Maya Boyle

Jim Hartley
Money and Banking

P R O P O S A L S O F F U T U R E R E G U L AT I O N
The emergence of the financial crisis was brought to fruition through
the roots of mismanagement of assets and unmitigated greed. In the wake
of this crisis, more stringent regulation must value the worth of the individual
over the worth of the company through an increase in required equity, the
simplification of the financial intermediary sector, and the acceptance of low
net-worth individuals as having a place in the financial market within their
budget constraints.
The Federal Reserve, under the eye of Chairman Greenspan, began to
increase the money supply faster than was expected from the state of the
economy. This steady increase in liquidity left the economy incredibly liquid
and offered lots of space available for mortgage transactions. Receiving
loans became far easier, increasing the money supply and increasing the
price level of houses. No longer merely singular assets, houses became the
latest investment trend. Mortgages were developed to facilitate this
investment strategy, not the practice of living in a home. For instance, the
emergence of 228 mortgages, which charged minimal interest for the first
two years and escalated prodigiously afterward, allowed those who sought to
play the market to purchase a home with minimal risk and reap the rewards
of its appreciation within a few years. Likewise, mortgages emerged
containing interest-only payments for the first five years and balloon

payments for any time period beyond. While these payment plans made no
sense to those who planned on living in homes, they were financially
desirable to investors who planned to sell their homes within the interestonly time frame. The continuation of this market required only the steady
increase in housing prices and the continued assurance that a majority of
borrowers would not default on their loans.
The expansion of the housing bubble was facilitated by the mitigation
of risk through the securitisation agencies of FNMA and FHLMC. Needing to
atone of an accounting scandal in 2004, the two securitisation agencies
began to offer mortgages to people with lower net worth in order to reestablish their credibility as a fair source of loans and mortgages. Due to the
conviction that bonds that go through these agencies would be backed by
the federal government, the demand for these bonds increased. Between
2004 and the 2007-2008 financial crisis, rates of home ownership increased
by 25 percentage points, and much of these loans were made to lower net
worth individuals The American Dream was suddenly within reach of
millions of people and the demand for these homes and these mortgages
was nearly insatiable. Backed by the assurance that the government
On the banking side of the mortgage crisis, the securitisation of the
security market mitigated loan risk, allowing investors to purchase debt with
the promise of a high return. By bundling the securities, financial
intermediaries were able to lower the risk that comes from shouldering
debts. Further, these bundles were separated into CDOs, or collateralised

debt obligations, which, by separating security bundles into three tranches,

ensured that any mortgage defaults would be shouldered only by those who
were willing to bear the risk. If securities were to default, the third trench
would suffer the financial burden until all securities in the third tranche
disappeared. This model was built on top of existing tranches to virtually
eliminate the perceived risk of securities. Further, insurance companies,
seeking to benefit from the insurance premiums in a seemingly safe market,
offered collateralised debt swaps, or CDSs, which promised to take on the
debt in the event of a default. Through these various risk mitigation
schemes, the demand for securities skyrocketed, making investors, banks,
and insurance companies immensely wealthy- as long as housing prices
continued to rise.
When housing prices began to decline, investors found that the
securities had been divided so deeply that it was no longer clear what
securities they in fact owned. As the amount of uncertainty in the market
skyrocketed, the demand for securities vanished. This combination of
defaults and plummeting demand crumbled the housing market. In
conjunction with the housing market, the insurance companies that had
backed the faulty CDOs found their assets evaporating. Investment banks
suddenly found their investments worthless, their cash vanishing virtually
overnight. The repo market followed, with investors demanding cash beyond
what investment bank reserves had available.

From this saga of financial mismanagement, it is clear that multiple

shifts in regulation are needed. In the short term, trust is imperative.
Financial intermediaries must remain as reliable for funds in times of crisis as
they are in times of prosperity, in order to prevent bank runs and economic
catastrophe. In the long run, however, the regulation changes must run
deeper to ensure that crises of this magnitude are prevented. While the
mortgage crisis necessitated an extraordinary response, further regulations
must be implemented to ensure that financial intermediaries do not exploit
their assets to this extent in the future. The mismanagement of money is, at
its core, simply the mismanagement of greed. When the return on assets
does not adequately reflect the risk involved, the market grows destabilised
and dependent on the stability of a single asset. This renders the economy
inherently riskier and endangers the solvency of financial intermediaries
themselves.
At its core, the best way to regulate banks would be to generate riskaverse financial intermediaries. However, the free market necessitates the
pursuit of profits, which by definition requires some modicum of risk. As has
been argued in The Bankers New Clothes, the best way to mitigate risk and
simultaneously maintain competitiveness may be to increase the amount of
required equity that must be held by banks at any given time. An increase in
equity will increase the safety of the investors holdings, which will mitigate
risk and the ability of banks to invest the vast majority of their assets in any
single venture. The increased amount of equity also decentralises power,

which gives shareholders more of a voice in financial ventures of

corporations or intermediaries.
Beyond the equity side, the increased complexity of the banking sector
has made it increasingly difficult to understand the state of corporate
investments. As took place in the securitisation and mortgage fiasco of 2007
and 2008, the increased interweaving of securities and tranches made it
impossible for borrowers to understand exactly what they owned. When this
fact became apparent to the market as a whole, the demand for securities
utterly collapsed, leaving investors holding assets that were meaningless,
and thus worthless. A simplification of the banking sector would allow for a
greater understanding of what assets are, and thus what they are ultimately
worth, given the state of the market.
The complication of the market is not limited to the market itself.
Financial intermediaries themselves may also benefit from becoming
smaller, more manageable, and less complex. The birth of banks that are
too big to fail generated an economic system where the government, the
original supplier of money, is dependent on private entities that manage
government-controlled funds. This puts the Federal Reserve at the mercy of
private corporations and intermediaries, which is inherently dangerous
because it creates a system where the governments control of the money
supply is subject to the private sectors drive for profits, not the well-being of
the aggregate market.

Finally, banks must be more vigilant in terms of to whom they lend and
the amount of their assets they render unstable. It is not necessary to block
low net-worth individuals from taking out loans entirely, but a more
structured and rigid system of who is eligible for large loans such as
mortgages is vital to ensure the stability of banks available capital. Smaller
loans to individuals with lower net worth would both decrease the rate of
default because it will increase the levels of solvency and increase the
likelihood that the debt will be able to be ultimately paid off.