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1 Introduction
The most frustrating realization of our current financial crisis in the U.S. is that it was avoidable. This was not an act of nature that we could not avoid. The causes were in our control and we must deal with the effects. To come to this realization questions must be answered. What factors caused the crisis? Who were the major players that ultimately put us in our current position? What must be done to recover? These are all questions I will touch base with and elaborate on throughout this article.

2 The Credit and Housing Bubbles

An economic bubble occurs when an asset is traded in high volume at inflated prices that do not reflect the assets actual price. There can be many factors that contribute to the development and expansion of a bubble. The two bubbles that played a significant role in the current U.S. financial crisis were the housing and credit bubbles. The first major contributor to the inflation of these bubbles was the inflow of foreign savings from developing countries in Asia as they invested in U.S. debt securities. According to Federal Reserve chairman Ben Bernanke the benefits from these inflows can be extremely beneficial as long as the funds are invested properly.1 The problem in the U.S. was that these funds were invested poorly. This was due in large part to the second major contributor to the bubbles. In 2001 former Federal Reserve chairman Alan Greenspan responded to the bursting of the tech bubble by lowering interest rates to 1%. Franklin and Carletti (2010) explain that, while this policy change was enacted to avoid recession after the bursting of the tech bubble, it was an unprecedented change in the sense that the interest rate was dropped lower than previous attempts to avoid recession. 2 The effects of this policy change, while beneficial in the short-term, has been
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Ben Bernanke (2009) Four Questions About the Financial Crisis, Federal Reserve Bank

debated by many experts to be the root cause of the crisis.2 With interest rates so low there were incentives for consumers to borrow to finance for homes creating a high demand in the real estate market. This high demand created immense amounts of competition in the mortgage industry, however not all consumers were viewed as creditworthy borrowers. Many institutions turned to the subprime mortgage market to find ways to finance these borrowers. In laymans terms a subprime mortgage is a mortgage designed for a borrower with low credit ratings and is charged a higher interest rate than a traditional mortgage. Why would banks take the risk of lending to borrowers who were at higher risks for nonpayment or default? The answer is simply that it is profitable. In order to understand where the profits come from, the change in banking methods must first be explained. In the traditional sense banks would raise the necessary funds needed to loan to customer and then screen potential borrowers, prior to loan approval, by issuing credit checks and looking into the credit history of the potential borrowers. If borrowers passed the screening process the banks would then lend the requested funds. This method ensured banks would be responsible in their screening processes and only lend to creditworthy borrowers. In the traditional method banks would hold their mortgages and thus be liable for any defaults. The problem with the boom in the real estate market was that it made mortgage backed securities (MBS) a desirable asset. With the emergence of investment banks a method referred to as originate-to-distribute (OTD) came to be common practice. In this new method the mortgage originators were paid on the number of the mortgages they approved thus creating incentive for bankers to approve less creditworthy borrowers. The banks would then go through a process called securitization. According to Richard Rosen (2010) Securitization is the issuance of bonds that are repaid by the payments on a pool of

Allen Franklin and Elena Carletti (2010) An Overview of the Crisis: Causes, Consequences, and Solutions, International Review of Finance 10: 1-26

assets, that also serve as collateral.3 While this method was profitable in the short-run it proved to be devastating for the economy in the long-run when the bubbles burst. In conclusion the two main factors that were the foundation of the housing and credit bubbles were that of unprecedented monetary policy by the Federal Reserve and the abundance of foreign funds flowing into U.S. financial institutions. While many other factors played roles in the expansion of these bubbles, many mistakes may have been avoided had these resources been utilized properly.

3 The Net Capital Rule

A key component to financing with debt is that firms must hold adequate capital, reserves, to cover any losses resulting from bad investments. In 2004 a decision to revise a rule known as the net capital rule not only released the big boys4 of the investment banking industry from abiding by this rule, but also encouraged them to take on excessive risk. Five members of the Securities and Exchange Commission (SEC) met with leaders from the investment banking industry on April 28, 2004 to discuss the proposed exemption to the net capital rule, a meeting that was not covered by any of the major media outlets. The meeting lasted only 55 minutes, and was voted unanimously to change the net capital rule, but the severity of the decision wasnt felt for a couple years when the housing bubble burst. The investment banks proposed an exemption that would allow only the companies with assets greater than $5 billion to be allowed to recalculate their tentative capital using innovative models based on Basel Standards.5 In simple terms this revision allowed banks to allocate the money they held in reserves and use this money to
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Richard Rosen (2010) The Impact of Originate-to-Distribute Model on Banks Before and During the Crisis, Federal Reserve Bank of Chicago Working Paper p.2 4 The big boys refers to 5 investment banks that were considered the largest firms: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley
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SEC Release 34-49830, 69 Federal Register 34428 (June 21, 2004)

purchase investments, primarily MBS, and no longer necessary have funds to use in times of turmoil. To put into perspective the amount of debt these firms were able to raise as a result to the change we look at the change in leverage ratios, debt-to-equity, of the firms (see figure 1). In 2007 these leverage ratios reached their peaks, with Bear Stearns having the largest at an astonishing 33 to 1.6 While these investment banks played a significant role into the rush of demand for MBS, none played quite the role that the two government sponsored enterprises (GSE), Freddie Mac and Fannie Mae, played. From 2001-2004 these firms were pressured by the U.S. Department of Housing and Urban Development, along with pressure from Congress, to invest in the housing market. The GSE responded to this pressure by purchase 40% of subprime mortgages7, leaving 60% for the investment banks and foreign investors. Much like the big boys in the investment bank industry, the GSE ignored the risk in allocating so much debt into MBS for the illusion that they were profiting in the short-run.

4 Credit Rating Agencies

Credit rating agencies (CRA) played key roles in the decisions of investors to invest their money into MBS. Most investors have neither the time to calculate risk for investments, nor the access to the information that a CRA has access to. The CRAs grade investments on a scale that ranges from AAA, investments with low risk for default, to C, investments with high risk for default. For a better understanding of the importance of the CRAs we look at an excerpt from the regulatory handbook of a federal reserve bank:

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Stephen Labaton (2008) Agencys 04 Rule Let Banks Pile Up New Debt, the New York Times Financial Crisis Inquiry Commission (2010) Testimony of Alan Greenspan , p.3-4

The rating agencies perform a critical role in structured finance evaluating the credit quality of the transactions. Such agencies are considered credible because they possess the expertise to evaluate various underlying asset types, and because they do not have a financial interest in a securitys cost or yield. Ratings are important because investors generally accept ratings by the major public rating agencies in lieu of conducting a due diligence investigation of the underlying assets and the servicer.8

The reputation and reliance on CRAs came from the fact that these agencies were able to provide independent evaluations on investments as the grades had no value to the CRAs. In the U.S. there are three firms that are responsible for more than 80% of credit ratings: Moodys Investor Services, Standard & Poors Rating Services (S&P), and Fitch Ratings.9 As the housing market was booming these firms, along with all other CRAs in the U.S., faced added pressure to churn out ratings in order to compete and make profit. In order for investment banks and other firms to sell their MBS they were required by law to obtain credit ratings. The investment banks paid a fee to a CRA to obtain the grades and were able to sell their securities. This relationship created a conflict of interest within the industry. CRAs relied on profit from the very firms that required their credit ratings. The investment banks desired the highest possible ratings they could receive and thus would hire the CRA providing the best rating. The fact that the firms purchasing the ratings were required to obtain the ratings allowed for CRAs to essentially name their price for high ratings. Piliero (2012) states, Less widely reported, however, is the fact that the new revenue model also provided that in most cases, the credit rating agencies compensation was conditioned on

Comptroller of the Currency Administrator of National Banks Comptrollers Handbook, Asset Securitization, at 11 (quoted in Carl Levin and Tom Coburn (2011), Wall Street and the Financial Crisis: Anatomy of a Financial Crisis, United States Senate Permanent Subcommittee on Investigations p. 30) 9 Alec Klein (2004) Smoothing the Way For Debt Markets, the Washington Post, p. A18

a successful placement of the bonds to investors. Put another way, the higher the rating, the more likely there would be a successful debt placement, and the more likely the credit rating agencies would have a lucrative payday.10 With little oversight or regulation by the SEC, until the Credit Rating Agency Reform Act went into effect in 2006, the credit rating industry was a proverbial cash cow. Between 2002 and 2007 the three previously mentioned CRAs managed to more than double their earnings from $3 billion to in excess of $6 billion.11 Unfortunately the worst damage had been done before the Reform Act of 2006 was passed. The worst subprime loans were documented to have originated between 2004 and 2007 (see figure 2). During this timeframe Moodys and S&P were documented to have issued AAA ratings to a large share of MBSs, and at times issuing AAA ratings to 95% of a single portfolio. 11 When the housing market finally reached its peak in 2006 (see figure 3), the housing bubble had to burst. The subprime mortgages that were issued, and inherently now flowing through the financial system, saw their delinquency rates start to rise. In response, S&P and Moodys commenced their first downgrades of their credit ratings. In 2010 it was discovered that over 90% of AAA ratings assigned to MBS to securities, originating in 2006 and 2007, were deemed below a rating of C and considered junk.8 The downgrading of the securities left investors with unmarketable MBS that were free-falling in value in a market that had frozen. In essence this was the gateway into our current financial crisis.

5 The Feds Response to the Crisis

The widely accepted start of the financial crisis occurred when BNP Paribas, the largest bank in France, ceased activity in three hedge funds that specialized in U.S. mortgages, causing overnight
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Robert Piliero (2012) the Credit Rating Agencies: Power, Responsibility, and Accountability, Westlaw Journal Derivatives, Vol. 18, Iss. 17 11 Carl Levin and Tom Coburn (2011), Wall Street and the Financial Crisis: Anatomy of a Financial Crisis, United States Senate Permanent Subcommittee on Investigations, p. 31

panic in the banking industry. Responsibility fell to the Fed, as the lender of last resort, to implement monetary policy and stabilize the economy. The Fed has three tools at it can use when choosing monetary policy: open market operations (OMO), discount policy, and reserve requirements. The first order of the Fed, in response to the panic, was to open the discount window on August 10, 2007. This policy instrument allows institutions to borrow money from the Fed on short-term basis to come up with adequate capital to cover potential losses. Once the Fed realized the severity of the crisis was increasing the Federal Open Market Committee (FOMC) lowered the federal funds rate to 1/4% from 5.25% in a sequence of seven shifts between September 18, 2007 and December 16, 2008. The Fed then realized that they were unable to provide further stimulus once the federal funds rate dropped to their targeted rates and financial institutions continued to struggle. The Fed then was required to take non-traditional approaches to provide liquidity to financial firms by setting up emergency credit facilities to fill the gaps between the discount window and OMO. These facilities issued short-term loans to firms backed by collateral that was in excess to the actual value of the loan.12 As financial conditions began to normalize, the Fed used its traditional OMO to keep balance in the progress that was made. Labonte (2012) sums up the OMO of the Fed, In March 2009, the Fed announced plans to purchase $300 billion of Treasury securities, $200 billion of Agency (Fannie Mae and Freddie Mac) debt (later revised to $175 billion), and $1.25 trillion of Agency mortgage-backed securities. These purchases were completed by the end of March 2010. Beginning in November of 2010 the Federal Reserve, dissatisfied with the high level of unemployment, took steps to encourage economic growth by purchasing an additional $600 billion of Treasury securities and continuing the practice of replacing maturing securities. The purchases were made at a pace of $75 billion a month and were completed in about six months. . 12

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Marc Labonte (2012) Monetary Policy and the Federal Reserve: Current Policy and Conditions, Congressional Research Service, p.10

This process of purchasing large-scale assets and leaving interest rates low has been referred to as quantitative easing. It has been the most debated use of monetary policy by the Fed and for good reason; thus far this policy has not shown employment or income growth and risks high levels of inflation. The credibility of the Fed hangs in the balance of the effects of their third round of quantitative easing (QE3). The main argument opposing QE3 is, by maintaining a large balance sheet policy, inflation will be noticeably affected, making the timing of exiting the QE3 process crucial. In summary there has been much debate on the implementation of monetary policy by the Fed. In the early stages conventional monetary policy was implemented but lacked the resources desired to stabilize the economy. In order to achieve the results desired by the Fed unconventional methods were implemented. As time went on the Fed was not seeing the results it had hoped in regards to stable prices within the economy. Spending was down and this caused a fall in output and a rise in unemployment. The idea behind implementing QE3 is that it will encourage businesses and consumers to spend and borrow money; in turn this will increase output and decrease unemployment. The problem is the previous rounds of quantitative easing werent as successful as hoped and fears of inflation by extending aggressive asset purchases combined with low interest rates will cause a rise in inflation. The independence of the Fed, in regards to making these decisions, has come into question. Should a small group of individuals have all the authority to dictate monetary policy? My opinion is no. This doesnt mean that I want the Fed to be abolished and lose independence. I believe a checks and balance system is necessary when it comes to monetary policy and the current system does not provide such method.