Government deregulation and failed regulation of the commercial and investment banking industries were important contributors to the subprime mortgage crisis. These included allowing the self-regulation of Wall Street's investment banks and the failed regulation of Wall Street rating agencies, which were responsible for incorrectly rating some $3.2 trillion dollars of subprime mortgage-backed securities.[1][2] The introduction of new mortgage products by the Alternative Mortgage Transactions Parity Act (AMTPA), passed by Congress in 1982, ended the long standing practice of limiting banks to making conventional fixed-rate mortgages.[3] Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages.[4] Fannie Mae and Freddie Mac also carry blame. The two GSEs purchased over $500 billion dollars in high risk Alt-A mortgage products, which they had previously classified as too risky for purchase in the 1990s.[5] Both Alan Greenspan and the SEC testified before Congress that the shadow banking system was not effectively regulated, even though it had become nearly as important as the regulated depository banking system in providing credit.[6]
Leverage Ratios of Investment Banks Increased Significantly 2003-2007The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. The SEC relaxed rules in 2004 that enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.[1][7]
The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs and Morgan Stanley).[8]
The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities.[9][10]
Economist Robert Kuttner and Paul Krugman have criticized the repeal of the Glass–Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree.[12][13]
Federal Reserve Governor Randall Kroszner says the CRA isn’t to blame for the subprime mess, "First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together… we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis," Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes."[25]
FDIC Chairman Sheila Bair disputes that the CRA was a problem "Let me ask you: where in the CRA does it say: make loans to people who can't afford to repay? No-where! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth ... pure and simple."[26]
Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008, of which about 8% were CDS.[29]
CDS are lightly regulated. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[30]
Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[31][32]
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."[33]
Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS).[34][35] A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.[36]
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.[37] U.S. Treasury Secretary Timothy Geithner has proposed a framework for legislation to regulate derivatives.[38]
[edit] Role of the SEC
The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs and Morgan Stanley).[8]
The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities.[9][10]
[edit] Repeal of the Glass Steagall Act
The Glass–Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.[11]Economist Robert Kuttner and Paul Krugman have criticized the repeal of the Glass–Steagall Act by the Gramm-Leach-Bliley Act of 1999 as possibly contributing to the subprime meltdown, although other economists disagree.[12][13]
[edit] Community Reinvestment Act
The CRA was originally enacted under President Carter in 1977. The Act was set in place to encourage banks to halt the practice of lending discrimination. There is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers[14][15][16][17] and defenders claiming a thirty year history of lending without increased risk.[18][19][20][21] Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages.[22][23] A study, by a legal firm which counsels financial services entities on Community Reinvestment Act compliance, found that CRA-covered institutions were less likely to make subprime loans (only 20-25% of all subprime loans), and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.[24]Federal Reserve Governor Randall Kroszner says the CRA isn’t to blame for the subprime mess, "First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together… we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis," Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes."[25]
FDIC Chairman Sheila Bair disputes that the CRA was a problem "Let me ask you: where in the CRA does it say: make loans to people who can't afford to repay? No-where! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth ... pure and simple."[26]
[edit] Financial Derivative Regulation / Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000 exempted derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.[27][28]Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008, of which about 8% were CDS.[29]
CDS are lightly regulated. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[30]
Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[31][32]
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."[33]
Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulate derivatives, including credit default swaps (CDS).[34][35] A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.[36]
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations.[37] U.S. Treasury Secretary Timothy Geithner has proposed a framework for legislation to regulate derivatives.[38]
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