Week6

At lest 2 pgs in length, and specificallyand personally reflect on the prompt.

1. Consider the following statement and explain the relationship between legal compliance on a global level and the ethical responsibilities of accountants and auditors: "Ethical values and legal principles are usually closely related, but ethical obligations typically exceed legal duties.".
2. Read (26) Open House and answer the question below:
   • How did mortgage securitization change lending officers' mindsets?
   • How did the "issuer pays" business model createa inherent conflict of interest for credit rating agencies such as Moody's and Standard & Poors?
   • Describe the conditions in 2006 that created the potential for economic collapse.

Reading of Case: Open House:

Fannie Mae and Freddie Mac ... made it possible for mortgage originators like Countrywide to overtake the dying S&L industry as the country's primary mortgage lenderthus keeping the mortgage spigot open even as the thrifts were shutting down.Bethany McLean and Joe Nocera1

The American thrift industry never fully recovered from the savings and loan crisis described in Chapters 10-13. Between 1990 and 2009, the number of regional and local banks and thrifts shrank from 15,000 to 8,000 while the number of regional and local credit unions shrank from 13,000 to 7,500.2 The declining numbers were caused primarily by smaller institutions merging with each other or being acquired by larger institutions. During the 1990s and 2000s, a few financial behemoths came to dominate an industry that had previously been characterized by large numbers of relatively small, independently owned institutions.

Several factors led the American financial services industry to consolidate. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 repealed restrictions on interstate banking, allowing federally chartered banks to open branches throughout the country. Five years later, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (FSMA) repealed key provisions of the Glass-Steagall Banking Act of 1933. For more than 65 years, Glass-Steagall had segregated banks, investment banks, broker-dealers, and insurance companies. The FSMA allowed mergers among different types of financial institutions, enabling the creation of financial "supermarkets" that could meet all of a customer's needs under one roof. The 1999 law also permitted depository banks to trade securities on their own behalf, blurring the distinction between depository banks and investment banks.

For most of the twentieth century, financing a home was a fairly simple transaction between two parties. The homebuyer visited her neighborhood bank or savings and loan, and applied for a 30-year fixed rate mortgage. The lender held the loan until maturity, earning interest month by month over the mortgage's life. The lending process grew more complicated toward the end of the century. By 2007, a home financing transaction might involve a borrower, a mortgage broker, a loan originator, a guarantor, a securitizer, an investment bank, a credit rating agency, and multiple investors. Each participant added complexity and introduced new risks of error.

Fannie and Freddie: The U.S. Congress chartered the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1938 and 1970, respectively. Their primary function was to buy loans from banks and thrift companies, giving the lenders capital with which to make more loans.

Fannie and Freddie often securitized the loans they purchased. That is, they assembled the loans into pools and issued mortgage-backed securities (MBSs). MBSs are bonds that pay out the cash flows from a pool of mortgages. In the simplest form of MBS, the pass-through participation certificate, all interest and principal payments collected from the mortgage borrowers (less a servicing fee) are distributed to the MBS investors each month. More complex MBSs divide the cash flows from the original loans into tranches (French for "slices"), with the rights to each tranche sold to a different set of investors. Like a cascading waterfall, mortgage payments flow into the top tranche. Subsequent cash receipts spill into lower tranches as each upper tranche fills. If too many borrowers default on their mortgages, there might not be enough cash to fill the lower tranches. Tranching makes MBSs attractive to a wide range of investors. Conservative investors purchase the relatively secure upper tranches. Hedge funds and other aggressive investors buy the lower tranches, which pay higher interest rates to compensate for the greater default risk.

While selling most of the MBSs to insurance companies, pension funds, and other financial institutions, Fannie Mae and Freddie Mac retained some of the securities in their own investment portfolios. During the 1990s, Fannie and Freddie made a strategic decision to keep more of the mortgages they purchased. The MBSs provided a rate of return above Fannie's and Freddie's cost of capital, making it profitable for them to hold the securities as investments. Fannie Mae's loan portfolio grew from $156 billion in 1992 to $415 billion in 1998.3 At the turn of the century, Fannie Mae was the third largest corporation in the U.S., ranked by assets. Freddie Mac was not far behind.

Wall Street Investment banks' traditional role was helping businesses raise capital. For a fee, investment bankers matched would-be borrowers with willing lenders. Alternatively, investment banks underwrote new issues of stocks or bonds. In the role of "underwriter," investment banks purchased stocks or bonds from issuing clients and resold the securities to insurers, pension funds, and other investors.

Over time, investment banks became involved with every step of the home financing process. They loaned money to mortgage originators, bought the resulting mortgages, securitized the loans into MBSs, sold MBSs to investors around the globe, and retained billions of dollars of MBSs in their own portfolios. In 1983, Wall Street bankers issued only $10 billion of "private label" MBSs compared to nearly $230 billion issued by Fannie Mae and Freddie Mac.4 A year later, the Secondary Mortgage Market Enhancement Act (SMMEA) made it easier for private companies to market their own MBSs. By 2005, the volume of private label MBSs issued by Wall Street financial institutions surpassed Fannie Mae's volume.

Investment banks took the concept of securitization one step farther by creating a new type of asset-backed security called a collateralized debt obligation (CDO). Whereas MBSs were supported by pools of residential mortgages, CDOs were collateralized by pools of diverse assets such as residential mortgages, commercial mortgages, corporate bonds, automobile loans, and even credit card receivables. Wall Street banks earned enormous underwriting fees by gathering various assets, mixing them in a blender, slicing them into tranches, and selling the resulting CDOs. The recipe proved so popular that sales of CDOs increased from $69 billion in 2000 to roughly $500 billion in 2006.5

After spending decades helping clients raise capital and invest their savings, the big banks decided during the 1990s to apply their financial acumen to managing their own investments. They built large portfolios of investment securities for the purpose of earning interest, dividends, and capital gains. Securities trading replaced underwriting as the banks' main profit center. Goldman Sachs, for example, earned 75 percent of its profits from trading in 2004, compared to 6 percent from underwriting.6

Expanding their asset portfolios required the banks to simultaneously expand the right side of their balance sheets. Even after the investment banks converted themselves from partnerships into publicly traded corporations, equity capital remained scarce. Almost all their asset purchases were financed through debt. And because the interest rates on long-term corporate bonds were relatively high, the banks chose to finance themselves through short-term sale and repurchase agreements ("repos"). In a repo, one party sells marketable securities to a second party while promising to repurchase the securities at a later date, at a higher price. The substance of the transaction is a secured loan. The seller/borrower receives cash today and repays a higher amount of cash at a fixed date in the future. The difference between the initial sale price and the subsequent repurchase price is simply the interest on the loan. The marketable securities, which are transferred temporarily from the seller/borrower to the buyer/lender, act as collateral for the loan. If the borrower is unable to repay the loan, the lender can keep the securities. Repos expose the lender to little default risk because they are fully collateralized by marketable assets. And there is little interest rate risk because the repos are typically for terms as short as overnight. Because of their low risk, repos have very low interest rates. Repos gave the investment banks a low cost of capital, but also required the banks to obtain billions of dollars of new financing almost daily.

New kids on the block: Traditional mortgage lenders obtained most of their capital through customer deposits. Banks and savings and loan associations accepted checking and savings deposits, and paid customers a modest rate of interest while holding their money. The banks and thrifts earned their profits from the interest rate spread, the excess of the rate they charged borrowers over the rate they paid depositors.

Securitization enabled a new type of mortgage company. Operating with only small amounts of capital, these nonbank lenders issued mortgages to homebuyers and quickly sold the mortgages to Fannie Mae or to private-label securitizers. Each mortgage the lenders sold provided funds for making new loans. Whereas traditional mortgage lenders earned their profits month by month over the 30-year life of a loan, these new companies earned profits primarily through fees charged to borrowers at the time of origination. As neighborhood lenders consolidated and securitization gained popularity, the market share of nonbank mortgage companies increased from 19 percent in 1989 to 52 percent in 2003.7

Securitization changed lending officers' mindsets. Mortgage companies that sold their loans had less incentive to make sure borrowers could repay the debts because the loan buyers bore the costs of defaults. Loan volume, not collectability, was paramount to lenders who earned their revenues through loan origination fees. Anxious to expand the population of potential customers and not terribly worried about defaults, mortgage companies began granting loans to customers with lower incomes and credit scores. Lenders also began waiving requirements for large down payments. Subprime mortgages (i.e., loans to borrowers with low incomes and/or impaired credit histories) often required a down payment of only 3 or 5 percent rather than the 20 percent required for conventional mortgages. As lenders sought new customers, subprime mortgage originations increased from $35 billion (5 percent of total originations) in 1994 to $625 billion (20 percent) in 2005.8

Despite the loans' higher risk, lenders had little trouble selling subprime mortgages. Congress, wanting to promote homeownership, pressured Fannie Mae and Freddie Mac throughout the 1990s and 2000s to buy more loans issued to low-income and minority homebuyers. Fannie and Freddie agreed in July 1999 to change their underwriting standards such that, by 2001, 50 percent of the mortgages they guaranteed would be loans to low- or middle-income borrowers.9 Wall Street's private-label securitizers bought subprime mortgages for their higher interest rates and included billions of dollars of subprime loans in their MBSs and CDOs.

Rating agencies Credit rating agencies evaluate debt securities and assign letter grades indicating the likelihood of default. The ratings range from AAA, meaning least likely to default, down to D, indicating the highest risk of default. Although ten companies are designated by the SEC as Nationally Recognized Statistical Rating Organizations (NRSROs), three companies dominate the market. Collectively, Moody's Investor Services, Inc. (Moody's), Standard & Poor's Financial Services LLC (S&P), and Fitch Ratings Ltd. (Fitch) issue 98 percent of all credit ratings and collect 90 percent of U.S. credit rating revenue.10

The credit rating agencies play a key role in the MBS and CDO markets. With corporate or municipal bonds, investors can review the issuing entity's financial statements to form their own judgments about whether the interest and principal payments are likely to be made on time. But an MBS may be backed by thousands of individual home mortgages. Without knowing each borrower's income, down payment, and credit history, it is impossible for investors to perform their own due diligence. The credit rating agency is essentially the sole determiner of an MBS's marketability and value.

When initially founded, credit rating agencies earned their revenue through subscriptions. Investors paid the credit rating agency a fee to receive publications containing the agency's ratings. The obvious drawback was that one subscriber, after receiving the publication, could share the ratings with any number of nonpaying freeloaders.

During the 1970s, the rating agencies began charging fees to the bond issuers and distributing their ratings free to investors. A rating agency typically received $40,000 to $135,000 to rate an MBS tranche and as much as $750,000 to rate a more complicated CDO tranche.11 After the initial fee to rate the security, a rating agency might charge the issuer an annual surveillance fee of $5,000 to $50,000 for as long as the security was outstanding.

The new "issuer pays" business model created an inherent conflict of interest. Debt issuers, who wanted the highest possible credit ratings to minimize their capital costs, selected and paid the agencies that determined their credit scores. Each rating agency faced pressure to give favorable ratings to attract more customers. Moody's, which controlled 35 percent of the MBS market in 2000, increased its market share to 59 percent in 2001 amid allegations from rival credit rating agencies that it had lowered its standards.12 In response, Moody's CEO Raymond McDaniel accused Fitch and S&P of going "nuts" giving investment grade ratings to risky securities.13

Housing Bubble: Long-term U.S. housing prices exhibited little real growth during the twentieth century. After dipping during the 1930s and surging briefly during the 1950s, inflation-adjusted home values in 1997 were nearly identical to values 100 years earlier. According to the Case-Shiller Home Price Index, which adjusts for changes in consumer prices, the average increase in relative home prices was only 0.09 percent per year between 1890 and 1997.14

After a century of relative stability, real house prices climbed 85 percent from 1997 to 2006 with most of the increase occurring between January 2000 and January 2006 when the Case-Shiller Index rose 72 percent.15 Low interest rates and easy credit contributed to soaring home prices. The Federal Reserve kept the federal funds rate at or below 2 percent from early 2002 through early 2004 to help the economy recover from the twin blows of the September 11, 2001 terrorist attacks and the Enron/WorldCom-induced stock market tumble. Low interest rates reduced borrowers' monthly payments, enabling them to bid higher prices for the houses they wanted. The growing availability of subprime loans allowed low-income families to join the bidding. The percentage of American families owning their own home reached an all-time high of 69 percent in 2004.16 Meanwhile, the number of available homes grew more slowly because of the length of time necessary to build a house. With cheap easy money fueling the demand for houses and the supply relatively fixed, prices climbed.

Sitting on Dynamite: Consider the situation in 2006. Nonbank mortgage companies, that earned their revenues primarily through loan origination fees, offered subprime loans to borrowers who could not qualify for conventional mortgages. Lending officers approved higher risk loans because loan purchasers, not loan originators, bore the costs of default. MBS and CDO buyers depended on credit rating agencies to tell them the risk of each security, but the "issuer pays" business model incentivized rating agencies to give generous ratings. Investment banks held billions of dollars of MBSs and CDOs in their trading portfolios. The banks' 30-to-1 asset-to-capital ratios meant that asset price declines as small as 5 percent could completely wipe out their owners' equity. The value of MBSs and CDOs depended on home values, but U.S. housing prices were at an inflation-adjusted all-time high with nowhere to go but down. An epic economic collapse in 2007 may not have been inevitable, but the prevalence of highly-levered financial institutions holding risky securities collateralized by overpriced houses created the potential for disaster.

Taylor, Bean & Whitaker (TBW) was one of the largest and most aggressive nonbank mortgage lenders. From 2004 through 2007, TBW originated more than 12,000 home loans per month, selling three-quarters of the mortgages to Freddie Mac and most of the remainder to private-label securitizers. When FBI agents raided TBW's corporate headquarters in August 2009, they found evidence the company had sold thousands of fictitious mortgages to the lenders who provided its financing. TBW's founder and chairman Lee Farkas received a 20-year prison sentence for his role in the fraud.

Lehman Brothers, which celebrated the 150th anniversary of its founding in 2000, was one of the largest and most highly respected investment banks on Wall Street. In 2007, Lehman held a $700 billion investment portfolio financed primarily through short-term sale and repurchase agreements (repos). The portfolio contained large numbers of mortgage-backed securities and collateralized debt obligations. Declining home prices in 2006 led to an increase in mortgage defaults and foreclosures, which caused MBS and CDO values to fall in 2007. Lehman's lenders stopped accepting its mortgage-backed assets as collateral for new loans, causing a liquidity shortage. The firm's bankruptcy on September 15, 2008 sparked a 500 point decline in the Dow Jones Industrial Average.

TBW and Lehman Brothers were only two of the hundreds of American and international financial institutions that collapsed or needed governmental support from 2007 through 2009. The three-year global financial crisis was the worst economic period since the Great Depression of the 1930s. The costly financial failures led the U.S. Congress to enact the Dodd-Frank Wall Street Reform and Financial Protection Act in 2010. The United Kingdom and the European Union appointed panels of experts to investigate whether accountants and auditors had been negligent in not helping avert the financial crisis.