Financial Policy and the Current Economic Crisis

Introduction

For the past two years, the United States has experienced perhaps the worst financial crisis since the Great Depression. A significant factor in the demise of the financial markets was the sub prime mortgage market coupled with the enormous devaluation of housing prices. However, the housing price devaluation further exposed a fundamentally flawed set of financial transactions. Specifically, financial management of mortgage backed securities combined with dubious accounting rules, created a financial disaster.

In the article “Good-Bye and Good Riddance (to Flawed Accounting Rules), author Gordon Yale argues that flawed accounting rules camouflaged the risks involved in mortgage backed securities. This allowed companies to post dubious profits and misrepresent their true financial standing. Furthermore, Yale questions why such standard setting bodies, such as the Financial Accounting Standards Board and the Securities and Exchange Commission, took so long to recognize and act on this issue.

The purpose of this paper is to analyze how management of mortgage backed securities cause a disaster for the mortgage finance industry by discussing: the securitization of mortgages, dubious accounting rules, failure of rating agencies and the consequential impact on the finance industry.

Mortgage Backed Securities

Mortgage backed securities are asset backed securities that represent cash flows from mortgage loans. Typically, these types of securities are created when a bank or other institution sells their mortgage loans to private institutions or government sponsored agencies such as Fannie Mae and Freddy Mac. In turn these institutions sell bonds to investors.

The investors in mortgage backed securities included banks, foreign investors, hedge funds and governments.

Total of U.S. Mortgage Backed Securities. Source: Federal Reserve Bank 2009

The total number of issued mortgage backed securities is significant. According to the Federal Reserve...