The History Of The Federal Reserve

Published Date: 02 Nov 2017

Furthermore, investment bankers were one of the causes that led to the financial crisis. The extent of a bank’s commitment, which was mainly assessed in term of prudent standard fail translate into action. 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 created flaws in the credit standard. Banks are excessive levered to earn more money which greatly increased the financial risk, without considering that they did not have enough capital in the event of a crisis. Investment bankers wanted to earn more profit, so they took excessive risk to make higher return. For example, Bear Stearns and Lehman Brothers leveraged their capital 30 to 1 or more. This was much higher than the usual limit of approximately 10 to 1. Therefore, Lehman brother cannot survive themselves when they faced unprecedented loss due to the subprime mortgages crisis. Moreover, most of the hedge funds invested much in mortgage-backed securities without fully understanding the risk of the product they invest. This made the financial market facing a huge loss when these investors realized the riskiness and fled from the mortgage backed security a. On the other hand, many of the investment firms used overnight repurchase 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 have limited 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.’ If regulator did not set a limit on leverage ratio, greedy investment bankers will continue to lend out the loan and make the system vulnerable.

Finally, Credit Rating Agencies (CRAs) are responsible for the financial collapse. Rating complex instruments such as collateralized debt obligations (CDOs) had caused 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 a result, almost all senior tranches had the highest rating of AAA. Investment grade ratings were given to CDOs that were created based on these risky subprime mortgage loans. These CDOs were then sold to investors. As the demand for CDOs grew dramatically, all investors from all over the world were attracted to these AAA rating securities that promised an attractive return, believing that these seemingly riskless investment was as safe as putting their money in a bank. The structured finance market collapsed and even ‘the highest rated (AAA) mortgage-backed securities fell by 70 percent between January 2007 and December 2008’. CRAs have been irresponsible in their duties by giving AAA credit ratings to CDOs that were very risky. The problem is that the assigned ratings did not fit the actual credit capacity, they were overvalued. 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 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 since 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 firms. Until then, the regulatory authorities should adopt and prepare an appropriate regulation and indicate the need for education of local staff in this field.

Mortgage Backed Security (MBS) is an instrument financed by the home mortgage payments. The invention of MBSs had altered the banking, mortgage business and housing. First of all, MBSs allowed more people to buy homes. During the real-estate boom, many mortgage companies and less cautious bankers allowed people to get into mortgages even though they couldn't afford. They made loans without the need of down payment. The lenders didn’t have to pay the consequences if the borrowers defaulted. This is why they didn’t care as much. They knew they could sell the loans and get incentives from it. Asset bubble was hence created, which then burst in 2006 in conjunction with the subprime mortgage crisis. Everyone experienced major losses since so many investors, pension funds and financial institutions owned MBSs. The ability to create MBSs was authorized by the 1968 Charter Act which created Fannie Mae.The purpose was to make financing available to homebuyers at lower costs and ensuring that funds were available throughout the country. The founders didn't anticipate that this would also remove a crucial discipline for good lending practices. The banks weren't cautious about the credit-worthiness of the borrower because they didn’t have to pay the consequences of it. 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 made investors can quickly buy and sell and borrowers benefited from a more ready willingness of originators to take their business. The high liquidity and other advantages of MBS helped increase utilization of MBSs. 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 (CDO) is a structured finance vehicle that issues multiple classes of liabilities to invest in cash assets and credit exposures through derivatives. Many institutions that had been buyers of CDOs lacked the infrastructure to monitor credit performance and estimate expected cash flows of underlying assets. After the real-estate bubbles burst, housing prices became unrelated to their actual value, people just simply wanted to sell the houses because they couldn’t afford it. , CDOs let banks to avoid having to collect on them when they become due, since the loans were now owned by other investors. This made them less disciplined in adhering to strict lending standards. Many loans were made to borrowers who weren't credit-worthy and it ensured disaster. Secondly, 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 CDOs without doing much research to ensure that the CDO was really worth the price. Thirdly, CDOs have been considered as highly complex instruments which are difficult to value. Warren Buffet called CDOs as financial weapons of mass destruction as per his philosophy of CDOs default risk is correlated and cannot be diversified. The complexity of CDOs created a market panic. Consequently the financial companies found that they owned CDOs in other banks which made it estimating the losses even harder. 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. As the results, CDOs led to the meltdown of the financial systems across the globe.