Financial Derivatives on Sub-Prime Crisis

¶ … Financial Derivatives on Sub-Prime Crisis

Impact of Financial Derivatives on the Sub-Prime Crisis

Over the last several years, the world has been struggling with a financial crisis, unlike anything that has occurred since the Great Depression. At the heart of issue, are various financial related derivates tied to what is known as subprime loans in real estate. Simply put, a derivative is financial product (based upon a contract) where the value is determined by another asset class or security. (Derivatives 2011)While subprime loans, were given to those individuals who may not have the ability to qualify for a traditional loan to purchase a home. This usually involved, the person making some kind of down payment on the property at the time of purchase (usually 10%) and they are in good financial standing with the different credit bureaus. In the case of a subprime borrower, there was usually something that prevented them from being able to qualify for a traditional mortgage (such as: low income, bad credit and someone who has large amounts of credit card debt / outstanding loans). For the larger risk, the investors in different subprime-based products were rewarded with: higher interest rates and the ability to have them adjusted upward (once the Federal Funds Rate began to rise). (Pritchard 2011) This is important, because within these two basic definitions, are the root causes of the financial crisis that is continuing to have an impact upon the world economy. As result, the aims and objectives of this project are to examine the overall effects and the how the lack of oversight of derivatives would lead to the crisis itself.

Introduction

The Subprime crisis began in late 2006. What happened was the real estate market had been performing relatively well for many years. However, since the late 1990's, the upward price appreciation and demand for real estate would increase rapidly. This would have an impact upon how properties were being sold to investors. As financial institutions wanted to offer mortgages, to those individuals who may not be able to qualify for a traditional mortgage through various loans. The idea was that there could be a low introductory rate offered to buyers, with little to money down. Since interest rates were relatively low and the economy was performing well, these kinds of products became incredibly popular during the early 2000's. (Schiller 2008) a good example of this can be seen with the total number of subprime mortgages that were sold to homeowners between: 2000 and 2006 (as this accounted for 1 million mortgages). At the time, many of the leading economists felt that the mortgage market was strong enough to withstand any kind of potential defaults from some buyers. Evidence of this can be seen with comment from Yuliya Demyanyk of the Cleveland Federal Reserve who said, "The subprime mortgage market was too small to cause big problems." (Ten Myths About Sub-Prime Crisis 2009) This is important, because it showing how the subprime crisis had a number of different working parts that all contributed to the underlying problems. As a lack of: supervision, regulation and common sense would fuel one of the largest asset bubbles the world has ever seen. To fully understand the scope of the crisis requires: examining how the use of derivatives and the lack of oversight would lead directly to the various predicaments and the subsequent recession. This will be accomplished through: conducting a literature review, looking at the role of the financial derivates market, how a lack of oversight contributed to the situation and possible recommendations about how these kinds of issues should be addressed in the future. Together, these different elements will provide the greatest insights, as to the how the U.S. mortgage market was the main contributor to: the worst global financial crisis the world has seen since the Great Depression.

Chapter 1: Literature Review

To identify the total impact that subprime mortgages would have the world economy requires conducting a literature review. This will be accomplished by focusing on three different areas to include: providing an overview of the financial crisis, how financial derivatives were utilized and possible lessons that can be learned from the research. Once this takes place, it will provide specific insights, as to what were the direct causes of the crisis and how it can be avoided in the future.

1.1: Overview of the Subprime Crisis

The piece of literature that was written by Schiller (2008) discusses the impact that subprime mortgages would play in: contributing to the financial crisis and implosion in asset values. Where, the source discusses how this crisis began with the increased amounts of deregulation that occurred in the area of finance during the 1980's and the 1990's. This would set the stage for, new derivate-based products to be bundled together and sold to investors in what is known as tranche. This is where the various mortgages would be combined into one package. Then, sold to investors offering: higher potential returns and they spread out the risk. The idea was that by offering these kinds of mortgages to investors and large institutions, they would provide another way of increasing their overall return (while improving diversification). However, the reduction in various regulations and the improvements in technology allowed these kinds of investments to be sold around the world. These two elements would cause the financial crisis to become more severe, as it would impact every nation on the planet. This information is useful, because it establishes a basic background as to the events surrounding how: subprime mortgages contributed to the crisis and the lack of oversight / regulations would help the situation to become worse. (Schiller 2008)

The article that was written by Gleason (2011), talks about the total impact of the financial crisis on the economy. This is accomplished by looking at: housing price increases, speculation and failures. The housing price increases and speculation, would work together to create the meteoric rise in home prices. Where, this caused many buyers and financial institutions to discount the overall amounts of risk. Once this took place, it meant that a host of financial institutions would face rising numbers of defaulting mortgages (placing their overall liquidity position in jeopardy). A good example of this occurred with insurance companies. Even though they were not directly selling these kinds of investments; the collapse in the real estate market would have an impact on their overall bottom line. This is because they were insuring the various mortgages against possible buyer defaults. Once these numbers began to rise sharply, is when insurance companies would not be able to cover the losses that were being seen. This is important, because it shows how the situation surrounding subprime mortgages would become more extreme (as time went by). Therefore, the information from this source is useful because it identifies various issues that affected the entire financial system.

The piece of literature that was written by Jansesn (2008), discusses the total impact of the financial crisis, by looking at the overall causes including: deregulation, the financial institutions, the economic backdrop, the stock market, greed, the rating agencies, the central banks and the risks that were posed to the system. These different elements are important, because they are highlighting how the subprime crisis was a number of factors working together, to create an implosion in asset prices. The information from this source is useful, because it is identifying the various causes and effects of the financial crisis. As a result, this can be corroborated with the previous sources, to understand the overall scope the different events that took place.

When you step back and look at the information that was examined, it is clear that the financial crisis began with deregulation and an attempt to offer consumers greater choices when purchasing a home. Over the course of time, these two factors would spiral out of control, as financial institutions became more creative in the way that were selling these different products. This would have an impact upon the economy by: interconnecting banking, insurance and other sectors together. Once real estate prices began to decline and interest rates were increasing, this would have an adverse impact upon economic growth. Where, many different institutions and investors were purchasers of numerous derivative-based subprime products. Over the course of time, this would mean that their risks increased and their liquidity positions would be placed in jeopardy. This is because, these institutions were left holding mortgages that were: in default and foreclosed properties that they could not sell. At which point, this would have negative implications on credit and their ability to withstand the financial storm. This is important, because the different sources are showing how the subprime crisis is a host of events that were interconnected (which led to the economic tsunami).

1.2: Financial Derivatives

Within the different subprime loans were a host of derivative products that were sold to investors. In this section, we review the most common and their impact upon the mortgage market. Once this takes place, it will provide the insights as to what products in particular were the main causes of the housing crisis and subsequent recession.

The article that was written by Conley (2011) discusses the impact that collateralized debt obligations (CDO's) would have upon the subprime loans. These were created in 1987, by the Wall Street firm Drexel Burnham. In this product, the investment bankers would take a number of different articles and combine them together as one investment. The various assets that were used included: junk bonds, mortgages and other high yielding investments from the debt. The idea with these different products is that the investment bank could offer customers a stated return on their investment. The way it worked is the brokerage firm would distribute each investor, the stated amount of returns that they would make off of the tranche (the CDO investment). This was derived using a complex mathematical formula that would divide the total amount of interest that was received, from the various high yielding products that were inside the CDO. At the same time, these products were promoted as way that will provide investors with a guaranteed return on their investment. Part of the reason for this, is because it was believed that by being diversified in various classes of high yield bonds would reduce the overall amounts of risk. This is from the belief that if one of the investment articles was in default, the other areas could address the shortfall that is being experienced. The problems with these kinds of investments began in 2007, when interest rates were rising on many different subprime mortgages. This would have a ripple effect upon, CDO's as many homeowner could no longer afford their mortgage payments and began to default on their loans. At which point, a whole host of assets classes inside the tranche would reduce the overall return that investors were receiving. While simultaneously, being unable to sell these investment in the open market, because they did not trade on public exchange (which made valuing them more challenging). Then, many of the different investment articles were not regulated under existing securities laws. The reason why, is because these investments did not qualify for registration under the existing legal framework. These various elements are important, because they are showing the overall way that CDO's contributed directly to the financial crisis. As they were: marketed as safe investments (providing a stated return), there was no way to sell them and they were unregulated. Over the course of time, these factors would lead directly to the subprime crisis and liquidity challenges facing these institutions. Where, they were unable to fully understand the overall risks of holding these investments and the impact that this would have on the business model. As a result, the information from this source is useful in, identifying how specifically the subprime crisis would contribute to host of economic issues.

The article that was written by Morriesy (2008) talks about how credit default swaps (CDS's) were a major contributor to the financial crisis. A CDS is an insurance contract that backs mortgage investments. The way it works, is if there is a default on the mortgage by the homeowner, the insurance company will protect the investor against any kind of losses. They were structured in a similar fashion as CDO mortgages, by utilizing a tranche and then distributing to each investor a stated amount of interest. During the height of the financial crisis, this asset class became so popular that they were valued at $44 trillion. This is twice the value of the U.S. stock market at its peak in 2007. What this shows, is how this asset class would have an impact upon a number of different financial institutions. Where, homeowners would default on their mortgages and then they would go to the insurance company to receive compensation for the losses. This proved to be problematic, as the value of the investments were significantly higher (while home prices were declining). At the same time, the inability to sell or revalue these investments meant, that the total losses would be unknown to: investors and executives at a host of different financial institutions. This is important, because it shows how CDS's would make the problem of subprime borrowers, by giving everyone the belief that they were guaranteed in the event of a default. However, due to the fact that so many were out there in 2007, this would cause the liquidity position for some of the largest banks to be placed in jeopardy. The information from this source is useful; because it shows how CDS's were one the primary causes of why the subprime crisis would affect so many financial institutions. As the investment article was interconnected to the financial system in numerous ways. Once a wave of defaults began to occur, is the point that the entire financial system would be placed at risk.

When you step back and analyze the different financial products, it is clear that both CDO's and CDS's would have an impact upon the economy. As these two different types of derivatives, were sold to investors under the belief that they were considered to be safe investment articles. Part of the reason for this, is because many investment professionals felt that they were diversified, in a host of high yielding investments that would protect everyone against sudden defaults. At the same time, the insurance protection offered on CDS' would give everyone the impression that these different products were safe. This is because they felt that in the event of a default, the insurance companies would protect them against any undue amounts of risk. As a result, the majority of investors believed that the subprime derivative-based products were safe and that the overall amounts of risk had been reduced substantially. However, beneath the surface: the sheer size of this market, the lack of transparency and the inability to sell these investments would make the economic situation worse. As there was no way to accurately determine their value when home prices are falling and defaults are rising. At the same time, the inability to sell them would mean that investors and financial institutions had no way of raising additional capital or cutting their losses in these particular investments.

1.3: Lessons for the Literature

The lessons from the literature that were examined above reveal that a number of different factors are playing an interconnected role in contributing to the financial crisis. What happened was a simple idea was started in the 1980's of: offering investors another way to receive a larger return and diversify their overall amounts of risk. This would have an impact upon how these products were sold in the future. Where, financial institutions would market them as safe way for investors to receive a stated amount of interest and reduce their overall risk. As a result, two of the most common subprime-based derivatives were CDO's and CDS's. These two investment articles were organized in tranche and would offer investors some form of protection (through diversification or default insurance). On the surface these kinds of assets appeared to be safe investments with relatively little amounts of risk. However, underneath it all, the strategies that were being used for these financial products were becoming more risky as time by. Where, investment bankers began to focus exclusively on the higher returns in subprime mortgage derivatives and the perceived levels of protection. Yet, when you look these asset classes, there should have been warning signs about the underlying amounts of risk (especially when you consider: the inability to trade these investments, understand what specific products they are using to achieve the stated return and the lack of oversight). These different elements are important, because they would set the stage for increasing amounts of risk that everyone was experiencing (without realizing what was taking place).

What made the situation worse is: globalization and improvements in technology. These two factors helped to spread these toxic assets across the globe to a host of: investors, financial institutions and governments. This is problematic, because the reduction in trade barriers and the lack of oversight of these products caused most investors to believe what they were being told. Where, they did not understand the products that they were investing in, because they were using a complex formula to show the potential returns and risks. Instead of asking questions, most assumed that this information was accurate. At the same time, these investors failed to follow up on how these kinds of assets are regulated and if they are publically traded. When you put these different elements together, this would set the stage for the financial crisis, as no one understood these investments or how they were affecting the housing market.

As a result, one could argue that the current financial crisis is the direct impact of the lack of understanding these assets and supervision on all levels. Where, these elements contributed to the spreading of these assets around the world (as their total market values would dwarf the U.S. stock market). This is problematic, because given the fact that these assets were unregulated and were not publically traded meant that a house cards was quickly developing in mortgage backed assets.

Once interest rates were being reset, was the point that these individuals would be unable to keep up with their increasing mortgage payments. As a wave of defaults occurred, leading to challenges in valuing these assets and the ability to sell them. These two factors would impact the economy, as no one from t economists to regulators were able, to understand the overall scope of the problem until it was too late. At which point, the only solution was to bail out these financial institutions or allow a wave of bankruptcies to occur. If these companies were allowed to go into liquidation; there were fears that this could create worse financial conditions, than what was experienced at the height of the Great Depression. This is important, because it is showing the total impact that subprime mortgage derivates would have on economic activity. As they became so engrained in the real estate market; that any kind of adverse changes in interest rates, would set off a tsunami of foreclosure. Once this took place, it meant that no one would fully understand the overall scope of the problem until it was too late.

Chapter 2: Financial Derivatives on the Market

2.1: A Brief History of Financial Derivatives

The use of financial derivates on the market goes back thousands of years. The earliest example occurred in ancient Greece with Thales. He came up with the idea of purchasing the rights to sell future sales of wine at a particular price (commonly called an agreed rent). This is where he would leave, a cash deposit, with another party for the right to purchase a particular asset or commodity at a stated price in the future. If there was an increase in prices, during the harvest this asset could be exercised to acquire the underlying product. However, if there was a decline in prices, the cash deposit would be lost, as the projected value of the asset by a stated amount of time was not realized. This is important, because it showing how the basic idea of derivatives was designed to provide investors with a way of speculating, about what will happen in the future (for certain assets). (Ware 2005)

Over the years, the use of derivatives would continue to have an impact upon the financial world. This is because they were often utilized, to project an increase in the value of a particular asset or as a way to protect against possible losses (through the use of put buying). As a result, a number of different derivative-based products were developed to include: forwards, futures, options and SWAPs. (Types of Derivatives 2009) a forward-based product is where one party will agree to deliver a physical asset to another (in the event that the price objectives are achieved). In most cases, this will involve either the use of commodities or stock. (Forward Contract 2011) Futures are when you are speculating that the underlying asset value will rise or decline to a certain point over a select amount of time. Options are used mainly in equities, as they allow investors to speculate and offset their risks (based upon the underlying value of a particular stock). (Options 2011) While a SWAP, is where one party will agree to pay another party a stated amount of return (interest) in the future, for investing in a particular asset class. This involves one party paying higher amounts of interest to the other, through various strategies that they are using to generate a larger return. (SWAP 2011) These different elements are important, because they show how derivatives are associated with taking large amounts of risk. Where, one party will use them to help improve their overall return or to protect themselves against some kind of uncertainty. When you put these factors together, they are showing how many different investors and regulators were overlooking the basic idea behind derivatives trading (speculation). As a result, one could argue that ignoring these obvious warning signs were the first clue that there could be problems facing the financial system (because no one was taking these different risks into account). At which point, many investors and regulators would be lulled into a sense of false security about the underlying health of the financial system.

That being said, both the government and private backed entities played a major role in creating mortgage-based derivative products. The earliest example of this occurred with the creation of the Government National Mortgage Association (GNMA) in 1971. The idea was to use this federal agency, to help improve the liquidity in the mortgage market, by having the government purchase mortgages and then repackage them (for investors). What was happening, is many of the different homeowners were having trouble purchasing a home due to the fact that the lending requirements were to strict. This often involved a person, having to save up substantial amounts of money for the down payment. Then, they must have a good credit rating to be able to qualify for the loan. The problem with this kind of strategy is that it was leaving millions of people out of the housing market. As they were unable to save the money for the down payment and their credit rating hurt their chances of receiving any kind of loan. When you put these different elements together, this meant that minorities, middle class / low income families and anyone who had any type of financial challenges were prevented from owning a home. Troubled by these strict lending standards, Congress enacted GNMA to address the underlying problems in the real estate market. As this agency along with FNMA, could address the liquidity challenges affecting the industry. Over the course of time, this would improve liquidity and it allowed a number of different loans to be offered to new home buyers. (Acrari 2011)

However, the basic mechanism used to create and sell these mortgages involved the use of derivatives. This is part of an effort to increase the return that potential investors are receiving, while being able to offer home buyers greater choices in financing. This is important, because it shows how increased amounts of risk were being utilized, to address the underlying problems affecting the availability of mortgages. As time went by, these practices became more common in the real estate industry, with the government playing a large role in the sector. This would help to develop the secondary loan market, but it would also establish a dangerous precedent for operating inside the industry. (Acrari 2011)

In this particular case, many private lenders and investment bankers would begin using the pass through option of these products, to creative even more mortgages. The idea was that since the government was actively involved in this market and they were guaranteeing most mortgages, meant that the overall amounts of risk were significantly less. The reason why, is because in the event that there is a default on the loan, the federal government will ensure that investors and the bank will receive their money. At the same time, many insurance companies began to offer added guarantees to: financial institutions and investors added protection against possible default. The reason why, is because since these assets were backed by the federal government indirectly, the chance of investors being short changed was relatively low. This is because the U.S. government had the authority and liquidity, to address any kind of adverse effects in the mortgage market. Over the course of time, these views would have an impact upon the underlying amounts of risks, as financial institutions and investors assumed that there was little to no downside with these kinds of investments. (Residential Backed Mortgage Securitization 2007)

At the same time, many of business schools began to use the modern portfolio theory, to determine how to balance risk through diversification. Simply put, this was a fancy way of deciding how much risk there was in: a particular investment class and how possible returns should be calculated (by taking these views into account). The idea was that using this formula would help investors to make more prudent decisions (while reducing the underlying amounts of risk). This was utilized by a number of investment firms, to show investors the returns that they are going to make off of the different CDO's and CDS's. While simultaneously, highlighting how the risks to their overall portfolio are reduced with this investment article. This is important, because it showing the way this theory would be used, to tell everyone how the returns are more consistent and the risks are less. As a result, the popularity of this asset class would increase, with the steady price appreciation that was being experienced in the real estate market. (Markowitz 1999)

When you step back and look at the use of financial derivatives on the market, it is clear that both the federal government and the states would play an interconnected role in addressing the underlying challenges facing the real estate market. As they were originally used to, reduce the overall amounts of risk and increase liquidity. However, the problem was that no one was taking into account the fact that derivatives trading is based upon speculation. This means that it is possible for someone to assume that the underlying amounts of risk are less. When in reality they have increased or remained the same. In the case of the mortgage market, the lack of transparency and information about these kinds of investments would help to create the illusion that they were relatively safe. Especially when you consider the facts: that the federal government was directly backing many of these mortgages, there was private insurance against possible defaults and they were diversified between a host of different mortgages. These various elements together, would create the illusion that these types of assets were safe for a number of organizations and individuals. At which point, their popularity would increase, fueled by these views and the desire to make a large return off of the boom that was taking place in the housing market.

Chapter 3: The Supervision of Derivatives

3.1: History of Derivatives Regulation

Another aspect that helped contribute to the $44 trillion in subprime mortgages was the lack of supervision that was taking place throughout the industry. In this case, there would be an emphasis on decreasing the overall amounts of regulations surrounding the financial sector. What was happening is a series of different Depression Era laws were enacted to protect the financial system against possible systematic risk. This is because several different Congressional investigations during the 1930's found that the reason why the Depression was so severe was from vast excesses in the financial system (bubbles). To prevent this from having an impact upon the financial system in the future, Congress enacted a number of different laws that forbid financial institutions from engaging in certain activities. As a result a host of different regulations were enacted to address these issues to include: the Securities and Exchange Act of 1934 as well as the Glass Stegall Act. The Securities and Exchange Act of 1934 forced any kind of investments to be registered with the Securities and Exchange Commission (SEC). The idea was that this would help to provide investors with greater amounts of information about the underlying risks. At the same time, the SEC was given the power to regulate the public equity, bond and commodity markets. This was designed to ensure that all markets were transparent and liquid enough to allow investors to sell or buy when they chose. The Glass Steagall Act was designed to prevent banks, brokerage firms and insurance companies from becoming involved in the activities of one another. This is because, it was determined that the interconnection of these activities made the economic situation worse. Where, a rise in mortgage defaults would have an impact on lending, stock price and economic activity. This is because there was excessive amount of speculation occurring during the 1920's. As a result, Congress enacted these different laws to prevent any kind of abuses from occurring. (Major Act of Congress 2010)

From the 1930's until the 1980's is when these views would begin to slowly change. As there were calls from many financial institutions that they could not effectively compete on the world markets (due to the regulations). This was problematic, because as global trade was increasing, there were new financial products that were being created that could only be sold to limited amounts of investors. At the same time, the Glass Steagall Act made it impossible for an investment bank to create a financial-based product that could reduce the overall amounts of risk (by incorporating components of insurance). This is important, because the effects of globalization meant that a number of different regulations would be repealed in an effort to give businesses greater amounts of flexibility. (Geisst 2009)

3.2: De Regulation the Beginning of the End

As a result, the Glass Steagall Act would be repealed in the 1999. This would give financial firms the ability to become actively involved in the derivates market. Where, they would conduct horizontal and vertical integrations around the world. This meant that you would see large financial super centers emerge. Their objectives were to offer customers any kind of financial product they wanted ranging from mortgages to financial planning. To promote these different activities many of these firms would become involved with other companies (through mergers and acquisitions) or strategic alliances. Under the Glass Steagall Act this kind of activity would have been prohibited. This is out of fear that it was placing too much of the nation's economic well being on a select amounts of financial institutions. However, given the fact that the law was repealed, meant that this allowed these companies to begin to offer total (one stop) financial services packages for customers. At which point, they would use their different mergers and acquisitions to help improve their overall outreach to new customers. (Repeal of the Glass Steagall Act 2008)

A good example of this occurred with the Citigroup merger. What happened was, Citibank wanted to expand into other markets that were prohibited under the Glass Steagall Act. This is because they saw tremendous opportunities in the field of insurance, by combining investment banking with insurance underwriting. However, because the act would let them become involved in this area, they felt that they were missing on tremendous amounts of competition and business opportunities. At which point, they began to lobby the Federal Reserve and members of Congress to loosen these restrictions (starting with the repeal of Glass Steagall). The main argument is that they could not compete with large financial institutions who are not limited by Depression era laws. Lifting these restrictions (they argued), would allow greater competition without increasing the risk to the financial system. The reason why is because a number of Depression era laws were still in place (such as: the Securities and Exchange Act of 1934). This (according to many proponents for repeal) would prevent any kind of possible abuses, while allowing these financial institutions to compete more effectively on a global scale. As a result, Citibank would merge with Travelers Group in 1999 and began aggressively perusing a host of different activities in the financial sector. The most notable was with the company offering a number of different mortgages to consumers, through its thousands of Citibank locations across the United States. Inside the package, they would give customers easy terms and flexible options. At the same time, they would cross market to these individuals a host of different financial products including: credit cards, homeowners / mortgage insurance and the actual mortgage. In the case, the idea was to give the company a strategic advantage by offering a host of different services to them. At the same time, the financing for these loans was taking place through CDOs and CDSs. With the company was telling investors that any kind of mortgage backed investment is considered safe due to the fact that there is insurance and the federal government is playing a major role. This is important, because it shows how the overall desire to increase their bottom line would create the situation for the company to cross market these products to investors and consumers. As a result, this created easy lending standards and the promise of larger returns that made subprime mortgages so attractive. (Citi Merger a Mistake 2008) (Repeal of the Glass Steagall Act 2008)

What this shows, is how the subprime mortgage crisis involved greed at all levels of the different financial institutions. This is because there was the desire from these financial service companies, to increase their market share and the number of products that they are offering. Once the Glass Steagall Act was removed, is when they could expand rapidly and market a host services to consumers as well as investors. As a result, this motivation fueled unprecedented amounts of greed, backed by the perception that these underlying investments were safe. This would push the limits even further, due to the fact that no one believed they would be taking losses when interest rates began to increase.

Part of the reason for this, is because the business model of the companies changed to the point, that they could have undue amounts of influence on other departments. This would have an effect upon how they would market their different products to consumers and investors. Where, the views of one department will affect the other from: increased amounts of communication and collaboration. At which point, the odds increase dramatically that some kind situation will occur, where the company will be focused on their own objectives vs. The underlying amounts of risk. The below diagrams illustrate the basic business models of these organizations before and after the Glass Steagall Act was repealed.

Financial Industry Business Model under the Glass Steagall Act

Insurance Banking Investing

Consumers / Investors

What the above diagram is showing, is the under the Glass Steagall Act the overall activities of banking, insurance and investing were restricted. This is because, if they become intermingled with each other, is the point that possible abuses could occur. As a result, one could argue that the regulatory structure under the Glass Steagall Act would protect the financial system against sudden shocks. This is due to the fact that it limited the size and exposure of one financial institution over the economy. In many ways, one could argue that this model is what prevented the economy and real estate market from avoiding crippling recessions (like the one that is currently being experienced).

Financial Industry Business Model after the Repeal of the Glass Steagall Act

Insurance

Banking

Investing

Consumers / Investors

In this diagram, it is showing how the business model of these institutions changed dramatically. Where, they began to collaborate with one another about how various components of each product could be augmented with other elements. At the same time, this means that these institutions would focus on aggressively cross marketing their different products to consumers and investors. Once this occurred, it meant that certain elements used to account for risk were ignored, in every aspect of the business ranging from: the economic viability of the consumer to the investment. When you put these elements together, this would create various CDO's and CDS's. As they were marketed to a risky group of homeowners and they were sold to investors as a risk free investment. This is important, because it shows how the elimination of certain laws and regulations would allow the underlying amounts of greed to increase. At which point, there is the possibility that all risks will be discounted (leading to massive speculative bubbles).

3.3: The Lack of Oversight

At the same time, there was a lack of oversight was occurring in many different sectors of the mortgage industry. What was happening is the push to reduce the overall amount of regulations would have an impact upon the attitude of regulators. Where, they would face increasing amounts of scrutiny over their activities. This is because, many of the government officials felt increasing amounts of political pressure to reign in their activities from supervisors. As various higher ups in their agency felt that the financial services industry should be given greater amounts of autonomy. As a result, their actions were not as carefully scrutinized by regulators. This is problematic, because it made understanding the various subprime mortgage investments more challenging.

At which point, a host of different bureaucrats would assume that there were no risks to the financial system because there were less audits and investigations. A good example of this can be seen with comments that were made former Federal Reserve Chairman Alan Greenspan in 1997. With him saying, "The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is whether government intervention strengthens or weakens private regulation." (Deregulation Redux 2011) This is important, because it shows the overall attitude of regulators about the changes that were taking place. As they felt that these various laws were making it more difficult to: address the underlying challenges in the economy and meeting the demands of consumers.

Over the course of time, these attitudes would filter down to regulators, who were facing increasing amount of pressure to back off on their strict enforcement of various securities laws. This is important, because if regulators were allowed to do their jobs, they could have been able to identify the fact that no one understood how CDO's and CDS's worked. At which point, they could restrict these kinds of transactions and how they were conducted. Evidence of this can be seen with findings that were reported by the Financial Crisis Inquiry Commission (FCIC). They are a committee authorized by Congress to investigate the causes of the financial crisis. In their report, they found that, "The prime example [of permissiveness] is the Federal Reserve's pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards." (Verengo 2011) This is significant, because it shows how the financial crisis was a lack of oversight at all levels of government. As any one of the different federal regulatory agencies could have increased standards enough to prevent such abuses from occurring. However, the political pressure was so intense that no one wanted to stand in the way of any kind progress that was being made.

When you step back and look at the statement that was made by Alan Greenspan and observations from the FCIC, it is clear that there was system wide pressure to reduce the overall amounts of regulation surrounding the financial services industry. With some of the most prominent and powerful officials (i.e. Alan Greenspan) questioning if imposing such regulations would be effective at addressing the underlying risks to the system. As a result, one could easily infer that there was so much pressure on regulators to look the other way that they allowed the financial crisis to occur. Over the course of time, this attitude of lax enforcement of different standards would set the stage for the financial crisis, by helping greed to become a major factor surrounding investments. At which point, it was only a matter of time until an inevitable collapsed would occur from the meteoric rise in real estate prices.

A good example of the effects to deregulate the financial services industry can be seen by looking no further than Fannie Mae and Freddie Mac. What happened was the mortgage provider was given permission by Congress to increase the overall risk exposure of their loan portfolio (by underwriting loans to individuals who did not qualify). This included many minorities and low income families. Commenting about what was taking place the Fannie Mae Franklin Raines said (in 1999), "Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements. Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market. Demographic information on these borrowers is sketchy. But at least one study indicates that 18% of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market. In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties." (Holmes 1999) This is important, because it shows how there was focus from within various political circles inside Washington to reduce the overall amounts of regulations affecting these financial institutions. At which point, the various lending standards and regulations were reduced dramatically. In this case of Fannie Mae, this would encourage many different lenders to engage in activities that could be considered to be questionable. The reason why, is because everyone is following the activities of the different federal agencies. As a result, when they begin to reduce lending standards all of the other mortgage providers will follow suit. This is because the government is the largest underwriter and provides guarantees on different mortgages. This would give everyone one the feeling that overall amounts of risk have been dramatically reduced. When in reality they have not, instead they have been increased to achieve different political objectives.

In this aspect, one could argue that these goals would change the way the mortgage industry would view risks. As they were following the different government standards, with the belief that if they were inappropriate the various regulations would be tighter. Over the course of time, this would change how these risks were presented to investors and consumers. With everyone assuming that various subprime mortgage-based products have limited down side.

When you step back and analyze what is taking place, it is clear that the lack of regulation would have a major impact upon the mortgage industry. This is because the existing regulations were considered to be anti-competitive such as: the Glass Steagall Act. Once these kinds' laws were repealed is when the underlying amounts of how risk was accounted for would change. As the lack of these regulations, gave everyone the false perception that businesses can be able to regulate themselves. This would have an impact upon the views of regulators who were facing increasing amounts of pressure to tone down their activities. At the same time, the federal government was taking actions to change the views of risk by allowing Fannie Mae and other government agencies to underwrite more risky loans. Since they account for 90% of all mortgage activity, this would have an impact upon these different views by creating a shift in how risks were evaluated. The reason why, is because everyone inside the industry would follow the activities of federal agencies as they were considered to be the most financially prudent. As a result, the changing lending standards would mean that everyone felt that the underlying risks had been reduced. Part of the reason this was taking place, is because there was increasing amounts of political pressure to give financial institutions greater amounts of freedom in their business activities.

Chapter 4: Conclusions and Recommendations

3.1: Recommendations

The overall problems that were identified with the financial system, means that some kind of changes need to take place in the future to prevent these kinds of abuses from occurring. In this case, there must be some kind of emphasis on: effective enforcement and addressing the lack of oversight in key areas. These two elements are important, because they must be used in conjunction with one another to ensure continued stability of the financial system.

As far as effective enforcement is concerned, this means that regulators must be given the power to go after those individuals who were knowingly violating the law (helping to exacerbate the financial crisis). The problem is that a lack of action is occurring in this aspect, where very few of the Wall Street executives have faced any kind of criminal charges for: the actions that they engaged in or the overall harm they caused to the economy.