CHAPTER II INTERNATIONAL BANKINC AND N4ONEY MARKEI

281

interestingly, the Asian crisis followed a period of economic expalsion i1 the

region financed by record ptivate capitai inflows. Bankers from the G-l0 countries
actively sought to finance the growth opportunities in Asia by providing busipesses in
the region with a full assottment of products and services. Domestic price bubbles in
East Asia, particLllariy in real estate, were fostered by these capital inflows. TI-re simul-
taneous liberalization of financiai markets contributed to bubbles in financial asser
prices as well. Additionally, the close interuelationships common among coilmercial
firms and financial institutions in Asia resulted in poor investment decisfun making.
The risk exposure of the lending banks iri East Asia was primalily to locai ba"nks
and commercial firms, and not to sovereignties, as in tlie LDC debt crisis. It may have
been implicitly assumed, however, that the governments would coure to the rescue of
their private banks should financial problems develop. The history of managed growth
in the region at least suggested that the economic and financial system, as an integral
unit, cottld be managed in an economic downtum. This did not turn out to be the case.

Global Financial Crisis

on December 1, 2008, the National Bureau or B"ono*ic Research oriciafly
announced that the U.S. economy was in a recession that had begun a year earlier
in December 2007. This announcement merely confirmed what ma'ny had suspected
for months. During the previous month, Japan, Hong Kong, and most of Europe
also announced that they were in recessions. What started as a credit crunch in the
united States during the summer of 2007, at least symptomatically, had turned into
a gfobal economic downturn that some feared could rival the Griat Depression of
L929-1933, which officially lasted for 43 months in the United States. At the tirne of
this writing (December 2010), the world economy appears to be recovering, but remains
fragile. June 2009 marked the trough, but some still fear a double-dip recession.
To gain a deeper understanding of-!& llqlgial cr5;is, thi!-Sec-tion srarrs with a dis,_
cussion of the credit crunch and how it escalated into a financial crisis. The changing
landscape in banking, which has seen the end of independent investment banking firmi
as a viable business model, is also covered. This is followed by a discussion of the
economic stimulus packages the U.S. Treasury and the Federal li"r..r" gank aeviseJ
to alleviate the economic turmoil in the United States and the coordinated efforts made
by the world's central bankers as the situation turned global, The section concludes
with a discussion on financial regulatory reform being enacted to prevent and mitigate
future crises. Appendix 1 lB discusses the characteristics of the derivative securities
that played prominent roles in the credit crunch.

The Credit Crunch The credit crunch, or the inability of borrowers to easily obtain credit, began in the
United States in the summer of 2007. The origin of the credit crunch traced
"rn1" regula-
back to tkee key contributing factors: liberalization of banking and securities
tion, a global savings glut, and the low interest rate environment created by the Federal
Reserve Bank in the early part of this decade.

Liberalization of Banking and Securities Regulation The U.S. Glass-Steagall (:1-)

Act of 1933 mandated a separation of commercial banking from other financial ier-
\ /
vices firms such as securities, insurance, and real estate. Under the act, commercial
banks could sell new offerings of government securities, but they could not oper-
ate as investment banks and underwrite corporate securities o, .ngug. in broker^age
operations. Because commercial banks viewed themselves as being aia clisadvantale
relative to foreign banks that were not restricted from investment banking functions,
pressure on Congress increased to repeal the act. Through various steps, erosion of
the basic intent of the act started in 1987, with its offrcial repeal coming in 1999 with
the passage of the Financial Services Modernization Act. The repeal of Glass-Steagall
.
I-
288 PART FOUR WORLD FINANCIAL N4ARKETS AND INST1TUTIONS

Causedablrruingoftlrefunctioningofconrmercialbanks,investmentbanks'insurar:ce
Srarting with the repeal of Glass-
;;;;;;;r, andl.eal estate morrga"ge banking firn-is.
in risky fi,ancial service activities that
i;ffi;ii commercial banks began engaging crunch'
,fr.V?r.ri"rsiy
""iri" would not have]which contributed to the credit
for federal regulation of trad-
u.S commoaity rxchange Act.of 19{6 provides Subsequent
derivative securities-
ing in futures contracts, which aie exchang+iraded (CFTC) was cleated in 1974
to this act, the co,rmodity rutrr"s
Tradinf Commission
price manipulation' to prevent fraud among
to oversee futures t,uaing'to guard against
Over-the-counter
market participants, uri o Jnrur. tf,e
soundness of the exchanges.
(oTc) derivarive ,""ori,il, ui" no, regulated by rhe CFTC under the act. As a result,
derivative security' were not regu-
)."Oir'a"fuurt swaps (CDSs), a typg of OTC-credit
e) i"rJ btin. CFTa. ffr" CDS *uii."t grew from virtually
earlier to a $5g trilion ma*et that w-ent
nothing a half dozen years
largely unregulated and unknown. In fact'
*.rv *.rr." prot"rrionJ. *"r" unawar.e.of its existence, or at least hTl!"
market
functioned, until the *iii.*n.r, hit. This was unforrunate, because cDSs played a
prominent role in the credit crunch'
account
Global Savings As was discussed in Chapter 3, a country's cunent
Glut
sum of its-exports and imports of goods and
balance i, tr,. airr","nce between the
';;;;i;ffi,h;;;;i ,h"- wortd. when a counFv runs a.current account deficit,
itgivesan,un.iutclaimtoforeignersofanamountgreaterthanithasreceived
againstthem.Countrieswithcurrentaccountsurplusesa-reabletospendorinvest
and O?EC members have had
their surpluses in deficit countries' China' Japan'
years. In U.S. dollars, the 2008 (2007) estimated
large.cunenr u."orni surpr*"! Lgl
i;;l;t;"d;'ii$id3i)biui;rorchina'$1s6'6($201'3)billionrorJapan'
($51.5) billion for Kuwait, and $22'3
biriio' ror suuai Arabia, $64.8
$132.6 tssa.gl
($36.1)billionforUAE.Manywesterncountrieshavehistoricallyrunlargedeficits.Intlre
deficit was -$706'1 (-$747'1) billion fo-r
U,S. dotiars, tte ZOOS (2007i estimated
the u.K., -$78.0 (-$57.9) biltion for ltaly,
united stut.r,'-s+iTeslri.ol billion for
and _$52.g t_sis.ql billioh Ioi France. china and Japan generare current aceount
surplusesu."uos"theireconomiesareorientedtowardexportsofconsumergoods'
OPECgeneratessurplusesthroughthesaleofpetroleumwiththerestoftheY?:id
The trade in *oifa commodities, such as
oil, islypically denominated in U'S' dollars
items
irr.ra. irr" p.o"J"1ars), which obviously are only useful for purchasing
"""
denominated in doflars or making dollar
investments'r2
1'tre feople;r-B;rk of China and the Bank of Japan, the central banks of these
sums as foreign currency reserves. At year-end
2008, it was
two countrier,frofa ,*,
estimated t# ah1;" held $1.955 trillion
in foreig_n currency reserves' with as mrrch
interest' countries
;-16 p*".";Jii O"no*inated in U | 991.j,-In order to earnor U'S' government
/ 2-\ ,vpi.irv^rr"io their U'S' dollar reserves in U'S-' !9asur1,s^lurities trillion in
\-- , agency ,."rJ,iar,t is estimated that at the end of June 2008, China held $1'2
portion of their current
L,.i. *."uriti"r. OpgC membgrs have typically spent alarge
but they too have huge
account rrrpfurar on ao*"rii. infrastiucture investments,
through sovereign wealth
in ..t*.nt*lriU.S. t".;tities and also make investments
awash in liquidity in recent
;:r;;r. d;*sr rhis backdrop, if is clear thar the world.was
investment' The bottom line
years, muctroiiiO.ro*inut.d in U.S. dgllars, awaiting
domestic investment' at a rate that
is that the United States has been able to maintain
l,1,";;ir" *;;i;t ar. ,"quir.d higher domestic slvilgs^ (or reduced consumption)
and also found a ready market with central banks
for U.S. Treasury and government
agency ,..riiii"r, helping keep U'S' interest rates low'

petrodollars in the foreign exchange

r2Note that even if oPEC does not desire to hold U.s. dollars and sells
..t",for,say,Britishpounds,thebuyerhasobviouslypurchasedthemtobuyorinvestinsomething
denominated in U.S- dollars'
PTER I] INTERNATIONAL BANKINC AND MONEY MARKET 289

Low Interest Rate Environment The federal funds target rate fell fron-r 6.5 percent
on May 16, 2000, to 1.0 percent on June 25,2Cc3, and stayed below.3.0 percenr unril
May 3. 2005. To decrease interest rates, the Fed buys U.S. Treasury securities in the
market, thus increasing the amount of bank reserves, and subsequently the supply
of loanable funds in the economy. The decrease in the fed funds rate was the Fed's
response to the financial turmoil created by the fall in stock market prices in ZObO
the high-tech, dot-com boom came to an end. Low interest rates created the means "* for 4) (
first-time homeowners to afford mortgage financing and also created the means for \
existing homeowners to trade up to more expensive homes. Low interest rate mort-
gages created an excess demand for homes, driving prices up substantially in most
parts of the country, in particular in popular residential areas such as California and
Florida. As home prices escalated and interest rates declined, or remained at low
levels, many homeowners refinanced and withdrew equity from their homes, which
was frequently used for the consumption of consumer goods. Many of these consum". ( g )
goods were produced abroad, thus contributing to U.S. curent account deficits.
During this time, many banks and mortgage hnancers lowered their credit standards
to attract new home buyers who cottld afford to make mortgage payments at current low
interest rates, or at "teaser" rates that were temporarily set at a low level during the early
years of an adjustable-rate mortgage, but wOuld likely be reset to a higher rate later on.
After having remaindd fairly stable for years, the percentage of Americans owning their
own homes increased from 65 percent in 1995 to 69 percent in 2006. Many of these
home b'uyers would not have qualified for mortgage financing under more stringent
.credit standards, nor would they have been able to afford mortgage payments at more
conwntional rates of interest. These so-called subprime mortgages were typically
not held by the originating bank making the loan, but instead were repackugia intt
mortgage-backed securities (MBSs) to be sold to investors. (See Appendix 118 for
a discussion of the MBS and other derivative securities prominent in the credit crisis.)
Between 2001 and 2006, the value of annual originations of subprime mortgages
increased from $190 billionto $600ti11ion.;tsaresutt-oftfi-e globai savings glut, inves-
tors were readily available to purchase these MBSs. The excessive demand for these
types of securities, coupled with the fact that most originating banks simply rolled the
mortgages into MBSs instead of holding the paper, created the environment for lax credit
standards and the growth in the subprime mortgage market. From 2001 to 2006, the
amount of outstanding subprime mortgages increased from $425 billion to $ I .8 trillion.
To cool the growth of the economy, the Fed steadily increased the fed funds target
rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on
June 25, 2003 to 5.25 percent on June 29,2006.In turn, mortgage rates increased and
home prices stopped increasing, thus stalling new housing starts and precluding mort-
gage refinancing to draw out paper capital gains. Many subprime borrowers found it
difficult, if not impossible, to make'mortgage payments in this economic environment,
especially when their adjustable-rate mortgages were reset at higher rates. As matters
unfolded, it was discovered that the amount of subprime MBS debt in structured
investment vehicles (SIVs) and collateralized debt obligations (CDOs), and who
exactly owned it, was essentially unknown, or at least unappreciated. (An SIV is a vir-
tual bank, frequently operated by a commercial bank or an investment bank, but which
operates off the balance sheet. A CDO is a corporate entity constructed to hbld a port-
folio of fixed-income assets as collateral. See Appendix l lB for an in-depth discussion
of SIVs and CDOs.) While it was thought SIVs and CDOs would spread MBS risk
worldwide to investors best able to bear it, it turned out that many banks that did not
hold mortgage debt directly held it indirectly through MBSs in SIVs they sponsored.
To make matters worse, the diversification the investors in MBSs, SIVs, and CDOs
thought they had was only illusory. Diversification of credit risk only works when a
portfolio is diversified over a broad set of asset classes. MBSs, SIVs and CDOs, how-
ever, were diversified over a single asset class-poor-quality residential mortgages!
 AND INSTITUTIONS
PART FOUR WORLD FINANCIAL MARI(ETS
290

Whensubptimedebtorsbegandefaultingon.theirmoftgages'commercialpaperinves- market
anitrading in theinterbank F'urocurency
tors were unwiliing t" ftffi;SNs' placing funds
i.urr.l of"ttre counterparty risk of
essentially ceased ", dried up'
"^i",ri".u* Uurtr. Liquidity wolt{wiae lsentially
wirh even tire strongesr'iniein"ali;l
Eurodollar.rare and three-month
u's' Treasury
The spread berween il:;";;-;""*h of credit risk' increased from
measure
Uills (the TED spreadl, i'"qutntfy-uttq::,a 2007'
t0'07 to 200 basis points in August
about 30 basis points il M;;;

FromCreditCrunchtoFinancialCrisisAsthecreditcrunchescalated,many
CDosfoundtt,"*,"t,",stuct<wittrvarioustranchesofMBSdebt,especiallythe
placed oi were- to place as
highest-risk tranches, iit'iii'
ii'"1'.,rt^d 1yble
i::-1"
around the country esialated'
commercial and investment
subprime foreclosure rates
w ere f orc e d'
anks
a"t* urui.o n *'i ::o:::i i* : :*'\tli'Sll#:liJ
b
"'*'it" "
:x}::J,'t';ii+Ji1t*:itl;*ln*L} milll:"J;?;?#,il|*"o""
me mortgage
#;;il;nd did,

ilffi s&R ana rirctr-rowere$ M l.:19'^:i:.T: after

5:E"f f ;;YHll*i?fr T'll,\li',iJui;"":i;,i#::**:X"ffi }i;"iffil11

;::itil3r'l1H,d: fi#;;ti;F *:1g"19"t'
MBSs'
;;"d.-l rating nrms downgraded manv
as foreclosures around the country
thor" suUirime
"onffi forbond insurers who sold cretlit default
esp'ecially
increased.an ,nru*tu'nuUi" p'oUtt* arose As the bond
swap (cDs)
Lu"t. rhat purchased this credit insurance'
uant-^wnsored Srvs as the MBS debt in their
insurers got hit *irh ;i^i-, trom
"onou.,.'ui"oiri"
required the insurers to put up more
the credit raring.agencies
ili;;;;iaott"a,
rhe .o,rn',""rp*i"r *t t,iA
the othei side of the CDSs' which
put stress
collateral with "creoit-rating downgrades, which in turn triggered
on their capital uu*" o-ni'i[mlteo Group (AIG)
;;il;*rurers such ule*"ri.un International
more margin ca,s. If be forced to write down
failed, tLq balks..th-at onrttg inlyTce protection would
'ef"a *r".n *orto t*tt.r
erode their Tier I core capital
even more ,nor,gug"-i;ai.ii CI-ui,
bases. By s"pt"mu",1"oo&
a worldwide nilnt to quality investments-primarily
10, 2008, the TED spread
October
short_term U.S. freastii *"t*i,i.*-"nru"a."On
si; o*. n"".,"r"0- 11.11 graphs the TED spread from
reached a record l"r"i:i great, at one
*iri.."*uer 2008. The demand for safety was so
January 2007 through was yielding only one basis
S. i."urory bill
point in November 200il1*;;oqthu place to put
point. Investo.. *t'"
wilhlB to accept zqro return for a safe
""t"iuUy paper that banks and industrial
biy commercial
their fundsl fn"y *".J n", *iUi"g to

7.00
ii
ii TED Spread (o/o) 6.00
i'
;r
ft 5.00
ii
[, 4.00

3.00

2.00

1.OO
i\
0.00 @@ cocoA
OO:?
'ob
O.O
a\
.-
ci RFER
-ooo
C)O
oo
C.l
tsd
;h
C.l
oOU
{aq
oou
t-- o)
fo ;Fd= =
 CHAPTER iI INTERNATIONAL BANKINC AND MONEY MARKET
291

corporations needed fofsurvival. The modem-day equivalent of

a bank run was operat_
ing in fuIl force, and many financial institutioris couid not survive.

Impact of the The financial crisis has.had a pronounced effect on the world economy.
As a result,
Financial Crisis dramatic changes have taken plaie in the financiat services inOu;-r,;;;;,"
iqdustry, and
in financiat markets worldwide. Some of thE most significant.h;;;;;;; detaited here.
Financial Services lndustry

' Northem Rock, a British bank, was nationalized as a resulr of a liquidity

crisis.
. Bear Stearns was sold to J.p. Morgan Chase in a forced sale for
$1.2 billion.
' The Federal National Mortgage Association (Fannie Mae) and the
Federal
Home Loan Mortgage coryoration (Freddie Mac; *er. pi*.a rra.r"''-'
conservatorship, where they remain.
. Bank of America acquired Menill Lynch after it
5eported large cDo losses.
' Lehman Brothers, a 158-year old firm, was aliowed to fail after
suffering 1
unprecedented losses from holdings of subprime mortgage
debi and other I

' AIG was rescued by theFed in a $150 billion deal, consisting of

$60 billion of
loans, $40 bilrion of prefened stock investmenr, and
$jdiiii";.f *;iil -;
enabled it to meet coilateral and orher cash obligati;, il;;;; business.
' Fearing aloss ofconfidence arnong eounterparties and facing
a liquidity crisis,
, Goldman Sachs and Morgan Stanliy, the lasi two.".uinint?uuige
bracker,,
investment banking firms, restructured themselves into corimercial
bank
holding companies.13
' washington Mutual, the largest u.S. savings and loan association,
was put into
receivership and sold to J.p. Morgan chase by the Fed after a
l0-day bank run.
. wachovia was acquired ryv/e+trftrgcwhrhofia-spmbieins begdn
-Golden with its
2006 purchase of west Finanlia] corp., a ,uuirg, *J l*" association
that built its business making adjustable-rate mortgage Ioans.
' fft_er
suffering a liquidity crisis, citigroup was rescued by the Treasury
and the
Fed, who viewed citigroup as too big and too important to ruil.
2010, the Treasury completed the sale of its ownership position
i, o""'";;;"-
in Citigroup,
earning $12 billion on its $45 billion cash bailout.

Housing and.unemproym.en! At mid-year 200g, over 9 percent of

the mortgages
on single-family homes in the united States were at least one
month late in payment
or in sole stage of foreclosure. This was the highest percentage in
:syears. tvtore
specifically, approximately 3-0 percent of subprime loans were ilero*,
;r;;."
) percent of prime loans. In september 200g, the s&p case_shiller composite
;;;;
House
Price Index of 20 U.S. cities indicated that i,our" pri..r;.;;;;;;ver
20 percent
from the high set in June 2006. This decre.ase
fut ro milion trom"r'iuna".*ut"r,,, i.e.,
market values were below the amount of mortglge balances.
ourlourly, new home
construction came to a virtuar standstiil, rrnr,"i'ri"ut"nirg;;.";;;;;.y.
The index
reached a subsequent row in April 2009-aown:: perleri-.r-J.i'ine
time of this
writing is up only 6 percent since then.
In November 2008,
$e u.s. Department of Labor reported that the unemployment
rate was 6.7 percent-the highest rate in 15 years. By
october the folrowing year it
stood at 10.1 percent and presently stands at 9.g perceiit.

'' "bulge bracket" is an old wall Street term for referring

to rhe former major investment banking
'h*t*lt derives from the fact that in print announcements of new security
firms issues, known as tombstones,
the
names of the prominent investmerit banking firms underwriting
an issue were printed in uotJ ront that appeared
to "bulge" out from the page.

ii
l

lr
I
I'

li
1i-
z

il
292 PART FOUR WORLD FINANCIAL MARI(ETS AND INSTITUTIONS

Auto Industry The finarrcial crisis had a huge impact on the auto industry, especially
as the Big
the Detroit auto firms of General Motors, Ford, and Ciuysler, formerly known
Three. problems for rhe Detroit automakers started when the iack of liquidity caused by
the credit crunch made it diffrcult for consumers to {inance new car purchases. Matters
: only worseled during the summer of 20p8, when gasoline prices hit $4 per' gallon.
.e*.ri.u6 questioneJ the practicality of owning the large gas-guzzling cars and SUVs
they so favoied and the Dett'oit firms manufactured. As the economic downtutn escalated
and employees in many industdeswerelaid off, -1uto sfes plummeted. Even
without the
effects of the financial crisis, the Detroit Tluee had a long history of poor management
and of investing in money-losing capital investments; a Iecent estimate places the corn-
bined total ar $465 bitlion for GM and Ford for the years 1998 through 2007. On
April 30,
A month latel the bankruptcy judge approved a
2009, Chrysler frled for bankuptcy.
plan whereby Fiat would own 20 percent of the "new" Chrysler, the autoworker's union
ietirement health care trust would own 55 percent, and the U.S. and Canadian gover4-
ments..would be minority stakeholders. On June 1,2009, GM filed for bankruptcy and
ir;o-^-'SsO i1ii"n bailout from the Treasury. Since then it tras ilimmeo
l:*fftlllt""ri *"u., by shedding brands and dealerships. on November 17, 2010,
the "new" GM was reoffered to stockholderl.in aI IPO thatraised $20.1 billion and
reduced the U.S. government's ownership positibn from 61 to 33 percent. Ford was the
orily member of the Detroit Three to avoid bankniptcy'
a.
Financial Markets The financial crisis had a devastating effect on financial markets
and on investmerts that depend on their returns. In the United States, stock prices fell
tolevels once thought unimaginable, although they have finally started to come back'
' As of December 2010, the Dow Jones Industrial Average was down 18.5 percent and
the Standard & Poor's 500 was down 21.0 percentfrom their peaks in October 2007.
Foreign stock markets in U.S. dollar terms were down as well. Over the same time

has be6o-iie'woniiome toinVdstorsand has been dcruv'ngraded by the rating agencies. In

particular, in exchange for long overdue austerity measures, G-r_eece needed a baiiout from
itrong"r EMU partners and the IMF when it encountered difficulty rolling over its debt
at reasonable interest rates in the second quarter of 2010. (In April, the two-year yield
, on Greek debt was 14 percent higher than on German debt.) Subsequently, in November
the EU agreed to give $89 billion in bailout loans to keland to helpit weather the cost
of the massive banking crisis that it had fiscally internalized. Fear of contagion spread-
ng to porhrgal, Italy, and Spain (other euro-zone countries with big budget deficits) is
p.oUuUty not warranted. Just the yme, a f_liehtlg-qotty investrnents denominated inahe
U.S. Ooit, resulted in an appreciation of the dollar. For example, in April 2008 the $/€
spot exchange rate was $1.60/€'and it presently trades at $1.33/€. The corresponding
Slg rare wen-r from $2.00/f to $1.58/f. The great advantage of the United States is that
the dollar is the major reserve currency. Nevertheless, the $3.+ trillion budget deficits
projected for the Unitea States over the next five years, which are partly required to
irnun"" the economic stimulus needed to work th9 co!1nq out of the financial crisis, are
themselves worisome. There simply is no precedent for this scale of deficits.

Ec on o m i c sti m u ru s [."'iHt*"ff iffffi];::'i H l:I"-HJSHes? :

gl
JJtfi:ThlT# ;XTi*::l
ing the fed funds rate, then-Fed Chairman Alan Greenspan said, "I don't know
what it is, but we're doing some damage because this is not the way credit markets
should operate."la I owering interest rates to such a low level and keeping them there

Ia GregIp and Jon F. Hilsenrath, "How Credit Got So Easy and Why lt's Tightening." The Wall Street Journal,
August 7,2007, pp. A1 and A?.
 CHAPTER 1i INTERNATIONAL BANKINC AND MONEY MARKET
293

for such a lo,g period df time was a mistake._In_retrospect, the global

savings glut
Iikely would have suppiied a good deal of the liquidity needed uyitte
U.s. and world
economies after the dot-com bubble burst; It is difficult to undlrstand
how the Fed
did not recognize this given the economic data available to it for uruiyrir.
Lowering the
fed funds rare only added additional liquidity to the U.s. economy and
exacer-bat"dA;;:
icans' ttnsustainable buying binge. when the Fed started increasing inr"r"r,
ru,"i,-,r,"
pafiy came to an end. Greenspan seems to have come to tenns with his
mistake. In testi_
mony before congress on october 13, 200g, Greenspan admitted that he
made a mistake
with the hands-off regulatory environment he helped foster. He further acknowledged
that he made a critical forecasting emor in his assumption about the resilience
of hote
prices and never anticipated that they could fall so much. Today we are paying
for these
mistakes and our excesses while attempting to work our way out of this
mess.
Many new initiatives were taken in 2008 to spur U.S. anO worta
activity:
".ono*ic
' Under
lrre egja1191of
cunent Federal Reserve chairman Ben Bernanke, on
18,2007, the Fed began reducing the fed funds rare from the recent
l:q"T!"1
high.of 5.25-percent to a range of 0-25 basis points on December 16,
200g.
. Obviously, the Fed had run out of ammo in this pouch.
' Similarly, central banks around the world reduced their short-term
rates.
A coordinated effort of rate cuts invorving the Federal R;;;, Er;"p*n
Cental Bank, Bank of England, and the people's Bank of china took pta"e
on
october 8, 2008. And, on December 17, 200b, central banks in Nor*uy,ihl --'
czech Republic, Hong Kong, Saudi Arabia, oman, and Kuwait cut intlrest
.rates, a day after the Federal Reserve slashed its rates.
' ' As a result of frozen credit markets, corporations encountered problems
obtaining working capitar. In an effort to provide creait, the iei-established
the Commercial Paper Facility to buy $1.3 tritlion in commercial paper
directly
from U.S. companies.
i,
' The Fedestablished the $54&bi11l6n- M5irey MarkeflinvedtorFund-iiig
Facility
to buy commercial paper and certificates of deposit from money I

market funds

' congress authorized the Federar Deposit Insurance colporation (FDIC)

to
increase the level of bank deposit insurance from $100,b00 to g250,000.
' The $700 billion Troubled Assets Rerief pro_gr1m (TARP), spearheaded
by
former u.s. Treasury Seclejq_v Henry (Hank-) pauison to'po'i"t ur" poorry
performing mortgages and MBSs from financial institutions,
was signedlnto
law on october 3, 2009. The idea behind the bailout plan was to geipoorly
performing assets off of banks' books to alleviate the fears of oep-osiiors.
in
a startling change of tactics, Secretary paulson announced
2008, that the govemment wourd no longer use TARp funds to
on Nou".u"i ii,
uuy aistressea
mortgage-related assets from banks, but instead it would aon""ntrut"
on direct
capital injections into banks. In total, $549.4 billion of the TARp
ruros we.e
paid out or committed. At present, about half of the disburr"J
runa, have been
repaid. Total losses are now only projected to be $50 billion.

The Aftermath The global economic crisis is ongoing. At this stage, virtually every
economic entity
has experienced a downturn. Many lessons should-be learned-from
these experi"n""s.
One lesson is that bankers seem not to scrutinize credit risk as closely -they
when serve
only as mortgage originators and then pass it on to MBS inr.rtorJ rather
than hold
the paper themselyes. As things have turned out, when the subprime
mortgage crisis
hit, commercial and investment banks found themselves exposed, i,
another, to more mortgage debt than they realized they heid. This "r.?"irri", ",
outcome is par_
tially a result of the repeal of the Glass-Steagall Act, whith alowed commercial
banks
 r
B I
'1
PART FOUR WORLD FINANCIAL MARKETS AND INSTITUTIONS I

to engage in investment bafiking functions. As we have seen, the n-iarket has spoken
with respect to investrnent banking as a viable business model-the bulge bracket
Wall Street firms no longer exist. It remains doubtful, however, if the subprime credit
crunch has taught commercial bankers a lasting lesson. As shown during the interna-
tional debt crisis in the 1980s or the Asian ciisis in the 1990s, for some reason bank.
ers always seem willing to lend huge amounts to bonowers with a limited potential
to repay. There is no excuse for bankers not to properly evaluate the potential risks
of an investment or loan- In lending to a sovereign government or making loans to
private parties in distant pafls of the world, the risks are unique, and proper analysis
is warranted.
The decision to allow the CDS market to operate without supervision by the CFTC
or some other regulatory agency was a serious error in judgment. CDSs are a useful
vehicle for offsetiing crediirisk, but the market is in need of more transparency with
respect to OTC derivatives, and market makers need 19 fully understand the extent of
tlie-risk of thqir posirions. Another lessgl is that credit rating agencilleea to refine
their models for evaluating esoteric credit risk in securities such as MBSs and CDOs,
and borrowers must be more wary of putting complete faith in credit ratings.
Ai anyone would expect, more political and regulatory scrutiny of banking opera-
tions urd tn" functioning of financial markets was a Virtual certainty in the aftermath
of the crisis. In this regard, as previously mentioned, the Basel Committee on Banking
SupervisiOn finalized a package of proposed enhancements to Balel II to strengthen
the regulation and supervision of internationally active banks. Additionally, a broader
prcgram labeled "Basel III" aims to strengthen the regulatory capital ftamework of
international banks. At the country level, in June 2010 the U.K. unveiled a new system
of regulation that, according to the U.K.'s Eeasury chief, "learns the lessons of the
greatest banking crisis in our lifetime." Already responsible for monetary policy, broad
new pow..s were given to the Bank ofEngland to prevent systemic risks and include
Monetary Union is
,day-io-day supervision of the U.K. financial sector. The European
---pt€prrsinfir
^ eeli.+ies.jtt6H*le.&gly-al{arsightfq[hedgeiunds -
In the United States, on July 21,2070, President Barack Obama signed intrl law
the Dodd-Frank Wall Street Reform and Consumer Protection Act. This Iegislation
institutes new broad financial regulations that rewrote the rules covering all aspects
of finance and expanded the power of the government over banking and financial
markets. Such sweeping new regulation has not been seen since the Great Depression.
Specifically, the new financial regulation gives the FDIC 99yer to seize and.break up
trOubled big financial seivice firms whose collapse would be a systemic_risk to the
economy-no longer will banks be viewed as too big to fail. The CFTC has been
given eipansive nlw power to regulate derivatives that hopefully will prevent the
*isus" of OTC derivatives, such as CDSs, in the future. Moreover, hedge funds
and private equity funds must now fegistelwith-the SEC.-And market-makers must
maintain an investment stake in MBSs, rather than merely create and sell them to
others. The Fed has been given new power to restrict proprietary trading and to ban
some types of derivatives trading by banks. A new consumer protection agency will
be established to write new consumer finance rules regulating home mortgages and
credit cards that require banks to provide more transparent disclosure to borrowers
and to ensure that borrowers have the means to rbpay loans. And a new Office of
Credit Ratings will watch over the credit rating agencies. In the area of corporate
governance, shareholders will have nonbinding votes on executive compensation and
golden parachutes. It should be clear that these new financial regulations have been
carefully crafted to address the weaknesses we noted that led to the financial crisis.
While some doubt the usefulness of financial regulations, and believe that financial
crises cannot be prevented, we believe that financial regulations serve as a useful
benchmark to guid" financial behavior and establish what is appropriate. When no
rules are present, anything seems to go.