Group Work Project

MScFE 560: Financial Markets

Contributors:

Abdullah Al Mostaeen - [email protected]

Mayank Khanna – [email protected]

Abstract:
The financial crisis of 2007–08, also known as the global financial crisis and the 2008 financial
crisis, was a severe worldwide economic crisis considered by many economists to have been the
most serious financial crisis since the Great Depression of the 1930s, to which it is often
compared. In this paper, our primary target was to discuss financial market components to
perform a research on the Global Financial Crisis. Then, the need and impact of regulation in
financial markets were discussed. Finally, we performed a case study where we determined the
option pricing using the Global Financial Crisis and explained why the potential benefits and uses
of mortgage-backed securities did not manifest in the Global Financial Crisis.

Introduction:
The global financial crisis (GFC) refers to the period of extreme stress in global financial markets
and banking systems between mid-2007 and early 2009. The crisis began in 2007 with a
depreciation in the subprime mortgage market in the United States, and developed into a full-
blown international banking crisis with the collapse of the investment bank Lehman Brothers on
September 15, 2008. Excessive risk-taking by banks such as Lehman Brothers helped to magnify
the financial impact globally. Massive bail-outs of financial institutions and other palliative
monetary and fiscal policies were employed to prevent a possible collapse of the world financial
system. The crisis was nonetheless followed by a global economic downturn, the Great Recession.
1. The Global Financial Crisis:
a. The primary causes of the financial crisis of 2007-2008, and the market features and conditions
that led to the crisis:

There is not one reason that can be attributed to the failure of the financial system in 2007-2008.
It was a complicated web of assets, liabilities, and people that set about a chain reaction when
one thing failed.

 In the 2000’s, investors looking for a low risk, high return investment started investing their
money at the US Housing market because home owner’s mortgages gave better returns than US
treasury bonds. Big money global investors bought investments called mortgage backed securities
– these are created when large financial institutions securitize (the process of taking illiquid assets
and transforming them into a security) mortgages. These looked like very safe bets. By the terms
of the deal, even if the borrowers default on the mortgage, the houses could be sold for more
money because the house prices were rising.
 Credit rating agencies were telling investors that these were safe investments and continuously
gave those AAA ratings. Hence, investors were eager to buy more and more of these securities.
 The rise in demand for these securities led to lenders loosening their standards and made loans to
people with low income through securities called sub-prime mortgages.
 Institutions started using predatory lending practices to generate mortgages. They made loans
without verifying income. Sub-prime lending practices were very new. Credit rating agencies could
resort to historical data to see which bet was a safe one, but it reality it seldom was.
 Traders started selling CDO (Collaborative debt obligations) which were made up of these risky
loans. Housing prices were going up and up as the lax lending requirements and low interest rates
drove prices higher. But in reality, people couldn’t pay for their houses.
 Borrowers started defaulting, which put more houses back on the markets for sale. But these had
no buyers. As supply was high and demand was low, home prices started collapsing. As prices fell,
some borrowers had a mortgage for way more than what their home was worth.
 Big financial institutions stopped buying sub-prime mortgages and lenders were getting stuck with
bad loans. Investors started losing money and lenders declared bankruptcy.
 Unregulated OTC derivatives included Credit Default Swaps, which were basically sold as insurance
against the default of a mortgage backed security. These were sold freely without money to back
them up if things went wrong because they were never expected to. Credit Default Swaps were
turned into other securities that let traders bet on the prices.
 The complicated web of unregulated assets all linked to one another made it hard to tell how bad
the institution’s balance sheet was. Panic set in, trading froze, and stock market crashed and
economy found itself in a disastrous recession.
 Some more market conditions that catalyze a crisis are as follows:

 Rise in price of an asset due to irrational decisions.

 Greed of investors and people.
 Perverse incentive – a policy ends up having a negative effect; one opposite to what was intended.
Mortgage owners got incentives for lending more money but this increased the rate of lending to
less- credit worthy individuals.
 Moral hazard – Person takes on more risk, because someone else bears the burden of that risk.
Banks and lenders were willing to lend the money because they planned to sell the mortgages to
somebody else. And thought they could pass the risk up the line. If big banks know they are going
to be bailed out by the government they have an incentive to make risky/unwise bets.

b. The response of policymakers and regulators to the Global Financial Crisis:

In both international and domestic level, Policymakers always tried to rectify the damage done to
financial systems and economies by introducing a wide range of financial reforms. A Financial
Stability Board (FSB) was formed in 2009. The FSB is now coordinating on an international level
the role of national financial authorities and standard setting bodies. Some of the key reforms
finalized and implemented under the guidance of the FSB can be summarized as follows:

 Improvements to the securitization model.1

 Adoption of standards for fair insurance policies, in order to avoid unfair risk conditions.2
 Agreement reached on one of two liquidity criteria envisaged.3
 Agreement on similar treatment in practice of certain types of financial transactions under U.S.
Accounting principles (GAAP) and International Financial Reporting Standards (IFRS) are generally
accepted.
 Several amendments of OTC derivatives.4

1
Credit rating agencies are required to report more; specific regulations have been introduced in
various jurisdictions requiring the protection of underlying assets; and accounting information on
off-balance sheet instruments, such as Special Investment Vehicles (SIVs) and conduits, needs to
be collected.
2
FSF (2009).
3
The LCR, announced by the BCBS in early 2013, demands that banks be given sufficient liquidity.
4
For reporting requirements and the centralized clearing in some jurisdictions of certain categories
of OTC derivatives.
c. The intended effects of policymakers’ and regulators’ responses:
The financial crisis, which demonstrated the negative feedback the real sector got from financial
markets, has stepped up the debate about the ability of financial market regulation for stabilizing
the financial markets. Here I will focus on the intended consequences of various regulatory
measures used for volatility elimination of financial markets.

The interventions we are researching are the ones suggested by regulators in reaction to the
financial crisis. When financial globalization has accelerated, the extent of countries’ incorporation
into global finance has shifted slowly. The banks in the developing countries had to go through a
massive change in system applications intended for operation. Another problem emerges from
the exclusive focus on fostering financial stability. Financial stability is important, of course, but it
is not the only appropriate policy goal for international financial regulation. It may be the case that
the sole focus on financial stability has come with the detriment of other important goals, most
importantly financial inclusion.

2. Evaluation of Regulatory Response:

a. A specific outline of the regulation:

The financial panic of 2008, and the scope of emergency public assistance required to stem the
tide, created the perfect storm for new financial regulation. On 21 July 2010 the US enacted the
Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or the Act).

b. The intended effect of the regulation and some context for why it was deemed necessary:

The Act marks the greatest legislative change to US financial regulation since the explosion of
financial legislation in the 1930s, which resulted in the Federal Deposit Insurance Act, the
Securities Act of 1933, the Glass-Steagall Act, the Securities Exchange Act of 1934 and the
Investment Company Act of 1940, to name only the most important. While the full weight of the
Act falls more heavily on large, complex financial institutions, smaller institutions will also face
heavier regulation.

Proponents of the Act lauded it as landmark legislation that will reduce the likelihood and
magnitude of future financial panics, end taxpayer bailouts of Wall Street, and enhance consumer
protection. Critics on the left argued that it was too weak, and did not punish Wall Street enough
for causing the panic. Critics on the right argued that it amounted to a vast expansion of
Government control over the financial sector without addressing the real causes of the financial
panic, ending too-big-to-fail or addressing the continuing public assistance to or moral hazards
caused by Fannie Mae and Freddie Mac. [1] Others observed that it was a lost opportunity
because it did not simplify the US regulatory infrastructure along the lines of the 2008 Treasury
Blueprint, [2] or improve cross-border coordination, but instead created an even more
complicated structure, increasing the risks of regulatory arbitrage and inefficiency. [3] Some
 economists predicted that its short-term effect would be to further contract the supply of credit,
reduce GDP and create further upward pressure on already high unemployment, [4] thus pushing
against the Federal Reserve’s liberal monetary policy and making the same mistake of tightening
credit by other means that the Federal Reserve made during the Great Depression.

One thing is certain – the Act will contribute to legal uncertainty in the United States in the short
run. [5] For the most part, the legislation creates only a general framework, leaving most key
issues to be resolved by implementing regulations. Indeed, the Act requires at least 243 new
federal rule-makings to implement its provisions. In the next phase of US financial regulatory
reform, regulators will face an intense period of rule-making for at least 18 months, and market
participants will need to make strategic decisions in an environment of regulatory uncertainty. The
legislation is complicated and contains substantial ambiguities, many of which will not be resolved
until regulations are adopted, and even then, many questions are likely to persist that will require
consultation with the staff of the various agencies involved.

Adding to this legal uncertainty, the legislation did not enjoy bipartisan support. Instead, it was
enacted largely along party lines, with nearly unanimous opposition from Republicans. House
Minority Leader, John Boehner, for example, called for its immediate repeal and promised to
dismantle it if Republicans again took control of Congress and the White House.

c. Unintended Consequences of Dodd-Frank Act

 An unintended consequence of the Dodd-Frank act is that the big banks appear to be retrenching
on some operations like market-making and trading for clients. This is leading to liquidity issues in
the bond market because banks have cut back on permissible and borderline bond trading.
 The LIBOR Scandal was another effect of the Dodd-Frank act which consisted of fraudulent
manipulation of LIBOR rates in trades between big banks which colluded for over two decades to
boost appearances of creditworthiness and to increase profits from rate rigging [6].

3. The Role of Mortgage-backed Securities and Option Pricing:

a. A detailed explanation of mortgage backed securities
A mortgage backed Security (MBS) is an investment similar to a bond that is made up of a bundle
of home loans bought from the bank that issued them. Investors receive periodic payments for
the same. It is a type of asset backed security. It is only as sound as the mortgages that back it up.

Essentially, a MBS turns a bank into a middleman for the homeowner and the investor. The
investor who buys a mortgage-backed security is essentially lending money to home buyers. An
MBS can be bought and sold through a broker. The minimum investment varies between issuers.
The MBS have to be generated from a regulated and authorized financial institution.
 There are two types of MBS’s:

 Pass through: Pass-trough’s are structured as trusts in which the mortgage payments are collected
and passed through to investors.
 Collateralized Mortgage Obligations (CMO): CMO’s are multiple pools of securities that are given
credit ratings that determine the return to investors.

b. Why they can be useful financial instruments:

Mortgage backed securities work like bonds where the investor is paid monthly returns. Hence,
they can help provide higher returns than actual bonds themselves; e.g. Treasury bills.

Mortgage backed securities enable lenders to buy home because the primary force behind the
loan is the investors and not the bank itself. The bank only acts as a middleman.

They can play an important role as a fixed income asset class that offers several benefits. In
addition to historically attractive yields compared to Treasuries and low volatility, these highly
liquid assets provide diversification, which can lower portfolio risk due to low correlation with
other asset classes.

The agency MBS market is large and highly liquid, with $7.3 trillion in assets outstanding and an
average daily trading volume of $270 billion. This liquidity makes it relatively easy for buyers to
find sellers and vice versa, and transaction costs tend to be lower. [7]

c. Role of MBS in the Financial Crisis:

Mortgage Backed Securities were central to the 2007-2008 financial meltdown. In retrospect, it
seems inevitable that the rapid increase in home prices and the growing demand for MBS would
encourage banks to lower their lending standards and drive consumers to jump into the market at
any cost. This was the beginning of Subprime MBS.

The quality of all Mortgage – backed securities declined and their ratings became meaningless and
in 2006 housing prices peaked. Subprime borrowers started to default and the housing market
began its long journey down. This made the homes less worth than the people’s debt. The
avalanche of non-payments meant that many MBSs and collateralized debt obligations (CDO)
based off of pools of mortgages were vastly overvalued.

MBSs are still bought and sold today. There is a market for them again simply because people
generally pay their mortgages if they can.

The Fed still owns a huge chunk of the market for MBSs, but it is gradually selling off its holdings.
Even CDOs have returned after falling out of favor for a few years post-crisis.
d. A comparison between 2) and 3), explaining why the potential benefits and uses of mortgage-
backed securities did not manifest in the Global Financial Crisis:

The securitization of mortgage-related debt has played a major role in the emergence and
proliferation of the current financial crisis (Brunnermeier 2009) [8]. Understandably, this has led
to widespread about the usefulness of such instruments for allocating macroeconomic risk. It is
now obvious that the repackaging of mortgage debt in mortgage-backed securities can have
enormous aggregate costs, but so far no one has empirically documented the macroeconomic
benefits of these instruments.

How should we measure such benefits? Some simple economic theory may help. One way to
assess the usefulness of a financial innovation (such as a mortgage-backed security) is to ask
whether it helps diversify risk. Now, at a macroeconomic level, the ultimate risk we all face is
fluctuations in consumption; our incomes and wealth may go up in booms and down in recessions.
But to what extent a recession really hurts is determined by whether we have to move out of our
house, sell our car, or just cut down on the odd restaurant meal. Hence, whether people are able
to maintain stable consumption over the business cycle is an important indicator of how well
financial markets allow them to spread risk. And the extent to which an economy securitizes
mortgage debt may impact society's ability to diversify such consumption risk internationally.

Hence, securitized mortgage debt is an important aspect of financial globalization that makes
people's consumption considerably more resilient to the ups and downs of the business cycle. One
possible reason why securitizing mortgage debt has such a strong effect on international risk
sharing may be that markets for residential mortgages used to be some of the most
internationally segmented parts of the financial system. Once banks were allowed to repackage
and sell parts of their mortgage portfolio (often to foreign investors), they were able to continue
to provide credit to consumers even in downturns, thus effectively providing consumption risk
sharing to private households.

Indeed, we find evidence that supports the view that a stabilization in bank loan supply has played
a role in the transmission – countries with more developed markets for securitized mortgage debt
have experienced higher growth in their credit to GDP ratios and this growth appears less sensitive
to changes in interest rates. This international evidence is consistent with findings for the US that
show that extending banks possibilities for diversification of their loan portfolios has measurable
positive effects on credit market access for households and firms and, ultimately, on risk sharing.
In related research, [9] Hoffmann and Sherbakova (2008) argue that US state-level banking
deregulation during the 1980s allowed banks to extend more credit to small firms in downturns,
which in turn has stabilized interstate risk sharing. [10] Loutskina and Strahan (2009) find that
securitization has weakened the link between bank financial conditions and mortgage loan supply.

The results surveyed here suggest some important policy lessons. Yes, securitization has
generated some severe moral hazard problems, such as reducing lenders' incentives to properly
monitor credit quality and promoting opaqueness (Demyanik and van Hemert 2008; Mian and Sufi
2008) [11]. But in regulating these markets, policymakers should be very careful not to throw the
baby out with the bathwater. Securitized mortgage debt also seems to have brought some
measurable macroeconomic benefits in the form of better international consumption risk sharing.
The regulatory challenge will be to improve securitization in a way that does not jeopardize these
benefits.

Bibliography:

[1] Brady Dennis, ‘Congress Passes Financial Reform Bill’, The Washington Post, 16 July 2010,
www.washingtonpost.com/wpdyn/content/article/2010/07/15/AR2010071500464_pf.html; Jeff
Madrick, ‘Obama’s Risky Business’, The New York Review of Books, 15 July 2010, available at
www.nybooks.com/blogs/nyrblog/2010/jul/15/obamas-risky-business; Associated Press, Historic
Financial Overhaul Signed to Law by Obama, NPR, 21 July 2010, available at
www.npr.org/templates/story/story.php?storyId=122793558

[2] The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure,
March 2008, available at www.ustreas.gov/press/releases/reports/Blueprint.pdf

[3] Michael Helfer, Panel Discussion, Regulatory Reform Overview – What’s Next?, at SIFMA
Regulatory Reform Summit, 15 July 2010

[4] Institute of International Finance, Interim Report on the Cumulative Impact on the Global
Economy of Proposed Changes in the Banking Regulatory Framework, June 2010, available at
www.iif.com/

[5] ‘The Uncertainty Principle’, Wall Street Journal, 14 July 2010, at A18, available at
http://online.wsj.com/article/SB10001424052748704288204575363162664835780.html?KEYWO
RDS=uncertainty+principle; The Uncertainty Principle II, Wall Street Journal, 16 July 2010,
http://online.wsj.com/ article/SB10001424052748704682604575369402612040086.html?KEY
WORDS=uncertainty+principle.

[6] Wharton School of Business – Wharton Public Policy Blogs and Archives

[7] Securities Industry and Financial Markets Association. As of March 31, 2019

[8] Brunnermeier (2009), "Deciphering the 2007-08 Liquidity and Credit Crunch", Journal of
Economic Perspectives, 23(1), 77-100

[9] Hoffmann and Shcherbakova (2008), "Consumption Risk Sharing over the Business Cycle: The
Role of Small Firms' Access to Credit Markets", Institute for Empirical Research in Economics
Working Paper No. 363; CESifo Working Paper Series No. 2544

[10] Loutskina and Strahan (2009), "Securitization and the Declining Impact of Bank Finance on
Loan Supply: Evidence from Mortgage Originations", Journal of Finance 64(2), 861-889
[11] Mian, A. and A. Sufi (2008). "The Consequences of Mortgage Credit Expansion: Evidence from
the 2007 Mortgage Default Crisis", NBER working paper 13936.