Group Assignment III - Submission M7

20/5/2019

Analysis of the global financial crisis

Abhishek Kumar, Shashank Sanket, Vishwanath Jeyaraman

*​
World Quant University

Abstract​- ​The following document contains an overall view of the global financial crisis, its primary causes, the responses of
policymakers, the intended effects of the policy makers, the potential downsides to such regulatory measures and other such
consequences. It also offers an insight into the Mortgage Backed Securities and how they contributed to the scaling of the problem at
hand. It also provides a detailed account of the Dodd - Frank Act , the policies and regulations in the aftermath of crisis.

Index Terms​- Global financial crisis, 2007-08 crash, Regulation of financial markets, Mortgage Backed Securities , Dodd Frank Act,
Subprime Lending , Financial Deregulation, Leverage,CDS , CDOs ,CMO's.

INTRODUCTION

The global economic crisis was caused by the coming together of several structural as well as business cycle factors that produced a
“perfect storm” of epic proportions. The factors ranged from the collapse of the housing market in the United States, reckless and risky
speculation and years of loose monetary policies and loose credit standards. In the aftermath of the collapse of Lehmann Brothers the
entire credit system froze and the global financial system came perilously close to collapse.
The global economic crisis originated in the USA but had its effects on all economies of the world. The US and the Europe were the
primary victims of the crisis and it can be said that countries like India and China were relatively unscathed in the wake of the
crisis.The United States and Europe were badly bruised by the crisis and it it took many years to rebuild the trust and stability in the
financial system.It also resulted in billions of taxpayers dollars used to reconstruct the financial system with increased scrutiny and
regulation of Wall Street banks and more barriers.

I. THE PRIMARY CAUSES OF THE GLOBAL FINANCIAL CRISIS.

The financial crisis of 2007–2008, also known as the global financial crisis was the most serious financial crisis since the Great
Depression of the 1930s. The crisis was nonetheless followed by a global economic downturn, the Great Recession. The European
debt crisis, a crisis in the banking system of the European countries using the euro, followed later. The major Causes of the Financial
crisis are :-

1. The bursting of the US housing bubble, which peaked in 2006/2007 caused by widespread failures of toxic mortgages.As housing
prices declined, major global financial institutions that had borrowed and invested heavily in subprime MBS reported significant
losses.Falling prices resulted in homes worth less than the mortgage loan, providing the lender to enter foreclosure.The ongoing
foreclosures drained significant wealth from consumers, with losses up to $4.2 trillion.1

2. .The relaxing of credit lending standards by investment banks and commercial banks resulted in subprime lending.The mortgage
lenders relaxed underwriting standards and originated riskier mortgages to less creditworthy borrowers.

3. Financial deregulation practices like phasing out a number of restrictions on banks' financial practices, broadened their lending
powers, allowing credit unions and savings and loans to offer checkable deposits, adjustable rate mortgages, relaxing the net capital
rule, which enabled investment banks to substantially increase the level of debt they were taking ,no regulation of shadow banking
systems all fuelled the buildup of the crisis.

1
"Subprime mortgage crisis - Wikipedia." ​https://en.wikipedia.org/wiki/Subprime_mortgage_crisis​. Accessed 7 May. 2019.
Group Assignment III - Submission M7
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4. Increased debt burden or over-leverage increased the banks appetite for risky investments and reduced their resilience in case of
losses. Much of this leverage was achieved using complex financial instruments such as off-balance sheet securitisation and
derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels. US
household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 1990.2

5. Innovative and complex financial products enabled firms to circumvent regulations, such as off-balance sheet financing that
affects the leverage or capital cushion reported by major banks. Ex . the CDS and portfolio of CDS called synthetic CDO enabled a
theoretically infinite amount to be wagered on the finite value of housing loans outstanding, provided that buyers and sellers of the
derivatives could be found.3

6. The collapse of the shadow banking system may have pressured more traditional institutions to lower their own underwriting
standards and originate riskier loans. These entities became critical to the credit markets underpinning the financial system, were
not subject to the same regulatory controls. These entities were vulnerable because of maturity mismatch, meaning that they
borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets.4

II. THE MARKET FEATURES AND CONDITIONS THAT CONSTITUTE A FINANCIAL CRISIS IN GENERAL.
The market features, economic data and conditions that constitute a financial crisis are :

1. The crisis following the Lehman failure in September saw the deterioration of many macroeconomic indicators. Industrial output
contracted sharply in much of the world. Commodity prices which had been booming declined significantly towards the end of the
year. There was a sudden contraction in the volume of world trade. 5

2. All of the world’s major economies were in recession or struggling to stay out of one. In the final four months of 2008, the U.S.
lost nearly two million jobs. The unemployment rate shot up to 7.2% in December from its recent low of 4.4% in March 2007, and
it was almost certain to continue rising into 2009. Economic output shrank by 0.5% in the third quarter, and there were cutbacks in
consumer spending.6

3. Asia’s major economies were swept up by the financial crisis, even though most of them suffered only indirect blows. Japan’s GDP
in second quarter of 2008 suffered with a 3.7% contraction followed by 0.5% in the third quarter. Its all-important exports plunged
27% in November from 12 months earlier. China’s economy continued to grow but not at the double-digit rates of recent years.
Exports were lower in November from October’s 19% increase.7

4. By September and October of 2008, people began investing heavily in gold, bonds and US dollar or Euro currency, as these were
seen as safer alternatives to the ailing housing and stock markets.8

2
"53 This housing bubble resulted in quite a few homeowners ...."
https://www.coursehero.com/file/p6mbrja/53-This-housing-bubble-resulted-in-quite-a-few-homeowners-refinancing-their/​. Accessed
8 May. 2019.
3
"Synthetic CDO - Wikipedia." ​https://en.wikipedia.org/wiki/Synthetic_CDO​. Accessed 8 May. 2019.
4
"Shadow Banking - Bloomberg." 23 Sep. 2018, ​https://www.bloomberg.com/quicktake/shadow-banking​. Accessed 8 May. 2019.
5
"The world has not learned the lessons of the financial crisis - Has ...." 6 Sep. 2018,
https://www.economist.com/leaders/2018/09/06/the-world-has-not-learned-the-lessons-of-the-financial-crisis​. Accessed 8 May. 2019.
6
"Cheap money once out of the bottle always looks to be taken for a ride ...."
https://www.coursehero.com/file/p7hcihc/Cheap-money-once-out-of-the-bottle-always-looks-to-be-taken-for-a-ride-It-found/​.
Accessed 8 May. 2019.
7
"Britannica Book of the Year 2009."
https://books.google.com/books?id=IaecAAAAQBAJ&pg=PA175&lpg=PA175&dq=Its+all-important+exports+plunged+27%25+in+
November+from+12+months+earlier.&source=bl&ots=Y6M1lV9xFd&sig=ACfU3U2T6kKx3D2XmkRpBkglWns0yh1FgQ&hl=en​.
Accessed 8 May. 2019.
8
"By September and October of 2008 people began investing heavily in ...."
https://www.coursehero.com/file/pgh8k4/By-September-and-October-of-2008-people-began-investing-heavily-in-gold-bonds/​.
Accessed 8 May. 2019.
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III. H​OW THE PRIMARY CAUSES OF THE GLOBAL FINANCIAL CRISIS WHICH LED TO THE FEATURES OF A FINANCIAL
CRISIS.
The primary causes like the mortgage market in USA led to a downward spiral resulting in a financial crisis of epic proportions some
of the causes and effects are :

1. The failure of large banking corporations like Lehman Brothers followed by Bear Sterns and the huge losses at insurance giant
AIG resulted in major declines in the USA stock market with investors withdrawing from individual stocks, money managers ,
hedge funds and mutual funds.

2. The collapse of mortgage markets and companies holding worthless MBS resulted in one subprime lender or another filing for
bankruptcy in the USA in start of 2007. During February and March 2007, more than 25 subprime lenders filed for bankruptcy.9

3. The interbank market froze completely, largely due to prevailing fear of the unknown amidst banks and no confidence on the
repaying capacity of others .The LIBOR was spiking.10 The British banks had to approach the Bank of England for emergency
funding due to a liquidity problem. The U.K. government provided $88 billion to buy banks completely or partially and promised
to guarantee $438 billion in bank loans.11

4. The crisis also created a run on money market funds. During the run, companies moved a record $144.5 billion out of their money
market accounts into safer Treasury bonds. This completely sucked the liquidity out of the market. 12

IV. THE RESPONSE OF POLICYMAKERS AND REGULATORS TO THE GLOBAL FINANCIAL CRISIS
Policy-makers have sought to rectify the damage done to financial systems and economies by enacting a large set of financial reforms,
both at the international and domestic level Some of these regulations are :

1. An emergency action plan was adopted at the G7 meeting held in Washington D.C. on October 10 after the Lehman crisis. Under
this plan, government actions included the massive supply of liquidity by central banks, expansion of deposit insurance, guarantees
for bank debts, capital injection using public funds, separation of toxic assets from balance sheets and governmental control of
troubled financial institutions13

2. In the second G20 summit in London in April 2009, the leaders agreed to mobilize funds from international financial institutions
such as the IMF, the World Bank and the Asian Development Bank and bilateral assistance from advanced countries in order to
support trade, infrastructure development and stimulus measures in developing countries, and to increase resources of those
institutions. 14

3. The group of regulators and central bank established the Financial Stability Board (FSB). The FSB now coordinates the work of
national financial authorities and standard setting bodies at an international level. It brings together national authorities responsible
for financial stability, albeit mostly from G-20 countries.15

9
"Subprime crisis impact timeline - Wikipedia." ​https://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline​. Accessed 8 May.
2019.
10
"A Network View on Interbank Market Freezes - Semantic Scholar." 8 Dec. 2014,
https://pdfs.semanticscholar.org/58f3/1a4b26cd9f64b4ecb0c059f5540e156c5575.pdf​. Accessed 8 May. 2019.
11
"UK government to partially nationalize banks - NBC News." 8 Oct. 2008,
http://www.nbcnews.com/id/27078582/ns/business-world_business/t/uk-government-partially-nationalize-banks/​. Accessed 8 May.
2019.
12
"Reserve Primary Fund: Broke the Buck, Money Market Run." 15 Nov. 2018,
https://www.thebalance.com/reserve-primary-fund-3305671​. Accessed 8 May. 2019.
13
"Response to the Global Financial Crisis and Future Policy Challenges."
https://www.mof.go.jp/english/international_policy/new_international_financial_architecture/ko_101023.pdf​. Accessed 8 May. 2019.
14
"BBC NEWS | Business | G20 leaders' statement." 2 Apr. 2009, ​http://news.bbc.co.uk/2/hi/business/7979606.stm​. Accessed 8 May.
2019.
15
"Financial Stability Board - Wikipedia." ​https://en.wikipedia.org/wiki/Financial_Stability_Board​. Accessed 8 May. 2019.
Group Assignment III - Submission M7
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4. Adoption of Basel III capital requirements, including a counter - cyclical capital buffer and a surcharge for globally systemically
important financial institutions (G-SIFIs), the identification of GSIFIs, domestically systemically important banks (D-SIBs), higher
capital adequacy requirements and more intense supervision, and national resolution schemes (including bail-in instruments) so
that failing institutions can be resolved without wider disruptions.16

5. Agreement in principle on similar treatment of some types of financial transactions under U.S. Generally Accepted Accounting
Principles (GAAP) and International Financial Reporting Standards (IFRS). The beginning of harmonised collection of improved
consolidated data on bilateral counter-party and credit risks of major systemic banks.

V. THE INTENDED EFFECTS OF POLICYMAKERS AND REGULATORS RESPONSES

The rapid and comprehensive monetary authority interventions helped to avert a global financial collapse at the end of 2008. The
broad nature and size of interventions—in most cases expanding the public sector balance sheet, has been unprecedented in modern
times. The size of interventions in the financial sectors during 2008–2009 was large, totalling on average for advanced economies
about 50 percent of their purchasing power parity (PPP) weighted GDPs. The intended consequences are :

1. The US recession that began in December 2007 ended in June 2009 and most other economies developed and developing
recovered during the same phase and the financial crisis ended about the same time. The actions that the national governments and
international organisation took helped to maintain confidence and liquidity in the financial system.17

2. Heightened prudential standards (e.g., higher capital and liquidity, stress testing) has made the financial system and
financial firms safer. Title II recovery and resolution planning and authority allows for orderly failure without transmitting risk to
the rest of the financial System.18

3. Derivatives transactions are safer and more transparent due to clearing and margin rules. Creation of the Financial Stability
Oversight Council and Office of Financial Research provide attention to systemic risk.19

4. Policymakers have successfully shielded consumers from risky financial products, by creating organisations such as the
Consumer Financial Protection Bureau (CFPB) to focus exclusively on consumer protection. Regulators mandated greater
transparency in bank balance sheets, activities, and products.

5. Businesses and consumers have maintained access to credit. Overall bank lending has been Increasing. Alternative means
of credit evaluation has been useful to gauge the ability of borrowers to repay loans.

VI. THE DOWNSIDES AND UNINTENDED CONSEQUENCES THAT CAN OCCUR WHEN APPLYING REGULATION AND POLICY
20
TO THE FINANCIAL MARKETS
The idea of a regulation is to steer the interested players away from an unwanted action towards the desired one.However,
sometimes there are downsides and pitfalls which arising due to mismatching incentives and non - due diligence. The unintended
consequences can be broadly studied as per their impact on major entities like :

• Market Participants
• Investors

16
"The G-SIB assessment methodology - Bank for International Settlements." ​https://www.bis.org/bcbs/publ/d296.pdf​. Accessed 8
May. 2019.
17
"Great Recession - Wikipedia." ​https://en.wikipedia.org/wiki/Great_Recession​. Accessed 8 May. 2019.
18
"A primer on Dodd-Frank's Orderly Liquidation Authority." 5 Jun. 2017,
https://www.brookings.edu/blog/up-front/2017/06/05/a-primer-on-dodd-franks-orderly-liquidation-authority/​. Accessed 8 May. 2019.
19
"Financial Stability Oversight Council (FSOC) - Federation of American ...." ​https://fas.org/sgp/crs/misc/R45052.pdf​. Accessed 8
May. 2019.
20
"The Unintended Consequences of Regulatory, Federal Reserve, and ...."
https://www.rmahq.org/WorkArea/DownloadAsset.aspx?id=6016​. Accessed 8 May. 2019.
Group Assignment III - Submission M7
20/5/2019

• Capital Markets
• Regulators/Policy Makers

1. Capital Markets:

A. The heightened regulations , defined levels of risk taking and leverage constraints may discourage participants to
participate resulting in less trading and search for returns elsewhere.
B. Regulations which increase the liabilities/scrutiny of agencies for their actions results in less growth of the market. The
highly publicised settlements to federal govt by banks after financial crisis have dampened the mortgage markets resulting in
weakened house prices and less issued home mortgages.
C. Some regulations may result in systemic risks to the market. The increased liability on credit rating agencies after the
mortgage bond crisis resulted in credit rating agencies refraining to be named “experts” in promotional material of asset backed
securities which resulted in the Division of Corporation Finance forced to omit ratings disclosure from ABS prospectuses.
D. The increased scrutiny and compliance burden and costs has resulted in several companies opting out of IPO’s or placing
foreign IPO’s leading to weaker domestic markets.

2. Market Participants :

A. The “cost of compliance” which includes hiring and training new staff to adhere to various regulations results in additional
charge on the entity which may be passed on to the clients leading to less business development.Ex . Dodd- Frank act was a 849
page legislation and had 240 laws to be implemented in a year.
B. Increasing regulation on activities of firms like prop trading , restrictions on short sale results in firms moving to less
regulated alternative financial services like prepaid credit cards , payday lenders which results in the same risks albeit in a different
market.
C. Conflicting regulations with mismatching incentives leaves little room for the entities to adhere to normal business
practices.Ex : U.S. Govt. always pushes for lax laws of home loans to low income households but the Dodd-Frank regulations
require the banks to strictly adhere to creditworthiness of individuals before underwriting loans.
D. The regulations generally involves making more and more data of the firm/entity public for investors to make better
informed decisions. However , this results in making the business strategy of the firm public and decreasing its competitiveness as
compared to private players.

3. Investors :

A. The lower interest policies by fed government resulted in lower returns on most assets encouraging investors to look for
returns in riskier investments.
B. Companies opting out of going public due to compliance burden results in less opportunities for retail investors to invest
in high growth startups and instead opt for low growth public traded companies.

4. Regulators & Policy Makers :

A. New legislations passed by government takes time and additional costs for the regulators to make laws upon, with the
burden passed on to taxpayers.
B. Introducing legislations like Federal Reserve Accountability and transparency(FRAT) act questions the independence of
FED and their monetary policy from government intervention.
C. Pursuing policies like ultra low interest rates with no structural improvements gives little leverage to policymakers at times
of genuine market cycle downturns. A return to normal rates may prove difficult without volatility.

VII. THE FEATURES OF FINANCIAL MARKETS WHICH OFTEN NEED REGULATION.

The objectives of financial regulators are usually to maintain confidence in the financial system, contribute to the protection and
enhancement of stability of the financial system and secure the appropriate degree of protection for consumers. Any new feature in the
Group Assignment III - Submission M7
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market which threaten above objectives needs a new Regulation. The features which often need regulation are :

1. The Capital and reserve requirements for banks to maintain consumer confidence about their savings .Ex : Banks and
insurance firms are required to hold a certain portion of their deposits as cash or extremely liquid investments.

6. Prudential supervision of important financial institutions whose failure could precipitate a financial crisis. These includes
regulations to assess their leverage ratios , stress testing their portfolios for extreme economic conditions and other measures to
prevent them from failing.

7. Regulation of investment products to ensure that information disclosed by product producers and sellers is sufficient for
investors to make well-based decisions (which may, of course, include a decision to invest in a highly risky venture), with the
ultimate objective of promoting efficiency in financial markets.

8. Making Regulations to provide investors with effective market infrastructure, transparent pricing mechanisms, good
settlement and clearing procedures, and freedom from fraud and malpractice. Reliable settlement procedures and arrangements for
handling a failure to settle also promote stability.

9. Regulations to prevent anti-competitive practices, including price fixing, monopolies and misleading conduct particularly
in the advent of a new market or a product.

VIII. DODD FRANK ACT

The Dodd–Frank Wall Street Reform and Consumer Protection Act is a United States federal law that was enacted on July 21,
2010. The law overhauled financial regulation and it made changes affecting all federal financial regulatory agencies and nation's
financial services industry. 21

i) ​The key components of the law were :

It reorganised the financial regulatory system, eliminated the Office of Thrift Supervision, assigned new responsibilities to agencies
like Federal Deposit Insurance Corporation, and created new agencies like the Consumer Financial Protection Bureau (CFPB).

The act also created the Financial Stability Oversight Council and the Office of Financial Research to identify threats to the financial
stability of the United States, and gave the Federal Reserve new powers to regulate systemically important institutions.22

The act created the Orderly Liquidation Authority to handle the liquidation of large companies and restricted banks from making
certain kinds of speculative investments (Volcker Rule).23 The act also introduced regulation of security-based swaps, requiring
transactions to be cleared through either exchanges or clearinghouses.

The act also proposed various measures aimed at increasing international standards and cooperation including proposals related to
improved accounting and tightened regulation of credit rating agencies.

ii)​ The intended effect of the regulation was to improve financial stability and consumer protection.The stated aim of the legislation is

21
"Dodd–Frank Wall Street Reform and Consumer Protection Act ...."
https://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Act​. Accessed 8 May. 2019.
22
"Financial Stability Oversight Council - Wikipedia." ​https://en.wikipedia.org/wiki/Financial_Stability_Oversight_Council​. Accessed
8 May. 2019.
23
"A primer on Dodd-Frank's Orderly Liquidation Authority." 5 Jun. 2017,
https://www.brookings.edu/blog/up-front/2017/06/05/a-primer-on-dodd-franks-orderly-liquidation-authority/​. Accessed 8 May. 2019.
Group Assignment III - Submission M7
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"To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end
"too big to fail," to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices,
and for other purposes."

Every part of the regulation served some necessary measure to promote greater transparency in the financial system and promote
stability.

1. The Volcker Rule promoted a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank's
own accounts. This was deemed necessary to restrict United States banks from making certain kinds of speculative investments that do
not benefit their customers.

2. The Wall Street Transparency and Accountability Act of 2010 24 concerns regulation of over the counter swaps markets.The Act
requires that various derivatives known as swaps, which are traded over the counter, must be cleared through either exchanges or
clearinghouses.This was done to enhance transparency and prevent situations caused by credit default swaps and credit derivative
that were the subject of several bank failures.

3. The Payment, Clearing, and Settlement Supervision Act of 2010 25 aims to mitigate systemic risk within and promote stability in the
financial system It provided the Fed with an enhanced role in the supervision of risk management standards for systemically important
financial market utilities; strengthening their liquidity and providing the Board of Governors an enhanced role in the supervision of
risk management standards for financial institutions.

4. The Private Fund Investment Advisers Registration Act of 2010 26 requires investment advisers to register as investment advisers
under the Investment Advisers Act of 1940.It requires many hedge fund managers and private equity fund managers to register as
advisers for the first time.It also increases the reporting requirements of investment advisers and limit their ability to exclude
information in reporting to many of the federal government agencies.

iii) ​An explanation of how this fits into the general theme and rationale of financial regulation in general :

The objectives of financial regulators are usually to maintain confidence in the financial system, contribute to the protection and
enhancement of stability of the financial system and secure the appropriate degree of protection for consumers.Any new feature in the
market which threaten above objectives needs a new Regulation.

The rationale for financial regulation arises as :

1. The Capital and reserve requirements are there for banks to maintain consumer confidence about their savings .Ex: Banks and
insurance firms are required to hold a certain portion of their deposits as cash or extremely liquid investments.

2. The regulations assess the leverage ratios , stress testing their portfolios for extreme economic conditions and other measures to
prevent large systemically important institutions from failing.

3. Regulation of investment products ensures that information disclosed by product producers and sellers is sufficient for investors to
make well-based decisions (which may, of course, include a decision to invest in a highly risky venture), with the ultimate objective of
promoting efficiency in financial markets.

4. Making Regulations provide investors with effective market infrastructure, transparent pricing mechanisms, good settlement and
clearing procedures, and freedom from fraud and malpractice. Reliable settlement procedures and arrangements are compulsory for
handling a failure to defaults

5. Regulations prevent anti-competitive practices, including price fixing, monopolies and misleading conduct particularly in the advent
of a new market or a product.

24
"Gibson, Dunn & Crutcher LLP Letter 2 - Federal Reserve Bank." 20 Nov. 2010,
https://www.federalreserve.gov/newsevents/rr-commpublic/gibson_dunn_letter_20101120.pdf​. Accessed 8 May. 2019.
25
"Dodd-Frank: Title VIII - Payment, Clearing, and Settlement Supervision ...."
https://www.law.cornell.edu/wex/dodd-frank_title_VIII​. Accessed 8 May. 2019.
26
"Private Fund Investment Advisers Registration Act of 2010: New Law ...." 29 Jul. 2010,
https://www.bclplaw.com/images/content/1/5/v2/1508/Client-Alert-Private-Fund-Investment-Advisers-Registration-Act.pdf​. Accessed
8 May. 2019.
Group Assignment III - Submission M7
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iv)​ A description of some of the possible downsides and/or intended consequences of the regulation.

The major downsides and unintended consequences are :-

2.The cost of compliance is high for smaller banks

3.It makes it difficult for banks to do business and greatly restricts lending

4.The community banks have declining market share in several key lending markets such as the small business market.

The Dodd Frank act tried hard to cleanse some of the bad features that had crept in the financial system which resulted in the Financial
Crisis. It also made bold provisions to improve transparency in the system and increase accountability of the participants. Most of the
academic research says that it had made the financial system more robust and compliant. But they differ on the question of major
positive impact of the Act on US economy. This may be due to the unintended consequences which had hampered the proper business
development of banks due to strict oversight and increasing compliance cost and burden. Overall it nearly set to achieve what it was
intended to do i.e to promote stability of the financial system.

IX. AN OUTLINE OF MORTGAGE BACKED SECURITIES27

Mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. A
mortgage bond is a bond backed by a pool of mortgages on a real estate asset such as a house or a commercial property. Mortgage
bonds can pay interest in either monthly, quarterly or semiannual periods.

The total face value of an MBS decreases over time as the principal in an MBS is not paid back as a single payment to the bondholder
at maturity but rather is paid along with the interest in each periodic payment (monthly, quarterly, etc.). This decrease in face value is
measured by t1he MBS "factor", the percentage of the original "face" that remains to be repaid.

The steps in creation of a MBS are as follows :

a. Mortgage loans (mortgage notes) are purchased from banks and other lenders, and possibly assigned to a special purpose
vehicle (SPV).
b. The purchaser or assignee assembles these loans into collections, or "pools".
c. The purchaser or assignee securitizes the pools by issuing mortgage-backed securities.

The mortgages are then sold to a group of individuals (a government agency or investment bank) that securitizes, or packages, the
loans together into a security that investors can buy.

The structure of the MBS may be known as "pass-through", where the interest and principal payments from the borrower pass through
to the MBS holder, or it may be more complex, like a pool of other MBSs. Other types of MBS are collateralized mortgage obligations
(CMOs) and collateralized debt obligations (CDOs)28. The shares of subprime MBS issued by various structures, such as CMOs, are
not identical and are issued as tranches each with a different level of priority in the debt repayment stream, having different levels of
risk and reward. The lower-priority, higher-interest tranches are often repackaged and resold as collateralized debt obligations.

X. USEFULNESS OF MBS
a. It transform relatively illiquid, individual financial assets like real estate into liquid and tradable capital market instruments.
b. It allow mortgage sellers(developers) to replenish their funds, which can then be used for additional development activities.

27
"Mortgage-Backed Securities and the Financial Crisis of 2008: a Post ...." 23 Oct. 2017,
https://www.ecb.europa.eu/pub/conferences/shared/pdf/20171023_credit_banking_monetary_policy/Uhlig_paper.pdf​. Accessed 21
May. 2019.
28
"CMO vs CDO: Same Outside, Different Inside - Investopedia." 11 Sep. 2014,
https://www.investopedia.com/articles/investing/111213/cmo-vs-cdo-same-outside-different-inside.asp​. Accessed 21 May. 2019.
Group Assignment III - Submission M7
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c. It can be used by banks to monetize the credit spread between the origination of an underlying mortgage (private market
transaction) and the yield demanded by bond investors through bond issuance (typically a public market transaction).
d. They are often a more efficient and lower-cost source of financing in comparison with other bank and capital markets
financing alternatives.
e. It allow issuers to diversify their financing sources by offering alternatives to more traditional forms of debt and equity
financing and remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more
efficiently, and achieve compliance with risk-based capital standards
f. It can be used by investors like pension funds or insurance as a steady stream of cash flow.

XI. THE ROLE MBS PLAYED IN THE GLOBAL FINANCIAL CRISIS

The United States subprime mortgage crisis occurred between 2007 and 2010, that contributed to the U.S. recession of December
2007 – June 2009 was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage
delinquencies and foreclosures and the devaluation of housing-related securities29.

a. The housing bubble preceding the crisis was financed with mortgage-backed securities (MBS’s) and collateralized debt
obligations (CDOs), which initially offered higher interest rates (i.e. better returns) than government securities, along with
attractive risk ratings from rating agencies.30
b. Subprime lending caused a dramatic increase in available mortgage credit. Many loans were made to borrowers who would
have previously had difficulty obtaining mortgages due to below-average credit scores. Private lenders made a lot of money
by pooling and selling the subprime mortgages. However, the risk of foreclosure increased with the relaxing of credit
standards.
c. MBS were not regulated. The federal government regulated banks to make sure their depositors were protected but those
rules didn't apply to MBS and mortgage brokers. Bank depositors were safe, but MBS investors were not protected at all.
d. As ​decline in home prices accelerated, an increasing number of people found themselves struggling to make their monthly
mortgage payments. This led to higher levels of mortgage defaults. For MBS's this meant that potential losses from defaults
were spread more widely than they otherwise might have been which means that even if the overall default rate for the pool
of mortgages is relatively low, the loss for a particular tranche of mortgage-backed securities was substantial.

XII. WHY THE POTENTIAL BENEFITS AND USES OF MORTGAGE-BACKED SECURITIES DID NOT MANIFEST IN GLOBAL
FINANCIAL CRISIS.
a. Due to the decline in the housing prices the value of Mortgage Backed securities started to decline and the trading activity
also reduced.31 Financial institutions started selling MBS at even lower prices because of no buyers which led to panic in the
marketplace.
b. The collapse of the housing bubble led to less demand for housing along with increased inventory of unsold houses. People
found it cheaper to foreclose the houses than to meet monthly rent payments sliding down the values of the mortgage backed
securities.Banks who had MBS in their balance sheet started reporting losses which caused further panic in the housing
markets.

XIII. CONCLUSION
The credit crisis reshaped the financial landscape, threatened the stability of international finance and changed Wall Street
forever.The crisis was a result of market failure and caused by deep regulatory failure which resulted in the creation of
housing bubble. The major lessons were the coupling of the financial markets which resulted in crisis in one sector of
economy quickly spreading to other parts of the economy.The policies and regulations created in aftermath of the crisis did
went a long way to protect the economy from further deteriorating and placed some important checks on the functionality of

29
30
"What role did securitization play in the U.S. subprime mortgage crisis?." 8 Mar. 2019,
https://www.investopedia.com/ask/answers/041515/what-role-did-securitization-play-us-subprime-mortgage-crisis.asp​. Accessed 21
May. 2019.
31
"Housing Bubble - Investopedia." 27 Mar. 2019, ​https://www.investopedia.com/terms/h/housing_bubble.asp​. Accessed 21 May.
2019.
Group Assignment III - Submission M7
20/5/2019

financial institutions.It is important to learn the lessons that it had provided us and have sufficient leeway to deal with
pressures on the economy during Business cycle downturns to avoid a catastrophe of massive scale.

XIV. REFERENCES

1. https://en.wikipedia.org/wiki/Subprime_mortgage_crisis
2. https://www.coursehero.com/file/p6mbrja/53-This-housing-bubble-resulted-in-quite-a-few-homeowners-refinancing-their/
3. h​https://en.wikipedia.org/wiki/Synthetic_CDO
4. https://www.bloomberg.com/quicktake/shadow-banking
5. https://www.economist.com/leaders/2018/09/06/the-world-has-not-learned-the-lessons-of-the-financial-crisis
6. https://www.coursehero.com/file/p7hcihc/Cheap-money-once-out-of-the-bottle-always-looks-to-be-taken-for-a-ride-It-found/
7. https://books.google.com/books?id=IaecAAAAQBAJ&pg=PA175&lpg=PA175&dq=Its+all-important+exports+plunged+27
%25+in+November+from+12+months+earlier.&source=bl&ots=Y6M1lV9xFd&sig=ACfU3U2T6kKx3D2XmkRpBkglWns
0yh1FgQ&hl=en​.
8. https://www.coursehero.com/file/pgh8k4/By-September-and-October-of-2008-people-began-investing-heavily-in-gold-bonds
/
9. https://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline
10. https://pdfs.semanticscholar.org/58f3/1a4b26cd9f64b4ecb0c059f5540e156c5575.pdf
11. http://www.nbcnews.com/id/27078582/ns/business-world_business/t/uk-government-partially-nationalize-banks/
12. https://www.thebalance.com/reserve-primary-fund-3305671
13. https://www.mof.go.jp/english/international_policy/new_international_financial_architecture/ko_101023.pdf
14. http://news.bbc.co.uk/2/hi/business/7979606.stm
15. https://en.wikipedia.org/wiki/Financial_Stability_Board
16. https://www.bis.org/bcbs/publ/d296.pdf
17. https://en.wikipedia.org/wiki/Great_Recession
18. https://www.brookings.edu/blog/up-front/2017/06/05/a-primer-on-dodd-franks-orderly-liquidation-authority/
19. https://fas.org/sgp/crs/misc/R45052.pdf
20. https://www.rmahq.org/WorkArea/DownloadAsset.aspx?id=6016
21. https://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Act
22. https://en.wikipedia.org/wiki/Financial_Stability_Oversight_Council
23. https://www.brookings.edu/blog/up-front/2017/06/05/a-primer-on-dodd-franks-orderly-liquidation-authority/
24. https://www.federalreserve.gov/newsevents/rr-commpublic/gibson_dunn_letter_20101120.pdf
25. https://www.law.cornell.edu/wex/dodd-frank_title_VIII
26. https://www.bclplaw.com/images/content/1/5/v2/1508/Client-Alert-Private-Fund-Investment-Advisers-Registration-Act.pdf
27. https://www.ecb.europa.eu/pub/conferences/shared/pdf/20171023_credit_banking_monetary_policy/Uhlig_paper.pdf
28. https://www.investopedia.com/articles/investing/111213/cmo-vs-cdo-same-outside-different-inside.asp
29. https://www.investopedia.com/ask/answers/041515/what-role-did-securitization-play-us-subprime-mortgage-crisis.asp
30. https://www.investopedia.com/terms/h/housing_bubble.asp​.