1

The House of Cards

By Garrett Leider
Directed Studies Report/ Professor Charles Ruscher PhD
April 25,2009
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Table of Contents:

I. Introduction.

II. A brief history of the subprime mortgage.

III. The recent sub-prime boom (1997-2007).

IV. Angelo Mozilo and Countrywide Financial.

V. Wall Street’s Role.

VI. It is now a truly global economy.

VII. Governmental Response.

VIII. Prevention Methods.

IX. Conclusion.

X. Bibliography.
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I. Introduction.

Corporate greed? Check. Astronomical upper-management compensation? Check.

Massive job losses? Check. Record quarterly losses and bankruptcies? Check. “He said,

she said” finger pointing? Check. The use of taxpayer money to attempt to solve the

problem and let management off the hook? Check. And still no responsibility taken for

the problem? Check. So then what makes the current economic crisis different from ones

of the past such as the 1979-1982 recession, the Chrysler bailout of 1979, the S&L crisis

of the 1980s and 1990s, and the dot-com implosion? In retrospect, not a whole lot. But

the reason why the current economic crisis is on a scale unimaginable to most people,

including many renowned economists is due to the interconnectivity of the global

economy, primarily achieved over the last fifteen years according to most scholars. In

this paper, I intend on laying out the reasons why we are neck deep in this mess today,

decipher the government’s actions to prevent the problem from getting worse, and

suggest methods to ensure that this never happens again.

II. A brief history of the subprime mortgage.

Although the sub-prime mortgage industry really took off after the terrorist

attacks of 9/11, enabled by interest-rate cuts championed by then-Federal Reserve

Chairman Alan Greenspan and a national economy recovering from a decline in growth,

the foundation of the sub-prime mortgage dates back a few decades before that. Sub-

prime mortgages grew out of the second lien mortgage business that was started in the

1960s by “pioneers” of the industry like “Peter Cugno and Beneficial Finance” (1). In the

beginning, companies like Beneficial Finance would not extend “credit to a homeowner
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if the first and second mortgages combined would have an LTV (loan-to-value ratio)

above 80 percent” (2), but Beneficial Finance niche was making second mortgages to

customers who had owned their house for years and seen with it an increase in its value;

with this a relatively conservative new lending industry was born. However, with the

S&L industry beginning to fail in the 1980s, large regional banks began looking for ways

to expand their business-lending units in order to shore up their balance sheets and

continue generating profits their investors clamored for. With these banks lending to

larger consumer finance companies like Beneficial, the smaller companies begin to

search out for ways to lend out more money to consumers without paying the fees that

large financial banks demanded: wealthy individual investors were the answer they so

desired.

The rise of the sub-prime mortgage industry was fueled by “rich professionals

who were looking to put their extra cash to work, becoming the backbone of the subprime

industry in the 1960s, 1970s, and early 1980s” (3). With this investor pool now secured,

large financial companies began to take notice, and Prudential Securities jumped in head

first, offering Aames Financial, a smaller consumer finance company, a $90 million

warehouse line. Yet Prudential was not just lending money to Aames and standing pat

while making a profit off their credit line, they began pooling the loans and securitizing

them into mortgage bonds and with it came the birth of a new industry and a security

instrument: the mortgage-backed security (MBS). With the advent of Prudential’s

relationship with Aames Financial, Wall Street firms like Lehman Brothers and Bear

Stearns began to rush into the sub-prime mortgage business via the underwriting of these

consumer finance companies IPOs, the buying and securitizing of their sub-prime
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mortgages, and the lending of money through warehouse lines of credit to these smaller

companies: Wall Street had tasted blood and the waters were dark.

When the Russian debit crisis began to unfold in 1998, spurned by the Russian

government’s devaluing of the ruble, Wall Street firms like Lehman Brothers and Bear

Stearns and the newly created hedge funds began to loose their appetite for buying the

least risky bonds and subsequently began cutting back the amount of money they would

lend to these subprime consumer finance companies. In addition to this, many subprime

loans began to refinance faster then consumer finance companies like Aames Financial,

Beneficial Financial, The Money Store, and First Plus had ever anticipated. Coupled with

the “gain-on-sale (GOS) assumptions that these firms had made turning out to be horribly

wrong” (4), investors began to flee from these companies in droves, and subsequently

resulted in many companies filing for bankruptcy. The lack of coverage on this first

crisis, according to one analyst, was “due in part to their busy coverage of the Russian

debt crisis and the meltdown of Long-Term Capital Management (LTCM)” (5), a

massive private hedge fund operated by John Meriwether. Yet an argument could be

made that the lack of media coverage on the first sub-prime crisis was also due to the fact

that the sub-prime industry of the 1990s was still “relatively small, accounting for just

10% of all mortgages funded in the United States” (6), keeping many of the financial

behemoths sheltered from the losses felt by the smaller finance companies of the time,

and their appetites for new profit sources just as intense.

III. The recent sub-prime boom (1997-2007).

With the booming American economy of the 1990s, the American dream of

owning a home was never more prevalent. With home prices rising 126% between 1997

and 2006 (source: economist.com), more and more average American consumers

believed the owning of a home to be a sound investment opportunity and they came to

lenders more then happy to finance them in flocks. With the advent of loan brokers who

took customers to smaller consumer finance companies like The Money Store, only

requiring to be paid a small fee, larger companies like Countrywide Financial led by

Angelo Mozilo, became heavily involved in the lending of money to these new

customers, and were happy to assist them in their dreams of becoming homeowners. And

with industry trade groups creating an “informal political alliance to beat down any type

of legislation that might harm their bottom line” (7), you subsequently had the perfect

storm brewing for economic catastrophe: lax-government regulations, eager new home

owners, and lenders and Wall Street firms with eye balls filled with dollar signs.

The business of loan brokering soon became a booming business: according to

David Olson, an economist who conducted research on the loan brokerage industry

through his firm Wholesale Access of Columbia, Maryland. “In 1998, mortgage lending

became a $1 trillion a year business. If loan brokers earned an average one point and

accounted for 70 percent of all loan originated each year (Olson’s estimate), that worked

out to $7 billion a year in fee income” (8). Due to this large amount of willing new

homeowners and lured by the prospect of huge earnings, as of January 2007, there were

roughly “200,000 individuals who worked for 53,000 loan brokerage firms and they were
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earning a lot more than one point per loan, and the fees paid to brokers on subprime loans

were a lot higher than the old standard one point” (9). With this profit source only

growing larger each year, loan brokers had an enormous incentive to sign anyone with a

walking pulse up for a new home and mortgage, regardless of their credit rating, income,

and capacity to repay. According to several interviews conducted by National Mortgage

News, few brokers were willing to admit they earned $1 million or more per year, but a

survey later conducted by the newspaper found that 80% of brokers contacted said they

earned north of $400,000 per year.

Any person with a simple business sense could understand that the higher the

yield on a loan made that particular mortgage even more valuable to wholesalers like

Countrywide, Wells Fargo, Washington Mutual, and Wachovia who could in turn sell it

to Wall Street at a higher price. Wall Street firms involved in the sub-prime debacle

would then pool these sub-prime loans into bonds and the bond investors couldn’t get

their hands on these assets paying a much higher-yielding rate fast enough. With loan

brokers, mortgage wholesalers, and Wall Street firms all in on the take, ignoring the risk-

aversion strategies they championed so much to the American public, there had to be an

under-laying reason for this reckless lending: bring in the US government.

The US government’s role in the sub-prime mortgage collapse lies in various

aspects, stretching through three administrations dating back to the Reagan

administration. President Reagan’s signing of the Garn-St Germain Depository

Institutions Act of 1982 ushered in an era of deregulation for the housing finance

business by allowing insured depositories to invest 40% of their assets in nonresidential

real estate and by permitting it to have just one stakeholder, attracting developers of all
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kinds to purchase S&L depositories or start their own and continuing the cycle of

irresponsible lending. Under the Clinton Administration, the U.S. Department of Housing

and Urban Development (HUD) in 1996 directed the Government-Sponsored Enterprises

(GSE) of Fannie Mae and Freddie Mac that “at least 42% of the mortgages they

purchased should have been issued to borrowers whose household income was below the

median in their area” (9), fueling the sub-prime mortgage boom even more.

While the Bush Administration’s role in the current economic crisis and sub-

prime mortgage market’s collapse is still widely debated, this much we know: under the

Bush Administration, the HUD mandated that the GSE purchase loans from borrowers

whose household income was below the median in their area to “52% of their total

purchases in 2005” (10), up 10% from 1996. The Bush Administration was also a vocal

supporter of free-market capitalism and relaxed government regulation. This is nowhere

more apparent then in former Federal Reserve Chairman Alan Greenspan’s monetary

policies, especially in the realm of interest rates, where he championed interest rate cuts

after 9/11 and kept rates historically low for a wartime nation. This led to the spigot of

cheap credit continuing to flow, allowing American consumers to continue their debt-

fueled spending binge and lowest in the developed world savings rate, aided not only by

government policies and decision makers but also by Wall Street’s ongoing gorge with

rising profits, regardless of the risks they carried with it.

IV. Angelo Mozilo and Countrywide Financial.

Countrywide Financial Corporation, led by Angelo Mozilo until July 1, 2008, is a

picture-perfect example of the greed that characterizes financial crises and economic
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collapses. By effectively tossing modern portfolio theory, diversification, and any risk-

analysis measures conceived in the last eighty years completely out the window,

Countrywide Financial became the largest lender and servicer of mortgages in the entire

world. With Countrywide Financial continuing its love affair with loan brokers as

“38,000 of the 44,000 brokers in the U.S. were approved and signed up to do business

with Countrywide” (11) and utilizing the new stated-income loan, Countrywide

originated “$150 billion in mortgages rated A- to D between 2004 and 2007” (12).

Driven by Mozilo’s quest to become the biggest sub-prime originator in the U.S,

Countrywide began to get sloppy; loan brokers would be approved in 72 hours,

background checks done on borrowers were outsourced to contractors in India, and due

diligence was taken off the back burner and left to rot.

Yet Mozilo was hell-bent on keeping Countrywide’s reputation as sterling as

possible, and in his quest for growth, Mozilo led Countrywide into the life insurance

business. To sell life insurance globally, companies need to maintain a triple-A credit

rating, something the company lacked due to its subprime mortgage business: involving

Mr. Warren Buffett would soon change this. Yes, the man proclaimed by many in the

world to be a financial genius, and the world’s smartest investor, the “Oracle” was duped

into selling an insurance policy, through Berkshire Hathaway, to Mr. Mozilo and

Countrywide Financial. With this insurance policy in hand, Mozilo quest for nationwide

financial dominance was complete.

Angelo Mozilo is the epitome of corporate greed: his executive compensation

during the U.S. housing bubble of 2001-2006 approached $470 million (13).

Countrywide’s payment of his annual country club dues at Sherwood Country Club in
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Sherman Oaks, CA, The Quarry at La Quinta golf club in La Quinta, CA, and Robert

Trent Jones Golf Club in Gainesville, VA only validates this point. This point is further

exemplified by his selling of company stock even when he was publicly touting the stock

and using shareholder funds to support buy back programs in order to support an inflated

stock price.

The example of Angelo Mozilo’s involvement in the sub-prime mortgage collapse

is sadly not unique; many other CEO’s and top managers of Wall Street firms, mortgage

companies, and other financial corporations participated in similar compensation

programs, designed to reward reckless risk taking, all in the name of huge annual profits

that kept shareholders happy and the governments of the world off their backs.

V. Wall Street’s Role.

Wall Street’s role in the sub-prime mortgage collapse and the subsequent global

economic downturn cannot be understated in any shape or means. Like Countrywide

Financial, Wall Street firms involved in the sub-prime mortgage business threw all risk

analysis, diversification strategies, and modern portfolio theories into the garbage can; all

for the sake of record profits that left top management fat, merry, and content. No Wall

Street firms were exempt from exposure to sub-prime mortgage backed securities and

derivatives yet a select group of firms were leading the pack and their lead was lengthy

and secured.

The firms at the head of this group now all have one thing in common: either they

endured embarrassing and disastrous bankruptcy hearings or were sold at fire sale prices

to their competitors, largely at the urging of the U.S. government. Lehman Brothers went
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up in smoke in September 2008; Bear Stearns and Merrill Lynch were sold later that

month, and Morgan Stanley and Goldman Sachs opted to become commercial banks, in

order to obtain government bailout funds, becoming the subjects of stricter regulation in

order to maintain a fiscal solvency that was quickly slipping away.

Wall Street’s love affair with sub-prime mortgages begin when Salomon Brothers

created a new financial instrument called the mortgage-backed security (MBS) in the

mid-1980s. This gooey, romantic affair continued when mortgage traders at First Boston

perfected the MBS through the development of the collateralized mortgage obligation

(CMO), a more predictable financial instrument. Seeing the profits that these instruments

had generated for their founders, many other Wall Street firms took the plunge, eager to

expand their companies’ income statements at a breakneck pace. Financing of these

mortgage corporations operations, IPOs underwrote by Wall Street firms, and the

securitization of these mortgage securities continued this wet and wild love affair. No one

fell more head over heals then Lehman Brothers.

Lehman Brothers bravado in the sub-prime mortgage industry led to record profits

at the company, $3.26 billion in 2005, $4 billion in 2006, and $4.125 billion in 2007 (14).

Yet this arrogance in the company’s financial superiority ultimately led to its downfall.

The house of cards they had slapped together without much consideration to situational

analysis begin to crumble in 2008 when they reported a $2.8 billion loss in the 2nd

quarter, forcing the company to sell $6 billion in assets (15). This loss, coupled with

another astronomical loss of $3.9 billion for the 3rd quarter (16) was apparently the result

of its large holdings in sub-prime and other lower-rated mortgage securities, while during

the same time securitizing the underlying mortgages of which these securities were sold
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upon. Former CEO Richard Fuld largely led this reckless quest for profit, and the

company under his leadership became the top U.S. underwriter of mortgage bonds in

2006 and 2007 (17), neglecting the massive risks that these bonds carried with them. Yet,

there were opportunities according to many Wall Street executives to sell the company

before it collapsed; ultimately it was Fuld’s arrogance that caused him to reject these

offers, as he believed they did not accurately reflect the value he so greatly defended in

the bank. And in accordance with other executives involved in this collapse, it did not

stop him from accepting ludicrous compensation packages, totaling $480 million over the

previous eight years (18). It appears as if they didn’t break the mold when Fuld was born.

Bear Stearns, once regarded by Fortune Magazine, as “America’s most admired

securities firm” became the litmus test for corporations on the verge of collapse during

this crisis. Its exposure to the sub-prime mortgage markets began in 1997 and though it

was shaken somewhat during the sub-prime mortgage collapse in 1998, it became hell

bent on dominating the mortgage securitization market through an industry-wide used

three-pronged approach whose goal was “sucking as many subprime loans as they could

out of nondepositories like Ameriquest, New Century, and others” (19). The 1st prong

started with the salespeople, pressuring them relentlessly in the hope that they would sell

you the loans at the cheapest possible price, and by the next day, the loans would be out

on the marketplace. Next came the outsourcing firms, whose only job was to

reunderwrite the mortgages in order to assure the investment-banking firm that the

mortgage can go safely into a security. The icing on the cake was the extending of

warehouse loans to nondepositories at no cost in order to get their business. Wash, rinse,

dry: repeat as often as possible.

Many Wall Street firms believed that “as long as home prices kept going up at a

rate of 25 percent a year, there would be nothing to worry about” (20). No one

exemplified this better then Bear Stearns; according to Fortune Magazine, Bear Stearns

contained a net equity position of $11.1 billion in 2007, supporting $395 billion of assets

and revealing a leverage ratio of 35.5 to 1: insane. Carrying with it was $13.4 trillion

dollars in derivative financial instruments: with a balance sheet that leveraged, just a

small fraction of these instruments failing would break the company in half; it is precisely

what happened. With two of its hedge funds collapsing due to its investments in

collateralized debt obligations (CDO), investors began to flee the company, and with a

rapidly declining stock price, Bear Stearns executives were forced to sign a merger

agreement with JP Morgan Chase on March 16th, 2008 in stock swap valued at less then

10% of its market value. When you realize that Bear Stearns once traded at $172 as

recently as January 2007 and that it was now being sold in a merger valued at $2 adjusted

per share, you realize just how much harm the company had done itself by exhibiting

such a reckless abandonment for profit. Perhaps greed is not as good as it once seemed.

Hi, I am John Thain and I am the poster boy for corporate greed, excess, and

irresponsibility. After our parent company, Bank of America, received $20 billion from

the federal government to complete our merger, I decided to refurnish my corporate

office at the taxpayers’ expense of $1.22 million; isn’t America great? Though John

Thain didn’t take over Merrill Lynch until December of 2007, Merrill Lynch’s place in

the corporate dysfunctional world had already been cemented. This position can be

summed up in the following quote of a former Bear Stearns managing director when

asked about former Merrill Lynch CEO Stan O’Neal and his jealousy of Lehman
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Brothers and Bear Stearns subprime securitization business: “Oh, it just pissed him off”

(21). Furthering the effect of resentment was the fact that according to Bill Dallas,

chairman of Ownit Mortgage, that “when the sub-prime business recovered, Lehman was

making money hand over fist; Merrill, was late to the party” (22).

Due to Merrill Lynch’s tardiness in the sub-prime mortgage business, CEO

O’Neal decided to jump in head first; be number one was his mandate. First order of

business: dump the senior manager of the mortgage department and replace him with

Michael Blum, a confident of O’Neal’s who would do anything to garner the praise of his

boss. That he did: the purchasing of sub-prime loans by Merrill Lynch increased

exponentially, even paying 3 to 5 cents higher then their next competitor for each sub-

prime loan available. With loan originations in the U.S. reaching “$3.9 trillion in 2003,

and sub-prime loans accounting for $390 billion or 10%” (23), Wall Street’s role in the

mortgage business had been cemented and Merrill Lynch began to see the fruits of their

labor. Merrill’s operating profit between 2003 and 2006 “averaged $5.2 billion, more

than double the $2.1 billion average in the proceeding five years” (24). Merrill’s growing

operations in the sub-prime mortgage market became Stan O’Neal’s #1 priority and he

emphasized this at whatever chance he could get; through press releases, internal memos,

speaking engagements, corporate meetings: he wanted in and badly, badly enough to pay

upwards of 105 cents on the dollar for every mortgage. Corporate lunacy was operating at

full throttle.

Through the selling of warehouse financing to subprime originators at nearly next

to nothing, Merrill began to pick up market share from other Wall Street firms unwilling

to go to such great lengths to secure their business. And by the end of 2005, Merrill had
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become the “seventh largest issuer of subprime ABSs in the United States, just a few

billion dollars behind its archrivals, Bear Stearns and Countrywide” (25). Like Lehman

Brothers and Bear Stearns, Merrill Lynch had launched and owned its own mortgage

company that enabled it to go directly to the source of the mortgages without having to

hassle with other Wall Street firms and intermediaries. With this company set and

operating, in 2006 Merrill began sending out feelers to potential companies it was

looking to acquire and it settled on First Franklin, a money center bank based in

Cleveland, Ohio. Paying $1.3 billion for a company that had sold for four times less in

1999 (26) completed O’Neal’s quest to become a giant amongst dwarfs; Merrill was now

able to manufacture loans itself and complete the cycle.

By paying top dollar for mortgages and through its institution of a policy that was

considered to be the most pro-lender friendly, Merrill’s exposure to the mortgage market,

both sub-prime and jumbo rated was of a prodigious scale. Borrower defaults on their

loan on the 61st day? That was Merrill’s problem. The majority of Wall Street firms made

the lender buy back delinquent loans up to 90 days; cutting that to 60 days only wetted

loan originators appetite for dealing with Merrill more. In Merrill’s quest to become the

biggest and baddest of them all, passing as many loans as possible, they began to get

lazy, buying loans approved by outsourcers that were rated a three (fail) and always

walking a fine line between reputable and fraudulent.

With home delinquencies rising rapidly in 2007, dozens of subprime lenders and

hundreds of loan brokerage firms began shutting their doors, and with the overseas

market for CDOs drying up, Merrill’s “luck” began to change and not for the better. In

November of 2007, Merrill disclosed to its investors that it would “write-down $8.4
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billion in losses associated with its mortgage business” (27) and remove Stanley O’Neal

from the CEO position; it was the only major Wall Street firm to lose money in the third

quarter of 2007. And the fourth quarter was even worse; Merrill “posted the largest loss

in company history of $8.6 billion, setting aside with it $12 billion to cover expected

losses on its subprime CDO bonds” (28). Totaling over $20 billion was the damage

Merrill inflicted on itself through its investment in the sub-prime business, and that is not

even including the cost of acquiring First Franklin and Ownit Mortgage Solutions. The

cards were beginning to fall and First Franklin was the first to go: Merrill Lynch pulled

the plug on it in early March 2008 and the collapse was complete in some regards on

September 14, 2008 when Bank of America agreed to purchase Merrill Lynch for almost

$50 billion according to the Wall Street Journal.

The preceding snap shot of three Wall Street firms heavily involved in the sub-

prime mortgage collapse illustrate just how reckless they were in their quest for profit

sources that they believed would never dry up. It appears as if these companies and the

executives who led them never learned from mistakes made during previous bubbles and

bull markets, though in fairness home prices had gone up every year “from 1890 to 2004

at an inflation-adjusted rate of 0.4%” (29). What is different about this bubble and

subsequent collapse is the effect it has had on all global economies, from the developing

nations of Asia to the developed countries of Western Europe. It is to this where I next

turn my attention.
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VI. It is now a truly global economy.

The global bull market of the mid to late 1990s was led by an American economy,

which experienced real GDP growth of 36% between 1990 and January 2000 (Source:

data360.org, a non-partisan organization), padding the wallets of many Americans and

leading to a debt-fueled spending binge that is partially to blame for the crisis we are

currently in. Some scholars have pointed to this decade as the truly second coming of

globalization; however I believe it would be better classified as an “Americanization” as

we were the primary source of many nations economic growth, both developed and

developing, through our purchases of their manufactured goods, and most importantly

their raw materials. The new dawn of globalization came in the 2000s and in no better

way is this illustrated then through the effects that the sub-prime mortgage collapse has

had on all economies of the world, further magnified by the world’s credit markets

freezing. Countries thought to be isolated from the U.S. economic decline have defaulted

on their debt, had their credit ratings downgraded, and their currencies have been on the

verge of collapse as investors flee to safer securities and central banks step in to attempt

to stem the tide through the use of their central reserves.

When American investors appetites for CDOs and ABSs appeared to be full, Wall

Street firms turned to international investors, flush with petrodollars and buoyed by their

own country’s economic growth, to continue purchasing the securities that Wall Street

firms were churning out by the second and investors located in all corners of the globe

were more than happy to oblige. The dangers of purchasing CDOs and ABSs originating

in the U.S. was that investors didn’t know one lick about the assets that these securities

were based upon, they didn’t know if the homes were palaces fit for a king or shacks that
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would seem more suited for the slums of Dhaka. They didn’t know what the borrower’s

household income was, whether it was a true figure or one made of pixy dust. They didn’t

know if the loan was based upon a real appraisal or one pulled from the Internet. These

investors just assumed that if a reputable Wall Street firm whose reach stretched

worldwide underwrote the securities, that it must be considered a safe investment. With

these securities carrying yields several points higher then traditional bonds, investors

gobbled up as many securities as they could possibly afford and continued Wall Street’s

reckless practices.

The global reach of the financial crisis began when CDOs that countries had

purchased from Wall Street firms started to default, causing huge losses both within Wall

Street and abroad at hedge funds and banks. Just a month after Bear Stearns’ two hedge

funds filed for bankruptcy, an Australian hedge fund called Basis Yield Alpha Fund filed

for bankruptcy protection in July 2007. Its lenders included who else but “Citigroup,

JPMorgan Chase, Lehman Brothers, and Merrill Lynch. In its bankruptcy filing, Basis

Yield Alpha Fund cited mounting losses from sub-prime mortgage assets” (30) sold to

them by investment bankers in the U.S. Banks that were once thought to be on a sound

economic foundation began to either fail or require capital injections made by their

respective governments, all because of their exposure to sub-prime CDOs. In France, one

bank took a $3 billion loss and in Germany, “the government was forced to merge two

ailing banks because of their subprime investments” (31). In September of 2008, the Irish

Government undertook a two-year guarantee arrangement to safeguard all deposits in six

Irish banks; the economic union of Belgium, Luxembourg, and the Netherlands was

driven to invest “$16.3 billon in Fortis, a huge banking and finance company that was
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partially nationalized under the plan” (32) after sustaining record losses and investor

confidence having crumbled. Iceland’s economy collapsed after experiencing difficulty in

their attempts to re-finance short-term debt. Though the fallout continues to this day, this

much is known: the national currency has plummeted, foreign currency transactions were

literally suspended for weeks, the market capitalization of the Icelandic stock exchange

fell by 90% and the government was forced to nationalize Glitnir bank. While scholars

and economists debate the causes of Iceland’s collapse, it is readily accepted that due to

reckless borrowing by Iceland’s newly de-regulated banks, when they were unable to re-

finance their debt on the interbank lending market, the debts expired, leading to the

collapse of the banks. Because these banks were so much larger then the national

economy, the hands of the Central Bank of Iceland and the national government were

effectively tied, and the damage was done.

Developing nations were not isolated from the chaos going on many time zones

away. With the world’s developed nations economies in free-fall, consumer demand for

the items these nations produced went into a nose-dive, as evident by China’s export total

to the U.S. dropping 14% in 2007 (source: The US-China Business Council). Shipping

rates, once sky-high due to the growing price of fuel, plummeted and the demand for raw

materials crashed as companies were producing less and less manufactured items. The

crisis had reached epic proportions and no one was unaffected.

These examples show that it was not only Wall Street firms who were on cloud

nine from past profits. Corporate institutions worldwide saw the money that these firms

were printing and wanted a piece of the action themselves; what they got was definitely

something more then they bargained for. While the blame for the global economic crisis
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resides predominantly in the United States, it is a fair statement to make that we buried

some of our garbage overseas. Nothing exemplifies this better then the following blurb

uttered by an investor in Abu Dhabi: “he said to the Wall Street firm that sold him the

CDOs: ‘How come I’m losing money? It’s triple-A rated.’ The Street firm just crapped

all over him” (33).

The preceding six sections of this paper were written to provide the reader with a

general conceptual timeline of how the sub-prime mortgage fiasco unfolded, who the

major players were, the results of their reckless actions, and how it has affected

companies, governments, and individuals in all corners of the globe. But as I have been

writing this over the past ten weeks, the same question continues to pop up inside my

head: what started and enabled this reckless sub-prime mortgage binge that has basically

caused the collapse of home prices and subsequently brought the U.S. economy and with

it, the global economy on the verge of disintegration? On the surface, it would appear that

first-time borrowers, loan brokers, mortgage lenders, Wall Street firms, and investors all

bear some responsibility for the sub-prime collapse and they rightfully do. But who were

the facilitators behind the boom of sub-prime mortgages, who enabled this reckless

lending practice to continue to take place even as the foundation was beginning to show

signs of cracking? And the answer I keep coming back to is the U.S. government and its

regulatory agencies.

By cutting interest rates to levels historically low for a wartime nation and by

continuing to champion free market monetary policies, the U.S. government, beginning

with the Reagan Administration and ending with the Bush Administration in 2008,

allowed these lending practices to begin, prosper, and implode, sitting on the sidelines for
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much of the time and taking action only when it was too late to stem the tide of red ink

gushing from American households, Wall Street, and corporations not even involved in

the lending business.

As evident from the previous section of “A brief history of the subprime

mortgage”, the U.S. government became the enabler for lower-income Americans to

achieve the American Dream of becoming a homeowner. It is my belief that if it wasn’t

for the U.S. Department of Housing and Urban Development (HUD) directive that Fannie

Mae and Freddie Mac must purchase a set number of mortgages from borrowers with

household incomes below the median in their area, that a majority of these risky

borrowers would have never signed on the dotted line for mortgages that enticed them

with low initial payments and no money down at closing only to jack up the interest rates

a few years down the line. Through this directive and mortgage lenders use of extremely

risky income verification tools such as stated income applications and no due diligence

necessary, first-time homeowners were setting themselves up for trouble.

This trouble was further inflated by the Federal Reserve efforts to keep interest

rates low, allowing the spigot of cheap credit to flood the U.S. economy, and making it

more affordable for borrowers to drown themselves in initially cheap debt, rack up credit

card bills with no possible way of repayment, and to continue a abysmal savings rate that

turned negative in 2005, the only one of the developed world.

With the Bush Administration embracing free market capitalism with open arms,

the regulatory agencies that were in charge of preventing such a bubble from happening

began to implant a “hands off” approach, believing that as long as home prices continued

to rise that it was not plausible for the bottom to fall out of the housing industry and
 22

consequently the U.S. economy as well. Though it is fair to say that Federal regulatory

agencies did not have any laws in place to prevent such reckless lending practices and

that lenders were not breaking any laws beyond common sense, there apparently was a

culture of “don’t ask questions” within the walls of the SEC and the CFTC, furthering the

era of free market capitalism and lack of government intervention within the U.S.

economy.

Regardless of the roles that borrowers, loan brokers, mortgage lending companies,

Wall Street firms, and the investors who purchased these securities played in the sub-

prime mortgage boom and collapse, the U.S. government is where the buck eventually

stops. The irresponsible lending practices and securitization of these loans were all

facilitated by the U.S. government, hell bent on continuing the economic growth

achieved in the late 1990s into the late 2000s, the terrorist attacks of 9/11 only being a

minor speed bump. Yet it was this same government that eventually realized the sheer

enormity of the problem that they helped facilitate and unleash. It is the government’s

responses to this problem that I now turn to.

VII. Governmental Response.

The U.S. Government’s response to the sub-prime mortgage crisis and consequent

global financial crisis has been spotty at best, with a number of the ailments it has

prescribed failing to stem the tide of negative economic news that continues to pour

through the airwaves. This flow of bad news as spread internationally, as other

government’s of the world deal with bank failures, negative GDP growth, currencies

plummeting, and defaults on debt issued during the boom times of the early 2000s.
 23

The U.S. Federal Reserve’s responses to the sub-prime mortgage crisis have

centered on what Chairman Ben Bernanke called “efforts to support market liquidity and

financing and the pursuit of our macroeconomic objectives through monetary policy”

(34). The Federal Reserve has lowered its target federal funds rate from 5.25% to 2% and

its discount rate from 5.75% to 2.25% ending in April of 2008 in order to encourage

lending between banks and to individual borrowers. These rate cuts have increased lately,

in fact they are effectively at 0% now, yet the thawing of credit markets has been

lethargic at best. With these actions not helping the credit markets, the Federal Reserve

increased the monthly amount of loans made to banks, to a cumulative total of “$1.6

trillion of loans made to banks for various types of collateral” (35) by November 2008.

The Federal Reserve in November of 2008 announced a “$600 billion program to

purchase MBSs of Fannie Mae and Freddie Mac” (36) in an effort to help lower

mortgage rates and stabilize Fannie and Freddie’s balance sheets.

With these initiatives in place, it soon became apparent that more was needed,

especially in the regulatory realm. Congress soon approved an expansion of Federal

Reserve regulatory powers, allowing the Federal Reserve to have jurisdiction over

nonbank financial institutions and the authority to intervene in financial crises. New

regulations have been proposed recently to subject nondepository banks to the same

capital requirements as of depository banks, regulation regarding restrictions of the

leverage used by financial companies, leading Alan Greenspan to propose that banks

should have a 14% capital requirement ratio, much above the historical 7-11% ratio

employed by many banks. The underlying problem of these proposed regulations which

has led to much debate in the financial world and Congress is the potential of
 24

overregulation, retarding future economic growth and profits, the effects of which would

be felt by many ordinary households and individuals. These cries of too much

government intervention have not squashed the government’s role in this crisis, evident

from the proceeding paragraph.

The government’s response to this economic crisis has centered on three things:

Federal Reserve monetary policy and new regulations, economic stimulus packages, and

government-led takeovers of some of the biggest financial institutions of the world.

President Bush signed into law a $168 billion economic stimulus package on February

13, 2008 that primarily consisted of income tax rebate checks designed to get consumers

spending again. The inflow of government money into consumers’ wallets did little to

help the economy as gas and food prices continued to skyrocket, largely negating the

gains that consumers had received and renewing calls for more government action to help

the economy; that help eventually came in some unexpected places.

With the government’s assistance facilitating JPMorgan Chase’s purchase of the

beleaguered investment bank Bear Stearns, it began a period of government economic

intervention unseen since the Great Depression. The Federal government seized IndyMac

Bank’s assets after it collapsed; Fannie Mae and Freddie Mac were placed into federal

conservatorship after both banks were on the verge of going bust, and insurance giant

AIG received an $85 billion loan from the Federal Reserve in September 2008, giving the

Federal government a 80% equity stake in AIG. Since September 2008, AIG has received

more money from the government and it has been estimated that it could eventually cost

taxpayers “$250 billion due to its critical position insuring toxic assets of many large

international financial institution through credit default swaps” (37). Yet the trouble
 25

continues: the USA Office of Thrift Supervision (OTS) seized Washington Mutual in

September 2008 and its assets were later sold to JPMorgan Chase. For reasons that

remain highly debated, the Federal Reserve, in the midst of all these government bailouts,

let Lehman Brothers slip into bankruptcy after talks to purchase the company failed with

Bank of America and Barclays, citing losses too big to absorb.

With losses on MBSs and other assets continuing to skyrocket at a numerous

financial institutions and the freezing of the credit market, the Emergency Economic

Stabilization Act of 2008 (EESA or TARP) was signed into law by President Bush on

October 3, 2008. This law included $700 billion in funding for TARP, which was

intended to purchase financial institutions’ MBSs and CDOs that were backed by now

toxic sub-prime mortgages. The U.S. Treasury began to inject funds into financial

institutions in exchange for dividend-paying, non-voting preferred stock. Major financial

companies that have since received money on multiple occasions include Citigroup,

Wells Fargo, JPMorgan Chase, Bank of America, Goldman Sachs, Merrill Lynch, and

Morgan Stanley. Yet with write-downs on losses increasing, a hesitancy to lend continues

to persist within the banks and it is apparent that more action will be needed. Under

President Obama, Treasury Security Timothy Geitner has revealed plans that, though

details remain murky, to increase these financial institutions solvency and get them to

begin lending again through the use of more taxpayer money.

The U.S. government has not been alone in the realm of government intervention

and takeovers: the British government has nationalized and provided bailout money to

multiple banks including RBS, the Australian government has approved measures to lend

“AU$4 billion to nonbank lenders unable to issue new loans” (38), the Chinese
 26

government has approved a stimulus package of roughly $600 billion and various

European governments including Ireland, Denmark, France, and Belgium have approved

government bank bailouts and stimulus packages.

With the signing into law President Obama’s $787 billion stimulus package that

includes large spending increases and tax cuts, it appears that the U.S. government has

began to obtain a grip on the economic crisis, though it remains to be seen just how soon

the effects of the stimulus will be felt and unknown when the economy will begin to

recover. What is readily apparent though, is that the regulatory agencies of the G-10

countries should be given more power to monitor the types of securities that

multinational financial institutions are writing and selling on the market. The calls for

caps on executive compensation for companies who receive bailout money should be put

into place; it is ludicrous that companies who have received taxpayer money be allowed

to issue billions of dollars in bonuses when the company itself is hemorrhaging money at

an alarming rate. At any rate, there must be prevention methods put into place that

prevents a global economic collapse from happening like this again; economies operate in

cycles, this much we know, but it is the duty of citizens and governments of the world to

work together to ensure that nothing like this ever happens again.

VII. Prevention Methods.

There have been many prevention methods voiced in the media on how to thwart

such an economic meltdown from happening again. Members of Congress, past and

present Federal Reserve Chairmen’s, current and former CEOs and CFOs of financial

corporations, economists, and academic scholars have all voiced their opinions on how to
 27

ensure a economic collapse like this never reoccurs. Yet the only thing these opinions

have in common is that no majority of American businesses or consumers agree with

their suggestions. The only thing that these suggested solutions have accomplished is

creating more public bickering and U.S. government’s continued dragging of their feet on

the issue. I believe this is the case because no one in the U.S. Senate or House of

Representatives wants to admit that the policies they pushed and agencies they had

oversight of were to blame for the mess we are in. Until a group of powerful and

respected elected officials say, “I don’t care if I am up for reelection, the truth needs to be

told in order for us to move on”, we will never have a strong consensus on the matter.

The solutions I have devised will not come cheap, nor will they likely be popular

among financial corporations and their respected investors. But it is my personal belief

that the market forces encoded in our economy’s DNA have failed us and that we must

take a more “hands on” and integrated approach to ensure that we do not find ourselves in

this situation ever again. Some may call me a Socialist; others perhaps will claim I don’t

have any regard for the American dream. Yet the reality is that we now live in times

exponentially different from the ones when the U.S. economy developed its main traits

and ideologies; our laws, guidelines, regulations, and principles must change in order to

maintain responsible economic growth in the 21st century. Yet, it must be ensured that

these integrated measures be of appropriate scale in order to ensure our economy once

again becomes an efficient and well-oiled machine, capable of carrying out the

innovation and prosperity that it once was known and envied for around the globe.
 28

Solution #1: Tighter Lending Standards.

Yes, Wall Street banks will scream, beg, plead, and lobby their hearts out in

Washington D.C. but it is something that must be done to prevent future irresponsible

lending. While I do not advocate the elimination of GSEs like Fannie Mae and Freddie

Mac, I do believe that the sooner America and its elected officials realize that the

American dream of owning a home is not for everyone, the better off we will be. We

should have uniform minimum lending standards implemented across the board that

would be clearly defined and void of any loopholes that would enable financial

institutions to return to the reckless lending practices that have defined this crisis. These

standards should be based on the five C’s of credit, which are capacity (borrower’s legal

and economic capacity to borrow), character of the borrower, capital (invested and

reinvested cash flows), available collateral, and conditions of the loan (economic climate,

state of the industry etc.), with the Federal Reserve in charge of enforcing these

standards. For starters, all borrowers should be required to show proof of income

verification through multiple sources including tax returns, payroll checks, and bank

statements. Loan officers must conduct a credit bureau investigation of the borrower to

review his or her current credit rating, past credit history, and other historical financial

information to gain an insight into the borrower’s fiscal discipline and history.

The practice of loan securitization should not be eliminated; rather lenders who

lend to borrowers deemed overtly risky by the bank through the use of credit checks,

income verification, employment history etc. should not be allowed to package these

loans and sell them to investors across the globe, it negates the lender of any fiscal
 29

responsibility and puts an unfair burden on the investors. Instead, lenders who are

inclined to making riskier loans to borrowers who fail to meet the minimum requirements

or are not up to par in one of the five C’s of credit should be required to retain the loan on

their books until its maturity, making them individually responsible for their actions.

Most professional money managers agree that a homeowners monthly mortgage payment

(principal, interest, insurance, taxes) consist of no more than 30% of their monthly gross

income, and because of this, borrowers should be subject to a uniform ratio that would

consist of the home price over the borrower’s income: if the ratio is beyond the 30%

threshold, the lender may be permitted to make the mortgage but not be able to sell the

loan to securitization firms, making them again individually responsible for their actions.

Though tighter lending standards are necessary, it doesn’t mean the death of the

adjustable-rate mortgage (ARM). Recently the FDIC sought public comment on sub-

prime mortgages and a majority of respondents including Citigroup agreed with the

FDIC’s suggestion that tighter lending standards should be put in place. It would be

beneficial to both borrowers and lenders if the FDIC enacted a mandatory lifetime and

one year maximum cap and floor on interest rate increases. This would provide an

incentive structure conducive to lenders desired outcomes as well as enabling borrowers

ability to obtain financing and an avoidance of the “bait and switch” pitfall many

borrowers find themselves in after the interest rate adjusts. Though the purpose of the

ARM is to shift any potential interest rate risk to the respected borrower, I still believe

the enactment of a minimum time period for the resetting of the loan’s interest rate would

be beneficial to both the borrower and the lender. A minimum time period of six months

to one year would give the borrower an ample amount of time to come up with the
 30

additional income needed as well as provide default protection for the lender. The

instituting of an interest rate cap and floor, and a minimum time period would achieve the

desired eradication of “teaser rates” that are obscenely low, protecting both borrowers

and lenders.

A measure that is sorely needed is for the elimination or reduction of the Housing

and Urban Development Department’s mandate that GSEs purchase a certain percentage

of their loans from borrowers whose household income is below the median in their area.

There is nothing wrong with the purchase of these loans; what must be established is a

series of due diligence performed to establish whether or not the borrower has the

capacity to repay. If the government insists that GSEs continue to purchase loans from

borrowers who meet their requirements, they could possibly set up a program mirroring

the government-backed SBA loans that banks currently make. These loans would be

guaranteed by the Federal Government up to a 75% level, with the lender responsible for

the rest. The program would back loans for only borrowers who were unable to obtain

conventional financing and if the lender is not comfortable with carrying 25% of the loan

value on its books as the sale of these loans would be banned, then the potential borrower

would be rejected and as a result of this, potential loan defaults would likely decline.

Solution #2: Creation of new Regulatory Agencies

I believe the SEC must be eliminated or dismantled: its inability to even remotely

foresee the irresponsible lending and securitization practices of financial corporations

during the last ten years suggests to me that it is a government agency that needs to be

dissolved. Even the events that the SEC foresaw were not acted upon, primarily because a
 31

majority of its agents and officers once worked in the industry that they were in charge of

regulating, creating enormous conflicts of interest. Reform is not the answer to solving

the SEC’s woes; it has been done in the past and nothing worthwhile or constructive has

been the result. Rather, the SEC needs to be broken into two components to eliminate the

problems of regulatory forbearance and conflicts of interests in order to be able to

correctly perform its regulatory duties.

I propose that a specific regulatory agency similar in structure and scope to the

Federal Reserve and the FDIC, with oversight being handled by a non-partisan

organization be created for the sole purpose of regulating all U.S. based lending activities

and the financial securities firms produce. This agency would be in charge of enforcing

all lending regulations and have the ability to file charges and prosecute all suspected

violators without having to go through any legislative committees or other regulatory

agencies. In order for this agency to be run in an effective, efficient, and most

importantly, an independent manner free of Congressional officials and budgets, it would

obtain its operational funds from mandatory membership fees paid by the financial firms

themselves. According to the U.S. Chamber of Commerce, the SEC has oversight of the

17,000 publicly traded companies in the United States, with the SEC’s 2008 fiscal budget

containing $906,000,000 dollars (39); annual fees would be based upon a percentage of

the company’s total assets as to not unfairly burden smaller corporations with excess fees,

yet still ensuring the agency with enough resources to regulate the larger institutions.

Though it has been suggested in recent news articles that this responsibility

should fall to the Federal Reserve and the FDIC, I do not think this would be immediately

beneficial as the Federal Reserve and the FDIC are already bogged down with TARP
 32

related activities and the recently announced toxic asset purchase programs. The

consolidation of this new agency with the Federal Reserve would give rise to potential

conflicts of interest as well as the Federal Reserve’s responsibility is the regulation of

financial intermediaries and the government’s monetary policy, it is plausible to believe

that powerful financial companies could influence decisions made regarding to changes

in the Federal Reserve’s monetary policy or regulations, leading to detrimental decisions.

Also, if consolidation were to occur, it is possible that the expanded Federal Reserve

would become too large and influential, negating the checks and balances of our

government. Nonetheless, I believe this newly created agency would be able to

streamline the regulatory process, allow for greater and more efficient oversight, and

most importantly reduce the bureaucratic red tape that the SEC finds itself covered in.

The second agency that I propose the Obama Administration creates is one solely

devoted to the regulation of publicly traded companies in the U.S. This agency would be

in charge of monitoring the accuracy of any financial information these companies

publish, ensuring corporations follow the accounting rules and methods already

established, and protect outside investors from insider trading. To ensure that the agency

is run in an efficient manner, I think it is prudent that its top management answer to only

one Senate and House committee and the President himself, similar to the way the

Federal Reserve is operated. To avoid the “purse-strings” of Congress, a separate fee

would be required of all publicly traded companies, again based upon a percentage of a

corporation’s total assets, would fund this second agency independently.

Though I suggested previously that regulatory agencies of the G-10 countries

need to be given more oversight over their respected national corporate activities, I do not
 33

believe that a jointly developed international agency similar to the U.N. Security Council

would be prudent as there would be too much time wasted determining the logistical

factors necessary for its creation and too many political games likely played. Rather, an

early warning system needs to be created to alert the world’s economies of possible

systemic risks facing the global financial system. It has become increasingly evident that

the practices of the IMF, World Bank, and the Financial Stability Forum cannot perform

the task of fostering stability throughout the world as these institutions also perform

lending activities that directly conflict with making unbiased analysis and formal

judgments. Rather, a “global risk assessor” (40) should be created unbounded from the

influences of the enormous economies of the world. This global risk assessor could be

staffed by previous Nobel-prize winning economists or respected senior level policy

makers which would ensure that their analysis be independent of his or her country of

origin and deliver prudent unbiased policy suggestions designed to ensure action is taken

before it is too late.

Solution #3: Overhaul of Executive Compensation

The executive compensation of U.S. corporations is in dire need for reform, as

evident from the recent public outrage over U.S. Government-owned AIG’s paying of

$165 million in bonus money to its top employees. However, it must be said that

implementing a 90% federal tax on bonuses, mandatory compensation caps, and

restricted stock options are not the right solutions to the problem at hand. Rather,

executive compensation should be tied to the long-term value of the corporation, as

opposed to profit-related goals, which would not eliminate the potential for executives to
 34

select risky projects that guarantee short-term profits yet harm the corporation’s long-

term profitability.

A possible executive compensation plan could consist of an incentives-based

package that would reward long-term value creation in the corporation. If the executive

were to meet specific year-end goals based not on numbers that can be manipulated with

accounting methods, rather a more independent barometer such as EVA, he would

become eligible for compensation that would be based upon a sliding-scale foundation

determining the total incentive-based compensation package for each year; this to be pre-

approved by the corporation’s board of directors. To appease the corporation’s

shareholders, the total incentive-based compensation package for each year would be

payable over a five-year period. If the specific goals were not met in future years, then

the corporation would be allowed to “claw-back” the unpaid balance to be paid for that

fiscal year and use it to reimburse shareholders for whatever company value was lost due

to the unmet goals. Also, it would be prudent to set a judicial review for complaints of

excess compensation; if a lawsuit is filed and the plaintiff is victorious, the company and

board of directors would be fined and the compensation returned, similar to Sarbanes-

Oxley’s requirement regarding financial statement accuracy. This would ensure that the

executive and board of directors would continuously behave and lead in the corporation’s

best interests and prevent reckless risk taking that harms the corporation’s sustainability.

What not to do.

While the preceding sections offers solutions to ensure that a economic crisis like

the current one does not happen again, it must be noted that there are certain solutions
 35

that we should not pursue as they would further damage the economy, American

consumers and businesses, bloat the government even further then it is already, suppress

innovation and technology gains, and retard future economic growth.

Calls have been made to tighten Federal monetary policy to prevent the cheap

credit spigot from ever being turned on again; this spigot was one of the causes of the

borrowing boom and debt-ridden households and companies was its end result. This is

not a solution to our economic troubles; rather, the Federal Reserve should pursue

responsible and moderate future monetary policy that aims to control inflation, make

credit available for responsible borrowers, and most importantly contain incentives for

households to save their money for the future through possible tax deductions.

It would be shrewd as well if the Federal Reserve were granted the powers to

properly deflate any possible economic bubble if it was to occur. To determine if a

bubble was forming, the Federal Reserve could measure any price increase, market gains,

or lending activity against historical figures that occurred during periods of similar

economic growth and then act accordingly with increased capital adequacy requirements

for corporations and higher restrictions on the amount of money allowed to be borrowed

by investors to purchase stock. The current initial margin requirement for purchasing

securities, known as the Regulation T requirement (set by the Federal Reserve), is 50%

and most brokerage firms employ maintenance requirements for securities at 30% of

market value or $3.00 per share, whichever is greater. If the Federal Reserve, in times of

possible bubble formation, increased these requirements to 70% and 50%/$3.60

respectively, it would greater assist the Federal Reserve’s ability to deflate a possible

economic bubble. Furthermore, while I believe the Federal Reserve Chairman should
 36

continuously consult with the President and his economic advisors, it is in the country’s

best interests if Federal monetary policy remains in the jurisdiction of only the Federal

Reserve and not influenced by the members of Congress.

In addition, some scholars and Congressional officials have voiced their support

for the nationalization of banks and government control and regulation of every financial

aspect of the economy. While the nationalization of a select number of banks would

result in quicker write-downs of the toxic assets they now carry, the wiping out of

management and shareholders that I believe should happen anyways, and a lack of

conflicts of interest, it could also result in the government nationalizing the entire

financial sector which not only would suppress future economic growth but would also

subject firms to government standards made by policy makers that have political

motivations for short-term economic growth, rather then the proper economic directives

of long-term, sustainable growth.

It would be prudent also to separate banks based on a function of overall size and

have the largest and likely unhealthiest banks subjected to increased capital adequacy

requirements in order to limit the size of these institutions and prevent their possible

failure, which would lead to a domino effect bringing the entire financial sector down

because of the systemic risks these institutions failure poses. It is in the best financial

interests of our economy if a tiered capital adequacy requirement system, based on a

sliding scale foundation that increases at a consistent rate were put into place that

required larger, more leveraged and less financially solvent banks to hold higher capital

levels and have lower leverage ratios. As the size of banks decreased, they would be

subjected to lower capital adequacy requirements and the ability to employ higher
 37

leverage ratios. The sliding scale could be based upon a hyperbolic function that would

increase the capital adequacy requirement of banks, as their total assets grew, similar to

the graph below with total asset size representing the x-axis and the required capital

adequacy rate representing the y-axis.

This would ensure that financial institutions are solvent and would protect the

overall economy from the systemic risks and threats that enormous, under-capitalized

banks pose.

If a bank is deemed by the Federal Government to be “bad” and unable to

continue its operations, the government could take over the institution, “clean” its assets

and balance sheet, and later re-introduce it to the market and financial sector as a “good”

and healthy bank. This would achieve the desired limitations regarding the size of

financial institutions and mitigate the probabilities of banks defaulting and ceasing their

operations.

Reform is badly needed in the financial sector, as I advocated above. Though I

believe we should take an integrated approach between market mechanisms and

regulatory oversight to this crisis, we must realize that a complete clampdown on the

sector would be a mistake. Newly created laws and regulations should determine the

desired behavior we seek; these laws and regulations should reward the desired outcomes
 38

and punish the undesirable ones. If the possible punishment were significant enough, then

this approach would significantly reduce the reckless behavior that is one of the

underlying reasons we find ourselves in an economic crisis.

The prosperity of the last 25 years, albeit with some hiccups along the way, was

partially enabled by the financial sector, enabling small businesses to thrive, innovation

to be made, Silicon Valley to rise etc. Since almost the advent of finance there has always

been crisis, it is just the nature of the industry. Evident from the past, whether it is a

Socialist, Communist, or Capitalistic government and system, attempts to make finance

safe always results in disaster, as clever people work around the rules or bend them. We

must find the right balance of economic growth and prosperity built upon state-imposed

stability and private innovation.

IX. Conclusion.

The consequences of an unhealthy and unsustainable domestic housing market

have showed their far-reaching capabilities and the detrimental effects these

consequences have had on the U.S. and world economies. From recent news reports,

various high-profile corporate bankruptcies, staggering job losses, and the personal tales

of greed and lack of financial due diligence performed, the message has become clear and

concise: the developed nations of the world, and most importantly the United States, need

to return to an era of fiscal conservatism and living within our financial means.

By no means am I advocating the dissolving of global financial corporations, the

instituting of a Socialist economic structure per se, or a firm cap on the amount of wealth

an individual or company can obtain. Rather, I believe the current global economic crisis
 39

has served us with the golden opportunity to look into the mirror and see what we have

become as well as the rare occasion to take a step back and realize that a life of second

and third mortgages, annual housing price increases of 20%, credit card debt that totals

more then our yearly income, a minuscule savings rate, and a lack of financial planning

for the future is not the life we should lead.

The effects of globalization will be debated until the cows come home but one

effect can not be overlooked: it has pulled millions of people out of relative poverty and

installed them with the ability to lead a better life. The United States plays an enormous

role in the affairs of the world and people look to our government and citizens for

guidance; that is very unlikely to change in the future. We must use the opportunity that

this economic crisis has granted us to return to a more sustainable way of life, a more

responsible way of corporate behavior, and most importantly, a more efficient way of

governing and regulating to ensure that this type of crisis never occurs again and that we

learn from our dramatic mistakes for the sake of the global society.
 40

X. Bibliography.

1-8: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.

9: Roberts, Russell; How Government Stoked the Mania. Wall Street Journal, October 3rd,
2008.

10: Buying Subprime Securities. Washington Post. June 10th, 2006.

11-12: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.

13: Executive Incentives, Wall Street Journal. November 20, 2008

14: YahooFinance.com

15: Anderson, Jenny & Dash, Eric; Struggling Lehman Plans to Lay Off 1,500. New
York Times, August 28, 2008

16: White, Ben; Lehman sees $3.9 Billion Loss and Plans to Shed Assets. New York
Times, September 9, 2008

17: Plumb, Christian & Wilching, Dan; Lehman CEO Fuld’s Hubris Contributed to
Meltdown. Reuters.com, September 14, 2008

18: Clark, Andrew & Schor, Elana; Lehman Brothers Chief Executive Grilled by
Congress Over Compensation. Theguardian.co.uk, October 6, 2008

19-26: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.

27: Anderson, Jenny; “NYSE Chief is chosen to lead Merrill Lynch”. November 15,
2007. New York Times

28: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.

29: Shiller, Robert; “Irrational Exuberance 2nd Edition”. 2005; Princeton University
Press, Princeton, NJ

30-31: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.
 41

32: van der Starre, Martijn & Louis, Meera; “Fortis gets EU11.2 billion rescue from
Governments”. September 29, 2008. Bloomberg.com
33: Muolo, Paul & Padilla, Mathew: Chain of Blame: How Wall Street Caused the
Mortgage and Credit Crisis. 2008 John Wiley & Sons, Inc. Hoboken, New Jersey.

34: Ben Bernanke speech; January 10, 2008. Federalreserve.gov

35: Goldman, David; “Bailouts: $7 trillion and Rising”. November 28, 2008.
CNNMoney.com

36: Press Release; “Fed- GSE MBS Purchases”. November 25, 2008. Federalreserve.gov

37: Fox, Justin; “Why the Government wouldn’t let AIG fail”. September 17, 2008. Time
Magazine.

38: “Australian Government to fund Non-Bank Lenders”. February 27, 2009.

39: U.S. Securities and Exchange Commission Fiscal Year 2009 Congressional
Justification, February 2008.

40: Stern, Nicholas; “The world needs an unbiased global risk assessor”. March 25,
2009. Financial Times pg. 9.
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