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Mortgage brokers (e.g.

Terry Dyer) Mortgage brokers charge a direct fee to the borrower and get an indirect fee from the lender known as the yield spread premium. This spread is the difference between the wholesale rate for the money charged by the lender and the rate charged to the borrower after the addition of various fees. The incentive scheme of the yield spread premium created many circumstances where the brokers earned most of their compensation through this financial instrument, thus creating potential conflict of interests in favour of the lenders. When faced the trade off of finding the best loan product for the borrower and originating a loan generating the highest revenue, many brokers chose the second option. Furthermore, the originate-to-distribute model is exposed to the principal-agent problem: mortgage brokers acted as agent for investors but did not often have the investors best interests at heart. The lack of screening resulted in issuance of loans without the requirement of a down payment or proof of income. With no skin in the game, brokers had the incentive to originate as many loans as possible by encouraging household to take on mortgages they could not afford, or to commit fraud by falsifying information on a borrowers mortgage applications in order to qualify them for their mortgages. This resulted in the large issuance of loans that could not been repaid by the borrowers. Mortgage lender (e.g. Countrywide Financial) Mortgage lenders such as Countrywide Financial did not offer the same interest rate to all buyers using statistical tools and the FICO score to assess the risk of default of the borrowers. When centrals banks flooded the markets with capital liquidity it not only decreased interest rates but also reduced risk premiums as investors looked for opportunities to increase their returns on investment. In order to satisfy the demand from investment banks for loans to be structured in mortgage-backed securities, lenders lent funds to people with poor credit scores and high risk of default. With large amount of capital to lend and a booming housing market mortgage lenders had a strong incentive to undertake additional risks in order to generated higher returns. The increased use of the secondary mortgage market (in 2005, 73% of mortgages classified as having a high interest rate were sold on this market) by lenders freed up more capital for even more lending possibilities. Instead of holding the originated mortgages on their books, lenders sold them off in the secondary market to earn originating fees and pass on the risk to the investors.

Investment banks (e.g. Morgan Stanley, Merrill Lynch) Investment banks earned large fees by underwriting mortgage-backed securities and structured products like CDOs. They fuelled the demand for risky mortgages by pooling them together into collateralized debt obligations to be sliced in several tranches, rated, and

then sold to the final investors. Investment banks earned hefty fees by creating synthetic financial instruments betting on the assets they referenced without any real assets to back them up (creating unlimited potential losses for investors). Those multilayered products were given AAA rating on their highest tranches while the risk of default was much higher than government-issued bonds. Investment banks faced the principal-agent problem by having weak incentives to make sure that the ultimate holders of the securities would be paid off. Credit ratings agencies (e.g. Moody's) Credit rating agencies operate with an inherent conflict of interest as their revenues come from the institutions the whose products they are suppose to critically analyze and rate. Not only they get paid to rate the securities but they also advised their clients (the financial institutions) to design those complex instruments. They gave higher ratings to bonds that had a higher priority in the distribution of funds but very often those instruments were backed in whole or in part by subprime mortgages. Credit rating agencies had no incentive to assign tougher credit ratings to financial instruments that for a few years increased their revenues, boosted their stock prices and expended their executives compensation. Furthermore, the complexity of structured products and multiple time sliced cash flow made it very hard to properly assess the risk inherent to those instruments. Despite the fact that credit ratings for mortgage-backed securities gave information for assessing the risk, they should have never been considered as a substitute for due diligence on the part of investors. Difference between GSEs MBS & private labels MBS GSEs mortgage-backed securities have an enhanced credit quality for investors. They must meet specific underwriting criteria (loan size, documentation, loan-to-value ratios, etc.). Holders of GSE mortgage-backed securities are assured of receiving payments each month (regardless of whether the underlying homeowners make their payments) and guaranteed to receive the full return of the face-value principal (even if the borrowers default on their loans).

Private label mortgage-backed securities often include different types of mortgage loans or mortgage loan pools that do not qualify for GSE securities. They are the sole obligation of their issuer and are not guaranteed by the US government or one of the GSEs. Based on their structure, issuer, collateral and any guarantees or other factors, they are assigned a credit rating by the rating agencies.

Mortgage lenders & adverse selection There is an information asymmetry between the lender and the borrower, as the latter knows more about his financial condition than the former. Adverse selection is a risk exposure that exists before the money is lent. Without information about those seeking funds, the theory would be that the bank charges an average interest rate for every borrower. In order to reduce adverse selection mortgage lenders gather information on potential fund receivers by checking the loan applicants credit files, credit scores, employment history, and their income (with the permission of the borrowers). Requiring collateral and a certain amount of net worth also reduce adverse selection, as only those with sufficient assets over liabilities will be considered for a loan.

Do you think that securitization is the main factor that transformed the housing crash into an economic crisis ? Securitization created the opportunity for lenders to lend more as once they sold the loan to
investors they removed it from their balance sheet. Banks became highly levered, borrowing colossal amount of money to buy loans and structured them in securities to be sold to investors. The financial innovations associated with the securitization of high default risks loans led to an increase in the complexity of the products and spread the risk to the whole financial markets as many investors, pension funds and financial institutions bought AAA rated instruments backed by declining value assets.