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How to Stop a Financial Crisis from Occurring Again LA 101H Akshay P Sankaran

In 2008, the United States of America experienced the most devastating financial meltdown it has seen since the Great Depression nearly a century ago. During this time American families lost more than 19 trillion dollars, nearly 10% of all the money in the entire world. Stock markets crashed and banks went bankrupt by the dozen. Thousands of people lost life savings that had been invested in financial markets. Deeds to houses worth hundreds of thousands of dollars became useless pieces of paper overnight. People all over the country succumbed to unemployment and were forcibly thrown out of their homes because businesses wanted to cut costs in order to cover their behinds. There are several reasons why this happened and they are not being disputed. The real question that everyone is asking is; could the government have prevented this disaster? And if they could, why didn’t they? Are the monetary policies that govern our country unable to keep up with the incredible financial innovation that was seen in the last decade? And now that the policies that are currently in existence have failed so terribly, how do we change them for the better? That is the question economists all over the country are trying to answer. The very one I will try to answer.

In order to understand how to prevent a meltdown of this scale from occurring in the future, we must first understand the factors that caused this one. The Financial Crisis Inquiry Commission was a ten member commission appointed by Congress to investigate and determine the causes of the financial

crisis. On January 17, 2011 they officially released their findings, which attributed the failure of the financial system to ten important factors. In the late 1990s there was an ever expanding credit bubble in the US and Europe, and a large and sustained housing bubble in the US (factors one and two). Lower credit costs lead to excess liquidity, and combined with lower financial regulations this led to an increase in non-traditional mortgages. Traditional mortgages, also often known as prime mortgages, are loans which required a down payment of 25% or so of the value of the property given as collateral security. These types of loans are rather expensive and cannot be made to people with low incomes and unstable employment. But they are also virtually risk free, because the borrower almost always has a high credit rating and a stable income. With the gradual fall in the controls that were set on the banking industry that was seen over the last few decades, banks could now make mortgage loans with lower down payments. These are nontraditional mortgages (factor three). However there is a serious risk associated with nontraditional mortgages, because they are cheaper, they can be made to people with lower credit ratings and less stable employment, which is why nontraditional loans are often called sub-prime mortgages. In other words, banks could now make loans to people who may not be able to pay them back. While these three factors contributed heavily to the crash, they alone were not powerful enough to cause a breakdown of this scale. The losses that were suffered in the recent crisis were largely borne by large highly leveraged firms. This begets the question; why were such prominent firms so exposed to the danger to such high losses? A failure on behalf of rating and securitizing firms turned sub-prime mortgages into toxic financial assets (factor four). Lower rating and security standards for financial assets led managers of huge funds to believe that bad investments were actually good risks. As a result of lower credit ratings, banks gave out numerous sub-prime mortgages. They then proceeded

to sell these loans in the form of bonds and other complex financial instruments to various investment banks, who then either resold them for a profit, or simply sat back waiting for the payment on interest and principle of the mortgages to come in over time. Therefore there was a huge amount of investment in assets that were never going to pay off. This risk was amplified multifold because of how little capital was held in reserve and how much was leveraged by short term debt (factors five and six). When the payments never came, investors began to suffer losses on an unprecedented scale, and in order to cover their losses they quickly began to foreclose the properties of the defaulters. This caused a huge increase in the supply of properties on the housing market. In a simple matter of demand and supply, excess supply causes the price to fall. And because of that property deeds became worthless pieces of paper, leaving investors down the creek without a paddle, only minutes from the waterfall. One by one like dominoes in a line, they fell to bankruptcy in fast order. And this was called the risk of contagion (factor seven). In other situations it was simply a case of severe shock in response to the sudden realization that the investments the firm had made were bad ones, that caused investors to bail out in a hurry, selling their bonds as fast as they could (factor eight). A rapid failure of ten of the largest investment banks in the country caused widespread financial panic and fear (factor nine). As a result any and all trust in the US financial system vanished overnight; this caused a tremendous contraction in the real economy (factor ten). These factors together led to one of the largest financial failures the world has seen this side of the last century. But could they have been prevented? Could more regulation have prevented the buildup of the causes into a gigantic snowball? According to the Commission’s report, the government could not have taken any steps that would have prevented the crisis and thus we are led to believe that the recession was inevitable. Factors one and two directly caused factor three, and banking regulation standards are something the

government can control. In fact the reason that banks were able to make these bad loans was because the government relaxed the standards in the first place. Factor four, lower standards of rating and securitizing firms could have also been prevented if government had intervened where the market had failed to do so. Typical investors do not have the means to fully investigate their investments, which is why the integrity of firms that rate securities and investments are so important. If they relax their standards investors can be lured into believing that they possess a safe investment when in fact they are holding onto one that could potentially be a huge loss. Factor six is also very straightforward, “holding too little capital in reserve” is a simple matter of passing regulations that insist on firms holding onto a fixed level of capital. While most of the other factors were well beyond the control of the government, had effective measures been taken where they could have been, the chain of events would have been broken and the recession either would not have happened or its effects would have been relatively negligible. While it is plain to see that increased regulation could have helped prevent the financial meltdown, where is the line that lies between too much regulations and too little? Unfortunately there is no straightforward answer to that question, simply because regulation has to be flexible enough to adapt to varying market conditions and any innovations in the financial field. There were several other countries that were not severely affected by the recession and most of them did it by having greater levels of regulation that did not severely affect economic growth. Countries like China and India, whose economic growth is among the highest in the world, require borrowers to hold at least 10% of the mortgage value. This ensures that only individuals with stable income are allowed to take on large loans, thus banks can give loans to a wider set of borrowers while

remaining safe from the dangers of sub-prime mortgages. If the government enforced stricter rating and securitizing standards, investments would have been appropriately rated and investors would have been more aware of the risks that they were taking. Implementing policies that force banks to hold onto certain minimum levels of reserve capital would have protected banks that held onto more risk in proportion to their reserves, from severe loss and bankruptcy. Rather than trying to implement entirely new policies, taking a leaf out of the books of other countries is a good idea. Financially conservative countries have managed to avert crises like this one without stifling economic growth. Looking at the financial policies of countries that have been showing increasingly rising GDP growth, and adapting them to our ever changing economy could be a very profitable move. Implementing policies that ensure that banks do not take on sub-prime mortgages, by enforcing a “floor” on down payments of about 10%, would prevent banks from taking on bad loans, while allowing people with lower incomes to borrow money at a relatively cheaper rate. Similarly, forcing banks to hold onto a certain amount of reserve capital would reduce their vulnerability to bankruptcy. India, for example, insists that banks hold onto about 20% of their total deposits as a reserve. But rather than making our policies rigid and inflexible, they should be able to adapt to ever adapting economic situations and financial innovation. Our inability to adapt to advanced products made it difficult to effectively rate their risk and chance of turning a profit. Financial regulation is not easy. It is not easy to read through the clutter that markets throw up into the air and even tougher to convince people that tomorrow will not be as easy as today and that they need to sacrifice some of their comforts in order to ensure a bright future. This is the challenge that regulators will always face. The economy is like a teenager; when do you let the reins run loose so

that the child might grow, and when do you pull hard on those reins to protect children from themselves? Regulation should not be strict and rigid legislation, but must instead be allowed to flow with the tide and times.