Leverage Ratio Of Investment Banks

Published Date: 02 Nov 2017

Diagram 1.0 Federal funds rate from 2000-2009 (cited in Grogan & Fisher 2010). RESEARCH PAPER wen han

Andrews (2008) identified that Greenspan proposed lowering the interest rate of housing price in order to let the people to buy a house by paying a lower interest rate loan. Andrew also stated that Greenspan did not succeed in governing the volatile growth of risky and regular fraudulent mortgage lending. Greenspan approved the Glass-Steagall Act repeal causing the credit bubble to expand much larger and 300 million dollar worth of lobbying efforts, culminated decades of deregulation (Ritholtz 2012). According to the homeownership and equity protection act, the Federal Reserve board had extensive right to regulate the mortgage industry. However, Alan Greenspan refused to use it. Instead, Greenspan enforced deregulation into the US financial market believing the activities of financial institutions in the financial sector can be motivated with less constrained rules and regulations. Unfortunately, due to the deregulation happened; the world’s largest financial organizations were caught laundering money, deceiving the customers and many other criminal cases.

The federal agency created Securities & Exchange Commission (SEC) during the depression did nothing to control investment banking. In 2004, Henry Paulson, the CEO of Goldman Sachs helped lobby the SEC to ease limits on leverage to permit banks to increase borrowing. The more the banks borrowed, the higher their leverage ratio.

Diagram 1.1 Leverage ratio of investment banks (Barth & Yago 2008).

According to the homeownership and equity protection act, since Alan Greenspan is the Fed Chairman, he had broad authority to regulate the mortgage industry to avoid the tragedy. Besides that, before the financial crisis happened, he should have listened to Robert Gnaizda who tried to give him an example on countrywide and adjustable mortgage rate. As part of the government institution, SEC should restrict leverage ratio, not be lobbied by investment banks for helping them to ease the leverage ratio (Labaton 2008). Besides that, Andrew states that Greenspan and the other banking regulators in Washington should have tighten regulation of subprime mortgages and other high-risk exotic mortgages that permitted people to borrow far more they could afford.

As for the second key party that participated in the crisis would be investment banks. One of the most well-known players would be Lehman Brothers. It linked trillions of dollars in mortgages and loans between home buyer’s and investors globally where investors bought CDOs backed up by loans. Banks sold CDOs to investors, which meant that homeowners secondarily paid their mortgages to investors. Besides that, CDOs seller like Lehman Brother paid rating agencies to evaluate their CDOs for the highest possible AAA investment grade. Since lenders did not care whether borrowers have the ability to repay the debt, they made riskier loans. According to Levin, Goldman Sachs was self-interested promoters of risky and complex financial arrangements that helped prompt the crisis (cited in Andringa 2010). http://documents.nytimes.com/goldman-sachs-internal-emails Levin also said that Goldman Sachs sold AAA securities rated by CRAs to investors, disseminating risk over the financial system and all recurrently wagering against the instruments they sold and profiting at the payment of clients.

They ignored the risks and only hoped to increase profit volume by selling more CDOs. In the early 2000s, there was a massive increase in the riskiest loans which are called subprime. Investment banks essentially preferred subprime loans as they can earn higher profit. It led to a substantial increase in destructive lending because borrowers were pointlessly placed in expensive subprime loans and many loans were given to people who could not repay them. Other than that, Lehman brothers lobbied SEC to push their borrowing ratios to as high as 40:1. This action led to the financial crisis by weakening the ability of them to recover from losses incurred when high risk CDOs and CDSs bets failed (Source Watch 2012).

Federal regulators are supposed to ensure that these risks do not become so large as it endangers the entire economy. Sanchez (2011) stated that tighter liquidity standards would allow banks to solve strain situations with more flexibility related to tightened finance sources and increased deposit withdrawals.

The third player involved in the crisis is credit rating agencies (CRA). There are Moody’s, Fitch and Standard & Poor’s. Investors use credit rating that reflects the probability of default to determine the creditworthiness of particular debt securities. In order to obtain AAA ratings, the securities issuers will pay the CRA to evaluate their securities .

http://prienceshrestha.files.wordpress.com/2012/01/cr1.gifDiagram 1.3 Investment grade ratings of CRAs (Shrestha 2012).

According to the lawsuit, S&P gave high marks to securities because it sought to earn more business from the the issuers (Wagnier & Rexrode 2013). It also stated that the large fees they earned from guiding clients on strategies to assembly products that they were rating destined that they had insufficient incentives to ensure accurate ratings. It denoted that CRAs had done a terrible work of evaluating the risk in the subprime products they had assisted to structure when housing prices began to drop and subprime mortgages began to default (Mishkins & Eakins 2012). Majority of AAA-rated products had to be demoted repeatedly until they achieved the junk status. Wagnier and Rexrode (2013) said that the resulting great losses on these assets were one of the reasons why there are so many financial institutions that were holding them got into trouble with absolutely catastrophic concerns for the company.

According to IOSCO CRA Code of Conduct section 2, a CRA should establish policies and procedures for reviewing the past work of analyst that left the CRA and join an issuer that the analyst has rated which an analyst has had noteworthy transactions as an employee of CRA (OICU-IOSCO 2008). Besides that, it also indicates that CRA should conduct official and periodic reviews of compensation policies and practices for CRA analyst to ensure that these policies and practices do not compromise the objective of CRA’s rating process. Securities and Exchange Commission (SEC) should entail CRA disclose more of how they govern ratings. For example, CRAs are required to show historical rating performance, including dates of downgrades and upgrades, information on underlying assets of a product used by CRAs to rate a product, and the methodology used to evaluate ratings. Other than that, the SEC may request CRAs to differentiate the marks on structured products from those issued on bonds. These changes will enhance the transparency of rating process and reduce the conflict of interest which played a major role in the subprime meltdown. For sure, all of these changes will avoid the crisis (Mishkin & Eakins 2012).

One of the financial instruments that were actively traded in the stock markets to create wealth that ultimately led to the downfall of the financial system worldwide is collateralized debt obligations (CDO). It generally pays out cash flows from subprime mortgages-backed securities (MBS) into a number of buckets that are referred to as tranches, with the highest-rated tranche paid out first, while lower ones paid out less if there were losses on MBS. Poor CDO performance was principally a result of the presence of low quality collateral originated in 2006 and 2007 with exposure to the U.S residential housing market. The failure of CRAs to accurately assess the risk of CDO securities stemmed from an over-reliance on computer models with inaccurate input. So, the reason why CDO led the collapse of the financial system was probably caused by a combination of poorly constructed CDOs, negligent underwriting practices and defective credit rating procedures (Barnett-Hart 2009). (http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf

Diagram 2.0 Increment in CDO of subprime loan during the year 1998-2006 (Barnett- Hart 2009).

The other financial instrument that led to the collapse of the financial system is credit default swap (CDS). According to Gilani (2008), CDS is created by an insurance company such as American International Group (AIG) in order to protect buyer and seller covering a corporation’s or sovereign’s bond or loan. She further stated that CDS are subject to the collateral and margin agreed to by a contract and re-sale to another party who is keen to enter in another contract. Insured buyer would not get back the money in the case of default or the insurer goes bankrupt. CDS are not standardized instruments because they theoretically are not true securities, transparent, traded on any exchange, subject to present securities laws, and it is not regulated (Gilani 2008).