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LAW7323 International banking and finance: law and practice- Assignment

THE ROLE
THE

OF

BANKING MISBEHAVIOUR, SECURITIZATION,
AS

AND THE

FAILURE

OF

REGULATORY SYSTEM,

UNDERLYING CAUSES CRISIS

IN THE

GLOBAL FINANCIAL

Contents
The Role of Banking Misbehaviour, Securitization, and the Failure of the Regulatory System, as Underlying Causes in the Global Financial Crisis.............................................................................................1 I. Introduction ..............................................................................................................................................2 II. Banking Misbehaviour ............................................................................................................................2 i. Subprime Lending and ARM’s...........................................................................................................2 ii. Mortgage Fraud and Predatory Lending...........................................................................................3 III. Securitization Gone Wrong ....................................................................................................................4 1 The Role of Securitization..................................................................................................................4 ii. Re-securitization of CDO’s and adverse selection............................................................................5 IV. Regulatory Failure. ...............................................................................................................................8 1 Failure to adequately regulate the Financial Services Industry..........................................................8 ii. Policy driven risk taking ..................................................................................................................10 iii. The creation of Moral Hazard.........................................................................................................10 iv. The failure of International Regulatory Standards .........................................................................11 V. Conclusion ............................................................................................................................................12 VI. Bibliography..........................................................................................................................................12 a. Journals Articles/ Nooks/ Reports.....................................................................................................12 b. Legislation..........................................................................................................................................14 Question (2) At the heart of the recent global financial crisis (GFC) is securitization gone wrong, banking misbehaviour or regulatory failure. Do you agree that any or a combination of the italicised causes is at the heart of the GFC? If yes, how and why? If no, why not?

Page 1

3 combined with the misrepresentation and fraudulent activities of mortgage brokers. (2009) 17 University of New Mexico Law Review. INTRODUCTION This paper will analyse the role of banking misbehaviour. including wide scale lending to subprime borrowers combined with. after which significantly higher interest rates and repayment schemes applied. 2-3. Subprime Lending and ARM’s Subprime lending. on the belief that rising house prices would increase their equity. and regulatory failure. . after the US housing market began to collapse. or less than the interest.7 There was a direct correlation between both prime and subprime Arner. as causative factors in the crisis. it was the nature of many subprime loans as Adjustable Rate Mortgages (ARM’s). 7 Gerding. 2-3. 3. and refinancing at a lower rate unavailable.6 As many of these ARM’s were approved in 2004-2005. and international levels. D Jaffe. and the role of Credit Rating Agencies (CRA’s). securitization. or payment option repayment schemes5 for the first two or three years. 5 Gerald H Lander. Other key factors will also be examined. that was the ultimate underlying causative factor. as the underlying causes of the recent global financial crisis. Payment option ARM’s allow the borrower to choose how much to pay each month. Katherine Barker. ‘The Global Credit Crisis of 2008: Causes and Consequences’ (2009) Asian Institute of International Financial Law Working Paper No. 2 Gerald H Lander. above n 3. to cover interest an principle. failures of due diligence. A combination of stronger and more effective regulation of the financial system at both national and international levels is fundamental to the prevention of future financial collapses. M Richardson. & S Van Nieumerburgh. 3. or interest only repayments. 4 2/28 and 3/27 ARM’s have a 2 or 3 year initial period of fixed low interest. This in turn. allowing subsequent refinancing at a lower rate. in Restoring Financial Stability: How to Repair a Failed System. Margarita Zabelina and Tiffany A Williams. ‘Mortgage Origination and Securitization in the Financial Crisis’.15. Rather.LAW7323 International banking and finance: law and practice. Katherine Barker. interest only. ‘The Subprime Crisis and the Link between consumer Financial Protection and Systemic Risk’. making such loans unsustainable. A Lynch.4 offered an artificially low interest rate. whilst a combination of these key factors. (2009). ARM’s. 6 Ibid. followed by the remaining 28 or 27 years (of a 30 year mortgage) at a higher adjustable rate.2 were not in themselves the cause of the subprime crisis.BANKING MISBEHAVIOUR Banking misbehaviour was a key cause in the US subprime crisis. D W. ‘Subprime Mortgage Tremors: An International Issue’ (2009) 15 International Advances in Economics Research 1. misassigned risk.1 i. 1. through the unsound and unethical practices of leading US banks and investment banks (IB’s).Assignment I. whereby loans are offered to individuals with lower credit ratings at higher interest rates to reflect the associated risk. Finally this paper will conclude that. including key policy decisions. the switch to higher repayments took effect in 2006-2008. and containment of systemic risk. operated to trigger the crisis threatening systemic collapse of the global financial system. 14. combined with mass securitization of the underlying loan stock. repackaging of securitized assets as Credit Debt Obligations (CDO’s). also known as 2/28’s or 3/27’s. Mortgage brokers induced subprime borrowers to borrow significantly higher amounts. II. often representing 90-100% of the property value. that led to the mass defaults. Margarita Zabelina and Tiffany A Williams. and complicity in allowing predatory lending by mortgage brokers. the creation of moral hazards. interest only. caused the spread of contagion risk that threatened global financial stability. respectively. 3 Erik F Gerding. it was regulatory failure at both the domestic. 1 Page 2 . above n 2. 127.

21 Additionally. 14 As such. Consequences and Solutions’. including ARM’s. above n 3.gov/bankinforeg/reglisting. November 2009.11 ii. US Treasury Department.pdf 14 Gerald H Lander.3% of such loans.LAW7323 International banking and finance: law and practice. 17 Gerding. 18 11 Ibid. to sign up to mortgages contracts that their income cannot support. the originating banks failed to independently review the loan documents and independently verify the income and credit history of subprime Stan Liewbowski.18 required for compliance with the Truth in Lending Act19 and related federal regulations. above n 2. ‘An Industry Assessment based upon suspicious activity reports analysis’. through the misrepresentation or nondisclosure of the terms and consequences of the loan agreement. 12 Gerding. Ibid. §§ 1601 et seq. 19 15 U. 9 Furthermore. whilst prime ARM’s represented less than 2% for the same period. above n 11.8 whilst. 4-5. 12 CFR §226 (2008).gov/MortgageLoanFraud. 18 Gerald H Lander. and foreclosure. July 12-13. for selling a product which charges a higher interest rate.fincen. 15-16. US Treasury Department. with little regard to the attached credit risk of delinquencies. 1. 14. 16 the loans were ultimately approved and facilitated by the originating banks and IB’s.S. and may also receive a “yield-spread premium” from the originating bank. 16 Office of US Regulatory Analysis. Katherine Barker. by relying upon the mortgage brokers to adequately disclose to borrowers the complex requirements of the ARM loan agreements. 3.C. 2. above n 3. 1. as the risk lies with the originating bank and the borrower. Mortgage Loan Fraud (November 2006). in many cases.15 Whilst the role of brokers in perpetuating predatory lending and mortgage fraud was a clear factor in causing the mass default on subprime ARM loans. involves the material misrepresentation or omission of information on loan documents with the intention to deceive or mislead originating lenders. 15 Ibid. subprime ARM’s represented nearly 7% of defaults by the second-quarter of 2008.20 Originating lenders of subprime loans increased lowdocumentation (or no-documentation) loans to account for 50. The Economists View. as most of the $1. 13 Office of US Regulatory Analysis. Predatory lending practices involve the inducement of vulnerable low credit rated consumers. Margarita Zabelina and Tiffany A Williams. 3-4. 3-4. Regulation Z. Caused the Mortgage Crisis’. ‘ARM’s.12 many of these loans would not have been approved without the predatory lending practices and mortgage fraud perpetuated on behalf of mortgage brokers. retrieved 1 June 2010.13 Mortgage brokers in the US are largely unregulated. www. ultimately causing a ‘credit freeze’. 15. default.17 who bear responsibility for failing in their due diligence. Bank and IB’s failed in their due diligence. Mortgage fraud for property. Margarita Zabelina and Tiffany A Williams. 12 CFR § 203 Home Mortgage Disclosure Regulations (c) http://www. and in return for arranging the loan. 2009. the affect of these increasing defaults was to destroy the value of securities.3 trillion in subprime loans issued between 2003-2007 10 had been packaged and sold as issued bond securities (securitized). 20 See also. above n 2. presented at the conference on Global Market Integration and Financial Crisis at HKUST.htm 21 Gerding. above n 3. a mortgage brokers profit incentive lies in the volume rather than the quality and appropriateness of loan products for individual borrowers. and the indirect complicity of banks and other financial institutions. 10 Franklin Allen and Elena Carletti ‘An Overview of the Crisis: Causes. (2008).8% of all subprime loans by 2006.federalreserve. the brokers collect a fee from the borrower. 8 9 Page 3 . Katherine Barker.Assignment ARM’s and the initial mass increase in defaults. Mortgage Fraud and Predatory Lending Whilst subprime loans increased to represent 20% of the US mortgage market by 2005. Not Subprimes. with ARM’s accounting for 91.

3. ‘Securitization and Subprime Crisis: A Critical Analysis of the Role of Credit Rating Agencies’ (2010) Department of Management Working Paper Series ISSN 1327-5216.31 resulted in the exposure of these financial institutions to previously unforseen risk.LAW7323 International banking and finance: law and practice.SECURITIZATION GONE WRONG 1 The Role of Securitization Unprecedented and excessive securitization of prime and subprime loan agreements became a major causal factor in the global financial crisis in several ways. July 12-13. A T M Tariquzzaman. & M A Yusuf. 25 (1998) This effectively repealed portions of the Glass-Steagall Act of 1933 (the Banking Act of 1933) and the Bank Holding Company Act of 1956. any assigned mortgage risk could quickly be diversified and off-loaded to investors. 28 Quamrul Alam. Consequences and Solutions’.. above n 1. above n 11. 11-12. can be attributed to increased competition between lenders as a result of low interest rates following the dot. ‘Systemic Risk in the Financial Sector: An Analysis of the Subprime Mortgage Financial Crisis’. 26 Quamrul Alam. resulting in the significant mispricing of risk by Credit Rating Agencies (CRA’s).27 As the subprime crisis unfolded. 27 Hellwig. magnified estimation errors. M.26 The underlying rationale behind the increased securitization of the loan assets was that. US Treasury Department. above n 27. As the originating lenders assigned the risk. and accounted for nearly 70% of early payment defaults in 2008. and threaten systemic collapse of the financial system. 24 Hellwig. A T M Tariquzzaman. above n 27. 18 30 Quamrul Alam. & M A Yusuf. M A. and the increased use of securitization to generate fees and isolate risk. above n 22. pooling the loans together.Assignment applicants. Firstly. prohibition on banks owning other financial companies . 5. & M A Yusuf. as well as underwriters and investors. leaving little incentive to apply due diligence to ensure that the credit risk was adequately estimated. unregulated securitization resulted in the misassigning and mispricing of risk by the originating financial institutions. their exposure was removed or reduced.22 with mortgage fraud estimated to represent between $1 billion and $6 billion in loans in 2005. either on-balance sheet or off-balance sheet. from heavy investments in Mortgage Backed Securities (MBS).23 This failure on the part of banks and IB’s to adequately review loan applications. 31 Arner. and then assigning the asset pool to a ‘Specialized Investment Vehicle’ (SPV) established by the bank. In its simplified form. and the originating bank is effectively isolated from any default risk on the underlying Martin Hellwig. 2009. securitization involves an originating bank that has created mortgages and other loans. Collaterized Debt Obligations (CDO’s) and similar securitized products. Where the loan pools are ‘offbalance sheet’. 2. 19-20.30 Thirdly. 24 the lowering of regulation of the banking and financial services sector through the passing of the Gramm-LeachBliley Financial Services Modernization Act25(GLB Act). A T M Tariquzzaman. continuing reliance upon securitization and CDO’s by banks and IB’s as a source of fee income. 22 Page 4 . 1. 29 Franklin Allen and Elena Carletti ‘An Overview of the Crisis: Causes. ‘ 23 Office of US Regulatory Analysis.com bubble. and the utilization of securitized assets to meet Basel II Tier 2 capital adequacy requirements and short term financing. M. the dubious value of securitized assets would ultimately result in a credit freeze between financial institutions. presented at the conference on Global Market Integration and Financial Crisis at HKUST. 3-4.28 III. continual repackaging of securitized assets into Collaterized Debt Obligations (CDO’s). 1.29 Secondly. and the real exposure of the banks and IB’s to the credit risk of the underlying securitized loans became apparent. (2008). the legal ownership of the underlying loans is transferred to the SPV. 43 Max Planck Institute for Research on Collective Goods. 10. above n 22. 9. a separate company or corporate trust.

32 33 Page 5 . and by selecting different tranches. 21-22. as well as borrower default risk. 34 As the bonds are nominally rated according to the quality of the pool of assets. 34 Hellwig.39 Securitization enabled lenders to generate new loans from the proceeds of selling the securitized loans.36 Furthermore. Lenders could convert long-term illiquid assets (mortgages) into short-term liquid assets. Finally. M. The apparent reduction and diversification of credit default risk only remains effective where. 36 Hellwig. above n 1. with the mix of loans adjusted to meet CRA requirements and ideally achieve a AAA rating. with investors purchasing the bonds to gain a predictable income stream (from the interest and principle repayments). with the security of the bonds ostensibly backed by the underlying assets against which the loans are securitized. above n 20. lenders effectively reduce and diversify both interest rate risk. 2. with income assigned firstly to senior tranches. above n 1. 963 40 Gerding. providing a greater ability to meet short term financing needs. A T M Tariquzzaman. resulted in the misassigning and mispricing of risk by the originating financial institutions. whereby a variety of securitized assets (bonds) are pooled.37 CDO’s involve a secondary or subsequent resecuritization of bond issues. 3-4. firstly. Re-securitization of CDO’s and adverse selection Arner. and re-securitized. and then equity or junior tranches.38 Securitization of loans benefitted lenders in a number of ways. concentrated the percentage of higher risk subprime loans pooled with prime loans. Jnr. above n 3. & M A Yusuf. followed by mezzanine. 38 Arner. where lenders are not continually dealing with securitized asset pools. an investor can diversify their risk by limiting exposure in the event of isolated defaults in the loan pool. above n 27. 3-4. Quamrul Alam. and providing less reliance upon inter-bank loans. above n 20. making it difficult to accurately estimate and assign risk. the bond securities and their underlying loan pool remain transparent and are not continuously repackaged. most AAA rated bond securities could be purchased with insurance underwriters guaranteeing the assets against default. as well as insurance underwriters. 12. by off-loading loans and the attached risks to bondholders and/or insurance underwriters. thereby increasing profits and return on investment.40 However. 10-11. where the market interest rates increases above the fixed-rate of issued loans. repackaged. and secondly. above n 2. provided a ‘true sale’ has transferred the legal debt obligation. 37 Quamrul Alam. 4 Connecticut Law Review. above n 22.33 The SPV then issues bonds to the investment market. 11. collecting the income and paying the bondholders investment returns. In the subprime crisis. 39 A E Wilmarth. above n 27.LAW7323 International banking and finance: law and practice. lenders earned servicing fees as providers. 35 Different tranches are assigned priority income rights. 32 The SPV then approaches a Credit Rating Agency (CRA) to have the bonds rated. Furthermore. based upon the overall asset pool.41 ii. ‘The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis’ (2009) Vol 41.Assignment securities. based upon the relative (not actual) probability of default. with adjustments for insurance guarantees and different tranches or classes. No. the lack of transparency in unregulated securitization and re-packaged CDO’s. 11-12. CRA’s. A T M Tariquzzaman. the continual re-securitization of CDO’s by banks and IB’s as a source of fee income and to diversify risk. 11. & M A Yusuf. M. 41 Hellwig. 35 Gerding. to be sold on the secondary investor market.

Georgia. when house prices fell below the amount of the mortgage. the risk attached to bond issues and CDO’s was inherently mispriced. within a similar time frame upon similar terms. in similar circumstances of rising house prices and record low interest rates. Hawaii. the second lowest rating above junk. M. As the previously small ratio of high risk loans in any given asset pool may increase with each resecuritization. having Gerding. above n 20. Wyoming. Note however. 46 See the California Code of Civil Procedure §§ 580a & 580b. . Bond Issues supposedly representing the underlying assets became so intermixed. 7. Alabama. 16. Idaho. ‘Regulatory Reform in the Wake of the Financial Crisis of 2007-2008’.LAW7323 International banking and finance: law and practice. and therefore determine its underlying value with any degree of certainty. above n 27. 7. above n 22. Adverse selection involves an inability of the market to accurately ascertain the risk attached to a category or type of product or investment. Montana (as long as non-judicial foreclosure is used). almost guaranteed default. The proportion of defaults within any given asset pool became concentrated rather than diversified. 50 Arner. necessarily introduced a strong yet unforseen correlation into the default risk. Minnesota. North Carolina. resulting in the market refusing to deal in such instruments. Oregon. A T M Tariquzzaman. due to the underlying nature of the loans. when the switch to high repayments under ARM loans.47 Additionally. Arkansas. there was little incentive not to default. Electronic copy available at: http://ssrn. Texas (but even in a non-judicial foreclosure. 16. District of Columbia (Washington DC). West Virginia. Colorado. 9.48 This uncertainty as to the underlying value of securities was to create a situation of ‘adverse selection’ when the sub-prime crisis began. 16-17. that a lender may decline to pursue deficiency judgments against subprime borrowers as they are unlikely to have any assets or sufficient income to settle any judgment obtained. transparency as to the attached risk and underlying value of the bond issues became obfuscated. New Hampshire. commonalities such as an increase in interest rates and the housing market collapse. However the following are states that allow non-judicial foreclosure. Rhode Island (lender can seek deficiency judgment). but remain effectively hidden amongst the mix of other bond issues. Virginia. Washington (as long as non-judicial foreclosure is used which is the most common). Quamrul Alam. Alaska. above n 22. 47 Andrew Lo. 42 43 Page 6 . Arner above n 1. above n 1. and the assets so diluted through continual re-packaging of securities into CDO’s.42 As such. Arizona. Missouri.49 The problem of adverse selection exacerbated the highly-correlated nature of subprime and ARM loans within asset pools. and the prevalence of non-recourse borrower protection. As non-recourse state laws46 in many cases protected defaulting borrowers from liability beyond the underlying property in the event of foreclosure. and/or where non-judicial foreclosure is more common and deficiency judgments can be obtained more easily: Michigan. through the successful securitization of the loans. errors in the calculation of default risk by rating agencies became magnified. 8.43 The default probabilities contained too many common factors to be effectively diversified. the subprime and ARM defaults would all be triggered by the collapse in the housing market within 2-3 years of issue. with the AAA rating no longer accurately reflecting the actual risk of default. Mississippi.50 Ostensibly. 49 Hellwig. 44 Hellwig.44 As the loans were mainly issued to similar high risk borrowers. were later downgraded to BBB. above n 20. Utah (lender can seek deficiency judgment).45 Effectively. 9-10. Mortgage Backed Securities (MBS) that had been conferred AAA (highest) rating when issued during the housing boom. above n 2. that it became impossible to trace the underlying asset security. and dubbed ‘toxic assets’.Assignment Continual re-securitization of CDO’s resulted in asset pools that bore little relation to the underlying asset security. and to determine which bonds were at risk in the event of mass defaults. the lender can pursue a deficiency judgment). nor the underlying security attached to the bonds. South Dakota. & M A Yusuf. Tennessee.com/abstract=1398207 48 Hellwig. Other states that have non-recourse laws include. the banks and IB’s should have been relatively isolated for the most part from default risk and the main affects of the subprime mortgage crisis. 45 Hellwig.

the mispricing and misassignment of risk resulted in many banks and IB’s holding large volumes of AAA rated securitized bonds. 55 Ibid. M. Municipal Bond Insurance Association (MBIA) had only $7. as well as the monoline insurance companies that Quamrul Alam.Assignment transferred the default risk to investors or underwriters. Following JP Morgan’s emergency buy-out of Bear Sterns underpinned by a $30 Billion non-recourse loan from Federal Reserve Bank. above n 27. 51 52 Page 7 . investors attempted to offload any remaining securities.LAW7323 International banking and finance: law and practice.55 By 2006. 57 Moody’s Investor Services.51 However. P. CDO’s. 56 Ibid. to massive liability as insurance calls crystallized. 59 Quamrul Alam.62 Institutions perceived as heavily involved in securitization. 7-8. P. When the subprime crisis hit. the market for securitized assets dried up. June 2008.52 Additionally. 1. 7-8. Lehman Brothers. and CDS including. including the Radian Group. whereby institutions ‘driven’ to engage in the same risky behaviour as their competitors in order to meet ‘industry growth standards.56 As ‘monolines insurers’ exclusively insured CDO’s and other MBS. and their value plummeted. competition ‘herding’ of banks. and achieve AAA bond rating. and investors. and MBIA. As such. This resulted in significant downgrades in the insurers credit rating which. & M A Yusuf. 61 market conditions proved optimal for a bond issue to prospective However.59 Additionally. 60 Haiss. and was later bailed out with $85 billion from the Federal Reserve Bank in exchange for US government taking 79. rather than ensuring the underlying loans had long-term reliability when originated. & M A Yusuf. 53 Ibid. 58 Moody’s Investor Services. banks and other financial institutions continued to trade in securitized bonds to meet the continuous need for short term liquidity necessary to finance the income streams to bond holders. 30-31 61 Arner.9% stake. the American Municipal Bond Corporation (AMBAC).58 As such. M. 54 Damette.2 billion in equity to secure $26. CDO underwriters faced enormous exposure. above n 1. to maintain capital adequacy through Tier 2 Basel requirements. 214. 1. often obtained bond insurance from underwriters such as American Insurance General (AIG) and monoline insurers. and by 2008 AIG revealed $62 billion exposure to CDO’s. in exchange for their collection fees as ‘providers’. the value of such insurance was relative to the exposure of the underwriters in the event of mass defaults. above n 1.53 Furthermore. many lenders had been habitually ‘warehousing’ a large numbers of securitized loans and CDO’s until a CRA rating was obtained. A T M Tariquzzaman. banks and investment banks such as Citigroup. 19-20. 212. with MBIA’s credit rating downgraded by Moody’s from AAA to Baa1. secure the provision of income stream payments to bondholders. ‘Bank Herding and Incentive Systems as Catalysts for the Financial Crisis’ (2010) VII The IUP Journal of Behavioural Finance. 8. by relying upon underwriters to guarantee income stream and maintain the AAA rating of the securities. Merrill Lynch. the collapse in the subprime market exposed the ‘monolines’. as the increasing number of mortgage defaults triggered the subprime crisis. above n 1. O. ‘Is the Crisis Treatment exacerbating Cautiousness or Risk Taking?. Arner. directly impacted the insured bonds rating. having leveraged their security up to 40 times the value of their underlying assets. whilst banks and IB’s. the originating banks and IB’s had misassigned risk. & Froute. Rating Action: Moody’s Downgrades MBIA from AAA to Baa1. UBS. Royal Bank of Scotland. 217. 1. A T M Tariquzzaman. (2010) 20 Applied Financial Economics. mortgage lenders including Washington Mutual.’ 60 resulted in the continuing reliance upon the securitization of loan pools and repackaging of CDO’s to generate transaction fees. and doubts emerged as to the value of the securities. Rating Action: Moody’s Downgrades Ambac from AAA to Aa3 June 2008. 62 Arner. 7-8. above n 27.57 and AMBAC from AAA to Aa3 in June 2008.54 to further isolate credit default risk.2 billion in debt.

69 Damette. CDO’s and other securitized assets (excluding government bonds) being traded. leading to a belief that institutions would not be allowed to fail. by pursuing policies that inadvertently encouraged excessive risk taking without the relative attribution of liability.Assignment underwrote potential default on securities. IV. and thirdly. Hellwig. Regulatory failure in the US. 1 Failure to adequately regulate the Financial Services Industry Regulatory failure as a dominant cause of the subprime crisis can be traced to the effective repeal of the Glass-Steagall the Banking Act of 193371 and the Bank Holding Company Act of 1956.72 through the Ibid. information contagion effects were triggered. ‘Is the Crisis Treatment exacerbating Cautiousness or Risk Taking?. This in turn created ‘domino effects through asset prices. as well as international regulations for capital maintenance requirements under Basel II. 66 Ibid. regulatory failure arose across three broad areas. firstly through the repeal of key legislation designed to contain systemic risk. 65 Ibid. came under increasing market scrutiny.68 and were also unwilling to sanction inter-bank loans. re-packaging of CDO’s.66 As a result. and reliance upon CRA’s. P. and failure to adequately regulate the financial services industry. 18. and inadvertently promoted the spread of systemic risk.70 However.57. REGULATORY FAILURE. 214 70 Ibid.67 Banks and other financial institutions. 58. implement and maintain sufficient control over the financial services sector.’65 as the liquidation of Lehman Brothers assets resulted in ‘adverse selection’ towards all MBS. secondly. it was facilitated by the regulatory failure by the US government and regulatory bodies. through the creation of moral hazard. and the counterparty providers of Credit Default Swaps (CDS) such as AIG. 71 the Banking Act of 1933 (US) 72 the Bank Holding Company Act of 1956 (US) 63 64 Page 8 . 68 Franklin Allen and Elena Carletti. At the domestic level. 67 Hellwig. above n 20. and underwriting of both the securities and the underlying assets.58. (2010) 20 Applied Financial Economics. & Froute. due to uncertainty as to the degree of exposure of any other financial institution potentially holding such securities. were unwilling to deal in securities due to the unknown toxic mix of assets submerged in any asset portfolio. O. above n 30.64 The collapse of Lehman Brothers simultaneously triggered all three aspects of systemic risk. meant that the three aspects of systemic risk were present. to establish. above n 20. with domino effects through contractual relations forcing the other institutions to write down any contractual claims against Lehman brothers.LAW7323 International banking and finance: law and practice. whilst unregulated securitization was undeniably a main factor in causing the global financial crisis. 69 resulting in a ‘credit freeze’ and systemic financial crisis. directly and indirectly facilitated the emergence of the other main causes for the subprime crisis.63 The interrelationship between these financial institutions and their heavy involvement in originating and securitizing subprime ARM’s.

85 Shin HS. 89 This increased competition also forced banks to become more dependent upon subprime loans and ‘Originate To Distribute (OTD) securitization.85 As such. 20-21. with the failure of any large institution could have drastic flow-on effects to other financial service providers. promoting speculation. H S. significantly increasing credit default exposure.75 CDS are bilateral contracts to insure against the default of financial instruments such as CDO’s. 74 Financial Services Modernization Act of 1998(US) 75 Shin.LAW7323 International banking and finance: law and practice. the GLB. and the Financial Services Modernization Act of 1998 (US) This effectively repealed portions of the Glass-Steagall Act of 1933 (the Banking Act of 1933) and the Bank Holding Company Act of 1956. 16. 73 Page 9 . the seller pays the buyer for the loss.84 whilst Lehman Brothers left an estimated $365 billion in CDS. the passing of The Commodities Futures Modernization Act of 200081 allowed US banks to self-regulate CDS and other Over the Counter (OTC) Derivatives. such as default. 77 Ibid. However. 84 Ibid.73(GLB). The GLB74 significantly increased systemic risk by removing prohibitions on banks owning other financial companies including IB’s and insurance company’s. which became nullified upon Lehman’s bankruptcy.79 and s 3A the Securities Exchange Act of 1934. (2009) Hong Kong Institute for Monetary Research Occasional Paper No. above n 75 . Germaine Depository Institutions Act of 1982 (US) 89 Shin. they were also bought and sold as bets against CDO defaults. prohibition on banks owning other financial companies . including “naked” CDS where neither party held the underlying loan. and the buyer is no longer liable for the periodic payments. 1. increasing competition. 78 Financial Services Modernization Act of 1998 (US) 79 The Securities Act of 1933(US) 80 the Securities Exchange Act of 1934(US) 81 The Commodities Futures Modernization Act of 2000 (US) 82 Financial Services Modernization Act of 1998 (US) 83 Shin. above n 1.77 Furthermore. 76 Ibid. leaving any holders of purported counterparty protection exposed to liability. which combined with artificially low interest rates. Additionally.87 Furthermore the Garn-St. 16-17.76 Whilst CDS were used to hedge against defaults. it also increased the systemic risk. if a credit event affects the underlying instrument. and systemic risk.5 trillion in CDS’s and interest rate-swaps. above n 75. whilst the GBL86 increased market competitiveness. 86 Financial Services Modernization Act of 1998 (US) 87 Arner. ‘Leverage. this in turn forced banks and IB’s to enter more risky transactions including CDO’s and CDS’s to generate fees and maintain profit margins. whereby one counterparty buys the risk of default on the underlying instrument (the likelihood that mortgagors securing CDO’s will default on the underlying loan). 14-15.78 specifically exempted security-based swap agreements from regulation by the Securities Exchange Commission (SEC). Whilst the GLB 82 allowed IB’s to enter traditional banking markets. US banks became interconnected with IB’s and insurance company’s who were not subject to the same capital requirements under Basel (and later Basel II). HS. 17. and enabling banks to become involved in areas such as securitization and Credit Default Swaps (CDS).Assignment passing of the Gramm-Leach-Bliley Financial Services Modernization Act of 1998. 88 the Garn-St. 14. Germaine Depository Institutions Act of 198288 relaxed lending criteria to allow banks to issue ARM’s. above n 75. by amending s 2A the Securities Act of 1933. HS.80 effectively removing any regulatory oversight. in exchange for periodic payments. Securitization and Global Imbalances’. which were later to form the weak link in the underlying security of many CDO’s.83 Bear Stearns’ exposure at the time of the forced takeover by JPMorgan was estimated at $2. 5.

By keeping interests rates at record lows reaching 1% in 200393 following the Dot. the excess supply of money fuelled the housing bubble and promoted speculation and excessive leverage. and control systemic risk amongst the financial services industry. Arkansas. above n 75. Tennessee. J L. the lender can pursue a deficiency judgment). Texas (but even in a non-judicial foreclosure. 95 Ali. Note however. by allowing unregulated mortgage brokers to issue ARM subprime loans to consumers with low creditworthiness. Idaho. as US housing prices continued to rise on average 10% pa from 20012006. P U. above n 1. that a lender may decline to pursue deficiency judgments against subprime borrowers as they are unlikely to have any assets or sufficient income to settle any judgment obtained.95 before the onset of the subprime crisis.92 The failure of US regulators to effectively monitor. HS. and without any attached risk to. ‘Credit Rating Agencies: Time to Act’. which inadvertently promoted speculation. The SEC was to reinstate the rule which in September 2008 in an attempt to prevent further declines. many mortgagors were risk isolated by relying upon non- ii.90 US regulators further indirectly promoted excessively risky speculative activity. Minnesota. and allowing short sale transactions to be entered at lower prices. 132. In addition. Virginia. Montana (as long as non-judicial foreclosure is used).96 iii.LAW7323 International banking and finance: law and practice. 94 Shin. Mississippi. Georgia. and widespread defaults. Colorado. South Dakota. District of Columbia (Washington DC). Alabama. When combined with the push to facilitate subprime mortgages. 96 Arner. Arizona. Alaska. Other states that have non-recourse laws include. Additionally. Missouri.Assignment heavy influx of foreign investment following the Asian financial crisis. Washington (as long as non-judicial foreclosure is used which is the most common). The creation of Moral Hazard Furthermore US regulators were to create significant moral hazards. beginning the downward spiral when assets began experiencing sharp declines. 49. Rhode Island (lender can seek deficiency judgment). later banking investments in CDS’s and CDO’s exposed many institutions to excessive liability.91 This failure to regulate mortgage brokers and financial institutions in the issuing of loans. Policy driven risk taking Failure of US government to adequately to regulate the supply of money in the US economy.Com bubble94 made credit artificially cheap. However the following are states that allow non-judicial foreclosure. 47. by creating a perception that the US government would not allow financial institutions to fail when deemed ‘Too Big Too Fail’ (TBTF). and to fairly attribute liability to consumers in the event of default. whilst encouraging mortgage fraud and predatory lending. created incentives to disregard due diligence and adequate consumer protection. 90 91 Page 10 . US regulators pursued policies of minimal market intervention. Hawaii. North Carolina. 93 Ibid. and/or where non-judicial foreclosure is more common and deficiency judgments can be obtained more easily: Michigan. West Virginia. Wyoming. although recourse laws in the event of default. See the California Code of Civil Procedure §§ 580a & 580b. also significantly contributed to the subprime crisis. whilst the originating banks ostensibly offloaded the loans using OTD securitization. New Hampshire. to fuel the housing bubble that would result in the subprime crisis. 32. 92 Simpson. (2009) 27 The Companies and Securities Law Journal 125. the brokers collecting their fees. with the SEC removing the ‘uptick rule’ in July 2007. Utah (lender can seek deficiency judgment). Oregon. ‘Were there warning signals from banking sectors for the 2008/2009 global financial crisis?’ (2010) 20 Applied Financial Economics. 18. combined with policies that encouraged the US housing bubble and speculative practices which resulted in the global financial crisis. which impliedly promoted further risk taking based on a belief that the US government would bail the institutions Ibid.

1. & Froute. 333. 30. ‘Is the Crisis Treatment exacerbating Cautiousness or Risk Taking?. 25-27.102 Whilst this intervention was necessary to prevent systemic collapse of the global financial system. O. (2008) Journal of Financial Stability. under the Standard Approach.107 As CRA’s base their rating upon the relative probability of default. 29. 30-31 100 Arner. the resulting credit freeze and threat of systemic risk. Damette. 107 Ackermann. above n 1.97 This moral hazards was originally founded on the US government bailout of Long Term Capital Management in 1998. and reliance upon unregulated CRA’s were further causes for the global financial crisis. and too readily rely upon the information provided by corporations seeking Ackerman. whilst also invest in CDO’s when need to prevent insurance payments for breaching FDIC requirements.98 and continued with the taking on of $30 billion paper securities of Bear Stearns following the takeover by JPMorgan.100 that the market began to question whether the US government would allow more failures. (2010) 20 Applied Financial Economics. . 101 Ibid. P. 97 98 Page 11 . above n 97. 106 Arner. ‘The subprime crisis and its consequences’. 4. regulatory standards facilitated the spread of systemic risk through the global financial system by. 103 Ackermann. with Basel II formally recognizing the role of CRA’s in determining bank’s risk assignment for asset categories. above n 97. ‘Bank Herding and Incentive Systems as Catalysts for the Financial Crisis’ (2010) VII The IUP Journal of Behavioural Finance. 104 Ibid. above n1. also placed excessive reliance upon CRA’s for the risk assessment.Assignment out. which was also required for the previously “government sponsored enterprises” of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). 105 Arner. above n 1. The failure of International Regulatory Standards At the international level.99 It was only when the collapse of Lehman Brothers’ was allowed leaving $650 billion in liabilities. 334.LAW7323 International banking and finance: law and practice. forced the US government to step in to bailout AIG with $85 billion loan in exchange for 79. above n 1. 337.. The 8% capital requirements under Basel II. the provision of government bailouts creates a moral hazard that encourages risk-taking. J. P.9% equity stake. iv.104 leaving many IB’s holding AAA rated CDO’s which were to later become almost worthless.101 However. 106 The reliance of Basel II and US regulatory authorities upon CRA’s to determine banks and other financial institutions risks were misplaced as the CRA’s methodology upon which ratings were based was inherently flawed for most securitizations.103 Basel II provided incentives for excessive securitization and leveraging by encouraging banks to develop internal risk models. rather than the actual instance of defaults. 214 99 Haiss. essentially a partial temporary nationalization. 102 Arner. allowing excessive leveraging based upon Basel II capital requirements. 30. and then allowing for the self assessment of risk by banks. The capital maintenance requirements under Basel II pursuant to international banking regulations. 336. encouraged banks and international banks to rely upon to utilize securitization to shift loans off-balance sheet.105 Risk assessment under Basel II. where the polling and re-pooling of assets may disguise higher risk assets amongst high rated assets.

CRA’s remained essentially unregulated until the Credit rating Agency Reform Act of 2006. and failed to understand the sophisticated securitization structure underpinning the sub-prime crisis.. ‘Securitization and Subprime Crisis: A Critical Analysis of the Role of Credit Rating Agencies’ (2010) Department of Management Working Paper Series ISSN 13275216. and had a conflict of interest. M A.LAW7323 International banking and finance: law and practice. Tariquzzaman. efficient and effective regulatory regimes can operate to minimize their occurrence and mitigate the affects of such occurrences through. and the role of Credit Rating Agencies (CRA’s). and was ultimately the underlying causative factor in the GFC. Whilst financial crisis are not always unavoidable. excessive securitization. CRA’s failed to downgrade their credit ratings quickly enough. A T M. 29. through licensing.Assignment the rating. the imposing of Deposit Insurance by the Federal Deposit Insurance Commission (FDIC). VI. is necessary to minimise the prevalence and impact of financial crisis in the future. which has imposed licensing requirements. Page 12 . Q.. more direct assignment of risk . CONCLUSION Banking misbehaviour. with Moody’s generating over 40% of revenue structured finance ratings109 such as securitizations. 4. Journals Articles/ Nooks/ Reports Alam.108 Additionally in many cases. BIBLIOGRAPHY a. were substantial causes of the recent global financial crisis. 108 109 110 Ibid Fabian. However.. 1. D. the creation of moral hazards. ‘The Credit rating Industry: Competition and Regulation’. Stronger and more effective regulation of CDO and CDS transactions.. and for the containment of systemic risk.110 V. greater transparency. that facilitated these other key causes. and international levels. underlying national and international political and economic factors.. 1 Ackermann. & Yusuf. and a closer review of capital maintenance requirements under Basel II. and stricter enforcement of regulations via independent government regulatory bodies rather than excessive reliance upon market forces and the private sector. may act as an impediment to any substantive developments in national and international regulation. University of Cologne. However. Furthermore. ‘The subprime crisis and its consequences’. July 2004. Ibid. it was regulatory failure at both the domestic. (2008) Journal of Financial Stability. along with other key factors including key policy decisions. having a vested interest in providing higher ratings. J.

P U. Katherine Barker. P. A. (2007) Law Society Journal. (2010) 10 Chicago Journal of International Law 581 Damette. Margarita Zabelina and Tiffany A Williams. Gray. Wachter.cfm?abstract_id=1568162 Liebowitz. O. http://papers. Bruce.com/abstract=1398207 Mamun. 1 Jaffe. ‘ Financial Regulation after the Global Financial Crisis’ Department of Finance Publication paper . Igan.LAW7323 International banking and finance: law and practice. Li. Giovanni. & Van Nieumerburgh.com/sol3/papers. 1. & Tower. February 4 2009. (2008). Not Subprimes. C R. P. 2-3. D W. Levitin. ‘Systemic Risk in the Financial Sector: An Analysis of the Subprime Mortgage Financial Crisis’. Page 13 . 2009. S. R. Rutgers University. L. E F. & Johnson. 30-31 Hellwig. ‘Is the Crisis Treatment exacerbating Cautiousness or Risk Taking?. 43 Max Planck Institute for Research on Collective Goods. Richardson. 1 Bowles Jnr. ‘Prospects for Securitization in Transition Economies’. Moody’s Investor Services. P U. A. ‘The Subprime Crisis and Financial Regulation: International. March 2010. K. Electronic copy available at: http://ssrn. A. 214 Davis. ‘Subprime Mortgage Crisis: A Legal Perspective’. The University of Melbourne and Melbourne Centre for Financial Studies Foreman. Monetary & Capital Markets Department IMF. ‘Bank Herding and Incentive Systems as Catalysts for the Financial Crisis’ (2010) VII The IUP Journal of Behavioural Finance. caused the Mortgage Crisis. June 2008. I. (2009) Gerald H Lander. (2009) 27 The Companies and Securities Law Journal 125 Ali. ‘Securitization: Cause or Remedy of the Financial Crisis?. M. ‘Lesson and Policy Implications from the Global Financial Crisis’. (2009) 17 University of New Mexico Law Review. Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management. M. Pavlov.ssrn. L. Institute for Law & Economics University of Pennsylvania Law School Research Paper No. K W. ‘Tail Return Analysis of Bear Stearns. A J. Dam. Credit Default Swaps’ Department of Economics. D. (2010) 20 Applied Financial Economics. June 2009. ‘How did the Fed do? An empirical assessment of the Fed’s new initiatives in the financial crisis’ (2010) 20 Applied Financial Economics. ‘Who Do You Trust?1 The Continuing Saga of the Lehman Brothers Sale’ (2010) 29 American Bankruptcy Institute Journal 2 Claessens. 15 Moody’s Investor Services. & Froute. M. ‘ARMs. (2010) IMF Working Paper WP/ 10/44 Cortavarria. 1. A. L. (2010) 28 The Companies and Securities Law Journal 63 Arner. D.Assignment Ali. Pradhan. B. Moody’s Ratings Symbols and Definitions. A D. ‘Subprime Mortgage Tremors: An International Issue’ (2009) 15 International Advances in Economics Research 1. Johnston. 09-31. 3. Kodres. M. Rating Action: Moody’s Downgrades MBIA from AAA to Baa1. Haiss. S M. & Laeven. 55 Gerding. in Restoring Financial Stability: How to Repair a Failed System. ‘Regulatory Reform in the Wake of the Financial Crisis of 2007-2008’. ‘The Subprime Crisis and the Link between consumer Financial Protection and Systemic Risk’. Narain. ‘Mortgage Origination and Securitization in the Financial Crisis’. 1. & Mizrach. ‘Credit Rating Agencies: Time to Act’. Hassan K M. D A. Liuling. S J. The Economists Voice November 2009 Lo. ‘The Global Credit Crisis of 2008: Causes and Consequences’ (2009) Asian Institute of International Financial Law Working Paper No. and Comparative Perspectives’. Lynch. S. S.

(2009) Hong Kong Institute for Monetary Research Occasional Paper No. International Finance: Transactions. H S. 47 Wilmarth. ‘An Industry Assessment based upon suspicious activity reports analysis’. (2008) Page 14 .pdf Scott. retrieved 1 June 2010. 4 Connecticut Law Review. US Treasury Department.Assignment Moody’s Investor Services. 1. Rating Action: Moody’s Downgrades Ambac from AAA to Aa3 June 2008. Securitization and Global Imbalances’. 2008) Scott. 1. ‘Were there warning signals from banking sectors for the 2008/2009 global financial crisis?’ (2010) 20 Applied Financial Economics. H S. Legislation California Civil Code Home Mortgage Disclosure Regulations (c)12 CFR Garn-St. International Finance: Law and Regulation (2nd ed. 5. Jnr. ‘Leverage. 963 b. 4-5. www. 2009) Shin. Mortgage Loan Fraud (November 2006). J L.gov/MortgageLoanFraud. ‘The Dark Side of Universal Banking: Financial Conglomerates and the Origins of the Subprime Financial Crisis’ (2009) Vol 41. Office of US Regulatory Analysis. A. Germaine Depository Institutions Act of 1982 Glass-Steagall The Banking Act of 1933(US) Bank Holding Company Act of 1956 (US) Financial Services Modernization Act of 1999 (US) Regulation Z. H S. e. 12 CFR (2008) Truth in Lending Act 15 U.S. 1 Simpson.fincen. No.C.LAW7323 International banking and finance: law and practice. Policy and Regulation (16th ed.

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