The Federal Reserve Bank And Treasury

Published Date: 02 Nov 2017

Federal Reserve should be blamed for the financial meltdown. The Federal Reserve announced the interest rate cut to 1%. This caused the real estate bubble burst as major financial institutions could easily borrow funds with such low interest rate even though borrowers had less purchasing power. Default borrowers were given the option of refinancing in order to avoid the increase in the mortgage rate. The prices started to deteriorate at an increasing rate of around 25% towards the third quarter of 2008. Hence, property market resulted in heavy losses in the financial system. Over the years, the Federal Reserve increased their interest rates, and it resulted in an increase in adjustable rate mortgage, making it more unaffordable to homeowners. Thus, the asset prices lowered making it more risky to speculate in housing, which had in turn contributed to the deflating of the housing bubble. Unfortunately, Alan Greenspan, Chairman of the Federal Reserve of the United States, chose to ignore several powerful signs that housing was a bubble. The Federal Reserve could have done much to prevent the crisis by exercising its power to set higher interest rate in the mid 2000’s as it became clear a bubble was growing in US housing prices. Higher interest rate also would have slowed the growth in financial sector leverage which proved so damaging in 2008. As John Taylor says, ‘the Federal Reserve had the power to avoid the monetary excesses that accelerated the housing boom that went burst in 2007’. Moreover, Federal Reserve could have reduced indebtedness and liquidity risk in the financial sector by exercising their powers to require banks and investment bank to have less leverage, by issuing rules to limit the risky asset-liability by raising margin requirements for off-exchange instruments.

Credit rating agencies (CRAs) are responsible for financial collapsed. Rating complex instruments such as collateralized debt obligations (CDOs) had given the boom of the housing industry in the US because CRAs such as Moody’s, Fitch’s and Standard & Poor’s were reaping in money-making profits. CRAs were helping issuers of CDOs on how to develop their financial instruments in a way that would receive the best possible ratings. As result of this, almost all senior tranches had the highest rating of AAA. [What role did CRAs play in the financial crisis, Amanda Bahena] Before the mortgage crisis took place, more loans were being offered to high-risk borrowers in a bid to reap in higher profits. Investment grade ratings were given to CDOs that were created based on these risky subprime mortgage loans. These CDOs were then sold to investors. The demand for CDOs grew dramatically, all investors from all over the world being attracted to these AAA rating securities that promised an attractive return, believing that these almost riskless investment was as safe as putting their money in a bank. When housing prices began to rise so high and the average household income could not afford these high prices. Financial meltdown occurs when people defaulting on their very first mortgage payment. CRAs have been irresponsible in their duties by giving AAA credit ratings to CDOs that were very risky. There were conflicts of interest between CRAs and the issuers of securities, leading to highly inflated ratings. CRAs were supposed to serve investors by providing a neutral and objective view for making decision on their investments. However, they maintained close working relationship with the issuers of these structured products and in many situations, advised their clients on how to obtain the best possible credit ratings just because they were paid for by the issuers. CRAs could have given the limited scope of the selected approach. It could make a qualified contribution to stabilizing the financial system, namely in areas where the instability has been caused by conflicts of interests or general corporate governance problems. Competition between CRAs could encourage high-quality ratings and their continuous improvement. CRAs could have switched to an "investor pays" model because the "issuer pays" model competition can lead to inflated ratings because the company chooses who should rate them. This dilemma could, however, be solved by decoupling the competition problem from the ratings market. The problem cannot therefore be resolved by increasing competition solely between CRAs but, above all, by seeking alternative approaches to assessing risk for regulatory purposes and thus for the purposes of determining capital requirements. Such a strategy has the potential to gradually reduce the role played by credit ratings in regulating the financial.

Furthermore, Bankers was the one of the cause that led to the financial crisis. The extent of the bank commitment, which was mainly assessed in term of prudential standard fail to fully implement. Bank commitment failed to limit banks risk to carry cost of the loan being securitized, or to securitize being distributed to investor, with losses on other held by investor. Banks were making too many mortgages to too many borrowers and flawed the credit standard. Banks are excessive leverage to earn more money which cause they takes higher operational risk and they did not have the enough capital survive themselves if something happen. Investment bankers wanted to earn more profit, so they took higher leverage and higher risk to make higher return. For example, Bear Stearns and Lehman Brothers leveraged their capital 30 to 1 or more. This has already over the limited bank leveraging to approximately 10 to 1. Therefore, Lehman brother cannot survive themselves when they faced unprecedented loss due to subprime mortgages crisis. Moreover, most of the leveraged hedge funds are invested much in mortgage-backed securities. They not really understand the risk of the product they invest and doing the same diversification. This makes the financial market facing a huge loss when mortgage backed security failed. On the other hand, many of the highly leveraged firms used overnight repurchase (repo) market as the source of funding; this made them more vulnerable to liquidity pressures and faced the liquidity risk. Regulator of the investment banks could have limited the leverage ratio. ‘Regulator should limiting leverage ratios (through higher capital requirements), a key factor in how much damage a particular shock can do. The ratios we saw prior to the crisis of 30-1 or more leave the system far too vulnerable.’ (Thoma, 2009: Online) If regulator did not set a limit on leverage ratio, greedy investment bankers will continue to lend out the loan and cause the system vulnerable.

Finally, the U.S. government should be responsible for the financial meltdown. U.S. government intervened like Fannie Mae and Freddy Mac which are sponsored by the government but they as Lehman Brothers started reporting gigantic losses, cash outflows exceed cash inflows, reporting high losses and many other problems to justify that they were not in position to save the firm. Hank Paulson the secretary of Treasury said that he did not want to give to the tax payers a liability for save a private company that did bad business so they asked a bunch of presidents from others companies to invest in Lehman or loan them money but everybody was informed about the problems and risks of the company and did not want to lend any money. Treasury Secretary Hank Paulson warned the Wall Street titans Lehman Brothers was about to collapse and that the government would not rescue him. Officials of the Federal Reserve Bank and Treasury, the bankers, lawyers and accountants looking for a way they could save Lehman but without government financial support was a mission impossible. U.S. Government could inject money to the company and prevent higher problems in the world economy, but they refused also because it could be seen as the government is acquiring a lot of private companies and increasing their role in other areas in the country, as government seems like they could have the money, but is like Paulson said, then tax payers should pay the bill of others.

Question 2

A bond financed by the home mortgage payments is called Mortgage Backed Security (MBS).The invention of mortgage-backed securities completely revolutionized the housing, banking and mortgage business. At first, mortgage-backed securities allowed more people to buy homes. During the real estate boom, many less careful banks and mortgage companies made loans with no money down, thus allowing people to get into mortgages they really couldn't afford. The lenders didn't care as much, because they knew they could sell the loans and get incentives from it. They knew they didn’t have to pay the consequences if the borrowers defaulted. Asset bubble was hence created, which then burst in 2006 with the subprime mortgage crisis. Since so many investors, pension funds and financial institutions owned mortgage-backed securities; everyone experienced the major losses, creating the financial crisis. The ability to create mortgage-backed securities was authorized by the 1968 Charter Act which created Fannie Mae. The intent was to allow banks to sell off mortgages, thus freeing up funds to lend to more homeowners. The founders didn't anticipate that this would also remove an important discipline for good lending practices. The banks got paid for making the loan, but didn't get hurt if the loan went bad. Therefore, they weren't as careful about the credit-worthiness of the borrower. Second, MBSs allowed financial institutions other than banks to enter the mortgage business. Before MBSs, only banks had large enough deposits to make long-term loans. The invention of MBSs meant that lenders got their cash back right away from investors on the secondary market. This created additional competition for traditional banks, which had to lower their standards to keep the loan volume up. Third, MBSs were not regulated. Traditionally, banks had been highly regulated by governmental agencies to make sure their borrowers were protected. However, MBSs was not regulated and hence it led to the collapse of the financial systems.

Collateral debt obligation is a complicated tool of financial system that converts loans of individuals into a product that can be sold in the secondary markets. After the asset bubbles burst, housing prices became unrelated to their actual value, and people bought homes simply to sell them. CDOs allowed banks to avoid having to collect on them when they become due, since the loans are now owned by other investors. This made them less disciplined in adhering to strict lending standards, so that many loans were made to borrowers who weren't credit-worthy -- ensuring disaster. What made things even worse was that CDOs became so complex that the buyers didn't really know the value of what they were buying. They relied on their trust of the bank selling the CDO without doing enough research to be sure the package was really worth the price. The research wouldn't have done much good, anyway, because even the banks didn't know. The computer models based the CDOs' value on the assumption that housing prices would continue to go up. When they went down, the computers couldn't price the product. This opaqueness and the complexity of CDOs created a market panic when banks realized they couldn't price the product, or the assets they were still holding. Overnight, the market for CDOs disappeared. Banks refused to lend each other money because they didn't want more CDOs on their balance sheet in return. This panic caused the 2007 Banking Liquidity Crisis. Not only banks were left holding the bag, but also pension funds, mutual funds and corporations. As the results, CDOs led to the meltdown of the financial systems across the globe.