Regulations, Derivatives, and the Financial Collapse of 2008-2009 - Example

Student’s Name Tutor Course Date “Regulations, Derivatives and the Financial Collapse of 2008-2009” The financial difficulties experienced by the US in the year 2008 could only be equated to what befell the world after the First World War, known to many as the “Great Depression”, and the main issue would be whether the financial recession could have been averted. It is contended by many financial analysts that something ought to have been done to avert the crises that is through better regulation of the market as well as it ought to have been foreseen, by financial institutions that new mechanisms for granting of loans and mortgages were vulnerable deterioration without effective control (Acharya and Richardson 2010). To others it is considered as a great eye-opener to the government to ensure that they have a well regulated and monitored financial system. It has been posited that the financial crisis of 2008-2009 could have been avoided by proper and effective control and regulation of the mortgage system. With the advent of mortgages, it was contended that most the mortgage offered as loans were defaulted as well as the sale and acquisition of low priced derivatives led to the financial meltdown. The housing bubble having been linked closely with the recession all based on the loose monetary policies created by the government , the misperception of risks associated with loans, the laxity by financial regulators in effectively knowing the financial status of the country as well as the lack of transparency by institutions of the existence of the deplorable state (Greenberger 2010). Derivatives in the USA are also considered to have been among the leading creators of the financial recession. The regulations of the financial system were only linked to the Modernization Act of 1999, formally created by the Clinton administration with no regulation by the subsequent administration. It is contended that the Act sought to change the prohibitions that were imposed against the commercial and investment banking but it had no direct regulation on the issues of mortgages. Generally mortgages involves banks and institutions taking risks of either default of payment or the fact that other institutions can acquire the mortgage at high interest prices. The two eras’ that of Clinton and Bush, one would say that there was an informal deregulation of the entire system of mortgages, by both the banks as well as the regulation authority such as the Department of Treasury and the Federal System (Stilglitz 2010). Transparency between the private institutions and the banks was not at its best in the regulation of subsidies and the loans offered by the private banks, and were considered as high risk loans, despite being under the regulation of the Community Reinvestment Act (CRA) (Granaut and Smith 2009). Concealment of facts that were crucial for regulation as well as making bad loans only sought to accelerate the occurrence of the financial crisis. According to Pinto (2009), he asserted that between the years of 1993 to 2007 there were many high risk loans that could not have been dealt away with by the traditional lending standards as well as without creating appropriate credit mechanisms through the regulation of the government. The rate of default in the loans was too high in contrast with those underwritten by Fannie and Freddie, and since it was even difficult to find data since the banks failed to disclose the number of CRA loans it had given out (Edwards 2004). To effectively understand how the regulation of finances, it would be crucial to have an understanding of how the US regulates its finances as well as the legal implications of their regulations. Currently, the US regulatory framework currently has the Federal Reserve System whose sole purpose is considered to be instrumental in regulating the American trading system by monitoring as well as regulating the monetary system. The institution as one would say aims at ensuring that there is a stable market price and ensure the economic growth of the entire country. The Federal system has other mechanism within its structure to oversee the payment system of the government, supervisor of the entire financial service industry, holding reserve as well as overseeing the functions of regional banks. It also has a Federal Open Markets Committee to ensure that it makes the appropriate financial policies, as well as it assesses the economic and financial lands (Jenkins 2010). It also has the reserve bank within its mandate to ensure that there is an intermediary between that local banks and the US reserve banking system. Secondly the US Department of the treasury is considered to be instrumental in the collection of taxes, it designs as well as mints all the US currency, it recommends as well as influence the fiscal policies. In financial regulation , through the Office of the Comptroller of the Currency and the Office of Thrift Supervision , the comptroller being in charge of ensuring that the U.S banks are chartered and giving stability , monitoring the portfolio of investments, liquidity and consumer banking laws. The Thrift Supervision office is charged with the supervisor of thrifts that is federally-chartered savings and loan associations. Additionally there exists the Securities and Exchange Commission widely known as an independent agency of the government whose sole purpose is to oversee the securities market, enforcing the securities laws and also monitors the exchange of stocks, options and other securities within the US stock exchange. Through this body, the government enforces such laws as the Sarbanes-Oxley Act of 2002 and the Credit Rating Agency Reform Act 2006. The others include the Federal Deposit Insurance Corporation dealing with issues of insurance; the Commodities Futures Trading Commission that deals with the trading of futures and the National Credit Union administration that is vested with the task of monitoring credit facilities and issuance. Through this understanding, one can be able to deduce the fact of whether it is over-controlled or whether the control was too little to not avert the 2008-2009 financial crises. The most important aspect about the financial meltdown is on the basis of the liquidity, and many proposals such as that from Paulson plan sought to have the Office of Thrift Supervision (OTS) to be removed with a proposal to merge the Securities and Exchange Commission (SEC) with the Commodities Futures Trading Commission (CFTC) they regulate the banks in terms of the savings and the loans. No one can therefore argue that the US had no effective institutions and framework to monitor the financial crisis, however it ought to have done better in monitoring the undertakings of other institutions involved in granting loans, mortgages and other derivatives. The failure of the Federal Reserve System for pushing for higher interest rates, even after the coming in of the Community Reinvestment Act (CRA) leading to banks to get prudent loans and lenders into the crisis only shows its contribution to the crisis. It has been advocated that amending of the Gramm-Leach-Bliley Act of 1999, which is attributed to having discarded the financial safeguard that the US applied during the great depression. With the onset of the Act, it gave a leeway for banks as well as to insurance brokers to offer investment products, hence leading to the divesting in regulation in those institutions. The Federal system role in the 2008 crisis was to provide the appropriate policy statements as well as asserting its control of the interest rates to tranquil the capital markets and also influence the legislative policies. Making money available to the US financial system was also seen as a great thing to be adopted by the Federal system to stimulate liquidity in the financial markets. The other important reform is that the Treasury Secretary Henry M. Paulson has recommended that there is need for the government to adopt a plan to ensure that there is liquidity stimulation within the financial market as well as proper and adequate capital given to the failing banks and financial institutions. A total overhaul of the regulatory structure mentioned above would go a long way in ensuring that the US does not plunge deeper into a financial crisis. A derivative is defined as a financial instrument whose value is mainly based on one or more underlying assets, with a contractual characteristic is which it does specify the terms of payments that the parties to it are to pay (Durbin 2010). To others derivatives are considered to be “unfettered markets” (Murphy 2008), and particularly the CDS was considered by Wall Street Journal of offering more liquidity than the actual cash market. A special Commission on Capitol Hill was specifically set up to determine if derivatives were the reason for toppling of banks and institution s and catalyzed the economic crises despite having been previously considered as “financial weapons of mass destruction” (Greenberger 2010) A view held by Murphy (2008) was that most of the derivatives were mispriced by those providing them, hence creating the crisis. The overpriced derivatives created the ambiguity for most people do default hence leading to credit default swaps, and with the swaps usually considered as mortgage default insurance on the already blocked mortgage securities. The other issue making the CDSs a contributing factor to the crisis was that their pricing was quite low hence creating risky mortgages, which was not regulated by the government. The deregulation in derivatives would also be attributed to the fact that banks sold the risky loans to private investors since the private investors sought to rely of CDSs which were cheap to cover the mortgage. Derivatives created a loophole in the financial market based on the fact that it did allow for persons to bet on the mortgage market with the sold CDSs but on the other hand it did allow also for the writing of conventional mortgage insurance or the buying of MBSs. Since this was not a financial instrument, as well as being mispriced, hence leading to the crisis since most of them were not priced by regulators but were left on the developers to determine the pricing of the CDS. The main attributes of the derivatives causing the 2008 financial crises was on the basis that in the default in the payment of mortgage there arose a real financial loss and an additional exponential loss derived from the bets. The CDS agreements are usually private and bilateral in nature therefore they cannot be effectively monitored and reported to the federal regulation system; hence in requiring fulfillment of obligations, the financial regulators were ambushed by their existence (Greenberger 2010). The other most important failure is that there was no sufficient capital to guarantee payment of mortgages hence leading to high house price hence creating risks for issuance of guarantees. Credit tightening was also linked to the CDS since the obligations created only sought to create more uncertainty on the role of financial institutions, with no trust whatsoever as other CDS had toxic CDS (Greenberger 2010). It is generally stated that the regulators that is the banks and financial institutions had an absolute power, indirectly to control the mortgage derivatives in the market, but they effectively failed to control them., It has been positively disproved that even though the central government was not in direct or indirect control of the derivatives, it was contended that the banks and financial institutions had an indirect control of the derivatives, since each bank has its own control on its institutions, hence would not have failed to notice the abnormally created by the derivatives. Further the institutions sold as well as bought by the banks as well as since they were considered as securities and there was swapping by the banks, then the institutions and banks ought to have asserted control over its sale as well as their acquisition by the interested parties. According to Ellen Seidman, he asserts that were it not for the Community Reinvestment Act (CRA) as well as the Fannie/ Freddie requirements the home ownership rate would have not increased (Tacker 2011). The fact that most people need homes, in a cheap and effective way, rather than seeking the loan from financial institutions, they went ahead to seek CDSs offered by private investors, with no proper regulation, hence contributing to the financial crisis. Inability to pay as well as high interest rates as well as defaults furthered the creation of the crisis. In conclusion, it can be underscored that the US has an effective monitoring system of the financial market, through government agencies as well as financial institutions and banks. However, there was no crucial way of ensuring that the finical system was coherent, since the government regulators were not in direct control of transactions such as the sale of loans to private investors, and left it to the banking institutions. This laxity, as well as coupled with other factors such as the use of derivatives in mortgages and also in the granting of risky loans only sought to propel the US into deeper financial crisis. The complexity of the issues involved in financial regulations such as disclosure to the government regulators only sought to widen the crisis as well as the purchase of the CDSs that were overtly less priced. It is therefore prudent to state that the institutions as well as the appropriate mechanisms for regulation do exist, however, there was no close working relation between the government regulators and financial institutions, to arrest the situation, before creating the irreparable harm to the nation. Works Cited Acharya, V.V. and M. Richardson. “Causes of the financial crisis.” Critical Review 21. 2 (2010):3 Durbin Michael. All Bout Derivatives. 2nd ed. New York: Mc Graw Hill, 2010 Edwards, S. "Financial openness, sudden stops, and current-account reversals” American Economic Review 94. 2, (2004) : 59-64. Garnaut, R. and Smith, D.L. The Great Crash of 2008. Clayton: Melbourne University Press, 2009. Greenberger, Michael. “The Role of Derivatives in the Finacial Crisis.” Financial Crisis Inquiry Commisssion Hearing Dirsken. University of Maryland 2010. Jenkins, Holman W. “Is Financial Innovation the Enemy”. The Wall Street Journal 2010. Murphy, A. “ An Analysis of the Financial Crisis of 2008: Causes and Solutions.” Social Science Research Network (2008) Pinto, E. “Acom and the Housing Bubble.” The Wall Street Journal. 2009 Stiglitz, J. E. “The anatomy of a murder: who killed America’s economy?” Critical Review, 61 (2010b): 2-3. Tacker , T. “Regulations, Derivatives and the Financial Collapse of 2008-2009.” Embry-Riddle University. Read More