BUSINESS INTELLIGENCE Analysis and decision making
This Edition Topics Decision and risk management that led to the Subprime Mortgage Crisis Major problems that led to subprime mortgage crisis Current state of the problem About the crisis now, possible solutions Issues for an excellent implementation of the SMC solutions
Decision and Risk Management ges are characterized by higher that led to the Subprime Mortga- interest rates and less favorable terms in order to compensate the ge Crisis
higher credit risk for the loaner.
For people who may not have facilities to maintain a repayment schedule were created some opportunities, based on the idea of “equality� of loans, inclusion for the discriminated and second-chance lending. The Subprime mortga-
Actually, this was not such a big deal, the financial institutions were able to handle this, but the real problem came when American subprime and American regular mortgages were allowed to
stay in the same place of prime loans. A bundle of mixed mortgages were the basis of ABS (Asset-backed securities) making the rate of return looks gorgeous, and supported by several assumptions like the idea of permanent real state augmented prices and completely saleable assets. Many mortgages had low interest rate for the first year, and with the time the numbers of buyers that couldn’t handle the prices increased. The bursting of the inflated House-Prices Bubble, added to the fall of property valuations and to an unpredictable return rate, dropped the confidence of people into these market options, considering those like worthless “Toxic Assets”. For example a simple increase of 6 porcentage-point (from 4% to 10%) of the interest rate would cause an increase in the payment of at least 75%. All along this edition of Business Intelligence, Analysis and Decision Making magazine, you will find a methodological close-up
to the Subprime Mortgage Crisis, its causes, prospective solutions, and more based on a Decision making model proposed by Herbert Simon: Intelligence, Design, Choice and Implementation. For further information you can write your suggest, questions and calcifications at jurort@mailobs.com Herbert Alexander Simon (June 15,
1916 – February 9, 2001) was an American political scientist, economist, sociologist, and psychologist, and professor—most notably at Carnegie Mellon University—whose research ranged across the fields of cognitive psychology, cognitive science, computer science, public administration, economics, management, philosophy of science, sociology, and political science. With almost a thousand very highly cited publications, he is one of the most influential social scientists of the 20th century.
Major problems that led to subprime mortgage crisis
D
ue to the phase of intelligence from Simon’s decision making model and according to the overview of the last pages, all the events that lead to an economic depression in U.S had its origins on decisions made with several data, solution designs based on the right models but probably a wrong choice for a specific problem. Within the phase of intelligence the important deal is to recognize the problem and its causes, classify them and have a problem statement. All this causes show below leads to a problem Subprime mortgage crisis,
borrower, the first one because of the lower incomes of the borrower and poor records of paying debts, so it is for the loaner because of the higher rates to be paid. That’s the reason why these transactions were supported on Asset-backed securities, or extremely high interest rates that make for the borrowers quite difficult to pay for it in some situations, leading to lack of payments, refinancing, default, as well from the loaner with other banks.
Indeed, the subprime loans are the fasted growing segment of the mortgage market, because of the house-price boom, the ranking of these loans as if they were prime ones. Dozens of mortgage lenders declare The subprime mortgages are ris- bankruptcy in a matter of weeks. ky for both, the loaner and the
The subprime mortgage crisis has numerous causes that are identified during this intelligence process: •-Analysis of the environment • Lack of government regulation to the mortgage types, causing misunderstandings and inconvenience. • Not enough understanding. Too little oversight. Too much greed. • Methods used to recover the economy from the tech bubble and its economic recession over the 90’s. • Expanding the money supply by lowing the federal funds rates. • Increasing expending, induce the people to buy (after September 11).
-Identifying problems situations and its causes: • With low interest rates, the real estate market began to grow rapidly with a great number of sale and good prices (2002), and people saw a unique opportunity to gain access into cheapest source of equity available. • Easy and extremely high volume of credits. • Increase of leverage. • Wall Street idea of combining Prime mortgages and subprime mortgages. Wall Street spun its new financial products, which ended up being spread far and wide and were included in pension funds and international government. • Misconception of selling the risk, believing that by selling the mortgage to other institutions,
or taking it to investors the risk wouldn’t reach the originator. • Using the Asset-backed security, which is a good investment option, to implement the same model for subprime mortgage as follow:
gage brokers and the lenders and some other “Real Smarts Guys” decided to put more risk to the mortgages, opening the options of loans to Subprime borrowers with no requirements of documents, down payments or income proves (having in their assets the houses of borrowers who couldn’t continuing paying their house mortgage, default puts the assets on the bankers hands, and having on their count that housing prices “are always rising”) increasing the number of loans, with an initial low interest rate for the first year, and a higher one for the rest of the payments.
Process: Borrowers through down payments accessed to a mortgage broker, connecting them to a lender for a commission, giving the borrower a mortgage assuming that house price will increase sustainably, which will be bought to the lender by an investment banker, creating the CDO Collateral Debts Obligation, putting together safe, medium risk and risky mortgages with its rate of return for -Problem situation: each case (credit default swap), then this classification was rate • These factors wouldn’t originaby institutions like Standard and te the crisis if: The real estate Poor’s and so on, giving them a market continued to boom and status of security for investment, if homeowners could pay their these CDO got such a big de- mortgages, but as some of them mand, inducing the market to were subprime classification look for more borrowers. and have not enough income to do it, default came, this end up Then it became really profitable with an increase of foreclosures. to originate mortgages, even the The institutions became owners risky ones. Therefore the mort- of the houses, but as the supply
of their houses with high pri- the current state of the problem. ces increased, the demand fell down, this make that the prices There is nothing wrong or bad of the market did the same about the collateral debts obligations or any of the similar fiAll this causes leads to a pro- nancial products. It is a natural blem Subprime mortgage crisis and intelligent way to diversify (on the early 2007), in the pha- risk and open up capital marse of intelligence the important kets. But if a strategy or instrudeal is to recognize the pro- ment is overused or misused blem, its causes, classify them there will be a problem. In this and have a problem statement. case, the situation is like follows: -Analysis of the environment: • As the prices of the housemarket plummeted, the owners and borrowers who were still paying for their mortgages, realized that it was more profitable to stop paying and just forsake, then the institutions got lots of houses with less value, they try to sell the CDO afterwards but there was no buyers, but most of these intitutions, borrowed Current state of the proas well from abroad or from others banks millions that now blem they weren’t able to pay, and so the actors of the chain: banks, brokers, investors, funds, realising once again the phase of zed all of them assumed the risk intelligence from Simon’s decision and now they are with houses, making model here is determined
U
CDO’s or mortgages without re- • Loss of confidence in products, venues, the whole economy is fro- credit rating, investment bank, zen, and started the bankruptcies. and mortgage brokers, pension funds, banks and its loans. -Problem situations and opportu- • Low prices houses in the market nities: •Bankruptcy of funds and some -Problem Statement Since 2008 to now, the economy mortgage brokers. • Financial losses for the inves- of U.S. has been trying to stabilize again the markets, refinancing tment banks. banks, redefining house-market • Borrowers that stop paying. • Several increase of foreclosure. prices and trying to reverse as • Collateral effects on the world’s much as possible all the effects of the crisis. economy.
About the crisis now, possible solutions
U
sing the phase of design ans choice from Simon’s decision making model here is dertermined which are the possible solutions for this situation. Immediate responses to the ongoing subprime mortgage crisis, as well as long-term reforms to the global financial system are needed. During 2008-2009, solutions focused on support for ailing financial institutions and economies. During 2010, debate continues regarding the nature of reform. Here is where can be implemented a Design phase of Simon’s decision making model. Key points to this design include: • The split-up of large banks: depository banks and investment banks should be separated; whether banks should be able to make risky trades on their own accounts; how to wind-down lar-
ge investment banks and other non-depository financial institutions without taxpayer impact. • The extent of financial cushions that each institution should maintain (leverage restrictions); the creation of a consumer protection agency for financial products; and how to regulate derivatives. • Major instability in world financial markets increased awareness and attention to the crisis. • Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. • To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. • Re-capitalize ailing banks through the investment of taxpayer funds. • Focus on obtaining private sector money to recapitalize the
banks, as opposed to bank na- for lenders to assist borrowers. tionalization or further taxpayer- Other alternatives include systefunded capital injections. matic refinancing of large numbers of mortgages and allowing Solutions may be organized in mortgage debt to be “crammed these categories: down” (reduced) in homeowner 1. Investor confidence or li- bankruptcies. quidity: Central banks have ex- 5. Regulatory: New or reinstapanded their lending and money ted rules designed help stabilisupplies, to offset the decline in ze the financial system over the lending by private institutions and long-run to mitigate or prevent fuinvestors. ture crises. 2. Deeply indebted institutions or solvency: Some financial ins- As is a financial issue, it would be titutions are facing risks regar- needed to make a probabilistic ding their solvency, or ability to model, to see the effect of each pay their obligations. Alternati- measure. ves involve restructuring through bankruptcy, bondholder haircuts, 1. Lower interest rates stimuor government bailouts (i.e., na- late the economy by making botionalization, receivership or as- rrowing less expensive, Lower inset purchases). terest rates may also help banks 3. Economic stimulus: Govern- “earn their way out” of financial ments have increased spending difficulties, because banks can or cut taxes to offset declines in borrow at very low interest raconsumer spending and busi- tes from depositors and lend at ness investment. higher rates for mortgages or 4. Homeowner assistance: credit cards. In other words, the Banks are adjusting the terms of “spread” between bank borrowing mortgage loans to avoid foreclo- costs and revenues from lending sure, with the goal of maximizing increases. On the other hand, cash payments. Governments The Fed can expand the moare offering financial incentives ney supply by purchasing Trea-
sury securities through a process called open market operations which provides cash to member banks for lending. 2. Determine which banks are insolvent. Immediately nationalize insolvent institutions or place them into receivership. The equity holders will be wiped out, and long-term debt holders will have claims only after the depositors and other short-term creditors are paid off. Separate nationalized bank assets into good and bad pools. Banks carrying only the good assets would then be privatized. Bad assets would be merged into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers. 3. Suggests deficit spending by governments to offset declines in consumer spending and business investment can help increase economic activity: Economist Joseph Stiglitz explained that stimulus can be seen as an investment and not just as spending, if used properly: “Wise government
investments yield returns far higher than the interest rate the government pays on its debt; in the long run, investments help reduce deficits. 4. “One-at-a-time” or “case-bycase” loan modification, as opposed to automated or systemic loan modification. 5. A government entity should have the authority to take over a failed or failing non-bank institution and manage that institution. The regulator should attempt to find a merger partner. If no partner can be found, the entity should ask debtholders to exchange debt for equity to make the company solvent again. If none of the above works, the regulator should arrange an orderly liquidation.
So does yours??
Subprime Mortgage Crisis
For crisis like this call the Real Smart Guys
Subprime Mortgage Crisis
For crisis like this call the Real Smart Guys
Issues for an excellent implementation of the SMC solutions
I
t’s important for an excellent implementation of the solutions to keep in mind that is important the system for supporting the decisions taken. In this case, the level of strategies proposed may have enormous amounts of data, and would be useful to guarantee stability of the economy, for example having control over the financial institutions. It’s quite important at the moment of implement any strategy the comparison of the accuracy and efficiency of each of these sets of consequences.
There should be control points, Verification statements of efficiency, economy, effectiveness, management, control of requeriments for each solution, continue improvement, for example in the case of liquidity, the government may assure that the strategy implemented enhance the consumption, low the prices by a higher adquisiction hability for people. The control points should be establish after some what-if and others proves for the solutions, if this work, the economical problems should minimize.
Making the right decision is a method.
“The human being striving for rationality ans restricted within limits of his knowledge has developed some working procedures that partially oversome difficulties. These procedures consist in assuming that he can isolate from the rest of the world a closed system containing a limited number of variables and a limited range of consequences.� Herbert Simon.
In this edition.. you will find information about the Subprime Mortgage Crisis, aborded in base of the Decision Making Model of Herbet Simon. Best Regards, Jury Paola Ortiz- Business Intelligence OBS Magazine Editor