Structured Finance and the 2007-2008 Financial Crisis

MA-Thesis / Master von Nadia Senanayake

Introduction:

The fundamental motive of this thesis is to locate the main catalysts that caused the 2007/2008 financial crisis, and the rationale of their unique interaction. The three primary avenues used to layout the analysis are the Structured Finance Instruments involved, the parties concerned and the channels that exacerbated the rapidity of the spread that ultimately increased the severity of the crunch.

Chapter One lays an overview of the Structured Finance Instruments prevalent in the financial spectrum, of which the main instruments that, contributed to the triggering and propagation of the financial turmoil are demonstrated and explained.

Chapter Two exemplifies the pre-cursors of the crisis which began in the sub-prime sector of the United States. The vital triggers that caused the bust of the subprime bubble are further illustrated as well.

Chapter Three examines the varying involvement of the contributing instruments to the rapid propagation and displays the connecting link between the Structured Finance Instruments and the very source of the turmoil.

Chapter Four illustrates in depth the involvement of the three vital players (the Rating Agencies, Banks and the Regulatory/Supervisory Institutions) and their effect on the propagation of the crisis.

Chapter Five analyses the two main regulatory catalysts that contributed to the crunch through Pro-cyclicality and will also examine the role and consequences of mark-to-market Fair Value Accounting and Minimum Capital Adequacy Requirements (Basel II Accord).

Chapter Six will present a post crisis status quo with recommendations and remedies for relevant counter-cyclical mechanisms.

Table of Contents:

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Chapter 4, The Vital Players:

In this chapter, the author attempts to portray the financial crisis of 2007-2008 by means of an analogy to a house caught in a devastating blaze. The portions and materials in this building are compared to various factors of the economy in order to better illustrate their role in the event to improve the thesis perspective.

Imagine a house of hay built with the haphazard and disjointed carelessness on muddy ground, standing in the midst of a field surrounded by forest. This dwelling of straw is symbolic of structured finance instruments and the muddy ground on which the house is built is symbolic to the lack of supervision.

This house is surrounded and tangled with ample and prodigious amounts of wiring. Most of this wiring may be compared with the housing and real estate sector. The subprime mortgages and the large losses incurred in the US real estate sector was the origin of the crisis and the occurrence of the housing bust was a short circuit that sparked off the blaze.

The very material which was used to construct the house, hay, being so easily ignited with a mere spark, enabled the crackling glows to burst into a blaze in rapid succession. Now a house of hay would normally be overwhelmed in flames and then be no more than ashes within a matter of minutes. However, imagine that at the top of this straw structure were reserves of crude oil. The very heat from the flames below, having melted the container in which such liquid was held, set free a stream of oil which not only fuelled, but also aggravated and kept the straw burning longer than predicted. Now imagine that the design of the straw building was such that any liquid poured from the top, without being channeled into a single pipe, in fact is conducted through a multitude of channels which spread the liquid over all surfaces before reaching the foundations.

This oil that kept this particular fire blazing longer is the sudden liquidity rush and rapid deleveraging. In addition regulatory measures such as marked to market fair value accounting and minimum capital adequacy requirements by the Basel II Accord (the oil) , intensified by pro-cyclicality (the multitude of channels), facilitated the speed and propensity of the blaze. That resulted in the flames spreading beyond the house, through the field and eventually resulting in a forest fire. Thus the ‘Subprime Crisis of 2007’ due to its global repercussions was renamed ‘the Financial Crisis of 2007-2008’.

Chapter 4 gives a detailed description on the characteristics that fuelled the heat of the blaze, illustrated via the three main players involved: the rating agencies, the regulators and supervisory institutions and the banks.

Chapter 5 progresses the analysis of the Pro-cyclicality inherent within the financial spectrum which was largely overseen by regulators. Using the Pro-cyclicality associated with fair value accounting and minimum capital requirements of Basel II, the speed and propensity of the spread is demonstrated. Finally Chapter 6 will conclude with policy implications that need to be adhered to in order to avoid a recurrence of pro-cyclicality and unintentional consequences within the financial spectrum.

The Role of Supervision by Regulatory Institutions:

The financial regulators possessed a large stake in the propagation channel. Alan Greenspan’s administration believed that markets could police themselves better without government intervention and thus hardly intervened during the subprime bubble. The dispersion of regulatory institutions globally and the overlapping of tasks disrupted the supervisory process and facilitated growing complications.

Greenspan and his failed motives:

‘The financial crisis was caused by lack of supervision of the financial sector, rather than bankers breaking the rules.’ (Adam Smith Institute).

The US Federal Reserve (Fed) not only regulates monetary policy but also plays a significant role in the regulating of banking infrastructure within the United States. The highly influential Fed has the capacity over any other regulator to implement policies irrespective of the opinion of the President and Congress. Alan Greenspan (head of the Federal Reserve during the time the subprime loans were being originated) believed that a well functioning market with appropriate incentives could police itself more effectively than government bureaucrats. The mortgage lending industry he believed qualified under this category and believed that lenders ultimately had to answer to self-interested global investors, who possessed no intentions to originate bad loans.

Furthermore the Basel II capital reserve requirements were implemented about during this era where rules where heavily reliant on market forces. The amount of capital that banks require was determined by the market value of their holdings. This allowed market forces to determine what was appropriate.

On three occasions, concerns were raised relating to the distortion of the US mortgage industry. Firstly, a Fed Governor proposed that predatory lending needed screening. Secondly, the House of Congress and the Senate of the United States passed the home ownership and equity protection act of 1994, which gave the Fed the authority to curb unfair or deceptive lending practices. Thirdly, the US congress pushed the Fed to use the federal trade act to set down the rules on the deceptive lending practices.

All three proposals were rejected by Mr. Greenspan and when he finally realised that the industry was spiraling out of control, the damage was irreparable. According to Mr. Greenspan the principal task of the regulators during the last decade was to supervise the existing principals and to ensure that internal risk systems within the institutions were functional. Following which the tasks were given to the senior managements to judge the prudence of overall risk levels. This was where the fundamental disputes arose.

The financial and services authority in the UK and the commodity future trading commission on the United States competed with one another to grant more liberal systems with motives to facilitate a comparative advantage amongst economies. This in turn resulted in greater profit maximizing opportunities for financial institutions. Mr. Greenspan has been accused of adopting a profit maximization approach among financial institutions and encouraging risk management structures that enhance self interests.

As Mr. Greenspan admitted the granting of internal risk management systems was a mistake. Although by granting the senior management the authority to manage their risk internally also spurred greater innovative thinking that was not prevalent in the previous restrictive regime. Mr. Greenspan acknowledged that the bank lenders misused this freedom and were not prudent in managing their risks.