Subprime Mortgage Crisis -situation analysis

Situation Analysis:
Following the history of the housing market it seems apparent that its growth is dependent on the macro economy such as interest rates and buying power. However, financial engineering has lubricated the market in the last few years which has lead to a phenomenal growth in the industry. Its growth was no more effected by the interest rates because subprime loans tend to be less responsive to changing interest rates. I do not find a reason that subprime mortgage crisis would not have survived the swing of interest rates if mortgage generation was not affected by moral hazards. The situation is more complex than it seems as there were frequent use of use of financial engineering such as securitization, what is called “originate-to-distribute”. This business model became a success story and begets a new form of financial intermediation. This system allowed lenders to ward off or disperse their credit risks of underlying assets over investors via markets. This market soon became favorites not only to the investors who had better returns but also to the realtors and home buyers as they were getting a better deal. But then the incentive to pass on the risk was getting bigger and no one realized that the trap they were designing will fall back on them. Stats for foreclosures are frightening but it is the cost that these house owners were paying for being greedy and speculating that the housing market will be a better investment or rising housing prices will help them to refinance their house even though they do not have enough equity to buy a house. But they never realized that all speculations have downside risk. On the other hand Investors were tempted for better returns and they miscalculated the risk involved in the MBS as the reason they had to suffer huge capital loss. Thus the complete vicious cycle was free flowing as funds keep flowing from one end to another.
Key issues:
1. Risk information of securities has been inadequately distributed between all stakeholders such as lenders, middleman arranging securitization, CRAs and investors.
2. Roles of the credit rating agencies, as there seem to be conflicts of interest as they tend to disclose inadequate information on their evaluation criteria and its validity.
3. Financial institutions and investors have failed to design a robust risk managements and disclosure procedures.
4. Moral issue related to the generation of mortgage. Little due diligence while issuing loans.
Analysis of Alternatives:
Reviewing the above mentioned issues states that the issue is not only due to the agency problems arising out of sub-prime loan generation but also due to inadequate risk management by investors. The market would not have experienced this growth if the risk evaluation was priced in the securities. Based on current situation there can be short term alternative or a long term alternative which will be useful to resolve the credit crisis in the mortgage market.
The short-term alternative of this plan is to temporary freeze the resets of mortgage rates as it will allow home owner to deal with the decline in the housing prices and at the same time it will help to arrest the numbers of foreclosures due to the higher ARM. This is nothing more than a temporary measure as it cannot be designed into the system for a longer period as it will be affected by the lending rates in the other market and sooner or later that difference in the lending rates will be priced in.
The long-term alternative is in essence, an agency re-organization scheme. Design a robust organizational level incentive schemes to minimize moral hazard which will not only check the current issue but also will ensure not to encourage similar irresponsible behavior in the future. I think that if the loans were issued with strict credit check and only those borrowers receive loans who can manage to pay their dues in time, then the issue would have never taken such a shape. Since the loan originator was concerned with the volume of the business and not with the risk involved of non-payment and this agency conflict has added fuel to the crisis.