INTRODUCTION

CAUSES

To analyze the main reasons for the meltdown of the financial sector resulting in a worldwide

recession and economic crisis one has to look back into US history. A complex mix of

government policy, financial market structure and the development of the real estate market in

the USA were only a few of the main forces to collapse the financial sector. In the following it

will be analyzed that also a mix of failed regulation and pure greed of money on side of Wall

Street bankers and investment firms enabled such a severe outcome for the global economy.

2.1 History – US government policy

After the second world war, the US government was interested to reestablish the domestic

economy as well as the creation of new housing grounds. Therefore, America introduced a new

lending system coming from England, called mortgage - a legal agreement between two parties

which transfers the ownership of a property to a lender as a security for a loan. 1 A mortgage

allows you to loan money from a bank or other institutions in order to finance a house.2 Main

characteristics of mortgage loans include a specific amount of down payment, usually between 3

– 20 % or private mortgage insurance to insure repayment. A verification of employment and

income are minimum requirements for taking a mortgage loan. If a mortgage borrower fails to

repay the monthly rates plus interest, the exchange value of the mortgage, as in this case the

property, gets into possession of the mortgage lender. Therefore, these loans were only made for

prime market citizens which means a lot of citizens were frozen out of the American dream of

homeownership. So back in 1992 the US government started to introduce a new lending policy to

1
Parkinson (2006)
2
Cambridge advanced learner’s dictionary (2013)
increase “the homeownership rate of low and moderate Americans”.3 Traditional underwriting

standards like down payment were relaxed and a second market for so called subprime

mortgages was created. Under President Bush, the National Bank of America – the Federal

Reserve, lowered interest rates 4 to 1% from 2001-2004 to again enable the dream of

homeownership for middle class citizens and also to bust economic growth and development and

to create new jobs during the recession of 2001. What followed was a fundamental change in the

housing market. Due to low interest rates the demand for the mortgage loans increased heavily as

more and more citizens saw their chance to own a house. At this time house prices were steadily

rising and were expected to rise further due to increased demand in the real estate market. In the

meantime, “some counties in California”4 reduced possible building grounds while “supply for

houses is somewhat inelastic because it takes time and investment of resources to produce new

homes for sale”5, the prices for houses rose even more. US Banks and other investors saw their

chance to gain money in the housing market. As interest rates were very low it was easy and

profitable for Banks to borrow money at 1% for itself to create mortgages.

US real estate crisis and housing bubble

The financial sector invented an own market to trade these mortgages. In order to obtain a profit,

US banks sold these mortgages, also called mortgage backed securities, to other Banks and

investors not only in America but all around the world. Against a specific fee the claim for

repayment plus interest gets transferred to the buyer party. As default rates were historically very

low due to high underwriting standards for mortgage backed securities and are also seen to be

secure because of the rising prices in the housing market, banks and investors as well as pension

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Matthews, Driver (2016)
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and retirement funds invested in MBS as they promised steady (continuous) interest payments.

The demand for these new financial products increased heavily and soon banks were not able

anymore to stimulate the demand given on the market. The maximum capacity of prime

mortgage takers was reached. Due to this, US banks started to issue subprime mortgages, to

borrowers with no proof of income and employment, to create more mortgages for the market.

Banks guaranteed low and flexible interest rates, diminishing down payments and often more

than one mortgage, which enabled low and middle class Americans to borrow even more money

for bigger houses they normally could not afford. In 2006 US housing prices reached their peak

and “many buyers were buying not for shelter, but to resell at a quick profit”.6 The housing boom

was created. What followed next is a downward trend due to several events. Subprime mortgages

default rates soon started to rise as borrowers were not able anymore to serve the monthly

payments. In 2006 the Federal Reserve increased interest rates to 5,25% which caused the

delinquency of even more and more loaners. Especially subprime mortgages with flexible

interest rates were effected the most. Their monthly payments increased heavily as interest rates

rose. The result was that these houses went into property of banks and investors who issued or

bought mortgage backed securities. As houses prices were up, the banks still had the opportunity

to sell their property with a profit, because emerging house prices protected investors from

losses. But soon the house supply in the US market exceeded the demand for houses which

indicated a stagnation of house prices immediately. As a consequence of stagnating house prices,

the value of houses in the market dropped also. The housing bubble busted and what happened

next can be described as a domino-effect. Feared of a downward trend, house holders, banks and

other investors wanted to get rid of their property before losing even more money. In the

subprime mortgage market, “foreclosure rates increased by 43% over the last two quarters of
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Matthews, Driver (2016)
2006 and increased by a staggering 75% in 2007 compared with 2006”.7 Therefore, in 2007,

“New Century Financial Corp., a leading subprime mortgage lender, filed for bankruptcy”.8 The

downward trend in the US housing market was now unstoppable. Even prime lenders got into

trouble as their houses value decreased steadily. At this time, continue paying the mortgage was

more expensive than selling the house. Suddenly as the riskiness of these subprime mortgages

became clear, the first actors in the financial sectors were concerned about the subprime

mortgage development.\

2.3 The role of US investment banks – CDO’s and rating agencies

The US banking and investment sector has a long history and has always had a central position

in the American economy with its important Wall Street in New York. It was the time around the

80’s where investment banks started to grow and expanded in America and all around the world.

Numerous of banks were now big enough to go public and further enlarge their business.

Through mergers and acquisitions, investment banks grouped together and soon reached a

monopoly status in the US financial market where only a few huge firms influence and control

the market development. Five investment banks like Goldman Sachs, Lehmann Brothers,

Morgan Stanley, Bear Stearns and Merrill Lynch, only three main insurance companies like AIG

and three big rating agencies: Standard & Poor’s, Moody’s and Fitch were dominating the whole

industry.

2.4 No regulation

In 2000 US government announced the deregulation of derivatives in the financial market. As

the financial sector was characterized by highly competitiveness and rather low profit margins

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for standard products, investment banks were encouraged to “search for new financial products,

especially those whose creditworthiness not everybody agrees on”. 9 Based on less regulation the

financial market was enabled to develop financial products with speculative character and

riskiness. At this time investment bankers were given almost free space on how they have to

build up their business and in which sectors they focus to speculate in. Because of the

introduction of subprime mortgages in the housing market, speculation for investment banks got

profitable as they created special financial products for the market. One innovation and form of

speculation was that mortgage payments can be sold to other actors in the market. US banks

started to sell mortgage backed securities to investment banks to sell them again to other

investors. Therefore, investment banks created a new financial derivative called collateralized

debt obligation (CDO). As the terms says, a CDO contains numerous debt obligations, in fact

thousands of home mortgages and other loans like car and student loans. As in the financial

markets are investors with different risk preferences, there is demand for different kind of yield

rates. At this time existing derivatives could not meet all the investor’s needs. With CDO’s there

was now a possibility to serve the needs of all investors, because this derivative is divided into 3

different slices, called tranches. Investment Banks then went to rating agencies to let them

evaluate the value and risk of their CDO’s. The idea of pooling different loans into one product

and later separate them into different tranches is that the risk gets divided and is seen to be lower

than one individual mortgage loan when different kind of mortgages can be put together into one

financial product. The senior tranche10 is seen to be the most secure. Senior holders of debt

obligations are the ones who get served the first when money repayments from mortgages and

other loans get filled in. For this reason, received interest rates were comparingly low but still

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more profitable than the 1% interest given by the Federal Reserve Bank. As this premium

tranche of a CDO is characterized by a triple A rating, the highest and safest investment rating,

investors with risk restrictions like pension and retirement funds were now able to invest into

these derivatives. The middle slice called mezzanine tranche11 is usually rated with A and B

ratings carrying moderate interest rates as debt holders of this tranche get served secondly. The

equity tranche12 is the one providing both the highest possible risk and highest possible interest

rates in the market. Only after all investors of other tranches have being served with payments,

money gets filled in the equity tranche. Therefore, rating agencies gave them the lowest possible

rating grade or did not even gave a rating at all for these “junk” debt obligations. Risky

investment seekers like speculative hedgefonds were typical for this kind of tranche. In the

following time the market for CDO’s grew tremendously as the demand for this new financial

product went global. Local banks and retirement funds from all over the world, especially in

Europe, started to buy CDO shares. This means that mortgage payments from American house

buyers were no longer transferred to their local lender but to banks and institutions all over the

world. Investment banks received their fees for every sold CDO share and made millions of

profit in this time. The new loaner and borrower relationship also added up to a new form of

complexity in the financial market. To serve the market demand, investment banks soon

struggled to fill in their CDO’S with mortgages.

2.5 Relationship between Investment banks and rating agencies

The investment sector had to create new CDO’s for the market. In contrast to old ones, they were

now filled up with a lot of subprime mortgages containing a high default risk. In order to sell

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them to investors, US investment banks paid rating agencies to continue giving high class ratings

(AAA) to their CDO’s, although these new “toxic” derivatives were risky securities. Rating

agencies not only tripled or quadrupled their profit, they also formed alliances with the big

investments banks to continue their partnership. The fact that competition was high under the

three main rating agencies, not giving the desired rating may have resulted that investment banks

just went to another rating agency next door to finally receive their triple A rating. And the rating

agencies had no liability if their ratings of CDO’s proofed wrong, to justify their rating, these

agencies claimed that it is just their personal opinion so they cannot be blamed for it. As no one

exactly knew what kind of mortgages and loans were bundled together in a CDO, not even the

investment banks, buyers trusted rating agencies and felt secured by the rising house prices in the

real estate market. As there were almost no government regulations requiring a certain amount of

retained equity capital for CDO’s to prepare for losses, investment banks did not care either

about the risks of their CDO’s and continued to sell them in large quantities, often with a single

volume of more than 700 million dollars. The financial sector created a ticking time bomb and it

was just a matter of time when the first losses for investors should occur before the whole

financial market was ready to explode.\

2.6 The role of AIG – the biggest insurance company in the world

The world’s biggest insurance company, the American International group, was not only selling

normal health insurances but also insurances for products of the financial market. A credit

default swap (CDS) is probably the most important one. For investors who owned CDO’s, credit

default swaps worked like an insurance policy. An investor who purchases a credit default swap

had to pay a quarterly premium to AIG. In case the investor’s CDO defaults, AIG had to pay the

investor out for his losses. In contrast to other insurance companies, AIG not only sold CDS to
protect CDO holders but also sold them to speculators in order to bet against CDO’s they did not

own. And they could also sell them in huge quantities as there was no government regulations

for CDS requiring to put money aside. Instead they paid huge bonuses for their employees as

soon as contracted were signed. Later when lots of CDO’s failed and AIG had to protect their

investors, it was clear that the world’s biggest insurance company could not serve their payments

duties itself. Not only AIG managers were greedy to boost their profit to the top, Investment

bankers were so too. The big players like Goldman Sachs and Lehman Brothers secretly bet on

their own CDO’s they were selling without disclosing their secret intentions to their customers.13

Purchasing CDS from AIG with a volume of $22 billion in assets, Goldman could bet against

CDO’s they didn’t own and did get paid when they fail.

THE CRISIS

Housing market crashed

Back in 2006, when the US housing market started to collapse and prices fell tremendously,

consequences for the economy as well as for US citizens had been severe. Unable to serve their

mortgages, people had to leave their homes for sale. Foreclosure of houses reached 6 million

until 2010. But not only people had to leave their homes, it was also the building industry and the

real estate sector facing hard times as there was no longer enough demand after the bubble

busted. Soon the first mortgage lending companies were sliding into bankruptcy and the

subprime mortgage crisis turned into a financial crisis. The credit markets reacted highly on the

ongoing housing market recession. As more and more CDO’s failed and property values oft

owned houses had to be adjusted in investment firm’s balances, first huge losses were generated.

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In 2008 two giant mortgage lenders, Fannie Mae and Freddy Mac, got taken over by the Federal

Reserve due to illiquidity. Soon the first investment banks began to struggle too. First Bear

Stearns was acquired by J.P Morgan later it was the famous investment bank Lehmann Brothers

which first faced a tremendous fall in the stock market price, later ran out of cash to serve their

clients and filed for bankruptcy. The entire banking industry was now affected and insecurity

around the credit and stock market caused even more problems. Afraid that loans could not be

paid back, mistrust among banks caused that they stopped making loans anymore and banks

were searching desperately for money lenders. In the case of AIG, the world’s largest insurance

company had to be taken over by the government as they made huge losses with credit default

swaps.

Probably the most severe consequences of the collapsing housing market and financial crisis had

to face investors. Not only investment firms and hedgefonds manager made huge losses when

their collateralized debt obligations and mortgage backed securities defaulted, there were also

smaller institutions and private investors who placed their money in CDO’s to profit from

interest earnings. Especially retirement funds and public employee pensions, who invested in the

most secure tranche of a CDO, almost lost all of their money.

As the financial downturn in the US continues irresistibly, the recession now starts to spread

globally. The world economy is nowadays linked together so close and interactions between

companies, investors and banks increased heavily the last decades. In late 2008 the world stock

market reacts to the crisis with a tremendous fall. In Europe several subsidiaries and offices of

the banking companies had to close and banks in Germany for example had to be rescued by the
government as they also invested heavily in American real estate securities.14 Consumers around

the world consume less and spend less because they either lost money or feared to lose their jobs

in an insecure development. As a consequence of that, exports especially in the US collapsed,

which affected suppliers from China and Japan. Highly dependent from the US market, Chinese

manufacturers faced problems as their major markets stopped to invest and reduced demand.

Only in China more than 10 million migrant workers lost their jobs.15 In the meantime,

unemployment’s rates in the US also “shot up to 7.2% in December from its recent low of 4.4%

in March 2007, and it was almost certain to continue rising into 2009.”16 Later at the end of the

crisis unemployment rates both in the US and Europe should be risen to 10%, the highest value

since the 70’s. The recession had reached almost every sector of the world economy.

PRINCIPLES FOR REGULATORY ARCHITECTURE AFTER THE CRISIS

There is no clear regulatory architecture that has proven itself so superior that one can with

certainty advocate for its adoption. Whether the regulator should be part of the central bank or

independent; whether there should be regulatory choice based on charter or geography; and/or

whether the regulator should deal with one or all of the issues of market conduct, prudential

behavior, or systemic events is more a matter of ideological conviction, cultural preference, and

judgment than demonstrable superiority. However, history, logic, and the lessons learned from

the current financial turmoil suggest the following principles as the bedrock of the regulatory

architecture of the future:

1. Universal Application of Similar Rules.

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All institutions that perform the same economic function within a marketplace, irrespective of

charter choice or name, should be regulated in an equivalent manner. Whether an entity is called

a fund, thrift, a national bank, a state bank, or a Jersey Island, English, French, or Latvian bank,

fundamental rules of prudential behavior and market conduct should apply and should be applied

for the same-sized entity, roughly the same way within that marketplace. Admittedly, this is a tall

order to accomplish. Certainly, rules of disclosure and market conduct can be extended relatively

easily to all market players. Prudential rules are another matter. Just look at the years of

legitimate effort required simply to harmonize capital requirements—one of many types of

prudential rules—for banks—one of many types of financial firms. However, we simply have no

choice but to move toward this goal. To do otherwise creates imbalances that threaten the safety

and soundness of the marketplace as a whole, and will surely lead to future financial crises

2. Increased Transparency to Regulators.

The regulatory mechanism should have as complete information as possible about all the

financial institutions operating within the regulator’s marketplace, and about the marketplace

itself.17 No financial institution or provider of financial services should be immune from

supplying this information. Admittedly, the Joint Forum on Financial Conglomerates and its

associated committees have done good work to address this through the principle of

comprehensive consolidated supervision, but we need to be absolutely sure this principle works

in an open and seamless way, and that it applies to all financial services providers. Just as

regulators need to see a whole institution, they also need to see products and risks across entire

markets, whether or not those markets stop at a regulator’s border.18 Mechanisms must be

17
Crockett (1998); and Financial Stability Forum (2008), 8, 3
18
Joint Forum (2008), 17; and McDonough (2002)
established to collect information on similar products and risks across different institutions and

markets. Supervisors and banks alike focus on what the historical data reveal and indeed have

built sophisticated models based on that data. What can get ignored are the new, unexpected

events—the tail events—that affect firms and markets in a huge way. One way to address this, is

through ample liquidity and capital cushions. But too often, information indicating that a tail

event is on the way is not seen until after the fact. Supervisors need to acquire, monitor, and react

quickly to timely, comprehensive risk information.

3. Regulatory Consolidation.

We have to reduce the number of international and national organizations setting and applying

rules. For the sake of the consistency and efficiency of the regulated sector, the fewer number of

bodies setting and/or enforcing the fewer number of rules, the better. This ultimately translates

into economic well-being, and also reduces the political friction that impedes information

sharing and the convergence of regulatory approaches. Neither complete harmonization nor

complete consolidation of regulation and supervision will be possible. However, we have come a

long way towards international regulatory convergence and this must continue. Having one

regulator makes a great deal of sense from the standpoints of equivalency and efficiency, but

large bureaucracies come with their own challenges. Another knotty problem is the application

of home and host country rules to multinational enterprises. International harmonization of rules

will eventually solve this problem—but eventually is a long time, and in the meantime

multinational enterprises are bedeviled by having to apply a multiplicity of rules to their

and an important goal.19

4. Assurance of Efficacy.

We should strive to ensure that our rules and supervisory techniques are indeed efficacious and

riskbased. Much more needs to be done at the national and international level to test the efficacy

of our rules. Just as we expect banks to back-test their models to see if they performed, we

should look back at our rules to see if they were effective. Of course, some rules will be as much

a matter of time-tested judgment as measurement. However, we should not take our rules and

practices for granted. In a dynamic financial world, change is the one certainty with which we

must keep up.

5. Burden Minimization.

A corollary to this notion is that we should strive to minimize excess burden. Regulations and

enforcement mechanisms grow like barnacles on a ship. And it is much easier to put a new one

in place than take an old one away. Eventually, too many barnacles affect a ship’s speed and

performance and can even cause it to sink. As regulators test to determine whether rules really do

achieve intended goals, they should be prepared to revise or remove those that do not. Continual

efforts should be made to minimize burden, as changes in finance will cause new rules to emerge

and others to become less necessary.

6. Countercyclicality.

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Financial Stability Forum (2008), 52
 Regulatory and supervisory framework should be counter-, not pro-cyclical.20 Although

regulators need to be referees, not coaches, and to call the game as they see it, supervision

and regulation can only do so much after the cycle has turned and mistakes have been made.

As the former chief national bank examiner in the United States is wont to say, “once the

bullet is in the body” there is only so much you can do. Accordingly, it is enormously

important to be at least as tough in good times as bad, and the regulatory framework should

reinforce this principle.

7. Market Conduct and Prudential Supervision.

Market conduct and prudential supervision go hand in glove. In today’s day and age, it is not

possible to have a safe and sound banking organization that is a rogue in the marketplace. Nor is

it possible to have a stable banking system where customers are cheated, laws are flaunted, or

conflicts of interest are disregarded. There is no better example of this than the recent auction-

rate securities fiasco. The mistreatment of customers exposed the firms involved to significant

financial and reputation risk, not unlike that which would result from asset quality problems.

Whether different organizations or a single regulator with different divisions should be

responsible for market conduct and prudential supervision is a decision for national regimes.

Either way, the prudential regulator must evaluate market conduct as a potential financial risk,

and should expect the institutions it supervises to do so as well. 8. Implementation. Eighth,

integral to the regulatory architecture that I have just described is the quality of implementation

by the regulatory bodies. This implementation must be accomplished with integrity, judgment,

and vigor. Perhaps the most important attribute of the regulatory process—and why it must be

20
Crockett (1998); and Stanley Fischer, “Basel II: Risk Management and Implications for Banking in Emerging
Market Countries,” William Taylor Memorial Lecture 7, presented at the International Conference of Banking
Supervisors in Cape Town, South Africa, 19 September 2002, http://www.group30.org.
independent from the political process and any other body that can compromise its mission—is

that an effective regulatory function must be thoroughly honest and hands-on in its practical

examination of the facts and in its application of the rules.

8. The Profession of Supervision.

If we are to have an effective supervisory service in this ever more complex financial world, as

well we must, then we need to step back and assure ourselves of several things:

Supervisors should be well prepared for their job. Why is supervision not a university major?

One can major in athletics instruction, modern dance, and film these days, but when a major

bank supervisory agency needs additional examiners, they must train their own. This has worked

well in the past, but with the growing challenges, and the need for global consistency of

approach, supervision should be elevated to a profession. The Basel Committee had the foresight

to establish the Financial Stability Institute in 1999 to assist with training of the non-G10 country

supervisors. It is now time to consider establishing a Financial Supervision Chair at a prominent

university.

Legislators that give supervisors their mandate must make the goals of supervision clear. We

are all familiar with the difficult policy tradeoffs inherent in supervision. These need to be

wrestled with at the highest levels of government, rather than dealt with on an ad hoc basis.

Supervisors must make the rules clear and transparent. Supervision works best when

regulated institutions know what is expected of them and when they receive a consistent and

swift reaction if they do not conform to these expectations.

market force of all is compensation. In this regard, Supervisors, as well as companies, align

compensation with safe, sound, and compliant behaviors, with a particular emphasis on the

longterm well-being of the financial concern, as opposed to shortterm benefits to the

individual.21

CONCLUSION

In conclusion, supervision should remain at the center of a new global financial architecture.

Clearly, central banks have a vital role in maintaining financial stability, and will continue to,

from time to time, intervene when they consider it necessary to stabilize markets. But a key

reason that this is a viable option for central bankers is the presence of a consistent, objective,

and reliable supervisory program. Regulators are all about calling the plays as they see them,

whether or not the truth is painful. Good regulators, like good referees, do not seek to be rock

stars, nor do they seek to win popularity contests. They should strive to meet the high standards.

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Financial Stability Forum (2008), 8.