Economic Concepts
In the world of economics, economists develop concepts and frameworks to describe the interplay of vital factors and elements of the economy. Similarly, to explain the mortgage crisis, several economic concepts are used, the first one being valued. Value refers to the value that goods and services have in exchange for other goods and services (Raychaudhuri, Banerjee & Rath, 2020). Generally, value is characterized by utility, scarcity and transferability. Before the mortgage crisis, the increase in liquidity translated to a higher demand for houses and consequently increased the value of homes.
Additionally, the ability of the banks to sum up the mortgage-based securities and resell them translates to the transferability feature of value as an economic concept. The other economic concept that is deeply explained by the documentary is wealth. While discussing the impacts of the mortgage crisis on the American economy, economists are referring to the country’s financial wealth. Financial wealth refers to the holding of money, stocks and bonds. Thirdly, the concept, which is optimization, refers to the process of using resources to overcome specific constraints and achieve maximum results (Chance, 2019). With the aim to optimizing the profits associated with the boom in the real estate industry, banks came up with the interest-only loans which were designed to entice the high-risk borrowers to invest in the sector. Additionally, the brokers who were receiving better compensation for encouraging borrowers to go for the interest-only loans were taking advantage of the situation and optimizing their gains.
Common Mistakes During the Mortgage Crisis.
In the twenty-first century, the housing and real estate industry was experiencing a boom in the United States. Based on this factor, many Americans put a lot of their investments into the industry, expecting to reap heavily. However, all that was just an illusion. In the documentary, at the end of everything, the banks were the biggest losers as the American economy went through a historic recession. Banks being the biggest losers, the loss is associated with several mistakes made by the banks. One is that they were overconfident, which made them dismiss Michael Burry’s predictions as impossible to occur (Christiano, 2017). Despite being the Capital hedge fund manager, Michael Burry was an odd individual, meaning he did not conform to the traditional presentation of the wall street individuals. He went to work in shorts and t-shirts, and he rarely wore shoes. The banks did not believe that such a person could predict the future of the real estate industry, having that they had predicted a boom.
The other group of losers were the hedge funds. These are investors whose central role is developing investment plans for protecting investment portfolios against market uncertainties and creating positive returns. During this time, the hedge funds generated a demand for securities that were based on mortgage, then paired them with guarantees (Christiano, 2017). This move was initially very productive and beneficial until the interest rates began to go upwards. An increase in the federal funds rate blew the mortgage interest rates over the roof resulting in plummeting of home prices. The massive sale of these mortgage-backed securities created the third problem; the boom in housing. The compact nature of these securities made it possible for the mortgage lenders to lower rates to encourage the new borrower to get on-board. Since it was possible to bundle these securities, then resell them, allowing for banks to have more money to lend out. However, this move led to the creation of a lot of liquidity in the market, thus creating the housing boom (Christiano, 2017).
Winning Ideas on Future of Market/Industry After the Mortgage Crisis
When coming up with the proposal on betting against the American economy, all the three groups base their works on three opinions. One of them is that “banks are stupid and don’t know what’s going on.” Before the mortgage crisis, banks relied heavily on mortgage-backed securities. They were selling off these securities indiscriminately, relying on the credit default swaps to insure them against the high risks relating to defaults, which were most probable to happen since the banks were offering interest-only loans to high-risk borrowers (Schoen, 2017). The banks were blindly overlooking the looming danger of over-reliance on derivatives. With time, the continued defaults in the interest-only loans combined with a reduction in the prices of homes and an increase in interest rates led to the subprime mortgage crisis. This move by banks to sell mortgages excessively to support the flow of derivatives is what the trio termed as a stupid move.
Secondly, while coming up with the decision to bet against the American housing market, Michael Burry based his argument on the assumption that the American housing market is built on a bubble inflated by high-risk loans (Schoen, 2017). To increase liquidity and to encourage Americans to buy more houses, the banks were offering interest-only loans that were most likely to default. The move to increase liquidity is equal to inflating a bubble. With time, the bubble eis bound to stretch to its limits and blow off. The result of this was the mortgage crisis. The third idea that won the argument was the high levels of unethical behaviour in the mortgage and real estate industry. Before the mortgage crisis, brokers were receiving higher compensations for encouraging borrowers to take the subprime loans instead of conventional loans. These brokers consciously pushed borrowers into taking high-risk loans while withholding vital information regarding risks to the borrowers (Schoen, 2017). Additionally, the process and models used by rating firms to rate mortgage-backed loans were utterly flawed.
References
Chance, D. M. (2019). Basic Concepts of Financial Risk Management. World Scientific Book Chapters, 161-218.
Christiano, L. J. (2017). The great recession: A macroeconomic earthquake (No. 17-1). Federal Reserve Bank of Minneapolis.
Raychaudhuri, A., Banerjee, P., & Rath, S. S. (2020). Block-1 Basic Concepts of Public Economics.
Schoen, E. J. (2017). The 2007–2009 financial crisis: An erosion of ethics: A case study. Journal of Business Ethics, 146(4), 805-830.