Knowing that the loans they made were about to be bundled, sliced up, and sold off made lenders more likely to relax their underwriting standards, according to a report released Tuesday by the Joint Forum, a consortium of government financial regulators from the U.S., Europe and Asia.
Banks and financial companies that originated loans like home mortgages, credit cards and personal loans were considerably more exacting when originating loans they knew they'd hold onto.
Private securitization of home and commercial mortgages -- the bundling and packaging of loans, which are then sliced into securities for sale to investors -- grew tenfold from 2000 to 2005, reaching a peak of over $1.5 trillion in 2006, the report notes.
The regulators' findings come from a report on special purpose entities, which are legal vehicles set up to finance assets and liabilities. They are heavily used for securitization deals, like those involving mortgage-backed securities.
With investors gobbling these up during the boom, and securitization feeding lenders' hunger for ever-growing profits, loans were increasingly made for the purpose of eventual sale and securitization -- making the immediate risk of a bad loan nearly zero.
And so a flood of loans -- made without proper underwriting -- were sold into the marketplace, resulting in the subprime crisis, the global credit crunch and the recession.
The report also found that:
* Senior managers were unaware of the full extent of their firm's overall linkage to and obligations toward complex business instruments their firms created, until the market disruptions.
* Large banks didn't necessarily understand the risks better than their smaller counterparts. In fact, senior managers at small firms may have understood these risks better.
* Investors in U.S. residential mortgage-backed securities seemed primarily unaware of
issues surrounding credit quality and asset performance.
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