To set the stage for the following arguments, we first analyze mortgage-backed securities in this paper, which are mostly to blame for the recent financial catastrophe. Later, we go through the characteristics of financial market regulation and the specifics of the great financial crisis, including what caused it and the regulatory responses that followed. Our discussion will pay special attention to the Dodd-Frank Wall Street Reform and Consumer Protection Act, its intended and actual implications, and how it fits into the regulatory framework. Our argument for regulation and the impartiality of derivatives comes last.
It is crucial to comprehend them as security, given their significant influence on the financial catastrophe. A sort of asset-backed security known as a mortgage-backed security (MBS) is guaranteed by the principal and interest payments of a group of mortgage loans. Banks pool the mortgages and sell them to government organizations or investment banks, who then bundle the loans into a security that investors can purchase on the secondary market. The type of real estate that underlies the mortgages distinguishes between residential and commercial mortgage-backed securities (MBSs).
The conventional MBS is called a “pass-through MBS” since the MBS holder receives fair value interest and principal payments from the borrower. Commercial and investment banks created innovative methods of securitizing subprime mortgages as the MBS market expanded by putting them into Collateralized Debt Obligations (CDOs) and then separating the cash flows into various tranches to appeal to investors with various risk appetites. CDO sales increased from $30 billion to $225 billion between 2003 and 2006, nearly a tenfold increase (Carla).
A federal government agency like Ginnie Mae or a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac issues and guarantees the majority of MBSs. However, the global financial crisis of 2007–2009 was mostly caused by the market for private, non–GSE backed mortgage-backed securities (MBS).
Benefits of MBS
MBS has advantages even though it hurts the GFC. They are impartial and dependent on individuals who use them, much like rules. Here, we make a case for them.
In the eyes of the banks, the ability to securitize their debts and sell them on the secondary market would allow them to turn long-term debt assets into short-term liquid assets and lessen the risk of interest rate changes brought on by their asset-liability mismatch. Debt securitization also gives banks access to a different source of funding, which can lessen their reliance on deposits and increase the flexibility of their business operations.
Additionally, externalizing their balance sheet also helps them lower hazardous assets, which can raise their capital ratio to meet legal requirements and improve their balance sheet liquidity. Since banks rely on their capital to absorb deposits, their credit rating impacts the cost of getting funds when they take on deposits. The underlying loans are guaranteed when they are securitized, allowing the securities to have a higher credit rating than the bank itself. In addition, since the funds raised do not need deposit provisions and there are no costs associated with a deposit insurance payment, the cost of capital can be decreased.
Finally, banks might focus on initiatives they excel at to exploit comparative advantage. Banks can take on large real estate loans with robust lending capabilities, which can then securitize and sell them to other investors. Then, investors who wish to invest in the real estate market but lack the resources to do so might do so. The concept of comparative interest is applied to debt securitization to maximize advantages for the entire financial system.
These real estate assets differ from bonds in risk, making them appealing to investors who need income over a long period and want an alternative to stocks and bonds. Risks specific to a given asset class can be diversified using them. Securitization can lower the cost of capital for borrowers. The availability of mortgage loans is never insufficient since the banks can sell these securities to investors to raise additional capital.
Characteristics of financial markets that frequently require regulation
Consumer protection is one of the characteristics of financial markets that frequently require regulation because it is impossible for competitive forces to shield consumers from information asymmetry or principal-agent issues on their own. As a result, regulation concentrates on the main entry points between the financial industry’s sophistication and consumers’ lack of sophistication (Wolak).
To ensure fairness, other parts of regulatory monitoring control how parties interact. Additionally, regulatory processes concentrate on creating regulations that best safeguard consumers and other financial participants from the ripple consequences of failed sophisticated financial players.
Regulations also focus on issues with social externalities. A significant bank collapse is a societal externality because it has the potential to destabilize the whole financial system and because its costs are beyond those incurred by the bank’s shareholders. Regulatory measures to prevent moral hazard behaviors include mandated safety capital for banks and government insurance for depositors.
Market characteristics and circumstances that define a financial crisis
A severe decrease in asset prices, debtors’ inability to make their loan payments, and financial institutions’ struggles with liquidity are all symptoms of a financial crisis (Kenton).
According to Aliber and Kindleberger, a financial crisis is frequently accompanied by a panic or a bank run in which investors sell off their assets or withdraw cash from banks out of fear that the value of those assets will decline.
The root reasons and market circumstances that resulted in the GFC
The primary causes of the financial crisis can be linked to a number of factors, including the financial industry’s deregulation, innovative mortgage securitization, the rise in subprime mortgages as a result of deregulation, and banks’ lax mortgage lending guidelines. These factors, along with the environment of low-interest rates, encourage excessive risk-taking under the presumption of consistently good economic conditions (Amadeo).
How the GFC developed and the part MBS played in it
Lenders no longer had to take the risk of loan failure thanks to the rise of mortgage-backed securities and the support of the mortgage market from Fannie Mae and Freddie Mac. As a result, lenders began to relax their requirements for mortgage applicants, and they began to work with subprime borrowers or those with below-average credit scores. Banks made mortgages available to anyone, including many unsuitable borrowers who qualified for interest-only loans but couldn’t afford conventional mortgages. The Financial Institutions Reform, Recovery, and Enforcement Act, which encouraged banks to lend money to formerly underprivileged neighborhoods, contributed to this (Federal Deposit Insurance Corporation). By 2006, private-label MBS was used for over 80% of subprime loans.
Additionally, lenders created several novel products, such as Adjustable Rate Mortgages (ARMs). Low-interest rates, no down deposits, and sometimes even the option for the borrower to defer monthly interest payments and roll them into the loan’s principal were all requirements. This larger pool of qualified borrowers raised the demand for homes and contributed to an increase in home prices. Housing costs reached their high in 2006. Financial institutions expanded their debt due to the significant speculative opportunities they were presented with to finance their acquisition of mortgage-related securities.
These subprime mortgage holders could not make interest payments when the federal government hiked interest rates between 2005 and 2006, rendering the mortgage-backed securities worthless. Mortgages with adjustable rates started to reset at higher rates, nearly doubling the monthly payments. Some homeowners owed more money than the value of their homes. As a result, there was a significant increase in mortgage delinquencies and the foreclosure rate. Around 9% of all mortgages in the United States were in default by August 2008.
In addition, in 2005, the supply of homes surpassed demand, which led to a decline in property prices (Haughwout et al.). As a result, mortgage holders could not sell their properties to pay off their due debt. Home loans were closely related to derivatives and credit default swaps, so when the housing market crashed, it had a knock-on impact that made all of these instruments poisonous as their value fell.
Mortgage interest payments that are unaffordable, as well as the sharp decrease in complicated derivatives that caused investors to quickly liquidate other parts of their portfolio out of panic, are characteristics of financial crises. Financial institutions experienced liquidity and solvency issues due to numerous positions on their balance sheet that was against them, which caused numerous financial institutions to declare insolvency. Important markets had almost no liquidity, and stock prices crashed. Credit became more restricted, putting many banks and financial organizations in danger of going bankrupt. The entire banking system quickly became unstable after Lehman Brothers’ failure (Julia).
Why Mortgage-backed securities did not Benefit from the Great Recession
Here, we examine potential reasons why the MBS may not have delivered the GFC-related benefits they anticipated. MBS were speculative investments during the Great Financial Crisis (GFC), resulting from clever financial engineering, and their inherent risks were poorly understood (Yeager). This implied that frequently the holders of these derivatives were not fully aware of the inherent dangers they were holding. The risk of default was also shifted to investors when the MBS were sold to hedge funds, who then sold them to them, but they were unconcerned because credit default swaps covered the derivatives. This indicated that they had assumed that these assets posed no risk and that the excess returns were unusual. This supposition would encourage careless risk-taking rather than a thorough, in-depth examination of the risk-return characteristics of the MBS.
MBS was also designed to lower risk for the banks by externalizing their balance sheet to boost their capital ratio and transforming long-term debt assets into short-term liquid assets. Banks loaded up their balance sheets with MBS for both selling and speculation, not to reduce risk but to increase it. Because their risk models did not accurately reflect their risks, they assumed much more risk than they were legally and operationally permitted to. The broker-dealer banks, which could create MBS and maintain inventory to serve as market makers, were particularly affected by this.
Lastly, MBS ought to have permitted banks with stronger lending capabilities to take advantage of their comparative advantage so that the entire financial system would gain. Almost every major bank wrote the MBS or had significant involvement in mortgage lending, unlike a few specialized banks writing the instruments. As a result, the MBS significantly impacted the whole financial system. Due to the extensive MBS inventory in the financial system, many financial institutions’ portfolios correlated with one another because they all owned MBSs. This implied that the entire financial system was in danger as the value of the MBSs fell.
Therefore, MBS was not helpful during the GFC since they were exploited as a tool for speculation and reckless risk-taking rather than being employed to maximize their benefits.
Policymakers’ and regulators’ response to the GFC
Governments from all across the world created rescue plans during the crisis to aid troubled financial firms. In October 2008, the Emergency Economic Stabilization Act (EESA) was passed by Congress, establishing the Troubled Asset Relief Program (TARP), and the US Federal Reserve reduced the Fed Funds Rate from 5.25% to a range of 0 to 0.25%. The Federal Reserve and Federal Deposit Insurance Corporation (FDIC) also developed extensive lending and guarantee initiatives in addition to TARP.
The reaction could be divided into initiatives with various goals, such as boosting market liquidity through Federal Reserve direct lending facilities or the FDIC’s Temporary Liquidity Guarantee Program.
The Term Auction Facility (TAF), first implemented in December 2007, is one of the solutions intended to increase market liquidity. It was a monetary strategy intended to boost American liquidity. The credit market. TAF allowed the Federal Reserve to auction off a predetermined number of short-term loans with security to depository institutions. Through it, the Fed began lending reserves in significant amounts for a considerable amount of time, starting with an initial $20 to $75 billion per auction for durations of 28 or 35 days. In the final quarter of 2008, central banks worldwide bought US$2.5 trillion of government debt and distressed private assets from banks to increase market liquidity and reduce the risk of a deflationary spiral.
Other strategies included buying illiquid assets from financial institutions to restore confidence in their banking system or giving financial institutions equity to rebuild their capital after asset write-downs. Examples of these programs include the Public-Private Partnership Investment Program. The nine largest banks received $125 billion under the Capital Purchase Program in the capital in form of preferred share acquisitions right once, with an additional $125 billion set aside for smaller banks. According to Webel and Labonte, the response also included involvement in particular markets that had ceased operating effectively.
Regulators measured and examined the events after the crisis and then developed policies to reestablish lost confidence in the banking system. They established a new framework for managing conventional and alternative assets, increasing market transparency, and lowering derivatives market risk.
The Undertaking for the Collective Investment in Transferable Securities (UCITS) is a regulatory framework based on European Union law that lays down uniform standards for managing and selling investment funds. Specifically, the Alternate Investment Fund Managers Directive (AIFMD) required managers in buy-side firms to hold permissions to manage investments (Eurpopa). UCITS offered high levels of investor protection because asset managers had to adhere to numerous legal and regulatory requirements (Eurobank).
Furthermore, the “US Dodd-Frank Act” forbade proprietary trading and certain investments in hedge funds and private equity firms to safeguard investors and taxpayers.
Act of Dodd-Frank
One of the most important pieces of legislation passed since the Great Recession is generally recognized as the Dodd-Frank Wall Street Reform and Consumer Protection Act (often known as the “Dodd-Frank Act”). The federal financial regulatory framework is significantly altered, with implications for all federal financial regulatory bodies and nearly every facet of the country’s financial services sector. The Act’s scope is wide-ranging. In addition to stricter regulation of over-the-counter derivatives and asset-backed securities, it also includes consumer protections with authority and independence, changes to executive compensation and corporate governance, oversight of credit rating agencies, and new registration requirements for advisers to hedge funds and private equity funds. In addition to increased control and regulation of banks and non-bank financial firms, it mandates significant changes to the Federal Reserve’s and Securities and Exchange Commission’s authority (David et al.).
The law also establishes a few financial organizations, including the Consumer Financial Protection Bureau, the Office of Financial Research, and the Office of National Insurance, in an effort to simplify the regulatory process. The Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Federal Housing Finance Agency, etc., will be tasked with formulating new regulations and conducting research, among other existing agencies, over which additional powers are suggested.
Effects Intended and Background for Need
The legislation was required because it was necessary to address several of the most evident regulatory flaws that the GFC had highlighted.
One example is lowering the potential costs of crises by giving regulators greater authority and mandates with better prudential standards, which should lower the likelihood of a crisis arising. Another example is lowering the potential costs of crises by providing the legal framework for taking over failing enterprises of systemic importance. Since one of the major causes of the 2008 financial crisis was the sophistication and complexity of hedge funds, the legislation also mandates that hedge funds and private equity advisors register with the SEC as investment advisers and give information about their trades to assess systemic risk.
Next, it was believed that credit rating agencies had done a poor job with mortgage-related instruments because many investment-grade assets defaulted more frequently than expected statistically. The Act instructed the SEC to create a new Office of Credit Ratings to supervise and audit credit rating agencies and to publish new rules for internal controls, independence, transparency, and sanctions for subpar performance to enhance the credit rating system.
The Act also established the Consumer Financial Protection Bureau, a new independent watchdog with the power to ensure that American consumers receive clear, accurate information about loans, credit cards, and other financial products and to shield them from abusive terms and hidden costs (Amedeo).
The Volcker Rule, which forbids insured depository institutions and bank-holding corporations from participating in proprietary trading or making speculative alternative investment ventures, was also created under the Act. As a result, banks were deterred from taking on excessive risk, thus protecting the consumers of the institutions.
Due to the role played by credit default swaps in the GFC, the legislation also significantly regulates OTC derivatives. The Act mandates that swaps be cleared through either exchanges or clearing houses, reducing the systemic risk of derivative trading and increasing transparency.
How the legislation relates to the overarching goal and purpose of financial regulation
To preserve the stability and integrity of the financial system, financial regulation is a type of regulation or supervision that places particular rules, limitations, and guidelines on financial organizations. The goals of financial regulators are often to promote market confidence, financial stability, and, as was already mentioned, consumer protection (FCA).
As was previously said, the Act increased regulation and oversight of organizations, including hedge funds, banks, and credit rating agencies, to protect consumers, foster market trust, and promote financial stability. The main goals of the Act are to reduce informational asymmetry between uninformed customers and skilled financial institutions and to establish laws that limit excessive risk-taking in sectors where the negative externalities can be transferred to consumers who lack financial sophistication. These are in line with what financial regulation aims to achieve. However, we highlight some negative side effects of financial regulation below.
Contrast the Act’s unintended impacts with its intended results.
Due to the capital constraints imposed by the Act, one of the unexpected outcomes of the Act is that the Volcker rule has decreased market liquidity. This is evident in the bond markets, where banks have reduced their trading in legal and illegal bonds due to closing their proprietary trading operations. Proprietary trading may become less regulated as more activity shifts into the shadow banking system, contradicting the Volcker Rule’s original goals (Skeel). The goal of financial regulation is to protect consumer interests while also ensuring stable markets.
Similarly, because banks are required to hold a bigger percentage of their assets in cash than was previously permitted, their ability to invest in marketable securities has been restricted. This action effectively limits the role of bond market-making traditionally played by these institutions. Potential buyers now have a harder time competing with sellers since banks no longer perform the role of market makers. Dodd-Frank makes it more difficult for potential sellers to find competing bidders, decreasing market liquidity. Reduced liquidity also undermines the stability of markets.
The Act’s unexpected consequences also include a reduction in the economy’s capacity for profit-marketing and a decline in the competitiveness of American businesses abroad. Additionally, businesses are paying more money to ensure they continue to comply with regulations, reducing the amount of money accessible to the overall economy. This is so taxpayers will be responsible for paying the costs of regulation (Chon, G).
Low-interest rates, a lack of market regulation, excessive risk-taking, and exotic derivatives contributed to the global financial catastrophe. The financial sector was severely hampered by the cascade effect of decreasing asset prices and market turmoil brought on by rising interest rates. To stabilize the financial sector, regulators then introduced several relief measures through strong monetary policy and deep liquidity programs. Later, procedures were established to avoid repeating the same errors. Our main finding is that businesses may forgo ethical considerations in favor of profit due to excessive deregulation, which might encourage reckless risk-taking. While there are advantages to deregulation, some areas of the market, particularly those dealing with fairness and principal-agent issues that affect consumers, should still be appropriately controlled for the general public’s good. The MBS is also subject to this regulatory dialectic truth. Despite their apparent advantages, they started as the main cause of the GFC because of their careless MBS risk-taking.
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Research Topic: (Choose only one)
· Financial Markets
· Capital Allocation Process
· Debt, Equity, and Derivative
· Mortgage-backed securities
· Federal Reserve Policy
· Investment Fund
· Regulation of Financial Institution
· U.S. Stock Market
· Financial Statements & Reports
· Working Capital
· Sarbanes-Oxley and Financial Fraud
· Performance Evaluation
· Return on invested capital
· The Federal Income Tax System
· Corporate Capital Gains
· Financial Analysis & Financial Ratios
· Common Size Analysis & Trend Analysis
· Comparative Ratios & Benchmarking
· Time Value of Money
· Perpetuities & Annuities
· What loans really cost
· The Great Recession of 2007
Choose a research topic from the chapter readings or from the list provided by your professor.
Research/find a minimum of at least four (4), preferably five (5) or more, different peer-reviewed articles on your topic from the University of the Cumberlands Library online business database. The article(s) must be relevant and from a peer-reviewed source. While you may use relevant articles from any time frame, current/published within the last five (5) years are preferred. Using literature that is irrelevant or unrelated to the chosen topic will result in a point reduction.
Write a four (4) to five (5) page double-spaced paper in APA format discussing the findings on your specific topic in your own words. Note – paper length does not include cover page, abstract, or references page(s).
Structure your paper as follows:
An overview describing the importance of the research topic to current business and professional practice in your own words.
The purpose of Research should reflect the potential benefit of the topic to the current business and professional practice and the larger body of research.
Review the Literature summarized in your own words. Note that this should not be a “copy and paste” of literature content, nor should this section be substantially filled with direct quotes from the article. A literature review is a summary of the major points and findings of each of the selected articles (with appropriate citations). Direct quotations should be used sparingly. Normally, this will be the largest section of your paper (this is not a requirement, just a general observation).
Practical Application of the Literature. Describe how your findings from the relevant research literature can shape, inform, and improve current business and professional practices related to your chosen topic.
Conclusion in your own words
References formatted according to APA style requirements
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