The Financial Crisis Inquiry Commission

Published Date: 02 Nov 2017

According to the Inside Job, in 1990s, they started using derivatives, which are advance in technology that led to an explosion of complex financial products. They appealed that they made the markets safer but instead, they made them more unstable because they did not take seriously in the threat of innovation on the stability of the financial system. By using derivatives, the bankers can gamble virtually anything as they could bet on the growth or drop on the oil of the price. As a matter of fact, the investment banks preferred subprime loans, which are the riskiest loans because they have the higher interest rates. Hence, the investment banks (mortgages lenders, such as Washington Mutual Bank) lent subprime loans to the outsiders easily even when those who were unable to pay back the money (Levin 2010). As a result, thousands of subprime loans were lent to the borrower and the volume of subprime loans increased which shown in figure 1 (Recovered History: Clinton’s role in The Housing Disaster 2011). By being just, CDOs were created and grew expressively, which shown in figure 2 (Bernstein & Eisinger 2010). In the meantime, housing prices also increased harshly as everyone could make loans easily to buy homes. Nevertheless, the default led to a fall in housing prices and stopped growing, and the bubble burst finally. Thus, it caused many people lost their home as their homes were pull backed by the banks.

Oppositely, the crisis would not take place if the investment banks not only meet their objectives and also consider the objectives of the clients (Wall Street Wannabe 2011). For example, they not only look for their interest and also provide investment opportunities to help the businesses raising funds by purchasing securities from companies and resell them to the investors (Meaning, Function, and Importance of the Investment Banker, Stock Market 2010).  Additionally, they should restrict their lending requirements because loose lending could deteriorate the US economy and bring into recession (CNBN 2013). They should issue their loans to the borrowers who fulfil their lending requirement so as to prevent from recommitting the same error as the crisis.

On top of that, the credit-rating agencies (CRA) have the responsibilities of evaluating the risk of capitalizing of government and companies and providing information on the securities. Nonetheless, they were one of the institutions that did not take responsibilities on their jobs and caused the crisis. It is because the CRA, specifically case studies of Standard & Poor's and Moody's Corporation rated the high risk financial products as AAA rating, which were safe investments and perceived to have lower risk of default (Levin 2010). It was to be like an analogy of assuring everyone that the poisoned water was safe to drink.

The CRA operate with an inherent conflict of interest because their revenues were come from the firms and they are supposed to monitor the market exchange and critically analyze the financial products but the firms exerted pressure on them who regularly put market share ahead of analytical rigor (Levin 2010). Consequently, what the analysts said publicly was different from what they said privately in order to make more profit. As a result, buyers failed to look behind the ratings and caused massive losses in mortgage backed securities. Hence, investors could not flip their homes for a quick profit as a result of failures in credit-rating and securitization transformed bad mortgage into toxic financial assets, which have lower price and could not be sold at the price satisfactory to the holder (Thomas, Hennessey & Holtz-Eakin 2013). However, the analysts denied that they were mistaken in rating the securities and claimed that the rating was an opinion. Therefore, they started to tighten their lending requirements after the financial crisis occurred. However, some of them could not afford the debts and collapsed, such as Washington Mutual Bank (The Associated Press 2008).

By preventing the crisis happened, the CRA should be answerable to reduce the information asymmetry and supplying unbiased opinion by analyzing the investments of the parties to determine how credit worthy they are in order to fulfill their role and the outsiders could reduce their losses (The Role of Credit Ratings In The Financial System 2012). Besides, they are accountable to improve the efficiency of the market by concentrating on how credit ratings contribute to the markets’ operation. It is because ratings play the role of equalizer in the fixed-income capital markets and help to put investors on more equal basis. By making better judgment about creditworthiness, credit ratings lessen the capability of investors to outperform another (The Role of Credit Ratings In The Financial System 2012). 

On the other hand, Federal Reserve is supposed to promote sustainable growth and high level of employment, stability of prices and moderate long-term interest rates. The Fed are also obligated to regulate banking institutions for sustaining the stability of the financial system (US News 2013). However, the super-low interests rates and extremely disagrees with the regulation of the derivatives market that were advocated by Alan Greenspan, who was the former chairman of the Federal Reserve, are one of the factors that triggered the credit crisis in 2008.

According to Mick (2008), Alan Greenspan stated that the system had spread out the risk from banks, however, it resulted that he was wrong as the risk had kept on with commercial banks as they were obligated to put aside part of reserves to prevent from making losses. With the super-low interest, this encouraged everyone to load up on debts to buy homes. Subsequently, the banks issued massive amounts of mortgage to people and the defaults triggered a housing bubble and it led to credit crunch finally. It is because Federal Reserve failed using its power to stop the banks from taking part in substantial amounts of high-risk mortgage lending and restrain the flow of toxic mortgage by establishing prudent mortgage-lending standard (Goldfarb & Dennis 2011).

In the meantime, Alan Greenspan also supposed that the repeal of the Glass-Steagall Act, which forbids the commercial banks from cooperating with brokerage firms and taking part of investment banking activities, would bring about lower costs and broader availability of investment banking services for businesses (Greenspan Urges Glass-Steagall Repeal 2013). In this manner, banks created fraudulent loans and they sold them to their customers in the form of securities. When the bubble collapsed, it led to enormous losses to them (Rickards 2012). In 2008, finally, he confessed that he had made a mistake in presuming that financial firms could regulate themselves (Neate 2012).

Consequently, Federal Reserve took action to retrieve its mistakes by supporting insolvent banks and increasing cash flow to others (Neate 2012). For example, the Fed provided funds to assist J.P. Morgan Chase to acquire Bear Stearns, which was a large financial institution that had recently plummeted in value (Sewell 2010 b). Federal Reserve has to establish regulation so as to be able to make policy decision by controlling and regulating the financial institutions. Thus, the Fed can govern and examine the conditions of banks and their agreement with laws and regulations (Federal Reserve Education Organization). Additionally, The Fed should employ the rule-based policy for adjusting the money supply and the interest rate. In order to get there without causing more market disruption, The Fed must proclaim and follow a clear exit rule, so that, its bloated balance sheet is regularly cut back by expectable amounts as the economic recovery picks up (Taylor 2010).

2. One of the popular financial instruments that were actively traded in the stock markets is collateralized debt obligations (CDOs), which comprise the pooling of the different types of debts and then split into different levels of risk and sold to the investors in order to minimize risk for raising funds (Knowledge Wharton 2013). According to the Inside Job, CDOs can be created when the commercial banks traded the mortgages with the investment banks. Then, investment banks combined the mortgages and loans, such as student loans, credit card loans to create CDOs. Then, the investment banks sold the CDOs to the investors and paid to the credit-rating agencies to evaluate the CDOs. The lenders and the investment banks did not care whether the borrower could pay and sold them as much as they can. It is because the more CDOs they sold the more profit they received. So, in 2000s, there was a huge increase in subprime and the CDO volume grew expressively as well because subprime loans created CDOs, which was shown in the figure 2 (Bernstein & Eisinger 2010). In 2007, it started declining intensely in subprime mortgage crisis and defaults were rising in the mortgage market. Many assets that were held by CDOs had been subprime mortgage-backed bonds. So, investors started to stop financing CDOs because it caused huge losses to the investors, and even several subprime lenders were bankruptcy.

In addition, credit default swap (CDS) was also traded in the stock markets, where the purchaser of the swap makes payment to the seller of the swap until the maturity date. The seller agrees to compensate a third party debt if this party defaults on the loan. Through the Inside Job, CDS was sold by AIG, the largest insurance company. CDS operates like an insurance policy. The investors, who purchase the CDS, had to pay AIG a quarterly premium. If the CDS went bad, AIG have to reimburse the investors for their losses. Besides, speculators could also buy CDS from AIG so as to bet against CDO that they did not buy. Therefore, there were getting more and more people to buy CDS in order to make more profit, which shown in figure 3 (Reserve Bank of Australia 2011). Since CDS were unregulated, AIG did not put aside any money to cover the potential losses. As a result of the value of these entities fell, AIG had massive written-downs and had to post more collateral. However, The Fed could not let Bear Stearns bankrupt because it would eliminate the trillions dollars of credit default swaps on its records (Gilani 2008). Finally, the government took over AIG from bailout and had increased potential financial support to AIG (Karnitshing, Solomon, Plemen & Hilenrath 2013).

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