Maya BoyleJim HartleyMoney and Banking

P R O P O S A L S O F F U T U R E R E G U L A T I O N

The emergence of the financial crisis was brought to fruition through

the roots of mismanagement of assets and unmitigated greed. In the wake

of this crisis, more stringent regulation must value the worth of the individual

over the worth of the company through an increase in required equity, the

simplification of the financial intermediary sector, and the acceptance of low

net-worth individuals as having a place in the financial market within their

budget constraints.

The Federal Reserve, under the eye of Chairman Greenspan, began to

increase the money supply faster than was expected from the state of the

economy. This steady increase in liquidity left the economy incredibly liquid

and offered lots of space available for mortgage transactions. Receiving

loans became far easier, increasing the money supply and increasing the

price level of houses. No longer merely singular assets, houses became the

latest investment trend. Mortgages were developed to facilitate this

investment strategy, not the practice of living in a home. For instance, the

emergence of 228 mortgages, which charged minimal interest for the first

two years and escalated prodigiously afterward, allowed those who sought to

play the market to purchase a home with minimal risk and reap the rewards

of its appreciation within a few years. Likewise, mortgages emerged

containing interest-only payments for the first five years and balloon

1

payments for any time period beyond. While these payment plans made no

sense to those who planned on living in homes, they were financially

desirable to investors who planned to sell their homes within the interest-

only time frame. The continuation of this market required only the steady

increase in housing prices and the continued assurance that a majority of

borrowers would not default on their loans.

The expansion of the housing bubble was facilitated by the mitigation

of risk through the securitisation agencies of FNMA and FHLMC. Needing to

atone of an accounting scandal in 2004, the two securitisation agencies

began to offer mortgages to people with lower net worth in order to re-

establish their credibility as a fair source of loans and mortgages. Due to the

conviction that bonds that go through these agencies would be backed by

the federal government, the demand for these bonds increased. Between

2004 and the 2007-2008 financial crisis, rates of home ownership increased

by 25 percentage points, and much of these loans were made to lower net

worth individuals The American Dream was suddenly within reach of

millions of people and the demand for these homes and these mortgages

was nearly insatiable. Backed by the assurance that the government

On the banking side of the mortgage crisis, the securitisation of the

security market mitigated loan risk, allowing investors to purchase debt with

the promise of a high return. By bundling the securities, financial

intermediaries were able to lower the risk that comes from shouldering

debts. Further, these bundles were separated into CDOs, or collateralised

2

debt obligations, which, by separating security bundles into three tranches,

ensured that any mortgage defaults would be shouldered only by those who

were willing to bear the risk. If securities were to default, the third trench

would suffer the financial burden until all securities in the third tranche

disappeared. This model was built on top of existing tranches to virtually

eliminate the perceived risk of securities. Further, insurance companies,

seeking to benefit from the insurance premiums in a seemingly safe market,

offered collateralised debt swaps, or CDSs, which promised to take on the

debt in the event of a default. Through these various risk mitigation

schemes, the demand for securities skyrocketed, making investors, banks,

and insurance companies immensely wealthy- as long as housing prices

continued to rise.

When housing prices began to decline, investors found that the

securities had been divided so deeply that it was no longer clear what

securities they in fact owned. As the amount of uncertainty in the market

skyrocketed, the demand for securities vanished. This combination of

defaults and plummeting demand crumbled the housing market. In

conjunction with the housing market, the insurance companies that had

backed the faulty CDOs found their assets evaporating. Investment banks

suddenly found their investments worthless, their cash vanishing virtually

overnight. The repo market followed, with investors demanding cash beyond

what investment bank reserves had available.

3

From this saga of financial mismanagement, it is clear that multiple

shifts in regulation are needed. In the short term, trust is imperative.

Financial intermediaries must remain as reliable for funds in times of crisis as

they are in times of prosperity, in order to prevent bank runs and economic

catastrophe. In the long run, however, the regulation changes must run

deeper to ensure that crises of this magnitude are prevented. While the

mortgage crisis necessitated an extraordinary response, further regulations

must be implemented to ensure that financial intermediaries do not exploit

their assets to this extent in the future. The mismanagement of money is, at

its core, simply the mismanagement of greed. When the return on assets

does not adequately reflect the risk involved, the market grows destabilised

and dependent on the stability of a single asset. This renders the economy

inherently riskier and endangers the solvency of financial intermediaries

themselves.

At its core, the best way to regulate banks would be to generate risk-

averse financial intermediaries. However, the free market necessitates the

pursuit of profits, which by definition requires some modicum of risk. As has

been argued in The Banker’s New Clothes, the best way to mitigate risk and

simultaneously maintain competitiveness may be to increase the amount of

required equity that must be held by banks at any given time. An increase in

equity will increase the safety of the investors’ holdings, which will mitigate

risk and the ability of banks to invest the vast majority of their assets in any

single venture. The increased amount of equity also decentralises power,

4

which gives shareholders more of a voice in financial ventures of

corporations or intermediaries.

Beyond the equity side, the increased complexity of the banking sector

has made it increasingly difficult to understand the state of corporate

investments. As took place in the securitisation and mortgage fiasco of 2007

and 2008, the increased interweaving of securities and tranches made it

impossible for borrowers to understand exactly what they owned. When this

fact became apparent to the market as a whole, the demand for securities

utterly collapsed, leaving investors holding assets that were meaningless,

and thus worthless. A simplification of the banking sector would allow for a

greater understanding of what assets are, and thus what they are ultimately

worth, given the state of the market.

The complication of the market is not limited to the market itself.

Financial intermediaries themselves may also benefit from becoming

smaller, more manageable, and less complex. The birth of banks that are

“too big to fail” generated an economic system where the government, the

original supplier of money, is dependent on private entities that manage

government-controlled funds. This puts the Federal Reserve at the mercy of

private corporations and intermediaries, which is inherently dangerous

because it creates a system where the government’s control of the money

supply is subject to the private sector’s drive for profits, not the well-being of

the aggregate market.

5

Finally, banks must be more vigilant in terms of to whom they lend and

the amount of their assets they render unstable. It is not necessary to block

low net-worth individuals from taking out loans entirely, but a more

structured and rigid system of who is eligible for large loans such as

mortgages is vital to ensure the stability of banks’ available capital. Smaller

loans to individuals with lower net worth would both decrease the rate of

default because it will increase the levels of solvency and increase the

likelihood that the debt will be able to be ultimately paid off.

6