The apex of the global financial crisis seems to stem from the un-regulation of the financial institutions within the American financial market, particularly as it relates to the mortgage sector of the economy. The prominence of the financial meltdown can be placed on the indiscriminate issuance of subprime loans which existed in the United States during the period 2002 to 2008. The negative impact of these loans culminated in 2008 which then sparked a downward spiral of all economies globally. This can be attributed to the lack of financial regulation that was prevalent during those formative years of the economic boom period of the housing market 2002 to 2007. According to the writer as outlined in his introduction, there are several factors which were suspected to cause the financial melt down; these included but not limited to: greedy mortgage lenders, a loose monetary policy of the USA, heartless and overpaid bankers, poorly priced risks and un sustainable domestic and international balances and Asian culture of saving too much.
Regulation as outlined by the writer should be one that is balanced since too little or too much regulation can have negative impacts and effects on the economy. Regulation as seen by him is very important for the financial sector of an economy. I agree with this point of view. To lend support to this statement it is said that "too little regulation discourages entrepreneurs, it gives rise to fraud and exposes small investors to expropriation of their wealth by managers and shareholders, too much regulation on the other hand acts as barriers to investment, and it discourages investors from investing in the productive sector of the economy." It can be argued that the American economy is an 'open' economy and is based on the free market system therefore self regulation was seen at the time as the best option where the market will dictate the best course of action for the financial players.
Lessons which should have been learnt form the failures of Savings and Loan (S&L) and Long Term Capital Management (LTCM) in 1998 were not adhere to. The end result in a mini collapse of the financial system, this was a precursor of things to come and only justifies the notion that financial regulation is definitely important since the activities of individual firms can create negative externalities that give rise to systematic risks.
Systematic risk is defined in the text as "a function of the total variability of expected returns of the stock relative to the market index and the degree to which the variability of expected returns of the firm is correlated to the expected returns on the market" (Michael Moffett). Based on my knowledge from international finance and other finance courses, I can safely say that, asset allocation and diversification of a company's portfolio(s) are two ways in which a company (investor) can protect against systematic risk. Case in point, the subprime crisis was an outgrowth of asymmetric distribution of risk and rewards. The risky behavior of the lenders was not only borne by them but the consequences of such bad decisions were passed on to third parties.
All things equal self regulation should take care of this since all stakeholders would ensure that their investments and interest would be best served. However, this was not the case with the emergence of subprime loans. The regulators of the economy (Federal Reserve, Office of the Controller of Currency, Securities and Exchange Commission, etc can all be blamed for this global financial crisis. Based on the textbook, "SEC is a careful watchdog of the publicly traded equity markets, both in the behavior of the companies themselves in those markets and of the various investors participating in those markets" (Michael Moffett). This had led to some questions; were they unaware of the extent that the failure -delinquent payment on these subprime mortgages would have on the economy or were they overconfident that the housing market would continue to show signs of appreciation which is the premise on which most of the subprime loans were issued? Or maybe the regulators wanted to be seen as the ones who presided over one of the longest stint of unbroken assets growth? In fact this type of behavior was pointed out as an attitude of "investor overconfidence".
To understand the genesis of the financial crisis one must first examine the housing market as explained by the writer. The developments that lead to the changes in the housing markets can be attributed to the growth of subprime mortgages.
Firstly, investors began to invest in mortgaged-back securities which were issued by government sponsored enterprises such as Fannie Mae and Freddie Mac.
Secondly, banks began to package these mortgages into collateralized debt obligations (CDOs) and sell them directly to investors. Other developments which were cited as part of the problem were the arrival of new investors and issuers of mortgages; the accelerated increase in house prices which started at the end of 1990 and peak in 2007; and the low interest rates which were introduced on the market coming out of the short recession in 2002.
Mortgages were issued under conditions which were not in the best interest of the buyers and lenders. Under normal conditions buyers who defaulted on payments would lose on their investment and lenders would be secured due to insurance on the loans and other securities. Furthermore, borrowers would have to show credit worthiness prior to secure the loans. However, this was not the case with these subprime mortgages; they were supported by mortgage back securities (investors). However, there were inherent problems with this:
Firstly, there were no independent assessments of these risks for buyers.
Secondly, these securities were rated by credit agencies whose high ratings were never questioned nor assessed. The assessment of the risks involve were left to the institutions. In hind sight this was a blatant flaw. Furthermore, some of the investors who took on those risks were financial institution. In most instances they too had a stake in the subprime industry. This scenario created two problems:
the individual losses created systematic risk for other participants
The potential size of the default was becoming too large for the investors to pay fully on the losses.
The writer used the termed "ninja loans" to describe the situation between the middle of 2006 and 2007. The termed is referred to borrowers that had no income, job or assets. Why were these loans issued in the first instance? As mentioned previously, these loans were issued on the basis that the housing market would continue to show growth and the values would appreciate, lenders would be able to recoup their investments against the appreciated value when borrowers default.
A significant proportion of these loans were held by banks, hence when the delinquent borrowers reached crisis level, many of the banks collapsed along with other financial institutions which were directly or indirectly involve in the subprime mortgage fiasco. According to Alan Greenspan former chairman of the Federal Reserve investors were not fully aware of the risk they were taking.
The writer alluded to three things which seemed to stand out as the main culprits for the subprime crisis. They are as follows:
Greedy bankers who paid themselves lavishly (bonuses and salaries) without showing any regards for the shareholders.
Innovations in the area of financial derivatives which allowed risks to be taken without the full understanding of what was involved.
Low interest rates after the 2002 period that was seen as a catalyst for changing the appetite of investors.
Though not elaborated much during this discourse subtle inferences were made about financial derivatives. Financial derivatives did play a major role in the subprime crisis. To further understand what financial derivatives are, it is an agreement between two parties that has a value based on expected future movements of assets to which it is linked, includes swaps, futures and options. It seems like the bankers were hedging with these subprime loans. The bust of the housing market not only created ripple effects but send shockwaves throughout the financial world.
What should have been done to lessen this subprime turmoil were:
Careful analyzing of the economy: regulators, investors, bankers, governments etc should have played their role fairly and really analyze the positives and negatives impact of these mortgages that the financial institutions were giving out and find out whether the benefit will outweigh the cost or vice versa.
Having a balance regulation system in place.
Bankers showing some remorse to investors and also cutting back on salaries and bonuses.
