THE INSIDE JOB

THE INSIDE JOB  

 

 

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The Recapped:

When the Lehman brothers an investment bank with a 158 year long history collapsed on Monday, September 15 2008 after failing to find a suitable buyer to bill them out, it shocked the world and the numerous individuals that had their hopes build on it went bankrupt overnight. Hours later last Monday, Merrill Lynch announced that it would be bought by Bank of America for $50 billion in order to save itself from a similar fate (Abrams, 2008). 

In response to the historic demise of these two great banking institutions, following on the heels of Bear Stearns’ government-sponsored rescue by JP Morgan, the market plummeted, hitting its lowest point since 9/11. In response, 10 major banks agreed to create an emergency fund of $70 billion to $100 billion that financial institutions could use to protect themselves from the fallout of these unprecedented financial firm failures.  

On September 17, the Federal Reserve announced that it would take control of the struggling insurance giant AIG, lending it $85 billion in order to stay afloat. A committee of state insurance regulators is being formed to oversee the break-up of the company’s far-flung empire of assets. This bailout followed the federal government-assisted rescue of mortgage lenders Fannie Mae and Freddie Mac, which received an infusion of billions of dollars of tax payer funds to avoid closing their doors. 

The landscape of Wall Street was starting to look like a war torn zone. Three of the five investment banking titans Bear Stearns, Merrill Lynch and Lehman Brothers, no longer existed, and the two left standing, Goldman Sachs and Morgan Stanley, had lost significant value and faced constraints on borrowing. 

On Monday, September 22nd, 2008 the final two contenders caved in both Goldman Sachs and Morgan Stanley required extensive assistance from the federal government to be classified as bank holding companies. The move would subject them to tighter federal regulation and would extensively limit the amount of money that can be borrowed in proportion to capital reserves. All five former investment banking giants have been laid low by the capital markets crisis stemming from exposure to sub-prime mortgage debt and the complex securities backed by it. Speculations signalled that this would be the end of the Wall Street era (Pat, 2009).

The final damage of this sub-prime mortgage crisis caused more than 26 million Americans to be out of job About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly USD $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away. Businesses, both large and small have felt the sting of a deep recession. There is much anger about what has transpired, and justifiably so. Many people who abided by all the rules now find themselves out of work and uncertain about their future prospects (U.S Financial Crisis Inquiry Commission, 2011).

The Subprime Mortgage Crisis:

To help us understand better about the subprime mortgage crisis, its occurrence was based on three fundamental conditions:

Firstly with the existence of previously over finance borrowers and investors, subprime borrowers were eager to use mortgage loans to finance home purchases. On the other hand a worldwide savings excess created large numbers of investors eager to earn the relatively high interest rates promised on U.S. subprime mortgage securities.

Secondly the catalyst of advances in technology allowed subprime mortgage securitization applied latest technology of security design and financial risk management. These allowed the expansion of a wider range of similar tools to earlier classes of high-risk securitization raging from credit card loans to natural disaster catastrophic bonds.

Thirdly when a benign and ever encouraging regulatory system and environment the various US mortgage lenders; Fannie Mae, Freddie Mac & First Alliance Mortgage Company impeded the origination of subprime loans. To make matters worse the existing system of commercial bank capital requirements provides banks with strong incentives to securitize many of the subprime mortgage loans they originated from (Dwight, 2008).

With these factors intertwine and progressing at a humongous pace the financial bubble was destined to burst. From an initial idea of building that American dream and creating that opportunity of homeownership it spun out of control which eventually spiralled to a world financial crisis.

Inaccurate Credit ratings

Credit rating agencies are now under scrutiny for having given investment-grade ratings to Mortgage backed- securities (MBSs) based on risky subprime mortgage loans. These high ratings enabled these MBS to be sold to investors, thereby financing the housing boom. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty (Elliot, 2008).

An estimated $3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or A+ mortgages) between 2002 and 2007. They were the party that performed the alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies." Without the AAA ratings, demand for these securities would have been considerably less. Bank write-downs and losses on these investments totalled $523 billion as of September 2008 (Elliot, 2008).

The ratings of these securities were a lucrative business for the rating agencies, accounting for just under half of Moody’s total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices. The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and collateralized debt obligations (CDO) securities issued by investment banks, which critics argued contributed to lower rating standards. Interviews with rating agency senior managers indicate the competitive pressure to rate the CDO's favourably was strong within the firms (Buttonwood, 2007).

Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors. Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms (U.S Securities and Exchange Commission, 2008).

(MBS credit rating downgrades, by quarter.)

Why are leaders responsible for the ethical climate of their environment?

Successful organisations or governments today are helmed by sturdy board members senior executives, ministers and politicians but it takes more than just good leaders to steer the ship to port. In fact it requires an overall team effort and implementation, which means despite the rank and file, everyone is important towards achieving the end result but as leaders they would need to lead the way.

Lee (2000) mentions that leaders are born and not made, these are unique individuals that command the respect of others and possess a sphere of influence that make others want to be part of them. We can see prominent leaders today like Steve Jobs from Apple Inc and President Barack Obama that carries a charismatic persona which sees thousands of ardent supporters rooting for them. The making of a leader depends on the individual’s characteristics and attitudes that we as individuals can associate and identify with closely. It is a wave of positivity that intrigues many to command that respect given to a leader. (Lee 1999).

Leadership is the doing process whereby one individual influences other group members towards attaining defined group or organizational goals (Greenberg & Baron, 2000). Board members and senior executives are the group of individuals that influence and set the culture that dwells within the organization. In short, the goals, vision, mission, directions and paths are weighed upon these individuals to be carried and role modelled out with reverence.

Ethics concerns with the study and identification of the behaviours, actions and standards that an individual ought to pursue. It is the assessment of moral standards and is developed actively through the use of theories and experiences. Therefore, it has relevance to the way people behave in organisations (Trevino & Nelson 2006).

There are two approaches to ethics, namely the values approach and the compliance approach. The values approach looks at being proactive and inspirational, it emphasises expected behaviours and high standards. The compliance approach on the contrary is reactive and punitive, it emphasises on required behaviour and obedience towards the law (Trevino & Brown 2004). Leaders could sometimes be seen applying these two approaches interchangeably, depending on the growth and status of the organisation

As leaders live up to the values of being an ethical individual this constitutes to the substantive basis towards ethical leadership. The biggest challenge would not just be being an exemplary steward but to transform these attitudes into behaviours despite the pressure and contention to do otherwise (Daft 2005).

In the business landscape it is challenging to ensure that ethics and values stand out amidst the fierce rivalry, competitions, meeting the quarterly key performance indexes (KPI) and profits. As moral managers, leaders too, face an uphill task of putting ethics as their forefront leadership agenda. Through the understanding of the leader’s scope of work, with work teams under them, immediate subordinates and peers, they have to role model through visible actions, recognise rewards and disciplines and constantly communicate ethics and values (Ponnu & Tennakoon 2009). 

The Key Players:

The earlier paragraph explains to us how leaders possess this sphere of influence which could cause radical changes. Whether the decision is ethical or non-ethical people will still believe and follow the leader. One of the greatest examples is Adolf Hitler; he brought the Nazi regime into power and made the German folks into believing his beliefs.

As we draw back to the subprime mortgage crisis a few leaders and men were closely linked to cause of the financial crisis. Under the Clinton administration it became federal regulatory policy to force the nation's financial institutions to abandon traditional lending standards for home mortgages, on the grounds that those standards were racially discriminatory, as African Americans and other minorities could not qualify for mortgages to nearly the same degree as whites and Asians (Ferrara, 2012).

This overregulation reached the point of forcing lenders to discount bad credit history, no credit history, no savings, lack of steady employment, a high ratio of mortgage obligations to income, undocumented income, and inability to finance down payment and closing costs, while counting unemployment benefits and even welfare as income in qualifying for a mortgage.

The other man George W Bush was also part of the puzzle. Under the Bush treasury supported a cheap dollar policy, falling for the Keynesian fallacy that a low dollar helps the economy by promoting exports. That cheap dollar monetary policy further inflated the housing bubble because it generated flight into real assets to escape the depreciating greenback. Because real estate is an especially long-lived asset, its market value is especially boosted by low interest rates.

When the Federal Reserves finally realized it had to rein in its loose monetary policy, or risk soaring inflation, skyrocketing housing prices slowed, flattened out, and then tipped into decline. The steep decline in housing prices produced chaos throughout the financial industry in the U.S., and ultimately the world, as widespread financial assets based on housing collapsed in value (Jon, 2008).

Ben Bernanke the Federal Reserve Chairman has also been in the lime light along with his predecessor Alan Greenspan for making the wrong decisions and the cover ups over the US financial crisis. Reports have shown evidence about Bernanke’s biggest blunders he has made mounting up to the Bubble burst. He mentioned in March 2007, saying subprime was contained but in fact it was escalating beyond controls. Then in July 2008, he claimed that Freddie Mac and Fannie Mae were in good financial control, but the truth was that they were on the verge of bankruptcy (Barr, 2011).

As these three men were being highlighted they had accomplices like the CEO’s of the 5 big investment banks and also the American International Group (AIG) to go along with. The fact that they were mentioned because they were the country’s leading frontman. The hopes and trust of the people were place in their but it seems that their actions and plans seems to be a cover up for each wrong moved made. So was it a brilliant plan that these men were implementing or was it just a cover up for the ugly truths they have made?

Extension Portion:
A brief introduction to Fannie Mae and Freddie Mac

Fannie Mae was introduced to the world in 1938 and is the name given to The Federal National Mortgage Association. It was founded following the financial worries that the Wall Street Crash of 1929 created as part of The New Deal, which was a series of economic programs implemented in the United States between 1933 and 1936. Despite being publicly traded since the late 1960’s, Fannie Mae is a government-sponsored enterprise that’s key objective was to ‘expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS)’.The Federal Home Loan Mortgage Corporation, otherwise known as Freddie Mac was established in 1970. As another GSE, the objective of this organisation was to ‘buy mortgages on the secondary market, pool them, and sell them to investors as mortgage-backed securities on the open market.’ This process was to increase the amount of money available for lending and therefore allow more people to get mortgages.

The hands that was played

Initially, Fannie Mae and Freddie Mac were able to increase home ownership rates in the United States due to the funds that they were able to free up using mortgage-backed securities. This gradual increase suited the people of the United States, and tied into the concept of the American dream. This period of time is clearly demonstrated in the cartoon as the ‘elves’ are preparing their presents for everyone in the workshop. The atmosphere is a happy one that depicts the positive emotions of the time and the growing economy.

In order to achieve this however Fannie Mae and Freddie Mac used many of the privileges bestowed upon them as the result of their GSE status. One key privilege that they had was that the treasury was allowed to buy up to $2.25 billion of securities from each of the organisations in order to support liquidity. Fannie and Freddie's GSE status created certain perceptions in the marketplace, the first of which was that the federal government would step in and bail these organizations out if either firm ever ran into financial trouble. This was known as an "implicit guarantee". Fannie and Freddie's GSE status created certain perceptions in the marketplace, the first of which was that the federal government would step in and bail these organizations out if either firm ever ran into financial trouble. This was known as an "implicit guarantee". Another benefit of their status was also that they were exempt from state and local taxation. Despite representing numerous organisational bodies, the ‘elf’ at the end of the production line in the cartoon also represents the government’s willingness to approve and support Fannie and Freddie in their efforts. In particularly he represents the Department of Housing and Urban Development (HUD) that was responsible for monitoring, limiting and enforcing their general housing missions.
This competitive advantage that being a GSE gave Fannie Mae and Freddie Mac allowed them to be extremely profitable for over 20 years. Over this time-frame several arguments arose about whether this was in the interest of the companies associated or the U.S homeowners that may not have got a mortgage under normal market conditions. The cartoon represents this debate through the use of a Christmas setting. Despite the good intentions that drive the giving of goods on a special day, it is also renowned for being pressure-bomb due to the stress level and complications involved.
Regardless of what was the main drive behind the growth of Fannie Mae and Freddie Mac, they were ultimately put in a situation that would allow them to monopolize the U.S secondary mortgage market due to their GSE status and their ‘implicit guarantee’. This would later greatly contribute to the infamous credit crunch of 2008.

Fannie Mae and Freddie Mac grew very large in terms of assets and mortgage-backed securities (MBSs) issued. With their funding advantage, they purchased and invested in huge numbers of mortgages and mortgage-backed securities, and they did so with lower capital requirements than other regulated financial institutions and banks.

Figures 1 and 2, below, produced by the companies' former regulator, the Office of Housing Enterprise Oversight, show the incredible amount of debt issued by the companies, their massive credit guarantees, and the huge size of their retained portfolios (mortgage investment portfolios). U.S. Treasury debt is used as a benchmark.

Figure 1

Source: Office of Federal Housing Enterprise Oversight

Figure 2

Source: Office of Federal Housing Enterprise Oversight

The growth of these two organisations was to bring much heat from their rivals. This was mainly due to the benefits that both Freddie and Fannie received as part of their ‘GSE package’. Much to the dismay of their competitors Freddie and Fannie were able to retain this status despite being red flagged by many of their critics. They were able to do this by hiring legions of lobbyists and funding non-profit organisations in order to influence members of the U.S Congress.

Eventually, Wall Street rivals began to create new types of mortgages in order to be able to gain a competitive edge with Freddie and Fannie. In turn this spurred them to establish a liquid and expanding market in mortgage products tied to short-term interest rates. These adjustable-rate mortgages were sold to borrowers as loans that the borrower would refinance out of long before the rate and/or payment adjusted upward. They frequently had "exotic" characteristics such as interest-only or even negative-amortization features. As Fannie Mae and Freddie Mac saw their market shares drop, they too began purchasing and guaranteeing an increasing number of loans and securities with low credit quality.

The web grew as other parties got hungry for a piece of the cake. Investors, funds and governments from all over the world were tied up in this ever growing ‘web of money’. The scale of the crises that would ensue worldwide is also demonstrated in the cartoon through the concept of Santa Claus distributing his presents world-wide down every chimney of every family.

It was not until 2006 that the penny dropped. The party would soon be over when house prices stalled and then fell, crashing to the ground.

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Hi valued reader (Add oil),

I refer to the comment which you have mention in your comment which we do not really get what you were exactly referring too; “The only thing you forgot to mention was how the banks after lending credit to would be F rated people….”??? We hope to hear from you soon as you repost your queries. Have a good day ahead.

Hi Bway Junkie,

If may refer to ‘40041500another perspective’, I guess this fellow reader has answered your perspective in why the people are not to be at blame. Yes we agree to a certain extend it takes two hand to clap but we have to keep in mind who the masterminds were. If the masterminds had not tossed the baits would the people have bite on it? Secondly what’s really shocking is that the masterminds which were none other the government, leaders of the banks already knew what the end result would be like and they allowed for it to happen. But anyway we thank you for giving us a good perspective from your angle. Hope to hear from you soon. Have a blessed day aheadJ

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Reference List:

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2. Barr, C. (2011, February 1^st). Bernanke’s Biggest Blunder. Fortune, CNN Money. Retrieved from http://finance.fortune.cnn.com/2011/02/01/bernankes-biggest-blunders/.
3. Buttonwood. (2007 September 6^th). Credit and Blame: The rating agencies operate on Shaky Foundations. Retrieved from http://www.economist.com/node/9769471?story_id=9769471.
4. Daft, RL 2005, The Leadership Experience, 3rd edn, Ohio, Thomson South-Western.
5. Dwight, J. (2008). The U.S Subprime Mortgage Crisis: Issues Raised and Lessons Learned. Retrieved from http://finance.fortune.cnn.com/2011/02/01/bernankes-biggest-blunders/.
6. Elliot, B. S (2008, September 24^th). Bringing Down Wall Street as Ratings Let Loose Subprime Scourge. Retrieved from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ah839IWTLP9s.
7. Elliot, B. S (2008, September 25^th). `Race to Bottom' at Moody's, S&P Secured Subprime's Boom, Bust. Retrieved from http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ax3vfya_Vtdo.
8. Ferrara, P. (2012, January 01^st). Bloomberg Hides Government Causes of Financial Crisis. The American Spectator. Retrieved from http://spectator.org/archives/2012/01/04/bloomberg-hides-government-cau/2.
9. Greenberg, J & Baron, R 2000, Behavior in Organizations: Understanding and managing the human side of work, 7th edn, Upper Saddle River: Prentice-Hall.
10. Jon, B. (2008, August 06^th). The woman who called Wall Street's meltdown: Star bank analyst Meredith Whitney says the economy is about to sink into a deep recession. Fortune, CNN Money. Retrieved from http://money.cnn.com/2008/08/04/magazines/fortune/whitney_feature.fortune/index.htm.
11. Lee, K.Y. 1999, The Singapore Story: Memoirs of Lee Kuan Yew. New York, Prentice Hall.
12. Lee, K.Y. 2000, From Third World to First: The Singapore Story: 1965-2000. New York: HarperCollins.
13. Pat, R. (2009, Feburary 27^th). New theories attempt to explain the financial crisis. Retrieved from http://moremoney.blogs.money.cnn.com/2009/02/27/the-financial-crisis-why-did-it-happen/.
14. Ponnu, CH & Tennakoon, G 2009, ‘The Association between Ethical leadership and employee outcomes- the Malaysian Case’, Electronic Journal of Business Ethics and Organization Studies, vol. 14, no. 1, pp. 21-31.
15. Trevino, LK & Brown, M 2004, ‘Managing to be ethical: Debunking five business ethics myths’, Academy of Management Executives, vol. 18, no.2, pp. 69-81.
16. Trevino, LK & Nelson, KA 2006, Managing Business ethics: Straight talk about how to do it right, 4^th edn, John Wiley, New York.
17. U.S Financial Crisis Inquiry Commission. (2011). Final report of the National Commission on the causes of the Financial and economic crisis in the United States. Pursuant to Public Law 111-21. Retrieved from http://www.gpoaccess.gov/fcic/fcic.pdf.
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THE INSIDE JOB TRAILER: 

If you are interested to watch the full movie we have found a link which allows you to view the full movie without any interruption: (http://www.theotherschoolofeconomics.org/?p=2499)

Hope you guy had a good time reading this blog, we look forward towards hearing your comments. Have a good day ahead and God bless:)