Case Study: Willful Ignorance and the Subprime Mortgage Crisis

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Subprime Mortgage Crisis

Much ink has been spilled in the aftermath of the Great Recession, which was spurred on in large part by the greed and ignorance of the major players on the financial stage. Unfortunately, it becomes a cautionary tale of what can occur if individuals and institutions look ONLY to their own interests and do not consider at all the catastrophic consequences such actions leave in its wake.

It seemed that no one, from the major banks, insurers and ratings agencies down to the mortgage brokers and homebuyers,cared about the long-term devastating impact to the global economy in general and to themselves in particular. One of the biggest culprits of the financial meltdown from 2007-2010 was associated with the mortgage crisis. A brief discussion of the majorevents that lead to the implosion of the global economy is warranted.

Prior to the securitization of debt (which will be discussed below), banks traditionally would lend money --via mortgages or a line of credit --to customers who were depended upon to pay the funds back at an agreed-upon time. Since most banks kept the mortgage or notes until maturity, it was critical that both the borrower was solvent and trustworthy and that the asset being mortgaged was stable and valuable enough to satisfy the note should it become repossessed.

Starting in the 1970s, banks discovered that it was far more lucrative to sell financial products securitized by a bundle of mortgages to the public and other financial institutions. These products were also known as mortgage-backed securities (“MBSs”). If there was interest or dividends due to the MBS investor or they wanted to be redeemed out, the Banks would need to rely on a steady cash flow from borrowers consistently paying off their mortgages. The beauty of this scheme is that poor-quality mortgages –known as subprime –could be mixed in with AAA rated mortgages without significantly impacting the MBS holder’s risk of loss under the theory that the underlying assets were diversified. It seemed that the public’s appetite for MBSs was endless, and many of the major financial institutions were happy to rake in the profits. There were also some other players indirectly benefitting from the MBS golden goose: insurance companies who gleefully received billions in premiums in exchange for insuring what they considered the unlikely event of loss should certain tranches of mortgages underlying the MBSs fail. These products were known as “credit default swaps” or “CDSs.” There were infinite permutations and secondary markets of the MBSs and CDSs and many came to the party. What many people failed to realize was that billions of dollars of “wealth” all hinged on whether the underlying assets –the bundle of mortgages ---were current and the houses which they secured had at least as much or more value than the money that was owed on them.

Unfortunately, a catastrophicnumber of mortgagesdefaulted, causing the MBSs to drop tremendously in value. Those owning the MBSs sustained direct losses, as did the insurance companies that underwrote them. Storied firms such as Lehman Brothers and Bear Stearns disappeared or were swallowed up by others. Massive lay-offs and the freezing of the credit markets caused the economy to go into a death spiral. Ordinary citizens who had little to do with the mortgage crisis found themselves as collateral damage. Most of us know of friends, relatives and perhaps yourself who experienced loss of job, reduction in wages, and tremendous financial stress. No one was unscathed.

What were some of the factors, which led to this monetary Armageddon?

Mortgage companies

such as Countrywide who were willing to lend money to individuals who were either not credit worthy or simply did not have the income level to support large mortgages. These companies knew they could underwrite faulty loans and profitably unload them on conglomerates who were repackaging them and selling them off in pieces via the CDOs. NINJA (No income, no job, no assets) loans, subprime mortgages, “liar” loans and unconscionable adjustable rate mortgages ultimately became some of the instruments of destruction.These mortgagecompanies neither knew nor cared whether the loans would go into default because it would not be their problem once the asset had been peddled to someone else.


such as the Office of the Comptroller of the Currency and the Office of Thrift Supervision which looked the other way even when the attorneys general of some of the states reported predatory real estate financing by several of the banks.


such as Goldman Sachs, Lehman Brothers, Bear Stearns, Citibank and JPMorgan, who recklessly purchased these mortgages and essentially foisted them upon investors even though an even cursory review would have revealed that the MBSs would be based on financial quicksand. These financial institutions also carried an enormous amount of debt comparedto their equity, in some cases 40-to-1. This created the situation where even a modest decrease in the value of the bank’s assets would almost immediately cause insolvency.


such as AIG who recklessly issued policies via the CDSs without performing due diligence. The losses sustained during the meltdown were greater than they had resources to cover The US taxpayers ended bailing out most of these insurers via the billions injected by the Federal Reserve.

Ratings Agencies

such as Moody’s Standard & Poor’s and Fitch’s which allowed their clients to “buy“ excellent ratings on these investments. The purpose of the agency ratings is to indicate to the investing public the risk level of financial product, and in theory these ratings are supposed to be impartial. However, the investment’s sponsor was the one having to pay for the analysis. As a result, agencies would obligetheir customers with inflatedratings in fear of losing their business Investors therefore bought MBSs and other derivatives –and insurers issued CDSs—based on these strong ratings not knowing or perhaps caring that they were taking on far more risk than they had anticipated.

Freddie Mac/Fannie Mae

strayed from their original purpose of being the purchaser and/orinsurer of last resort for troubled mortgages. Originally, these entities were designed to be a mechanism for keeping capital smoothly flowing into the lending market. Due to misguided governmental expansionist policies, Freddie and Fannie became willing dumping grounds for these home loans that would have never happened had the lender been completely accountable for the losses. When a critical number of the mortgages that had been guaranteed started to go into default, Freddie and Fannie experienced huge losses. They were then unable to continue purchasing any more mortgages, resulting in a freezing in liquidity and adding precipitous momentum to what became the Great Recession.


who were willing to borrow up the limit all the money the mortgage companies were offering even though common sense would have easily shown that they did not have the personal wherewithal to support the debt. Many people allowed the promise of sudden riches by “flipping” houses cloud their judgment and sign on to loans that were unsustainable. One could argue that had individuals not been enthralled by the idea of owning their “dream home” or by greed of quick success, they would have borrowed only a sensible amount. The real estate bubble may not have been as dramatic, and perhaps the implosion of the economy would have been far more muted.

What becomes obvious in reviewing this debacle is that all the characters involved were acting almost entirely in their own interests and were indifferent as to how their individual callous and unethical behavior would collectively bring the world economy nearly to a complete collapse. In the interim, many individuals who had nothing to do with the mortgage shenanigans were indelibly affected through loss of job, home and family.

Suicide became more prevalentas some people became increasingly more desperate as the Great Recession dragged on. It can be argued that those parties who willingly participated in what many people described as a mortgage Ponzi scheme have blood on their hands.

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