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SEF
27,2 Greed, financial innovation
or laxity of regulation?
A close look into the 2007-2009
110 financial crisis and stock market volatility
M. Imtiaz Mazumder
School of Business, SUNY Institute of Technology,
Utica, New York, USA, and
Nazneen Ahmad
Economics Department, Weber State University, Ogden, Utah, USA

Abstract
Purpose – The purpose of this paper is to shed light on the causes of the 2007-2009 mortgage crisis,
liquidity crisis, stock market volatility in the USA and their spillover effects on the global economy.
Design/methodology/approach – The paper critically reviews the 2007-2009 financial crisis from
both academic and practitioners’ viewpoints.
Findings – The paper explores how the liquidity crisis has evolved with the advent of poorly
supervised financial products, especially the credit default swaps and subprime mortgage loans.
Further, it analyzes the laxity in regulations that encouraged high financial leverages, shadow
banking system and excessive stock market volatility and worsened the recent financial crisis.
Originality/value – The implication of this paper is to understand numerous policy reforms that
will help the global capital markets to be more transparent and less vulnerable to systematic risks; the
suggested policy reforms may also help to prevent such financial calamities in the future.
Keywords United States of America, Financial risk, Credit, Capital markets, Regulation, Stock markets
Paper type Conceptual paper

Today, we are continuing to build on that essential premise: that investors have a right to know
the truth – and the risks – about the securities that trade in our public markets. Never in this
agency’s history has this fundamental mission been more relevant, and more urgent. The
current credit crisis has shown the importance of transparency to a healthy marketplace – and
how costly hidden risk can be (Christopher Cox, Former Chairman of the SEC).

1. Introduction
Since the third quarter of 2007 until recently we were delivered a series of unpleasant
surprise about the USA and global financial markets. News that mostly shocked us are:
bankruptcy protection filed by a number of big home mortgage lenders including
New Century Financial Corporation (largest in the USA) and Northern Rock (largest in
the UK), bankruptcy petition filed by Bear Stearns to bail out two of its hedge funds
and acquisition of Bear Stearns by JP Morgan Chase, nationalization of Fannie Mae
Studies in Economics and Finance
Vol. 27 No. 2, 2010
pp. 110-134 The authors would like to thank the Guest Editor Dr Sabur Mollah, an anonymous referee,
q Emerald Group Publishing Limited
1086-7376
Edward Schunk and seminar participants at SUNY Institute of Technology for helpful
DOI 10.1108/10867371011048616 comments and suggestions. Any remaining errors are the responsibility of the authors.
and Freddie Mac (with portfolios equivalent to 40 percent of the $12-trillion US Financial crisis
mortgage market)[1], liquidation of 158-year old Lehman Brothers (with $700 billion and stock market
pre-bankruptcy petition assets), acquisition of 94-year old Merrill Lynch by Bank of
America, control of American International Group (AIG) by the Federal Reserve Bank volatility
(Fed)[2], and Goldman Sachs and Morgan Stanley becoming bank holding companies.
Volatility in the US stock markets was the highest during September-November
2008[3]. During peak of the financial crisis, Bernard Madoff (former chairman of 111
Nasdaq) was accused of approximately $65 billion fraudulent loss in a Ponzi scheme.
More than 125 US commercial banks, savings banks and thrift institutions with
cumulative assets of approximately half a trillion went bust during 2008-2009[4].
The magnitude (both in terms of number and amount of assets) of bankruptcies during
current financial crisis is far greater than any past evidences. The financial crisis
spilled over from the USA to rest of the world as most of the big US financial
institutions have significant global assets and operations.
History reveals that most of the previous capital market disasters were triggered by
asset price bubbles. The first asset price bubble, known as the Dutch Tulip Bulb Craze,
originated in the Netherlands in early 1630s when people used to pay a fortune for a tulip
bulb; some investors even liquidated their homes at ludicrously low prices to acquire
funds for tulip speculation[5]. Japan experienced land and stock price bubbles during
1989-1990. Total market value of Japanese land was approximately $20 trillion in 1991
(equivalent to 200 percent of world’s equity market and 100 times higher than the US
land prices at that time) and stock value was around $4 trillion (equivalent to 45 percent
of world’s equity market capitalization) (Stone and Ziemba, 1993). The Nikkei 225 index
value dramatically rose from about 10,000 in January 1984 to approximately 39,000 in
January 1990 but declined to approximately 20,000 in October 1990. Between January
1990 and August 1992, the Japanese stock and real estate indexes fell by approximately
65 percent. During the 1997 Asian financial crisis that started in Thailand and spread to
other South-East Asian countries, currencies, stock markets and gross domestic
products (GDP) of most of the affected countries declined by 25-90 percent. A large
number of Asian banks also failed. The Asian crisis spilled over to the US equity
market especially on October 27, 1997, and the Dow, S&P500 and Nasdaq declined by
7.18, 6.87, and 7.16 percent, respectively[6]. The US capital market observed a
technology (or dotcom) bubble in late 1990s. Cooper et al. (2001) show that the dotcom
effect produced average cumulative abnormal returns of 74 percent for ten-days
surrounding the announcement day (i.e. when the firms added.com or.net to their
names). Returns of some dotcom companies were surprisingly as high as 3,000 percent
just within a month of their inception. The dotcom bubble finally busted between
late 1999 and early 2000. Most of the technology companies were wiped out and the
surviving companies lost up to 90 percent of their market capitalization.
Similarly, the rise and fall of the long term capital management (LTCM), one of the
biggest hedge funds, was a shocking financial event of late 1990s. The LTCM looked
for arbitrage opportunities in global market (Lowenstein, 2000). It practiced financial
engineering and dynamic portfolio hedging based on sophisticated asset pricing
models including Black-Scholes’ option pricing model. In a dynamic hedging, LTCM
was required to constantly rebalance its derivative portfolios to make it riskless as the
value of underlying assets fluctuated constantly. But when the price movement was
huge and sudden (as during any crisis), it was difficult to readjust and move portfolio
SEF positions instantly. The LTCM was successful during 1994-1998 and nearly went
27,2 bankrupt in late 1998 when the Russian government defaulted on its international debt.
What factors caused the above bubbles and their subsequent demises? The tulip and
dotcom bubbles appear to be an outcome of irrational and excessive risk taking behavior
of investors (Shiller, 2003). Government sponsored expansionary monetary policies and
financial liberalization are said to be responsible for the land and stock price bubbles in
112 Japan. Academic finance research shows that complex derivatives products are partially
(if not completely) responsible for causing the 1987 stock market crash, the collapse of
LTCM and Barings Bank[7]. Since late 2007 along with the series of abysmal financial
and economic news we observed a great deal of blame game. What factors caused the
recent financial crisis? What are the factors that compounded the crisis? This paper looks
into the causes of the 2007-2009 financial crisis and stock market volatility. Shortcomings
of different rules and regulations of capital markets that might have fostered the crisis
are analyzed carefully. As such, our paper contributes to the literature on understanding
the causes and implications of current financial crisis, and the regulatory reforms that are
necessary to prevent such a crisis in the future.
The remainder of the paper is organized as follows. The following section presents
the theoretical background on liquidity crisis, Section 3 analyzes the causes of current
financial crisis, Section 4 presents different aspects of stock market volatility, Section 5
proposes a number of regulatory reforms. Section 6 concludes our paper.

2. Liquidity crisis: commercial vs investment banks

While causes behind a major financial crisis are not unique, scarcity of cash flows (also
known as “liquidity crisis”, “credit crunch”, etc.) appears to be a common outcome of
any financial crisis (Brunnermeier, 2009). Cash flow shortage may occur due to turmoil
in the banking sector and credit, currency, and debt markets and is intensified by stock
market volatility and systematic declines in macroeconomic variables such as
production, employment, real income, and increases in interest rate spread.
A bank experiences liquidity crisis when its liabilities (i.e. depositors’ accounts,
borrowings, shareholders’ equities, etc.) exceed its assets (i.e. loans, securities, capital
investment, etc.). Commercial banks usually extend loans to the real estate markets and
household consumptions. If banks do not earn the required returns from real estate
loans, liquidity crisis emerges resulting in bankruptcy situation. Similarly, if a large
number of customers unexpectedly withdraw deposits, commercial banks suffer from
cash flow crisis. On the other hand, investment banks invest more aggressively as they
enjoy relaxed regulations and reduced supervisions by the Fed. Investment banks help
firms to go to public, underwrite securities and raise money through initial public
offerings. If the values of equities, financial instruments, securities received as
collateral, etc. decline, or any of its investments fails, investment banks end up with
more liabilities than assets resulting in liquidity crisis.
Liquidity crisis is more likely to occur when banks rely on short-term debt to
finance long-term investments (i.e. when maturities of their liabilities are shorter than
assets). Faced with liquidity crisis, banks find it difficult to raise capital; creditors
begin to withdraw money fearing further insolvency in near future. As such, crisis
intensifies and may lead to bankruptcy. This is one of the major reasons why banks
prefer to use “securitization” to raise long-term funds for mortgage loans (elaborated in
next section).
3. Causes of current crisis: digging deeper Financial crisis
Financial illiteracy and greed of the homeowners who bought houses that they could and stock market
not afford, greed of Wall Street investment bankers who took excessive risk,
innovation of complex and inadequately regulated securities as well as laxity of volatility
financial regulation that encouraged superfluous risk taking behavior are generally
blamed for causing the recent financial crisis. Zandi (2008) documents that 27 percent
(42 percent) of homeowners with (without) college education did not understand 113
various features of their adjustable rate mortgages (ARMs) loans. Boeri and Guiso
(2008) document that financial literacy was very low among the subprime mortgage
borrowers and approximately one-third of the borrowers do not know how to measure
compound interest and half of them do not understand the effect of inflation on their
mortgages.
Lack of households’ financial literacy might have intensified the problems in
subprime mortgage loan market; however, it is natural to wonder what made credit so
easily accessible and caused subprime crisis. How did a crisis in relatively small
subprime mortgage sector impair the entire financial sector? Were there some inherent
flaws in the mechanism within the financial system that caused crisis to escalate
beyond subprime loans? Greed and the tendency to take excessive risk have rather
been a constant factor in the financial market – they prevail in good times, in times of
turmoil and especially during bubbles[8]. Often times risk taking behavior is an
outcome of indulgent regulations. To investigate the “cause” of current crisis we look
into the factors that have recently changed in the financial market. In recent years the
US financial market has experienced widespread liberalization, long regime of cheap
credit, innovation of complex derivatives securities and also massive changes in
regulations (Crotty, 2009; Reinhart and Rogoff, 2008). We explore below whether and
how these changes might have contributed to the financial crisis of 2007-2009.

3.1 Financial innovation, emergence of subprime loans and housing bubble

The Fed reduced broader interest rates immediately after the dotcom crisis and
9/11 disaster. Federal funds rate was reduced from 6.5 percent in May 2000 to
1.75 percent in December 2001 and ultimately to 1 percent in late 2004 to boost the
troubled economy. At low interest rates credit became cheaper and was extended to
people even with sub-standard and troubled credit history with poor credit rating
(i.e. subprime loan)[9]. While the reduced interest rate stimulated investment,
employment, output and consumer spending, it also encouraged risk-taking behavior
of banks and other financial institutions (Allen and Gale, 2007; Bernanke and Blinder,
1992; Kashyap and Stein, 2000). The “credit boom” created by low interest rates during
2001-2004 was accentuated by some financial innovations that took place in recent
times. Wide varieties of mortgage-backed securities (MBS) and residential
mortgage-backed securities (RMBS) were developed in last few decades and more
than 50 percent of mortgages were securitized (Bhattacharya et al., 2001). Since there is a
mismatch between duration of assets (i.e. loans) and liabilities (i.e. deposits) in banks,
mortgage loans are converted to a financial security – which is known as securitization
of mortgages.
The Federal National Mortgage Association (Fannie Mae), Government National
Mortgage Association (Ginnie Mae) and Federal Home Loan Mortgage Corporation
(Freddie Mac) were established in 1938, 1968, and 1970, respectively, to buy mortgage
SEF loans from banks and sell MBS written on those loans to domestic as well as foreign
27,2 investors. The purpose of creating and distributing MBS in the secondary market is to
reduce the probability of default and spread risks and increase diversification. It also
reduces the probability of down payment and other servicing fees. MBS are also sliced
and diced into different degrees of risk classes (prime vs subprime) and maturities[10].
Presumably, MBS written on subprime loans bear higher interest rates and risks with
114 fragile documentation (infamously known as liar loans). Many of these subprime
mortgage loans were created without any or little supervisions (Gramlich, 2007;
Krinsman, 2007). Lenders were able to convince the borrowers that investing in housing
was a foolproof investment. Gresham’s law worked perfectly in mortgage markets and
bad lenders began to drive good lenders out of market. To entice borrowers, mortgage
lenders came up with a variety of subprime loans instruments such as teaser rate
(an initial rate under ARMs which is usually lower than the current market rate), no
income, no job, and assets loan, 40-year fully amortized mortgage loan (which replaced
standard 30-years loan) subject to balloon payments after 30-years; 2/38 ARMs loan
(fixed mortgage rate for the first two years and adjustable for the remaining 38 years),
3/37 ARMs loan, reduced doc loan (less than full documentation), split doc loan
(for co-borrowers) and no doc subprime loan, closed-end second lien mortgage loan
(secured by a second priority mortgage lien on a residential real estate), Piggyback
loan (a kind of second lien loan and alternative to private mortgage insurance to avoid
down payment) among many others. Muni and Kothari (2006) report that the proportion
of full documentation loans (which require pay stubs, W2 forms, tax returns, bank
statements, verification of employment and assets, etc.) declined from 81 percent in 2002
to 69 percent in 2005 for fixed loans and from 72 percent to 55 percent for ARMs loans.
During 2001-2004 employment in mortgage banking and brokerage increased
significantly; wholesalers and brokers were encouraged and paid several hundred
thousand dollars for selling mortgage loans. Ip et al. (2008) report that income and/or
assets of numerous mortgage lenders increased by threefolds due to issuance of
subprime loans. The magnitude of subprime mortgages increased from $35 billion in
1994 to approximately $100 billion in 2001, $700 billion in 2006, $1 trillion in USA and
$1.5 trillion globally in 2007. The number of subprime mortgage loans issued in the
USA also increased from approximately half a million to more than four million during
2001-2005.
Real estate loans in commercial banks almost doubled during 2000-2006 ($1.5 trillion
vs $3 trillion). The outstanding MBS increased from approximately $2 trillion in 2000 to
$4 trillion in 2007. Out of a $12 trillion US real estate market, $7 trillion loans are
securitized as MBS. Different real estate indexes show that house prices on average
increased by more than 125 percent during 2000-2006[11]. The house price inflation was
caused by an artificial increase in demand for housing, which in addition to easy and
cheap credit was crafted by brokers and wholesalers. Reinhart and Rogoff (2008)
document a significant run-up in house-prices in the USA and other developed countries
mostly because of cheaper credit policy world wide. However, house prices began to
decline and return to their fundamental value as the artificial bubble started
disappearing in late 2006[12]. On the other hand, an economic boom fostered by reduced
interest rate started increasing inflation. To combat inflation the Fed began to increase
interest rates; the federal funds rate increased from approximately 1 percent in late 2004
to more than 5 percent in mid-2007 (source: http://research.stlouisfed.org/fred2/ ).
Homeowners particularly the subprime borrowers started feeling difficulty to pay off Financial crisis
their mortgages. and stock market
The collateral value of mortgage started declining along with the declining house
prices. As such, lenders were forced to withdraw credit or ask borrowers to put volatility
more collaterals or down payments. These along with high interest rate reduced home
affordability and increased default in home loans and foreclosures. Numerous lenders
offered modifications of mortgage loans to avoid foreclosures. These include a 115
reduction in mortgage interest rate, principal amount owed, and past due amount
and/or conversion of ARMs loans to fixed rate mortgages loans, extension of terms and
maturities of amortized mortgaged loans. However, Grow et al. (2009) allege that
window dressing was very common in modified mortgage loans. Mian and Sufi (2009)
show that the recent mortgage defaults are predominantly found in subprime zip codes
(where growth in income and mortgage credit was negatively correlated during
2002-2005) or zip codes with significantly larger share of subprime borrowers. They
also find strong correlations between subprime mortgage securitization and expansion
in mortgage credit to subprime zip codes. Moreover, negative correlation between
relative (and in some cases absolute) income and mortgage credit was found only in
these three years out of last 18 years. They argue that the low interest rate during
2001-2004 partly explains the mortgage credit expansion; mortgage credit expansion
was also fostered by greater risk diversification, government subsidies in mortgage
related products and moral hazard associated with securitization. Berndt and Gupta
(2009), Demyanyk and van Hemert (2010), and Keys et al. (2010) also document that the
quality of credit declined significantly after 2000 due to excessive securitization of
loans. The financial sector is hard-hit by mortgage meltdown because most of the
collateralized securities and complex derivatives based on mortgage loans are issued
by financial institutions especially banks and insurance companies.

3.2 Capital market regulations and executive compensations

The factor that changed most in the financial sector over the last decade is regulation.
Housing bubble certainly is one of the causes of the financial crisis; however, regulatory
policies that encouraged speculation and excessive risk taking behavior helped creating
the bubble. The Community Reinvestment Act of 1977 encouraged commercial banks
and savings associations to extend loans and increase home ownerships. Likewise, the
American Dream Down Payment Act of 2003 allowed $200 million annually as down
payment assistance to low-income people and increased the loan-limit for first-time
home buyers. The internal revenue service offered several tax incentives and credits to
first time home buyers. All of these regulatory initiatives were intended to support the
low-income households but encouraged financial institutions to extend risky and
insecure mortgage loans to people with less credit worthiness.
A major change in regulation was replacement of the Glass-Steagall Act of 1933 by
the Gramm-Leach-Bliley (GLB) Act of 1999. The Glass-Steagall Act, passed following
the great depression, legally separated commercial and investment banking activities
and prohibited banks from serving as insurance firms. The GLB act, on the other hand,
allowed banks to offer commercial and investment banking and insurance services
under a Financial Services Holding Company which created a gigantic and complex
financial supermarket. The consequence of this act is when trouble develops in one
part of a firm’s operation it spills over to all other entities to which the firm is connected
SEF through credits, insurance deals, deposits, derivatives, and other complicated financial
27,2 arrangements. The GLB act also reduced the Fed’s control on investment banks and
implicitly allowed investment banks to undertake additional risks.
The Commodity Futures Modernization Act of 2000 (replaced the Shad-Johnson
jurisdictional accord) allowed single-stock futures contract and deregulated numerous
over-the-counter (OTC) derivatives including swaps. In 2004, Basel II accord proposed
116 international standards for bank capital management in order to mitigate
concentration risk, credit risk, financial risk, legal risk, liquidity risk, market risk,
operational risk, pension risk, reputation risk, strategic risk, systematic risk, and
arbitrage opportunities. Basel II is based on three pillars: minimum capital adequacy
ratio; supervisory review process for regulators; and enhanced disclosures for greater
market discipline and stability (source: www.bis.org). Most importantly, Basel II
requires a globally active bank to hold at least 8 percent capital of its outstanding
loans. Unfortunately, Basel II has not successfully been implemented either in the USA
or many other developed and emerging markets[13]. Academicians as well as
practitioners contend that appropriate implementation of Basel II accord could have
prevented the financial crisis at least partially (Brunnermeier, 2009; Goodhart, 2008;
Cannata and Quagliariello, 2009).
The Securities and Exchange Commission (SEC) allowed hedge funds to be self
regulated, and there was no federal restriction on the amount hedge funds could
borrow; these might have fostered excessive risk taking behavior by the hedge funds.
Assets and capital of banks, insurance companies and corporations were wiped out
following mark-to-mark accounting rule[14]. Ryan (2009) argues that there is a
“negative” feedback effect associated with mark-to-market rule because asset value of
a firm that reports unrealized losses further suffers in the market which increases the
overall risk of that firm.
Executive compensation revealed during the crisis was astonishing. It is argued
that the compensation structure of executives, which was not aligned with performance,
encouraged excessive risk taking behavior. According to a several Wall Street Journal
reports (Soloman and Meckler, 2009; Lucchetti et al., 2009) and Forbes web site,
executives’ compensations in 2007 for Goldman Sachs, Morgan Stanley, Citigroup,
Bank of America, and J.P. Morgan Chase were $68.5, $8,00,000, $5,74,000, $24.8, and
$27.8 million, respectively. These companies received $10, $10, $45, $45, and $25 billion,
respectively, as troubled asset relief program (TARP) fund from the US government.
AIG also paid bonuses to its executives and employees during 2008-2009 even though it
is bailed out by taxpayers.

3.3 Growth of credit default swaps

Credit default swaps (CDS) are insurance for debt-securities. CDS are unregulated
securities with no central clearing house, privately negotiated between buyers and
sellers, and dominated by major global dealers with limited public disclosures. CDS were
challenged with serious adverse selection and moral hazard problems as they were
brought into the market without adequate regulatory supervision; the monitoring and
transactions costs associated with CDS trades were also high. Bond holders buy CDS to
protect themselves from credit losses in case the original issuers of bonds are in default.
Buyers of CDS regularly pay a premium to the CDS issuers who promise to pay if the
original bond issuers are in default or file for bankruptcy protection (i.e. hedging risk).
The premium varies according to credit rating of underlying debt or other floating Financial crisis
events such as shortfall in interest or principal. Unlike traditional buyers of insurances and stock market
where you insure goods that you own, buyers of CDS do not require to hold underlying
debts on which CDS are written (i.e. speculation or bet on a firm). Since CDS are OTC volatility
instruments, the market is not as liquid as an organized equity market. As such the
efficient market theory may not apply to the CDS, i.e. prices of these instruments are
not discovered fairly. Moreover, contractual disputes between buyers and sellers 117
may exist[15].
Each party in a CDS transaction is exposed to a counterparty risk caused by failure
of the counterparty to comply with its contractual obligation. Suppose you buy a bond
issued by general motors (GM). As insurance, you can also buy CDS written on GM’s
bond by a third (counter) party, say AIG. The counterparty (i.e. AIG) insures you
against default in GM’s bond. You pay a fraction of the total bond cost as premium to
the CDS issuer. The premium is inversely related to bond rating, i.e. if the rating is
higher (lower), the premium is lower (higher). If GM defaults, the question is whether
AIG is capable of paying you to compensate your loss. Thus, by buying CDS, you enter
into a counter party risk. CDS-holders may ask CDS-writers for additional collaterals if
the value of underlying debt securities declines. Similarly, if the credit rating of
underlying debt securities declines, CDS issuers (in this case, AIG) may be in trouble.
Moreover, if the market value of bond declines, issuers of CDS also have to take
write-downs. Thus, operational and liquidity risks may also increase with an increase
in the size of CDS market.
Since early 2000, investment in risky projects (e.g. subprime loans) increased
dramatically. The demand for CDS also increased mainly for two reasons: first, investors
wanted to hedge and second, there was a speculation that the risky investments may
default. In addition, less regulatory oversight on CDS markets attracted investors
towards buying CDS. CDS were written not only on subprime mortgages but also on
auto loans, credit cards, accounts receivables, student loans, etc. The market for CDS
was $900 billion in 2000 and grew to approximately ten trillion in 2005, $45 trillion in
mid-2007, and $62 trillion in late 2007 (which is twice the size of US stock market,
ten times higher than the US corporate debt market, three times the size of US GDP,
and twice the size of combined GDP of the USA, Japan, and EU) and reduced to
$54 trillion in June 2008[16]. Portfolios of CDS in different sectors including financials,
housing, automobiles, industrial, energy, consumer staples became popular during
2007-2008 both in the USA and Europe[17]. Numerous investment banks, corporations,
insurance firms, institutional investors, portfolio managers of mutual, retirement and
hedge funds, and other financial institutions used CDS to bet on a company’s fate. Illegal
insider trading using CDS was also revealed. Contrary to the buy side, many firms also
sold CDS to garner premiums on speculation that the probability of default for
underlying bonds on which CDS are written is low.
Owing to increased default in borrowers’ payment, numerous CDS written on
subprime MBS turned sour during the early stage of recent financial crisis. Bear
Stearns, AIG, Lehman Brothers, Morgan Stanley, Merrill Lynch, Goldman Sachs, etc.
were buyers (i.e. hedged or speculated) and sellers (i.e. acted as counterparties) of CDS
and linked to many commercial banks, corporations, insurance companies, hedge
funds, and institutional investors in CDS markets. Bear Stearns alone was responsible
for issuance of about $3 trillion CDS and all of these guarantees became worthless
SEF when Bear Stearns was bankrupted. Under such circumstances, corporations like GM
27,2 or international business machines (IBM) (even though they were not directly involved
in this process) were also hurt because insurance policies written on bonds of GM or
IBM were reduced to $0. Similarly, bankruptcy filings by Bear Stearns and Lehman
Brothers forced other banks, financial institutions, and insurance companies (who had
written CDS on bonds of these two investment banks) to pay buyers of these CDS.
118 Besides, counterparties of Bear Stearns and Lehman Brothers needed to re-hedge their
positions with other firms.
Goldstein and Henry (2008) report that Lehman Brothers had almost one million
derivatives deal with 8,000 firms during 2003-2008. Morgan Stanley had $7.1 trillion
derivatives contacts when it was bankrupted in September 2008. AIG sold more
than $500 billion worth of CDS insurances written on debt securities including
subprime mortgages. AIG had to pay buyers of CDS as several of the underlying debts
were in default. AIG was also exposed to counterparty risks as the value of its
underlying debt securities declined or ratings were downgraded (including AIG’s own
credit rating). Ng and Rappaport (2008) report that according to Depository Trust and
Clearing Corporation data, Morgan Stanley, Merrill Lynch and Goldman Sachs were
among the top ten debt issuers in terms of CDS. Moreover, investors around the globe
use CDS either to hedge or bet on their exposures to not only corporate bonds but also
sovereign bonds issued by Brazil, Italy, Russia, Turkey, and other emerging countries.

3.4 Flawed financial models and credit rating

Financial risk models of the institutions that used CDS were based on huge
data-intensive and computer-driven techniques and sophisticated mathematics (such
as Ito’s calculus, a form of stochastic calculus used by rocket scientists to monitor the
projectile of a rocket). These risk-models were based on historical data, assumed
normal economic conditions but overlooked the possibilities of future write-downs,
collateral damages or crises; as such, the risk models were not appropriate to use for
hedging. Danielsson (2008) argues that models in social and behavioral sciences are
fundamentally different from those of basic sciences. Quick responses of the market
participants which happen especially in a volatile market, as observed in 2008, change
the underlying statistical properties of models in economics and finance. As such,
financial models may not provide accurate outcomes as forecasted. Mollenkamp et al.
(2008) argue that according to Wall Street Journal Market Data Group Staff Reports
stock prices of Merrill Lynch, AIG, and Lehman Brothers lost more than 70 percent,
80 percent, and 90 percent, respectively, in 2008 mostly due to collateral damages from
CDS. This evidences that the models these institutions used either could not predict
future write-downs or inaccurately assessed future collateral damages. Further, they
report that AIG had to post $16.5 billion as collateral (1/3 rd of which was called by
Goldman Sachs alone) on CDS written between August 2007 and August 2008.
AIG had to borrow and increase its financial leverage significantly to put up collateral.
The spiral effect continued further as credit rating agencies, Moody’s, S&P, and Fitch
downgraded AIG’s rating. As such, AIG had to write-off its assets worth of billions
of dollars. This is why CDS were notoriously known as greed index during current
financial crisis.
Investors, banks, insurance companies and broker-dealers traded debt securities
based on the rating provided by rating agencies. However, credit rating agencies
apparently had assigned incorrect ratings to different debt securities and firms. Financial crisis
They used flawed models, inappropriate assumptions and inadequate historical data and stock market
for companies with complex subprime debts and derivative securities. These agencies
were also unable to identify the underlying quality and value of individual loans volatility
(including complex subprime debts and derivatives written on these) which were
pooled to create collateral debt securities. Most of the MBS, RMBS, collateralized debt
obligations (CDOs), and CDS written on these were mistakenly considered less risky 119
and more diversified (because these are pooled assets sliced, diced and repackaged
several times but backed by intermediary and sub-standard collaterals) and rated
either “AA” or “AAA” by rating agencies. Many MBS with AAA rating continued to
earn a few hundred basis points or bps (where 1 percent ¼ 100 bps) higher than an
AAA-rated corporate bond – this is inconsistent with the finance theory which
suggests that securities with similar ratings should earn approximately identical
returns. Credit rating agencies use “issuer pays” business model where bond issuers
pays rating agencies to rate their debt securities. Theoretically, issuers pays’ model
suffers from both adverse selection and moral hazard problems. It is also alleged that
rating agencies were paid by the subprime mortgage loans’ issuers to favorably rate
their securities. Portes (2008) documents an upward bias in rating subprime MBS
which is caused by artificially increased house prices. Portes also argues that the
underlying assumptions behind rating complex structured financial instruments might
not have worked as actual correlation risk might be higher during an economic chaos
than estimated by models’ parameters. In general, it is apparent that investors were
misguided by ratings provided by the rating agencies.

3.5 High financial leverage and bank run

Since the beginning of 2000, leverage ratios for many commercial and investment
banks, insurance companies and financial institutions started increasing[18].
A leverage ratio of 30 implies that with an original $1 billion capital, if the value of
a bank’s portfolio declines by 3.5 percent (i.e. $1.05 billion ¼ $30b *0.035) of its capital,
it will lose its original $1 billion capital and face bankruptcy. The problem further
accentuates if the equity value declines. For many financial institutions, the leverage
ratio was high especially during 2004-2008 for two reasons. First, these institutions
borrowed short-term debt (mostly by issuing commercial papers) to put collateral on
CDS they had written[19]. Second, their equity and asset values declined. Since
borrowers started defaulting on their subprime loans, banks, and insurance companies
had to write down credit losses as early as from January 2007 and bad assets piled up
in their balance sheets[20]. The total write down for bad credit is estimated to be more
than $1 trillion world wide during 2007-2008.
Mutual funds also used financial leverage during 2005-2008. Anand (2009) reports
that mutual funds that used a 130/30 strategy (i.e. for every $100 invested they
borrowed $30 worth of stocks to sell short and raised gross investment to $130)
suffered more than the loss of general market indexes. The federal law allows mutual
funds to borrow up to one-third of their assets; however, hedge funds do not have such
a restriction. Moreover, hedge funds are mostly self-regulated and required to have less
disclosures than mutual funds or exchange traded funds (ETFs). Both hedge funds
and funds of hedge funds (i.e. portfolios with shares in numerous hedge funds)
increased significantly with extremely high leverage and excessive risk-taking
SEF activities and spread their risks in speculative investments such as subprime MBS and
27,2 CDS written on these. When credit crunch was in its peak during the third quarter of
2008, banks asked for higher servicing fees and either additional collaterals or higher
insurance premiums on loans they had extended to mutual and hedge funds, naturally,
it put pressure on funds to sell their portfolios. As a result, portfolio managers of these
funds had to dump securities that they were holding and excess sales reduced prices of
120 these securities. The contagion effect also diluted values of individual stocks and
bonds as well as portfolios of retirement and pension funds.
Owing to the high leverage ratio, credit ratings of many banks deteriorated and
toxic assets were accumulating. Fearing bankruptcy, depositors, and investors began
to withdraw money from banks. This resulted in a bank run during 2007-2008 (Gorton,
2009). Both commercial and investment banks were forced to sell assets to meet
depositors’ demand. These toxic assets were naturally sold at low prices. As such,
numerous banks including Merrill Lynch had to abandon their assets at fire-sale prices
and opted for bankruptcy protection.

4. Stock market volatility

Stock markets in the USA as well as many foreign countries were highly volatile
during 2007-2008. The Chicago Board Options Exchange (CBOE) Volatility Index
(VIX) (known as fear index) which is used as a benchmark to measure overall stock
market volatility was the highest on September 30, 2008 since its inception[21]. Most of
the major indexes in US stock market declined by 40 percent on average in 2008.
The Dow Jones Industrial Average index, S&P500, Nasdaq and Russell 2000 dropped
by approximately 32.7, 37.6, 39.6, and 33.7 percent, respectively, in 2008. During the
most volatile five-days (1st week of October) of 2008 Dow, S&P500, and Nasdaq
declined by approximately 13, 15, 16 percent, respectively. Stock markets of Argentina,
Austria, Croatia, Estonia, Greece, Hungary, India, Indonesia, Ireland, Lithuania,
Luxembourg, The Netherland, Peru, Serbia, Slovenia, Turkey, UAE, Vietnam, etc. lost
more than 50 percent of their values and Bulgaria, China, Iceland, Romania, Russia,
Ukraine’s market lost more than 75 percent of their values.
What factors contributed to stock market volatility during 2007-2008? Economic
news, flows of information, corporate and accounting data, changes in regulations, etc.
are major driving forces in stock market volatility (Campbell and Ammer, 1993;
Chen et al., 1986; Pearce and Roley, 1985; Schwert, 1989). News about a possible
mortgage meltdown, which was in the air since mid-2006, might have played a role in
causing the enormous volatility. However, causes of volatility go far beyond only this
news. In recent years, introduction of sophisticated electronic technology in the stock
market outpaced many regulations that prevailed when the exchange predominantly
followed an open outcry system. Technology has become the game planner for market
variations in liquidity and volatility. Brokers and dealers revealed that in recent years
they used to receive several thousands of messages per second especially in the first and
last 30 minutes of a normal trading day which used to be less than 50 a decade ago[22].
This message tracker was more than doubled in October 2008, the most volatile month of
recent financial crisis, compared to any other normal trading months of 2007-2008.
Brokers-dealers used to receive tremendous amount of information from their clients
and also around 300 orders per second on average especially during September-October
2008. Clients used to switch their positions almost every two seconds. Further they argue
that huge redemptions by portfolio managers and “dark pool liquidity” (institutional Financial crisis
order flows, usually in block trades, but not available to the pubic) are partially and stock market
responsible for high stock market volatility.
A recent document filed in New York State Court reports that bankers, brokers, volatility
dealers and traders involved in CDS trading used text messaging to share private
information about a firm’s interventions and positions before actual trades (http://
compliancex.typepad.com/compliancex/2008/11/spotlight-shine.html). Many hedge 121
funds, in addition to using CDS to hedge their portfolios (or bet against a company),
sold short financial stocks. While these actions by the hedge funds helped them to
make profit from a target company’s diminishing financial performance and value,
they created a downward pressure on the stock prices of numerous companies and
contributed to high volatility. Leveraged investors were also forced to sell their stock
holdings unfavorably if short sellers used stop-loss orders, margin calls, etc. diluting
returns for all investors. During the third quarter of 2008, many hedge funds short-sold
stocks of financial and insurance companies including stocks of Lehman Brothers,
AIG, Citi Bank, Merrill Lynch, Morgan Stanley, etc. Then, hedge funds also bought
CDS written on these financial and insurance companies. As the demand for CDS
increased, the value (i.e. premium) of CDS increased sending a negative signal to
investors about riskiness of the underlying assets. Panicked investors began to throw
away stocks of these financial and insurance companies diminishing their prices.
As their stock prices began to fall, portfolio managers made profit from their short-sale
position. It is also alleged that numerous hedge funds managed to collect private
information and data from analysts of different firms and made bets that the stock
price of those companies would decline (Strasburg and Bray, 2009). McGinty and
Scannell (2009) report that there had been several lawsuits filed against different hedge
funds including SAC Capital Advisors, Third Point Limited Liability Company,
Kynikos Associates LP as they paid analysts to get hold of private reports and data
and traded on those information.
Restriction on short-selling, elimination of the uptick rule, and allowing naked
short-selling also contributed to the higher stock market volatility. Short-selling is a
trading mechanism that allows broker-dealers and investors to sell shares of stocks by
borrowing now (i.e. selling stocks that they do not own) and profit if the share price
declines in future as they can buy it back at lower prices. The uptick rule of
short-selling allows traders to short sell a stock only after price of that stock moves up
(i.e. uptick) from its immediate previous trade. The uptick rule was implemented under
rule 10a-1 of 1934 Securities Exchange Act with the objective to make short selling
more expensive by limiting the ability of short sellers to manipulate and drive the stock
price down especially during turbulent periods. The uptick rule was abolished on
July 6, 2007 in order to increase market liquidity and accurate stock price discovery[23].
In absence of the uptick rule, during 2007-2008 short sellers were able to bet heavily
especially on financial stocks, and drove their prices down (even by ten-25 percent in a
single day especially during the last quarter of 2008).
Instead of restoring the uptick rule fully, the SEC surprisingly imposed temporary
ban on short selling in September 2008 on some stocks if their prices go below a
threshold level[24]. The SEC asked large institutional money managers to publicly
disclose their short positions on almost 1,000 financial companies’ stocks and
derivatives written on these stocks within a week. Broker-dealers were also asked
SEF to physically deliver short-sold stocks within three days of an actual trade. Further, the
27,2 SEC imposed restrictions on naked short-selling (selling stocks without actual
borrowing) on July 15, 2008[25]. Since stocks are actually not borrowed, naked short
selling theoretically creates an excess supply of a particular stock and reduces its price.
The ban on short-selling was not well received by many brokers and dealers. It was
argued that short-selling is necessary to prevent artificial bubbles in asset prices.
122 As most of the trading and hedging strategies were based on short-selling, when it was
banned, liquidity dried up; volatility and spread increased significantly. It was also
argued that public disclosures of a short-sold stock might put more pressures on a
particular stock leading to further decline in price as individual investors might get
panicked assuming that the stock is targeted by certain brokers-dealers or hedge
funds. However, Brunnermeier (2008) argues in favor of short selling prohibition
during a crisis especially for stocks with serious maturity mismatch.

5. Regulatory reforms: some proposals

As pointed out in Section 3, expansionary monetary policy as well as loopholes in some
capital market regulations contributed to the recent financial crisis. The 2007-2009
financial crisis suggests that extensive regulatory fix is warranted to heal the troubled
banking sector and supervise the financial institutions so that systematic risk is
reduced and long-term stability of global capital markets is restored.
Recently, the federal and state authorities are investigating the mortgage messes
and financial fraud and manipulation through civil and criminal lawsuits (Grant,
2008)[26]. The Federal Bureau of Investigation is currently scrutinizing more than
25 big firms that include top investment banks. It is important that regulators
scrutinize mortgage loans and their risk exposures and bring structural changes in
federal-sponsored enterprises (e.g. Fannie Mae), banks and other financial institutions
that brought mortgage products to consumers and households. Strict regulations and
consolidated investors and consumers’ protection rules for risky lending products
should be implemented by the Fed, Federal Deposit Insurance Corporation (FDIC),
Federal Trade Commission (FTC), and relevant state regulators. To reduce global
systematic risk, these rules should be coordinated with foreign regulators for risky
lending products especially with huge global exposures.
The Fed should fully implement the capital adequacy requirement as proposed
under Basel II accord. For example, it is important that capital and liquidity levels and
requirements in the banking sector are kept fixed irrespective of business cycle. Basel II
can be modified to reduce adverse selection and moral hazard problems in global
capital flight which will eventually diminish the level of capital risk and restrict
shadow banking activities (e.g. off-balance sheet items). In addition, new and tougher
regulations with respect to auditing banks should be enacted. The liquidity
management of commercial banks and other related financial institutions should be
brought under tight scrutiny of the Fed. Similarly, the SEC should strictly supervise
investment banks’ risk and liquidity management units. All of these proposed changes
are expected to increase accountability and discourage excessive risk taking behavior
by financial institutions.
Brunnermeier et al. (2009) argue that the current regulatory system is based on flawed
assumption that a secured individual bank will make the overall financial system safe.
This is partly because actions taken by an individual bank especially during crisis may
impose negative externalities and undermine overall financial stability. They propose Financial crisis
global coordination in micro (or bank) and macro (or system-wide) levels regulations and stock market
which should be accomplished by separate institutions (e.g. financial services
authorities and central banks, respectively). volatility
One of the crucial lessons of the 2007-2009 financial crisis is that any financial
institutions that played important roles in the financial system and engaged in hedging
or speculating should be regulated and is subject to strict public scrutiny. In retrospect, 123
self-regulation of hedge funds was a flawed decision of the SEC. We argue that more
transparency, accountability and SEC’s authority are required for hedge funds, ETFs,
CDS, insurance products, financial derivatives, and private equities. The SEC’s close
oversights on hedge funds, especially on their cash inflows and outflows, type and
settlement of each transaction, etc. are essential. Hedge funds, venture capital, as well
as private equity firms should be registered with the SEC; the SEC should monitor
these institutions’ record keeping, reporting, income and balance sheet disclosures,
off-balance sheet items, redemption size, leverage, and liquidity levels. The SEC’s
supervision of the above will help to reduce systematic risk exposures and shadow
banking activities of hedge funds, venture capital and private equity firms.
Since money market mutual fund was either targeted by predators or suffered
adversely during the current crisis, it requires regulatory protections from the government
as numerous retirement plans and pension funds are aligned to it. Similarly, ETFs are
created by authorized participants and taken to markets without any underwriters
suggesting lack of accountability and transparency. Since short-selling ETFs even on a
downtick pose a risk to stock market volatility, ETFs must frequently disclose (at least
once a day) the weights and returns of their underlying assets. Naked short-selling (either
of stocks or ETFs) must be considered illegal unless the short-sold stocks actually are
delivered within the settlement period (usually three-days)[27]. However, short-selling
privileges should be continued as short-sellers provide liquidity and make the market with
different trading strategies[28]. The SEC can consider reinstating the uptick rule of short
selling with some restrictions (such as limited circuit breaker for certain stocks).
Transactions of complex derivatives securities including CDS and other off-balance
sheet derivatives items should be reported and disclosed in details (with information about
the nature of underlying assets, settlement sizes, volume, and market capitalization) to the
SEC within two days following their trades. This should be in line with public disclosure
requirements of insider trades under the Sarbanes-Oxley Act of 2002. The SEC should
consider creating a special entity of risk regulator who will routinely monitor complex
financial derivatives[29]. Moreover, regulated and centralized clearing houses (like
New York Stock Exchange and CBOE) with electronic trading facilities are needed for
payments, settlement of prices and volume, and monitoring collaterals and margin
requirements of all counterparties involved in CDS-like complex derivatives transactions.
Central clearing house makes the transactions of CDS more visible with greater
transparency and liquidity and also reduces counterparty risks. Smaller OTC derivatives
should also have a clearinghouse like Nasdaq. Traders and brokers of CDS should also
be subject to reporting requirements and book-keeping each transaction. CDS must be
bought by those who essentially own underlying debt on which CDS are written; this will
discourage any speculation and arbitrage trades. The International Swaps and
Derivatives Associations should introduce standardized contract rules for CDS to
increase its global transparency and reduce risks.
SEF Proponents of international common accounting standards argue that introducing a
27,2 single set of globally accepted accounting standards and principles across the borders
will reduce probability of future financial crisis. The SEC is currently working on the
International Financial Reporting Standards (IFRS) and all US companies must comply
with the proposed IFRS by 2014. Broader interpretations are required to minimize
ambiguities between the IFRS and its counterpart US Financial Accounting Standards
124 Board (FASB). Mark-to-market accounting rule and pricing illiquid, idiosyncratic and
intangible assets are challenging (as there might be trading halt, infrequent trading,
market instability, liquidity crisis, positive, or negative feedback loop) and should be
under scrutiny[30]. The FASB and SEC should reevaluate mark-to-market accounting
standards to ensure fair values of illiquid and infrequently traded assets and CDS-like
derivatives. In this regard, the SEC and FASB should also share information with the
International Accounting Standards Board to ensure that there is a global coordination
in revising mark-to-market accounting rule.
We argue that the SEC should regulate the Nationally Recognized Statistical Rating
Organizations or credit rating agencies. To reduce conflict of interests between bond
issuers and rating agencies, the objective of rating agencies should only be limited in
selling rating and not rent-seeking. In addition, investors, and not the issuers, should
pay for ratings of financial securities and bear the consequences of risks associated with
ratings. This will reduce rating agencies’ incentive to rate the securities falsely higher.
In this regard, the SEC recently has judiciously proposed some rules and restrictions, to
be implemented from mid-2009. These rules include conflicts of interest prohibitions,
submission of financial reports to the SEC, record keeping requirements and public
disclosures of all trading criteria used by the rating agencies. When these rules are
implemented rating firms can no longer rate debt that they helped to structure; rating
analysts will not be able to participate in fee negotiations or receive gifts and/or
entertainment worth more than $25; issuer-paid rating firms will be required to publicly
disclose a sample of 10 percent of their ratings on their web sites within six-months,
disclose ratings irrespective of upgrade, downgrade, or default for each asset class
within a year after the ratings are made, keep records of complaints against analysts or
when bond rating by an analyst differs from rating implied by a quantitative rating
model, offer more documentation and record for each input used in quantitative models;
and employees of rating agencies will be prohibited to trade securities of firms they rate.
All the above are expected to increase transparency and accountability of the rating
agencies (SEC, 2008). To reduce the conflict of interest associated with “issuer pays”
model, Richardson and White (2009) also propose an alternative method: the SEC may
create a centralized clearing platform for rating agencies where enhanced competition
will determine a particular rating agency to rate a particular debt. They also propose an
“advertiser pays” model which is a blend between “issuer pays” and “investor pays”
model. They argue that the “advertiser pays” model is a two-sided market, like the
newspaper where it collects fees from both the advertisers and readers. The advertiser
pays model may mitigate the “conflict of interest” associated with “issuer pays” model
and “free rider problem” associated with “investor pays” model.
As stock market volatility adversely affects investors’ confidence, as such the
economy, the SEC should constantly work on avoiding excessive volatility. To keep
volatility within limit, the SEC should have more interactions with the industry people
(at least once in each quarter), and consider revising current financial regulations,
e.g. leverage buyouts (especially when a public company is taken to private), corporate Financial crisis
stock buy-back, necessary skill, training and educations on risk management for and stock market
employees of financial institutions involved especially in derivatives and hedging
(new tools and courses on financial risk managements can be offered in business volatility
schools), transparencies in corporate governances especially risk management
practices of commercial and investment banks and insurance firms.
One major area that must be paid attention to is the compensation of CEO and other 125
employees. A compensation structure should be in place that rewards good (and
long-term) performance and discourages “greed” and/or excessive risk taking
tendency. The US Congress has recently imposed 90 percent surtax (which will be
equally shared by both employees and employers) to recoup some of the disputed
bonuses paid by AIG or other banks and financial institutions that received more than
$5 billion as TARP money. On February 4, 2009 President Barack Obama imposed
strict regulations on executive compensations and bonuses (performance, incentives, or
retention) of firms that received federal bailout and stimulus money. These include a
$5,00,000 salary cap (and pay structure should be disclosed to the shareholders and be
approved by their non-binding votes) for top executives; no golden parachutes for
executives who were terminated from jobs; limited bonus for executives and bonus can
be taken away if they cheat (such as misleading information); disclosures of luxury
purchase policies such as expenditures on aviation services, office and facility
renovation, conferences, holiday parties, and other entertainment events (Lubin and
Weisman, 2009). These regulations are expected to increase accountability of the
executives and discourage speculative investment. We argue that CEO and other
employees’ compensation should not be focused on short-term contracts as it may
dilute the earnings of both shareholders and debt-holders; also compensations should
be approved by the representative shareholders. Clementi et al. (2006) document that
restrictive in-kind compensation (like stocks) allows managers to meet the goal of
shareholders as the conflicts of interests are reduced. John et al. (2000) suggest that
most of the compensation should be tied to both equity and debt securities (i.e. deferred
compensation with options and warrants) to provide the top-executives and employees
with long-term incentives. Recently, Acharya et al. (2009) argue for a multiyear based
executive compensation structure (which cannot be cashed out within a certain period)
where bad performance in future will erode the accumulated bonus from good
performance.
The US equity and options markets are regulated by the SEC, Fed, and Department
of the Treasury. Congress is particularly responsible for implementing rules and
regulations in equity and option markets. Futures, derivatives on futures, and debt
products are regulated by the Commodity Futures Trading Commission (CFTC), which
also oversees commodity trading firms and futures exchanges. Mortgage markets are
regulated by the Fed, Office of the Comptroller of the Currency (OCC), FDIC, Office of
Thrift Supervision (OTS), National Credit Union Administration, and state regulators.
The OCC also oversees national banks and FDIC. The Fed oversees bank holding
companies and state-chartered banks. The OTS oversees thrift holding companies and
thrifts. The FDIC oversees state-chartered banks. The SEC oversees brokerage firms,
stock exchanges, investment banks, corporate disclosures and enforces rules and
regulations in securities markets. Besides, 50 US states have different automobile
and home insurance policies. Failure of these less-integrated and multiple supervisions
SEF has recently increased the public demand for a single regulatory body to integrate the
27,2 US capital market.
Since the US market largely impacts the capital markets of other developed and
emerging countries, a single and integrated global regulatory body is required
especially for risky debt securities and derivatives with large global exposures. Both
the G8 and G20 countries should lead this initiative. This may coordinate among global
126 capital and financial markets and oversight the sizes and types of cross-border
banking and financial flows; off-balance sheet items; capital, leverage and liquidity
requirements; centralized clearing house of derivatives, etc. The objective is to reduce
spill over of negative externalities and associated adverse selection and moral hazard
problems. It should be mentioned here that the SEC and Fannie Mae were the outcomes
of great depression. We are optimistic that we will have a unique but integrated
regulator for not only the USA but also global markets. It is also important for
transparent corporate governance globally.
Semaan and Drake (2009) document that deregulation related to the current
financial market turmoil may temporarily impose huge idiosyncratic risk but reduce
systematic risk in the long run. Further they argue that the overall risks associated
with deregulation decline over time because deregulations offer product innovations
and competitions. We expect more financial innovations in future with greater
transparencies and better regulations. Regulators cannot fix each of the problems that
we discussed above but can prevent them so that these do not appear in future.
Understandably some of these proposed regulatory changes may require months
(or even years) to be implemented[31].

6. Discussion and conclusion

This paper analyses the causes of the 2007-2009 financial crisis and stock market
volatility and proposes a number of policies that may help to prevent such crises in the
future. While the long-term effects of the crisis and stock market volatility are yet to be
unfolded completely, the US economy as well as economies of many developed countries
are currently confronted with liquidity crisis, credit card debt crisis, decline in consumer
confidence, decline in major macro variables, e.g. GDP and employment, and mass of
toxic assets in financial institutions’ balance sheets. As the lender of last resort the
federal government of many countries including the US has come forward to bailout
bankrupted financial institutions and injected several trillion dollars as economic
stimulus. This bailout is expected to stimulate economies by injecting liquidity and
stabilize distressed values of loans, assets and credits to their fundamental value. The
federal government is financing the bailout by buying short-term private portfolios and
holding them in long-term government portfolios. When the fundamental values of these
securities are restored, government will recoup their current spending. This plan is also
consistent with Gorton and Huang’s (2004) theoretical proposition that the central
government can supply liquidity more cost-effectively. In the USA, the Fed has allocated
approximately $1 trillion to bailout near-collapsed companies. In addition, $1 trillion is
pledged to buy toxic assets of troubled banks and financial institutions[32]. Economic
stimulus package includes various short, middle and long-term remedial such as
covering bad loans, offering loan guarantee schemes and commercial paper funding
facilities, alleviating foreclosures, offering new debt especially to the banking and
financial sectors, recapitalizing banks and buying banks’ illiquid financial assets
(through reverse auctions, preferred stocks and warrants), exchanging illiquid securities Financial crisis
for government secured debts, increasing FDIC’s guarantee for debt instruments with a and stock market
maturity of up to ten-years from current three-years limit, transferring cash to long-term
debt investors, alleviating liquidity crisis in foreign exchange markets, refinancing volatility
corporate foreign debt, guaranteeing unlimited deposit insurance especially to small
businesses, guaranteeing interbank transactions and credit, supporting stock markets
and retirement funds, etc.[33]. 127
Given that the ineffectiveness of monetary policy tools (e.g. reduction of interest rates
or reserve ratio) during the recent financial crisis, we observed a liquidity trap because of
low interest rates. For example, interest rate was gradually cut from 5.25 percent in
August 2007 to 0.25 percent in December 2008 which is the lowest in Fed’s history
(similar to quantitative easing that Japan adopted after its land and stock price bubble in
early 1990s). An important lesson the Fed should take from the recent crisis is that low
interest rate may help to stimulate the economy in the short run, but it has unwarranted
long-term implications. As such, the interest rate should not be kept too low for too long.
It was rational for the Fed to use fiscal policy stimulus (e.g. tax-cut, payroll tax
credits, and increased public spending) to combat the recent financial crisis. However,
the expansionary fiscal policy implemented by the government is a politically debated
issue. While some argue whether the pledged amount of bailout money is sufficient to
stimulate the economy, there are debates about how much and whether the
government should pay for toxic assets.
As is clear from our discussion in Sections 3 and 4, the recent financial crisis is not
caused only by greed, or financial innovation or lax regulation; causes of the crisis are
numerous and complex. A cheap credit regime fostered by financial liberalization and
expansionary monetary policy after the dotcom bust and 9/11 terrorist attack;
unprecedented growth in subprime mortgage loans; inadequate regulations that helped
creating a housing bubble; excessive securitization of mortgages and other consumer
loans; extraordinary high financial leverages; colossal growth of unregulated CDS and
other complex derivatives, all are responsible for the current financial crisis and
systematic global market failure. Excess volatility in the stock market is a result of
sophisticated technology that outperformed numerous regulations in stock markets.
We argue that federal assistance is necessary but certainly not sufficient to boost the
economy. Banks, insurance companies, financial institutions, etc. need to revise their
business models and adhere to strict financial regulations not only to recover from the
current crisis but also to prevent such financial calamities in the future.

Notes
1. Mortgage bonds of Fannie Mae and Freddie Mac are exposed to the global market. For
example, Asian investors own approximately 20 percent assets (or $1 trillion) of Fannie and
Freddie and particularly, Chinese investors own half of this $1 trillion. This is why the crisis
of Fannie and Freddie spilled over to other countries almost immediately.
2. AIG had assets over $1 trillion and was operating in more than 100 countries before the Fed
took control of it. AIG also had CDS worth of $450 billions of which $300 billion were held by
different European banks and approximately $60 billion CDS were written on insurance
contracts contingent upon subprime real estate mortgage loans.
3. The Dow, S&P500 and Nasdaq declined by approximately 25, 30, and 35 percent, respectively,
from September to November 2008. During the same period, standard deviations of returns and
SEF volumes of these indexes were about 5 and 20 percent, respectively, and higher than any other
comparable months of 2008. The VIX also increased by more than 150 percent from September 2
27,2 to November 28, 2008. The lowest and highest value for VIX was 21.43 and 80.86, respectively,
during September-November 2008.
4. An interactive list of failed banks with assets, deposits and estimated costs of FDIC insurance
is available at: http://s.wsj.net/public/resources/documents/info-Failed_Banks-sort.html
128 5. As panic seized the tulip market, some prudent investors began to liquidate their holdings in
early autumn of 1636 and tulip prices lost its value by 90 percent within six weeks (Hirschey,
1998). Hirschey also documents that one tulip bulb was worth of approximately US $34,584
in 1998. Given the inflation rate since 1998, one tulip bulb is worth more than US $40,000
in 2009.
6. The fall of Dow on October 27, 1997 was treated as the tenth largest decline since 1915.
The cross-market trading halt circuit breaker procedure (imposing temporary trading halt
following significant market volatility) had been used first time on October 27 since its
adoption after 1987 stock market crash (SEC, 1998).
7. McCarthy (2000) documents that derivatives were responsible for huge losses in 1990s,
e.g. LTCM – $4 trillion losses mostly in currency and interest rate derivatives, Orange
County – $2 trillion losses in reverse repurchase agreements and leveraged structured notes,
Baring Brothers 2 $1.24 trillion losses in options, Askin Securities 2 $0.6 trillion losses in
Mortgage Backed Securities.
8. Weitzner and Darroch (2009) also documents how greed and poor corporate governance may
lead to a financial crisis.
9. Zandi (2008) reports that according to Fair Isaac Corporation, subprime loans are meant for
borrowers with a credit score of below 620 (on a 300-850 scale).
10. Some of the cash flows generated through MBS are sold as separate securities such as
collateralized mortgage obligation and CDO. Moreover, structured investment vehicles
(SIVs) are very popular in these slicing and dicing processes (i.e. tranche) where short-term
securities such as commercial papers or other money market instruments (which charge low
interest rates) are used to finance long-term investments (which offer higher interest rates).
However, the quality and rating of some of these SIVs created between 2003 and 2008 were
questionable because the original debts were based on subprime loans.
11. For example, S&P/Case-Shiller Home Price Index (CSI); Fiserv/Case-Shiller index; Zillow real
estate market report; Integrated Asset Services 360 National Index; Radar logic’s Residential
Property Index; Metropolitan Statistical Area Index; Moody’s/Real commercial property
price indexes; Federal Housing Finance Agency House Price Index; Home Equity Index
Composite; National Association of Realtors; Loan Performance House Price Index; Office of
Federal Housing Enterprise Oversight housing price index, etc.
12. According to CSI, home prices in 20 major metropolitan areas in the USA went down by
18 percent during December 2007-December 2008. Home prices have been declining more
than 30 months in a row starting from late 2006.
13. The Fed, OCC, FDIC, and OTS are working on various aspects of Basel II accord, however,
it is unlikely that Basel II would be unanimously implemented in the very near future
(source: www.federalreserve.gov/GeneralInfo/basel2/ ).
14. The mark-to-market is an accounting rule (under generally accepted accounting principles)
that allows public firms to compute values of assets and liabilities on the basis of their
current market values. As such, it is associated with unrealized losses (when the value of
assets declines or liabilities increases) or gains (when the value of assets increases and
liabilities decreases).
15. For example, Merrill Lynch filed a lawsuit against security capital assurance (SCA) Ltd on Financial crisis
March 19, 2008 for violating contractual obligations on seven CDS which it bought from
SCA.
and stock market
16. According to the Bank for International Settlement Quarterly Review (2009), OTC
volatility
derivatives had an outstanding value of $592 trillion as of December 2008 and more than
65 percent of it was linked to different interest rates. See www.bis.org/statistics/otcder/
dt1920a.pdf for details. 129
17. For example, CDS Index (CDX in the USA and iTraxx in Asia and Europe), Asset Backed
Securities Index, Loan Credit Default Swap Index, and Commercial Mortgage Backed
Securities Index.
18. Sanford C. Bernstein & Co. report that the broker-dealers’ combined leverage ratio for Bear
Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch, and Morgan Stanley increased
from approximately 20 in 2000 to more than 30 in 2008.
19. Brunnermeier (2009) argues that maturity mismatch (i.e. short-term borrowing for long-term
investing) created a shadow banking system and exposed banks to funding liquidity risk
due to liquidity backstop (an off-balance sheet scenario when issuers of commercial papers
or repos had to extend credit line to investors to buy these commercial papers).
20. For example, Citi Bank had to write down assets worth of $60 billion in mid-2008; Wachovia
and Merrill Lynch – more than $50 billion each, Washington Mutual and UBS – more than
$40 billion each, HSBC, Bank of America, JPMorgan Chase – more than $20 billion each,
Morgan Stanley, Lehman Brothers, Deutsche Bank, Well Fargo, and Credit Suisse – more
than $10 billion each (see www.reuters.com/article/etfNews/idUSL321728320090903 for
details).
21. The US regulators (both the congressman and senators) were divided and rejected the initial
bailout plan which contributed to increase in stock market volatility from September 29 to
October 3, 2008. This is an evidence of why regulations are important or how regulations can
impact the market.
22. Some of these statements are based on speeches from brokers-dealers at the Baruch Financial
Markets Conference on “Volatility” held in Baruch College, New York, October 23, 2008
(in which the lead author of this paper attended).
23. Diether et al. (2009a, b) document that trading activities of short-sellers are independent of
the uptick rule suggesting that it has very limited effect on the market.
24. Details about the SEC proposal can be found at www.sec.gov/rules/proposed/2009/34-
59748.pdf. Australia, Japan, Malaysia, Pakistan, South Korea, Taiwan, and the UK also
imposed trading restrictions on either short-selling or naked short-selling in late 2008.
25. Scannell (2009c) reported that between January 1, 2007 and June 30, 2008 the SEC had
received more than 5,000 complaints regarding naked short-selling. Only 123 complaints
(i.e. 2.5 percent) were forwarded for further investigations. Short of manpower in the SEC
was probably responsible for lower execution of these complains (only four persons handled
1.38 million emails that the SEC received during this period).
26. One of the notorious financial frauds was deceptive financial statements sent to the clients
by Bernard Madoff. These statements were audited by an audit firm which was not
registered with the Public Company Accounting Oversight Board. The Madoff’s fraud calls
for introduction of SEC’s tough supervision and regulation on financial and investment
advisers. Scannell (2009b) reports that the SEC recently asked investment advisers to audit
their financial reports and investors’ assets by an independent third party prior to
submission and may ask Congress to enhance its “whistleblower incentives” under which
SEF a whistleblower is paid if (s)he provides the SEC with information regarding insider trading
or fraud by a third party.
27,2
27. Boulton and Braga-Alves (2009) document a positive market reaction to the announcement
of banning naked short-sale by the SEC even though it may reduce liquidity and trading
volume and increase spread and volatility. Fotak et al. (2009) also find similar results.
28. Jones and Lamont (2002) and Bris et al. (2007) also document that short-sales constraints lead
130 to less liquidity, higher volatility, and inefficient prices for stocks.
29. For example, the CFTC is currently overseen by the agriculture committees in the House and
Senate. But they mainly keep an eye on agricultural related derivatives such as commodity
futures but not other complex and OTC financial derivatives such as CDS. It should be
mentioned here that the House of Agricultural Committee passed a bill on February 12, 2009
that proposed a central clearinghouse for OTC derivatives and empowered both the CFTC
and SEC to monitor activities of central clearinghouse and imposed restrictions on capital
and margin requirements (Scannell, 2009a).
30. See Allen and Carletti (2008), Plantin et al. (2008), Sapra (2008), etc. for details on the merits
and demerits of mark-to-market accounting rule.
31. It should be mentioned here recently the USA Department of the Treasury (2009) has either
proposed new regulations or called for revisions to:
.
promote robust supervision and regulation of financial firms;
.
establish comprehensive supervision of financial market;
.
protect consumers and investors from financial abuse;
.
provide the government with the tools it needs to manage financial crises; and
.
raise international regulatory standards and improve international cooperation.
32. Under this plan, the Treasury and FDIC will finance buyers to purchase toxic assets through
public auctions which is also known as Public Private Investment Partnership (Rappaport and
Karmin, 2009). However, the Treasury and Fed will be co-owner with the highest bidder(s)
and provide purchase support significantly through FDIC-guaranteed debt financing. The
Treasury will also create several private investment funds with joint partnerships to raise
capital and Fed’s Term Asset-backed Securities Loan Facility will be expanded to buy toxic
assets.
33. Preferred stocks are bought by the Fed to avoid diluting current shareholders’ stake.
However, preferred shares may be converted to common shares after a certain time period.
Warrants provide the Fed with a right to buy shares at a fixed strike price in future.
Theoretically, the Fed will exercise this option when the strike price of the stock is higher
than its market price. If a TARP recipient firm wants to get rid of the federal money, it has to
provide the Fed with an independent valuation of the warrants; however, if the Fed disagrees
with independent valuation it can sell the warrants to private investors.

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Corresponding author
M. Imtiaz Mazumder can be contacted at: [email protected]

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