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Tuesday, October 25, 2011

Essay on Analysis of "Toxie"

Are you looking for an essay on toxic assets or mortgage-backed securities? Have you ever encountered the following question:

Write a five  page essay analyzing “Toxie” and any related issues connected with toxic assets/mortgage backed securities?

Below is our sample essay in connection with the essay on "Toxie"

            During the 1930s the United States first suffered the longest and worst depression in its history.  This was the period of Great Depression where the country experienced a steep decline in the production and sale of goods, increase in unemployment rate, foreclosure of mortgages, and closure of banks. The Great Depression was so bad that it affected every person regardless of his social status. 

            Several decades after the country surpassed the difficulties of the Great Depression, the United States is now facing another crisis which could be worse than the Great Depression.  For the first time since the Great Depression, many Americans are now faced with the reality that the amount of their mortgage obligation already exceeds the value of their home. (Alex Blumberg 1)          Faced with the dilemma of paying for their mortgages which are worth more than the actual value of their home many homeowners are forced to choose from the following options: to continue paying for the mortgage; to sell the property to another buyer; or to voluntarily default on the mortgage and let the banks foreclose on the mortgage. 

            One the part of banks, these assets that have lost their value are called toxic assets.  Toxic assets are assets which are held by banks which are backed by sub-prime mortgages.  The toxic assets are the primary reasons why many banks have suffered huge losses and why some banks eventually closed down.  Toxic assets are also the reasons why banks have refused to lend money to individuals and business investors.  They are also the reasons why individuals no longer have money to spend.  Business investors do no also have enough money to put up their businesses and sell their products and services to the people.  Money has stopped circulating in the economy as banks have started to hold on to their money.  

            The situation, however, could have been averted.  In fact, there were warning signs as early as the beginning of the year 2000 that the housing bubble would eventually burst and the economy will suffer.  The rampant property flipping or the fraudulent sale of property to another by one person who just acquired the property from another person should have been a warning sign for many banks. (Braga, Davis and Doig 1)  The lending of money to borrowers whose credit standing weak should have alerted many bankers.  The rising interest rates and the increase in the number of foreclosure are also symptoms of an ailing industry. 

However, the lure of the money for banks who wanted to take advantage of the real estate boom was too tempting for bankers.  Larger banks were also drooling over the number of investors who were salivating over the mortgage-backed securities which were selling like hotcakes at the time were too much of a temptation to pass up.  Many investors and bankers alike negligently decided to ignore the warning signs.  As a result, when the mortgaged-backed securities became toxic assets everybody suffered.

            As a matter of standard banking practice, a mortgage obligation is supposed to be fully secured by collateral on the house.  For example, the appraised value of house and lot at the time the obligation was entered into is $20,000.  The banks will only lend as much as 70% or 80% of the house’s appraised value.  This means that there is an excess of 20% to 30% which offsets any cost which the bank may incur in case the property is foreclosed.  If the value of the collateral increases over time the bank will earn income from the foreclosure should the borrower defaults in his mortgage obligation. Since the banks can easily sell the properties they are protected in the event that the borrowers default on their obligation. 

            Banks also have strict requirements before a borrower may be able to apply for a mortgage loan.  The borrowers are required to undergo character investigation to determine their credit history, present work, assets, and liabilities.  This process ensures that the borrowers have the financial capacity to pay the loan. 

            But there was a time when real estate was a boom in the United States.  Everybody wanted to buy houses.  Most were buying houses for investment purposes thinking that they could eventually sell these houses at a higher price in the future.  All these buyers wanted to take advantage of the increasing value of the real estate.  Because the demand for real estate was high banks started selling these mortgage loans to bigger and larger banks.  In turn, the larger banks bundled the mortgage loans and package them as an investment scheme called mortgage-backed securities. 

Essentially, a mortgage-backed security is a pool of mortgage loans that allows the investors to receive a return of their investment from the homeowners who pay their mortgage loans.  Thus, when homeowners pay their loan obligations from banks, the payment is divided among the investors of the mortgage-backed security. 

            At the time, nobody thought that the investment of buying mortgage-backed security was risky.  The investors were just thinking about the potential return on their investment which was virtually guaranteed at the time considering the real estate boom.  Since banks were making a lot of money from these mortgages, they started to open to almost everybody the mortgage loan applications.  They also relaxed the rules particularly the character investigation, proof of income, assets and liabilities.  Borrowers whose credit standing are not good or did not have sufficient income to pay off their loans were also accepted by banks.  Banks also failed to property appraise the value of the houses which allowed the fraudulent real estate professionals to inflate the value of the houses by selling them to friends, family members and business partners. (Braga, Davis and Doig 1)  Thus, when these buyers applied for a loan with the bank they were able to get a higher value for the house.  Of course, they did not have any intention to repay their mortgage obligation.  

The borrowers who had weak credit standing are called sub-prime borrowers and their mortgages are called sub-prime mortgages.   These mortgages were also sold to larger banks which also sold these mortgage-backed securities to investors.  Since these mortgages were sub-prime and risky the rate of return for the investment was also higher.  For investors, however, the risk was immaterial considering the higher return on their investment.  This is also another reason for the collapse of the real estate market.

            Logic will tell that if the interest rate is high, payment on these loan obligations will become very difficult for borrowers.  Some borrowers started to default in the payment of their monthly amortizations.  Banks started to foreclose on these mortgages.  After some time, the number of foreclosures started to increase.  The real estate started to collapse and their value started to go down.  Borrowers realized that the value of the real estate had become so low that it would no longer be wise and practical for them to continue paying on their loans. Consequently, they stopped paying their loans.  As a result, banks could no longer collect from their borrowers.  As much as the banks wanted to foreclose these mortgages to sell to other buyers they could not do so since there are no takers in the market.  It must be stressed that banks need to be liquid for it to operate.  Real estate properties are worthless to banks if they could not sell them eventually. 

            In fact, the collapse of the real estate had created a situation in the United States where even the borrowers who can pay their monthly amortization have refused to pay their banks.  Borrowers chose to default on their mortgage.  In the study conducted by the Reecon Advisors, nearly one out of ten homeowners or 9.2% or 7.4 million people are more likely to choose default. (Lita Epstein 1) Moreover, Guiso, Sapienza and Zingales (2009) in a research found that 26% of the existing defaults are strategic (p.1).  They also found that no household would default if the equity shortfall is less than 10% of the value of the house.  However, 17% of the household will choose to default if the equity shortfall reaches 50% of the value of the house. (Guiso, Sapienza and Zingales 1) The intentional failure to pay an existing and outstanding debt that is secured by a mortgage allowing banks the option to foreclose the mortgage is called Strategic Default.  There are many reasons why many people in the United States choose strategic default instead of paying for their loan.  Among these reasons are to get a lower house payment, to get out of a mortgagee, to buy a bigger house with the same payment, to move into a better neighborhood and to give the homeowner opportunity to settle his other debts. 

Since the mortgage-backed security depended on the ability of the borrowers to pay their mortgage obligation, investors started to move away from these investments.  Mortgage-backed security also started to lose their value on the market.  Consequently, larger banks have also lost liquidity since their assets are full of worthless mortgage-backed securities that have lost their value in the market. 


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