A combination of deregulation, artificially low interest rates, unethical practices by many mortgage brokers and lenders lowering the standards for loan approval all contributed to the housing crash. After the dotcom crash the Federal Reserve held the interest rates very low for a long time. This made credit cheap. Lenders lowered their loan qualification standards and began issuing a large quantity of risky adjustable rate mortgages (ARM) to low-moderate income (LMI) borrowers. This made credit easy. Cheap, easy credit also attracted speculators and it all caused sudden increases in demand followed by extremely rapid increases in prices. Later, LMI borrowers would be unable to afford the mortgage payment when the rates increased. A large proportion of the risky credit was extended to two types of buyers that typically exhibit higher default rates. Americans purchased substantially more houses at much higher prices than ever before. They believed the house values would not decrease.

The government made it legal for banks, insurance companies and securities agencies to integrate into financial giants. They were free to create and sell mortgage-backed-securities (MBS). A large proportion of all MBS's were sub-prime mortgages mentioned earlier. Selling the risky debt as MBS provided funds to issue more mortgages. Then the government made it so the over-the-counter-securities known as credit-default-swaps (CDS), created and sold by these giants, were exempt from any regulatory control. This just added to the culture of greed and high risk behavior. CDS's were used to bet that MBS's would fail and the purchaser collected the difference. The CDS is probably the biggest of the many reasons for the crash being so severe. It created a demand for more MBS's and therefore, more sub-prime mortgages. Mortgage brokers, under pressure to create more loans, used unethical tactics to make it happen because there was money for them. This frenzy of risky debt being bought, sold and gambled with resulted in substantially more money tied up in derivatives than the value represented by the underlying houses. However, no one was responsible for the underlying debt. When interest rates rose and the ARM's reset, large numbers of borrowers defaulted, and the whole thing quickly collapsed.

15g. What happened to the housing market in the 00s and why did it crash? A: Although a lengthy topic with many opinions on what caused it, many of the primary causes blamed are Greed, Wall Street, Relaxed lending regulations, Real Estate Professionals who had their own interests in mind (Loan Officers ignoring lack of qualifications of applicants to get a commission, Realtors only thinking of a higher commission based on higher sales prices, Appraisers in collusion with Loan Officers, etc.), Lending to applicants who weren't qualified or did not have the ability to pay for a given loan type/loan amount, Applicants who lied about income on stated loans, Applicants who claimed multiple properties as "owner occupied" to get lower rates, Credit Default Swaps, Erroneous ratings (AAA, etc.).

15g. The crash was caused by an abundant of people that were approved for loans and mortgages that could not afford to pay them. These people where approved with the help from Fannie Mae and were able to buy properties that were out of there finance stability. The housing market spiked causing the housing prices to rise drastically and loans were higher than normal for the type of properties. Once people were unable to pay the large payments they walked away from the homes leaving a large amount of debt. The price spike is really messed the economy up. Some houses where more than double what would be normal. Once the market started to crash, the housing market was at such a low but no one could buy because with so many loans at such a high price. Multiple people filed for foreclosure all in the same period.

15g. What happened to the housing market in the 00s and why did it crash? A: I believe the crash was caused by the push of the secondary markets for mortgage backed securities. This demand resulted in lenders creating new markets through the promotion of subprime loans to marginal homebuyer. Many of these buyers lacked qualifying incomes, capital or equity to qualify for traditional mortgage loans. As a result, when the economic decline occur these subprime buyers could not avoid default.

While many will blame the buyers, I hold it was the greed of investors and irresponsible and criminal underwriting by lenders which were the foundation that lead to the crash. Once the economic market started to declines lenders realize they could profit from foreclosures through federal mortgage loans guarantee programs. [this entry by Donald Taylor, fall 2013]

15g. In the aughts the U.S. economy witnessed a tremendous housing bubble, with home prices rising in astronomical numbers from year to year. While many causes may be discussed, this student cites some of the most important and conspicuous reasons for the growth and inevitable crash. Firstly, the extremely laissez-faire approach of Federal Reserve Chairman Greenspan helped fuel an alarming growth of Adjustable Rate Mortgages, unseemly financial beasts rarely witnessed in the residential housing market prior to the late 1990s. Balloon payments buried millions of borrowers and forced them into foreclosure. Secondly, the tremendous rise in derivatives trading allowed mortgages to become co-opted as bundled trading commodities and ensured as "no lose" investments. Virtually unregulated and completely uninsured, these instruments grew in size to the point their very existences were poison to all investors associated with their inflated and unrecoverable worth. Additionally, a poorly regulated lending industry completely eschewed all prior traditional lending standards in a push to extend loans to as many purchasers as possible. This gave rise to what is now called "liar loans". These loans could oftentimes be obtained for $0 down. Thousands upon thousands contained exaggerated declarations of earning potential of borrowers and at times outright manipulated the lending process in order to procure maximum fees. There was a stunning lack of due diligence demonstrated across the spectrum and many individuals across all levels of the real estate industry spectrum were complicit in exacting trillions of dollars of damage on the American financial landscape.

15g. What happened to the housing market in the 00s and why did it crash? A: Loans were made available to parties that would not qualify under traditional lending qualifications. This was made possible by deregulation. The borrowers over extended the market, however the banks were greedy and eventually when all the sub par loan programs dried up the market crashed.

15g. What happened to the housing market in the 00s and why did it crash? A: People who could not or would not repay a mortgage with low FICO scores were given loans in the subprime loan market. The assumption was home values never go down too many people jumped into the market to make a quick buck brokers, lenders, flippers and speculators. The basic problem easy money and greed, in the end the market self-corrected.

Study Chapter 10, "The Secondary Mortgage Market" (p. 197), and explain what happened in the secondary mortgage market to contribute to the economic meltdown of 2008. It is vital that you possess a basic understanding of this history, because those who cannot remember the past are condemned to repeat it. Please write 250 words (one page, double spaced).

It could easily be summed up as "Government Backed Greed." Fannie & Freddie Mac with the backing of the government created a false sense of security. Fannie & Freddie created a liquid secondary market allowing lenders to free up more money. The secondary market increased sub-prime lending which created loans with "exotic characteristics." Loan application guidelines were lax, often without requiring anything more than stated income (which we are now seeing the government step in and go after those who committed fraud), and loans that were interest-only, negative amortization and adjustable rates. The majority of these loans were given to individuals who could not afford the home under a traditional alone but given creative financing could. Both lender and buyer hoped that the home would continue to increase in value and they would be able to refinance to a fixed rate or sell the property with a profit. When the housing market "bust" and home prices fell, buyers no longer had equity in their homes, were unable to adjust to the new loan terms and now are walking away from their homes. Now there is a surplus of homes on the market that are bank owned, a surplus of homeowners that are upside down in their loans, and those doing strategic defaults because they are considering the home a "bad investment." Educating the consumer is a portion of where we failed. Shame on home buyers for lying about their income, but lenders should have also educated the Buyers. 90% of the Buyers should never have qualified for the amounts they did. Finances should never have to get "creative or exotic" to complete the deal. Finances should be very black and white. You can afford or not. Most homeowners saw the greed just like the lenders and now we are all paying for it.

In 1938, Congress established the Federal National Mortgage Association also known as FNMA as a subsidiary of the Reconstruction Finance Corporation (RFC). The main purpose was to form secondary market support for FHA and, later VA loans. Up until the 1980s, the FHA and VA set a limit on the rate interest lenders could charge on these loans so as to keep the housing affordable. As interest rates rose, lender were reluctant to originate FHA and VA loans because of the large amount of points they would have to charge. At the end of World War II through the early 1990s, the residential mortgage and housing market went through some dramatic structural changes. In the 1960s and early 1970s, the secondary market was developed. Between 1980s up to 1990, the secondary mortgage market exploded because it was so large and pervasive that the government agencies have to get involved to dictate the types and terms of mortgages that would be originated in the primary market. Loans that do not conform to agency requirements are not available for exchange in the secondary market and will not be originated, except for retention in lender's portfolios. In the mid 1990s subprime lending became popular. Subprime loans are ones that made to a borrower who does not have a top grade credit record. Because subprime loans have a higher interest rates and these loans can contribute to higher profitability. Many lenders and agencies kept thinking that they have the federal government to back up, so they created a substantial number of subprime loans. Because of these loans the outstanding debt went up tremendously in 2006. However, the housing and mortgage market crisis that started when the housing bubble burst in 2007. The housing price bubble has been blamed on a number of factors. Some pointed at politicians and regulators, others blamed greedy speculators and regulators for keeping interest rates low. Still others pointed to the vast amount of money that was made by mortgage lenders. Well, whatever the case was, in 2008, the mortgage delinquency rate had risen to 10 percent, housing inventories were up and vacancies were at an all-time high. By the end of 2008, it was estimated that 16 percent of homeowners were "underwater" or owed more on their mortgage than the value of the house. In addition, subprime mortgages and option adjustable-rate mortgages (ARMs) were even worse at 50 percent and 65 percent negative equity.

So I think I got it figured out now from what you told me- the lenders knew the loans they made were bad but they could sell them on the secondary market cause the government allowed it and make more money. If they were making a loan that they held onto they would never do it but they sold the loan so they made money. So laws were made to create this problem then laws made to solve it. I get it now, it wasn't all the governments fault it was the lenders fault too.

The government made banks loan money to anyone even people that weren't in a financial position to pay the loan. So eventually a bunch of loans defaulted because the people that couldn't pay for the loan in the first place, guess what, couldn't pay the loan payments. Seeing what was taking place with loans allowed the observant to predict the crash, an example of someone like that is Peter Schiff. Lending to anyone that wants money and expecting to get paid back doesn't make sense. It is like letting 300lb out of shape people play in the NBA, and not expecting anyone to get hurt. Or its like giving 100lb people that don't work out 300lbs of weight to carry, eventually they're going to fall, but financial strong people can carry the weight of a mortgage. Mortgage debt reached $700 billion in 2004 and then increased another 40% into 2006 and the subprime mortgages began to reset and resulted in foreclosures. The government got involved and this kind of terrible result is usually what happens. Some people think Bear Sterns busting on 2 hedge funds had to do with the housing crash, but that was a later event not as significant as the government telling banks to loan money to anyone who asked. Nothing like the subprime mortgages has ever been done before so since there was such a radical rise in home prices because of demand its not unexpected that there would be a radical drop in home prices. What I learned from this is that when the government starts putting a bunch of money into an industry, get out soon cause its about to go down.

In 1938, Congress established the Federal National Mortgage Association also known as FNMA as a subsidiary of the Reconstruction Finance Corporation (RFC). The main purpose was to form secondary market support for FHA and, later VA loans. Up until the 1980s, the FHA and VA set a limit on the rate interest lenders could charge on these loans so as to keep the housing affordable. As interest rates rose, lender were reluctant to originate FHA and VA loans because of the large amount of points they would have to charge. At the end of World War II through the early 1990s, the residential mortgage and housing market went through some dramatic structural changes. In the 1960s and early 1970s, the secondary market was developed. Between 1980s up to 1990, the secondary mortgage market exploded because it was so large and pervasive that the government agencies have to get involved to dictate the types and terms of mortgages that would be originated in the primary market. Loans that do not conform to agency requirements are not available for exchange in the secondary market and will not be originated, except for retention in lender's portfolios. In the mid 1990s subprime lending became popular. Subprime loans are ones that made to a borrower who does not have a top grade credit record. Because subprime loans have a higher interest rates and these loans can contribute to higher profitability. Many lenders and agencies kept thinking that they have the federal government to back up, so they created a substantial number of subprime loans. Because of these loans the outstanding debt went up tremendously in 2006. However, the housing and mortgage market crisis that started when the housing bubble burst in 2007. The housing price bubble has been blamed on a number of factors. Some pointed at politicians and regulators, others blamed greedy speculators and regulators for keeping interest rates low. Still others pointed to the vast amount of money that was made by mortgage lenders. Well, whatever the case was, in 2008, the mortgage delinquency rate had risen to 10 percent, housing inventories were up and vacancies were at an all-time high. By the end of 2008, it was estimated that 16 percent of homeowners were "underwater" or owed more on their mortgage than the value of the house. In addition, subprime mortgages and option adjustable-rate mortgages (ARMs) were even worse at 50 percent and 65 percent negative equity.

Regarding Glass-Steagall

One important thing to be aware of in our economy is the way the government insures banks. It started as a reaction to the banking crash at the beginning of the Great Depression. People who put their money in savings accounts lost everything. The Glass-Steagall laws, commonly known as "Glass-Steagall," allowed the taxpayers to insure individual depositors. When they say "breaking Glass-Steagall," it means the 1999 Gramm-Leach-Bliley Act merged different types of financial institutions together. This allowed FDIC insured banks to invest in any risky thing they wanted, and force the taxpayers to pay if anything went wrong. Those changes were in place a few years before the big real estate bubble crash, and since banks sold their loans into the secondary market, they didn't care if their actions would have consequences. This led to risky investments like mortgage backed securities where most of the loans were bad.

When people lament the breaking of Glass-Steagall, this means we once again must pass laws to limit the type of investments taxpayers must insure. Most people believe the taxpayers should insure individuals, which was the point of Glass-Steagal after common folks lost their shirts in the 1929 run on the banks. The provisions of Glass-Steagal were never meant to protect billionairs and too-big-to-fail financial conglomerates. Under Glass-Steagall, if a bank fails, the customers would be reimbursed up to a fixed amount per depositor. The current amount is $250,000 per depositor. The bank executives could also be reimbursed if they have savings accounts, but other losses would not be tax payer insured.