Why Regulation of Wall Street Protects the Big Firms from Small Players Competing

Financial Crisis and its Impact on Financial Institutions and Markets

The financial crisis that began in 2007 has been reviewed by a number of researchers, many of whom have offered up conflicting interpretations of events and of factors that led to the crisis in the first place (Healy, Palepu & Serafeim, 2009; Laux & Leuz, 2010; Young, 2008). While mainstream journalists like Lewis (2010) focused on the more sensational narrative of players orchestrating a “big short” in the housing market bubble through credit default swaps (CDS), others have focused more intently on the role that mark to market accounting played in the exacerbation of conditions that ultimately fueled a collapse of financial institutions like Bear Stearns and Lehman Brotehrs (Flegm, 2008). This paper will examine the causes of problems for financial institutions during the financial crisis, discuss the impact of the crisis on financial market liquidity, and address the issue of whether sound risk management was demonstrated by those who participated in the market for mortgage-backed securities (MBS).

Causes of Problems for Financial Institutions during the Financial Crisis

The background causes of the problems faced by financial institutions during the financial crisis are complex. Not only had the groundwork for a housing market bubble been set by a relaxation of lending standards under the Clinton administration (in a political show of solidarity with the working class aimed at getting more home owners and thus promoting the idea of an American Dream still existing), but the Financial Accounting Standards Board (FASB) had given the green light to fair value accounting, i.e., mark to market accounting, which allowed firms to adjust the book value of assets based on current market prices. It has been argued that this opened the door to financial shenanigans that exacerbated the marketplace and led financial institutions into regulatory traps due to unforeseen market panic when demand for previously highly liquid assets like collateralized debt obligations (CDO) dried up and demand for CDS soared (Flegm, 2008; Healy et al., 2009; Posen, 2009).

Underlying Causes of Problems Experienced by Financial Institutions

Regulation of the financial industry is meant to reduce the risk of instability among financial institutions. Ensuring that financial institutions have adequate capital to manage stress is one of the objectives of the Federal Reserve. Yet systematic regulation of financial institutions with regard to capital adequacy may have actually had the same effect on financial markets as forest fire prevention has had on forests: by over-regulating what should be more of a natural process with manageable risk to the downside, regulators create an environment in which downside risk becomes explosive when unnatural market conditions prevail and then burst all at once (Prosner, 2014).

The demand for yield brought about by low interest rates caused investors to buy up risk assets like CDOs in the run-up to 2007 and equities at all-time high valuations in the run-up to the COVID collapse of 2020. A combination of fair value accounting practices of firms and financial institutions and regulatory requirements regarding capital adequacy put certain constraints on institutions once the markets turned down in both cases. A dramatic shift in sentiment in 2007 and in 2020 was followed by crashing valuations, which in turn forced institutional selling, which in turn begat more selling as investors sought to escape a collapsing market at any price. Financial institutions saw a liquidity crisis coming in 2019, and the Federal Reserve intervened at the time by injecting liquidity into REPO markets.

How These Problems Might Have Been Avoided

Though regulations are meant to ensure quality in the market, Posner (2014) has argued that they hurt more than they help because they handcuff institutions from being able to use capital as they see fit. Regulations essentially deny financial institutions the ability to make decisions and live or die by the consequences. Rather than a free market, the effect produced is a command economy in which centralized control of a market is held by a power such as the Federal Reserve or the federal government, which writes the regulatory legislation.

Another way the problem could have been avoided is this: the Federal Reserve could have raised interest rates, giving investors an alternative to risk-on, high yield assets in the run-up to 2007 and 2020. By keeping interest rates near zero, the Federal Reserve has been in line with other central banking policies around the world, but the problem is that such rates are artificial and do not reflect actual market sentiment. Central banks are buyers of sovereign debt at massive amounts (the Federal Reserve’s balance sheet has soared by trillions of dollars since March 2020 alone) in order to cover the fact that there are no buyers for sovereign debt. If no buyers emerge, yields rise precipitously as yield is determined by the market. Thus, the Federal Reserve like other central banks is the buyer of last resort and thus, again, seeks to control the market. The issue of what happens when so much money is created (causing inflation) exacerbates market conditions by causing investors to seek assets that will keep track with inflation (i.e., precious metals, real estate) but also to buy equities and bonds out of fear that prices will only go up since so much new money is now entering the system. The spillover effect from bonds to equities has been duly noted in the past (Bernhard & Ebner, 2017). In the end, extremes are reached as available funds are leveraged, volatility becomes a serious concern, and any crack in market conditions is enough to unleash a flood of selling that essentially crashes the market—whereupon central banks are called upon to intervene once more and repeat the act of “saving” the economy.

The FASB banning mark to market accounting could also have helped to prevent the situation. Institutions’ books would not have appeared as damaged (losses are not recorded until assets are sold—as opposed to movements in mark sentiment under fair value accounting practices). The issue of high-frequency trading (HFT) also exacerbates market movements because of the rapidity with which computer algorithms execute trades and conduct strategy shifts. In short, things happen fast in the world of HFT and institutional funds have to make sure they are positioned on the right side of the trade, i.e., on the right side of market sentiment. HFT will make them pay if they are not. If they lack liquidity to cover positions, they may have to close out others, which can lead to monumental losses considering the extent to which the firm is leveraged. Leverage laws (rehypothecation) are another matter altogether; suffice to say, the causes and possible preventions are myriad and complex.

Impact of Financial Crisis on Financial Market Liquidity

The link between the financial crisis and lack of liquidity in financial markets can be found in the fact that debt markets became inactive at the time, interest rates were low and made to go lower, and IPO activities came to a halt. Without liquidity in the marketplace, the spread between the bid and the offer grows too wide and a great deal of damage can occur as financial institutions have to adjust their holdings based on market movements. Leveraged funds cannot deleverage all at once without

Reasons Debt Markets became Inactive at the Time

Debt markets become inactive in times of financial crisis because there is a shift from risk-on to risk-off strategies. Firms are loathe to buy the debt of others, whether corporate, junk or sovereign, without guarantees that there is no risk of default or without a discount on the debt purchase. Investors know that a company that is badly in need of money and must tap the equities market will pay a higher yield than a company that does not require a liquidity injection to keep operations going. In the COVID collapse of 2020, companies like Exxon have had to take on billions in new debt to protect the dividend in the face of oil prices falling and demand drying up. In 2007, the situation was the same. Issuing new debt was a problem as a sudden risk-off market mentality emerged and companies like Lehman and Bear Stearns were forced into bankruptcy. Today, with bankrupt Hertz almost going through with a debt offering to investors (stopped only by the bankruptcy court) in order to pay prior debt holders, it is no wonder why debt markets would become inactive in a time of crisis. Investors do not invest with the intention of becoming bag holders.

How Interest Rates were Affected

To prevent a run on financial institutions, central banks drive down interest rates by engaging in purchasing programs like quantitative easing. In 2007, the Federal Reserve purchased trillions of dollars’ worth of MBS and government debt. Supplying the demand ensured that yields would not rise to a point where investors in equities would see a safer return on their money by shifting to bonds. By suppressing interest rates, the central bank signals to investors that the only effective play for ROI is to go “all-in” on risk assets. Pension funds, mutual funds, sovereign wealth funds and hedge funds all generally respond to the signal by bidding up prices and thus commences the “v-shaped recovery” seen following the 2007-2008 crisis and the March 2020 COVID collapse. By September 2020, markets had reached new all-time highs—such was an effect of hyper-intervention by the Federal Reserve with both its suppression of rates and its infusion of liquidity.

What Happened to IPO Activities

In response to market conditions worsening, IPO activities came to a halt. No private company wants to make an initial public offering to investors so as to give equity holders an exit from their positions (purchased earlier in private transactions) when there is a risk-off market mentality. The fear is that shares will not price as highly as they could in a market where the prevailing mood is risk-on. Thus, in 2007, IPO activity came to a screeching halt, just as it has done in 2020. AirBnB for instance had plans to go public in 2020, but those plans were shelved in the wake of the COVID collapse. With the worst believed to be over, the company is now considering going forward once more with its IPO. It is merely in an issue of risk-off vs. risk-on sentiment, and the furious rebound in the equities market (driven by central banking intervention) has surely helped the firm to see that risk-on appetites are alive and well.

Risk Management

Institutional investors that purchased mortgage-backed securities containing subprime mortgages did not follow reasonable investment guidelines or engage in effective risk management strategies. MBS were full of subprime mortgages but were being marketed as AAA-rated by the ratings agencies, which did fool some investors—but those who bothered to look at what was actually contained in these instruments saw immediately why they were a “short” (Lewis, 2010). Hedge fund manager Michael Burry for instance recognized the incredible risk in the trench-structure of the MBS being marketed by financial institutions, and to short the market for these subprime-laden CDOs, he purchased CDS at bargain basement prices. Essentially, he and a few other players took the trouble to consider what was fueling the housing boom and saw that it was indeed unsustainable and that debt-holders would become bag holders when the blowout arrived and subprime borrowers began defaulting on their loans causing the derivatives market to collapse. Financial institutions like Goldman Sachs also began to see the trouble in the housing boom/bubble and likewise began hedging its risk in MBS by buying CDS—and JP Morgan did as well—even as these same firms were engaging in moral hazard by continuing to sell the highly risky CDOs to naïve investors, convincing them of their low risk of default (Lewis, 2010).

When the defaults began arriving and the selling of MBS commenced, the price of CDS skyrocketed and savvy fund managers like Burry made billions in profit selling the insurance to panicking MBS investors. In short, few financial institutions were prepared or hedged to manage the risk of an MBS market implosion. Even those firms that did hedge their positions still required the government to bail-out AIG, since AIG had written the CDS to Goldman and now could not pay without going bankrupt (Lewis, 2010). Thus, even though the hedge was in place, the term “too big to fail” was coined to explain why some companies could not be permitted to go under when their bets went the wrong way: if those companies (like AIG) did go bankrupt, Goldman would have a harder time getting the ROI it expected. Considering that the Treasury Department was run by former Wall Street executives, the bailout is not a surprise. What it does show, however, is that the ultimate risk management strategy as demonstrated by Goldman is to always have an ace in the sleeve in the form of former C-suite executives running the federal government’s most important agency.

Pension funds, commercial banks, insurance companies, and mutual funds all had a part to play in contributing to the financial crisis. Yet they all have rules in place that determine what kind of investments they can make, and thanks to the faulty AAA-ratings given these MBS investments these funds and firms were, technically speaking, within compliance with their own rules. The problem was that the ratings agencies were not rating these derivatives effectively. The funds and firms also were not looking closely at the products—at least not as closely as some active fund managers like Burry were doing. Instead of hedging accordingly with CDS, they plunged headlong in a chase for yield. Can they be blamed? Pension funds are deeply underwater and have no choice but to chase yield. Insurance companies’ business model is predicated on their ability to obtain a specific ROI, which necessitates a certain amount of fixed-yield income. All the same this does not excuse the amount of risk-taking involved, but it does help to explain why the risk-on mentality persists among these institutions: they have obligations of their own that they must meet and if the central banks persist in keeping interest rates low, thus starving fixed-yield investors, these funds are pushed into purchasing instruments that are “hot”—so long as they are rated safe (which they were).