The New Mortgage Landscape: Conflict of Interest
In the previous article, we understood the new mortgage landscape and how it came to redefine the lending business. We also saw how a single lender now came to be replaced with multiple entities each of who were performing one specific function required in the mortgage market.
The financial alchemists at the investment banks came to believe that they had created the perfect financial system. The idea was to keep the risk spread out amongst multiple individuals.
However, as we shall see in this article, the system was not nearly as perfect as it seemed at that time. Instead it was riddled with imperfections and flaws. These flaws were being criticized by critics. However, the voices of these critics were not heard at that time. Later when the system came crumbling down, these flaws became apparent. In this article, we will list down some of the flaws of this system.
Conflict of Interest - Originator
The originators in a traditional loan environment were very cautious about whom they lend their money to, particularly in the case of a mortgage. This is because a mortgage was a long term loan which would last for decades. Hence, the lender should have sufficient trust in the borrower.
However, in this new age financial system, trust was not required. The originator did not hold the loan for more than a few days on their books. Hence they were not really lending their money for decades. They were actually lending their money for a week or so. If the borrower did not default in this time frame (which is impossible since no payments become due) then they could make a loan to pretty much anybody and suffer no consequences.
Hence, the originators had no reason to be conservative about their lending. Each year they would try to get as big a piece of the origination market as possible with little regards as to whom they are making this loan to.
Conflict Of Interest - Servicer
Just like the originator, the servicer had no real reason to do their job dutifully. They had time bound and service level agreement bound contracts. As long as they adhered to those contracts, they would be paid in full. Since they had no stake in the mortgages, they had no incentive to collect information that could help the banks predict default rates.
Conflict Of Interest - Underwriters
The underwriters were also at the center of conflict of interest debate. In essence they were guaranteeing the mortgages. However, the investment banks were creating shell companies and corporate structures to ensure that the liabilities of these mortgages never come upon them. They were creating special purpose entities which were guaranteeing these mortgages. These shell companies were limited liability companies and had no connection to the investment banks whatsoever. Hence there was actually no one guaranteeing the loans!
Conflict Of Interest - Credit Rating Agencies
One of the biggest conflicts of interest situations was created between the underwriters and the credit rating agencies. The credit rating agencies were central to the secondary mortgage market concept. It was based on the accuracy of their ratings that the market would function efficiently. If they were of the view that a particular underwriter was going to face a credit crunch, they were supposed to reflect that opinion in that rating. However, it would not make any business sense for them to do so. This is because the underwriter is the one that had appointed them in the first place and paid them to conduct the very analysis.
Hence, giving the underwriter a bad rating would mean no repeat business and hence loss of revenue. However, if they always gave the underwriter a good credit rating that would mean loss of trust and therefore once again loss of business.
Therefore, credit rating agencies always stuck to the middle path. They would not give very glamorous ratings or very distressed ones. In this way they could maintain both their repeat business as well as their reputation.
Critics had seen this coming a long time ago. However, agencies denied the allegations stating that their analyses are accurate and reflect the true underlying position. However, once the business model fell apart, this conflict of interest became readily apparent and was heavily criticized by the media and the general population. Credit rating agencies like Moody’s and Standard and Poor’s had to orchestrate massive public relations campaigns in the aftermath to save their reputations.
The new business model had therefore not improved the mortgage business at all. In fact, it had ruined the business. This is because earlier banks i.e. informed lenders would make loans to credible borrowers.
Under the new system, all the institutions were mere intermediaries and had no interest in seeing the loan get paid off. Instead, the people making the loans were uninformed lenders in the securities market. They did not have the information required to judge the credibility of the loans. Instead, they were just making bets on the market. Also, the borrowers had purely speculative motives and very few of them were actually interested in the underlying house.
Thus, the new financial system which was riddled with conflicts of interest from the start to the end had created a massive casino out of the lending market.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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- Dot Com Bust: Starting Point of Subprime Mortgage Crisis
- Political Incentive for Home Ownership
- The Case Of Freddie Mac, Fannie Mae and Ginnie Mae
- Advantages to Freddie Mac, Fannie Man and Ginnie Mae
- Types of Mortgages
- Types of Mortgages from Borrowers Point of View
- Mortgage Products - Negative Amortization & Home Equity Line of Credit
- The New Mortgage Landscape
- The New Mortgage Landscape: Conflict of Interest
- New Age Financial Securities - Mortgage Backed Securities & Credit Default Swaps
- Collateralized Debt Obligations and Tranching
- Benefits of Collateralized Debt Obligation (CDO’s)
- Subprime Crisis: Problems Caused by Accounting
- The Self Reinforcing Housing Loop
- Integrated Financial Systems
- Credit Market Freeze
- Borrower Approach vs Collateral Approach
- How Reverse Mortgage Works ?
- Reverse Mortgage: Pros and Cons
- The Big Bust – Washington Mutual (WaMu)
- General Motors and the Subprime Crisis
- The Return of Subprime Mortgages
- The Big Subprime Bust
- Executive Compensation and Sub-Prime Mortgage Crisis
- The Big Fall: Lehman Brothers
- The Big Fall: Bear Stearns