Greg Billington
Lauren Davis
Joseph Hall
The Role of Deregulation and Financial Innovation in the Credit Crisis
The Subprime Mortgage Crisis of 2007 was born from the union of negligent
deregulation and avaricious risk taking. With $20 trillion lost and incessant double digit
unemployment, it stands as the greatest instance of financial turmoil since the Great Depression.
Although proof of causation is often hazy at best, many of its origins and the avenues through
which it was amplified have been identified. The systematic deregulation of the banking industry
during the decades leading up to the crisis paved the way for over-sized and unmonitored loans;
these in turn fueled the lending and mortgage boom that triggered the initial collapse
(Brunnermeier, 2009). Once the housing bubble burst, the financial innovations which had
grown out of and alongside deregulation inflated the worldwide loss of wealth (Krishnamurthy,
2009). A complete analysis of the crisis necessitates an understanding of how the financial sector
was able to create so much systemic risk and why a relatively small number mortgage defaults
burgeoned into a pandemic economic crisis.
Alan Greenspan served as Chairman of the Federal Reserve of the United States from
1987-2006. As chairman, Greenspan’s involvement with the deregulation of the financial
markets was so deep that his stint has virtually become synonymous with the risky practice
altogether. The era primarily centers around four laws: the Glass-Steagall Act (1933), the
Depository Institutions Deregulation and Monetary Control Act (1980), the Garn-St. Germain
Depository Institutions Act (1982), and the Gramm-Leach-Bliley Act (1999). This mindset of
deregulation completely opposed that which dominated immediately following the Great
Depression. Prior to WWII, all regulatory structures and legislation set in place were in response
to several financial crises that occurred from the late 19th century into the 1930s. In 1927, the
McFadden Act was passed, which banned interstate banking in order to evade much of the
interstate competition that would eventually lead to risky lending. National banks were only
permitted to operate within the state in which they were situated. Due to the Great Depression,
the U.S. government was primarily focused on setting better sustainable regulatory structures in
place. 1929 marked the year of the stock market crash that led to the Great Depression. As a
response to the crisis, the Glass-Steagall Act was passed in 1933. Banks, whose profit stemmed
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from the gap in interest paid from depositors and to lenders, faced intense competition for
interest rates on the payments, which encouraged them to make riskier loans. The act provided a
formal separation between commercial and investment activities. Regulation Q, one of the act’s
provisions, authorized the Federal Reserve to “regulate interest payments on deposits”
(Hammond and Knott 14).
Three federal agencies were authorized as part of the regulatory structure supervising
banks: the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Federal
Deposit Insurance Corporation (FDIC, 1984). In the possession of the Office of the Comptroller
of Currency (OCC) lay an arsenal of methods that not only act to effectively regulate national
banks, but ultimately to foster the health of the financial industry (Stiller, 1994). The OCC
fulfills duties including: ensuring that all Americans gain fair and equal access to financial
services, enforcing anti-money laundering and anti-money terrorism attacks, as well as
investigating and prosecuting all those not willing to abide by sanctions set forth by the U.S.
government (Stiller, 1994). To further strengthen its executive authorities, the OCC is allowed to
intertwine its efforts with other leading policing and investigative units of the United States
government, including the Federal Bureau of Investigations and Federal Deposit Insurance
Corporation (FDIC). The FDIC offers insurance of up to $250,000 on the deposits of member
banks as well as safety monitoring methods that overlap the actions of the OCC also working in
conjunction with the Federal Reserve (FDIC, 1984). With these three main agencies in place,
theoretically speaking, a catastrophe the size of the most recent crisis should never have been
allowed to take shape. In looking back, one can deduce that the deregulation that took hold of
the American economy began at a reasonable pace, “with the Carter administration’s abolition of
restrictions on airline routes” followed by deregulation of the telecommunications, media, and
financial services industries (Cassidy 7).
The financial deregulation and unchecked financial innovation picked up in the 1980s
and continued into the twenty first century. Whereas at one time banks were not allowed to
merge, their mergers have become “Capitol Hill’s longest and most expensive show,” and,
similar to a bad horror film, “the issue appears as a rerun in Congress after Congress” (Lewis,
“Financial Deregulation Fiasco”). To begin, the Securities and Exchange Commission eradicated
fixed brokerage fees in 1975 (Hammond and Knott 5). Three years later, Congress passed the
Airline Deregulation Act, and in 1980, “statutes deregulating aspects of the trucking, rail,
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financial and television industries were all approved” (Hammond and Knott 5). According to
Hammond and Knott, “economic, technical, and legal changes in and around the financial
industry” created “altered positions toward the regulatory status quo within the financial
industry,” thus generating “competitors to the status quo outside the industry” (7). The two
authors also coin the phrase “deregulatory snowball” to exemplify that once laws initiated a
partial deregulation, this only promoted further deregulation.
The benefits and stability created by the regulatory structure were not recognized until
the ‘deregulatory snowball’ had already begun, forever altering the financial sector. The 1960s
and 70s saw changes in the financial environment which ultimately led to the passage of several
of these deregulatory laws. The two decades were characterized by “growth in the Eurodollar
market, interbank borrowing of funds, electronic transfers of funds, and the invention of other
financial instruments outside the regulatory scope of Regulation Q” (Hammond and Knott
15).Under regulation, banks and savings and loans were able to reap extremely high profits
compared to other industries (Hammond and Knott 14). Additionally, the probability of the two
sorts failing was incredibly low. Between 1944 and 1974, less than ten banks failed on an annual
basis (Cargill and Garcia 10). However, after the passage of the Depository Institutions
Deregulation and Monetary Control Act in 1980, the probability of failure dramatically
increased. In 1980, 10 banks failed, and by 1985, nearly a thousand banks and five hundred
S&Ls were considered to be troubled institutions requiring government intervention (Hammond
and Knott 14). In other words, the FDIC handled close to $10 billion in bank failures through
1980, followed by a processing of $30 billion between 1981 and 1984 (Hammond and Knott 14).
In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control
Act. This new legislation allowed banks to expand their practices and lending capabilities along
with raising the deposits insurance limit from $40,000 to $100,000. Immediately following its
passage, the economy spiraled downward into a recession that spread over two years: 1981-1982.
This was bad news for many of the banks that had become involved in speculative lending and
real estate. A couple of years later, in 1982, Congress passed the Garn-St. Germain Depository
Institutions Act, giving S&Ls the ability to make a variety of short term loans, and “fully
deregulated price competition between brokerage money market funds and banks” (Hammond
and Knott 20). To do this, banks were now allowed to offer “Super NOW accounts and money
market demand accounts which paid market rates of interest and bad checking privileges”
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(Hammond and Knott 20). Even after the enactment, several banks failed in the ensuing years.
Without Regulation Q, the cost of attracting funds was much higher for banks, and “without
corresponding increases in the return on bank loans, the spread between costs and revenues
declined,” which motivated riskier lending with higher interest rates (Hammond and Knott 20).
Here, the ‘deregulatory snowball’ picks up pace: “with bank deregulation by price in place, the
banks want deregulation by geography and by product” because they believe that “price
deregulation has increased their risks, which other kinds of deregulation would spread and
reduce” (Hammond and Knott 21).
Further deregulation quickly picked up into the 1990s. In 1990, for example, JP Morgan
became “the first commercial bank to underwrite securities,” and in 1996, Fed began allowing
banks “to acquire investment banking affiliates, with some restrictions” (Cassidy 229).
Greenspan did not make these decisions without objections, however. Many argued that the level
of shock deregulation had caused in the financial system would lead to serious problems. He
responded: “risks in financial markets . . . are being regulated by private parties” and “purchasers
of financial products, even the most complicated ones, would regulate Wall Street” (Cassidy
230). Greenspan so strongly believed in the self-regulating, efficient free market, that he ignored
many public concerns. Others attempted to reinstall regulation or to merely slow the deregulation
to combat the risk taken on by the financial industry, but Greenspan fervently opposed these
efforts.
In 1999, Congress enacted the Gramm-Leach Bliley Act, also known as the Financial
Services Modernization Act. Senator Phil Gramm declared, “the hallmark of the bill is that it will
make an array of financial services available to every American consumer that will provide
lower prices and one-stop shopping at financial supermarkets in every city and town in the
country” (Weissman 6). Many of the provisions of the new bill included: to “pave the way for a
new round of record-shattering financial industry mergers as banks, insurance companies, and
securities firms line up to take their marriage vows” and to “leave financial regulatory authority
spread among a half dozen federal and 50 state agencies, all uncoordinated” (Weissman 6).
Citibank and Travelers had merged prior to the enactment. However, this merger was prohibited
under the Glass-Steagall Act, which had forbidden mergers between banks, insurance companies,
and securities. This merger and several others were authorized post-enactment.
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Many blame deregulation as one of the causes of the current economic crisis. Others
argue that the Fed held interest rates down for too long, over-stimulating the economy. Phil
Gramm, one of the sponsors of the Financial Modernization Act, still defends the deregulatory
act and the deregulation that has taken place in financial markets. He mentions that the 1992
Housing Bill “set quotas or ‘targets’ that Fannie and Freddie were to achieve in meeting the
housing needs of low and moderate-income Americans” (Gramm, “Deregulation and the
Financial Panic”). Gramm also defends the bill, saying that no one has ever fully explained how
deregulation has caused the financial crisis though people tend to point fingers at the GLB act
and the Commodity Futures Modernization Act of 2000. The politician also claims that if the
GLB act were the problem, the financial crisis “would have been expected to have originated in
Europe where they never had Glass-Steagall regulations,” adding that “the financial firms that
failed in this crisis, like Lehman, were the least diversified and the ones that survived [J.P.
Morgan] were the most diversified” (Gramm, “Deregulation and the Financial Panic”).
According to Gramm, regulators were extremely well equipped to handle their duties, and that
one cannot say that the industry would have turned out differently if financial regulators had had
more resources or authority at their disposal.
In July of this year, the Financial Oversight Bill was passed, which requires more federal
oversight and creates more regulatory bodies, but leaves the actual regulating up to their
discretion and utilizes most of the same individuals within those bodies that had responsibilities
during the financial crisis. One element that contributed to the financial crisis was the lack of
regulatory structure and oversight, and “as traders and lenders increasingly drove the nation’s
economic growth, politicians of both parties” got out of the way, “passing a series of landmark
bills that allowed financial companies to become larger, less transparent, and more profitable”
(“Financial Oversight Bill Signals Shift on Deregulation”). The Bush administration pressured
banks to lend to less credit worthy and less wealthy consumers so that every American could live
the American dream and have a home. Officials, however, did not consider the extent to which
deregulation of the financial sector would harm the economy in relation to how dependent the
health of the financial market became on the housing market.
This history of deregulation set the stage for an environment on Wall Street that not only
permitted, but necessitated excessively risky behavior in order to remain competitive (246,
Cassidy). Leverage grew and finance teetered on an increasingly unstable platform. The
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derivatives market, which the Gramm-Leach-Bliley Act played a part in deregulating, (Cottrell,
Lecture) had swollen to $900 trillion in value (Tolios). By the time delinquent subprime
mortgages had triggered the 2007 Financial Crisis (Brunnermeier, 2009), institutions had become
so leveraged that a small shock would have reverberated throughout the entire economy. So even
though the initial effects of mortgage defaults were limited to the housing and financial sectors,
and “the direct losses due to household default on subprime mortgages are estimated to be at
most $500 billion... the effects of the subprime shock have been far reaching” (Krishnamurthy,
2009). In just the first year after the economy began its collapse, there was an estimated $8
trillion worth of wealth lost in the US (Brunnermeier, 2009). Since then, a further $12 trillion has
disappeared from the collective pocketbook of America (DeLong). Clearly, the total depression
of the US economy far outweighs the initial crisis. In order for the $500 billion loss of wealth to
have increased 16 fold in merely one year (and 40 fold in three!), large multipliers must have
played a role. By the time the crisis began, the financial derivatives market, which was based off
little more than hedged monetary bets, had swelled to 16 times the size of the world’s economic
output; to believe that such a bloated and risky system did not accelerate the economic meltdown
would be blind, naive, and dangerous.
Not only did deregulation play a role in permitting unsafe practices on Wall Street, but
financial firms also began creating new, riskier methods of funding which existed outside of
regulations. So although increased delinquencies were the root cause of the mortgage crisis
(Brunnermeier, 2009), the development and increased usage of financial innovations played a
large role in amplifying the effects of defaulted mortgages (Krishmanurthy, 2009). Over the past
two decades, the advancements in finance changed the fundamental way in which balance sheets,
risks, mortgages, and credit were handled (Krishnamurthy, 2010). Structured investment vehicles
were involved in a ‘shadow banking system’ that provided new sources of funding, but only by
hiding systemic risk and increasing leverage (Rajan, 2006). Credit default swaps and securities
were meant to move risk to those most able to bear its burden, but instead ended up increasing
the number negligent loans and decreasing liquidity during the crisis (Gennaioli, 2010). The
increased liquidity associated with Collateralized Debt Obligations and Credit Default Swaps,
although at times socially desirable, also significantly increased risk by increasing the rate at
which the prices of securities deteriorated (Rajan, 2006). Structured Investment Vehicles and the
‘shadow banking system,’ meanwhile, increased effective leverage by providing a source of
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funding and of debt that was not bound by regulation and capital reserve requirements
(Brunnermeir, 2009). Thus, despite contrary intentions, banks ended up with increased leverage,
increased systemic risk, increased debt, and a financial market that was on the brink of collapse.
Credit default swaps and similar financial derivatives constituted a market that was at the
center of the economic crisis, having grown from a $180 billion pittance in 1998 to a $57 trillion
monstrosity in 2008 (Stulz, 2010). They initially had the benign intent of capitalizing on the
various propensities of individuals to own risk (Brunnermeier, 2009). One benefit of CDSs, then,
is that the market can more efficiently allocate risk by providing insurance to the individuals who
are more risk averse. This insurance gave companies which issued loans the ability to hedge their
bets by insuring against the default of specific assets. Those who bore the risk of delinquencies
in the loans backing a CDS would be paid a premium until they needed to compensate an insured
individual for a defaulted loan. This distorted incentives, however, because the individuals who
made the loans could then immediately purchase insurance in case these assets went bad (Stulz).
Combined with the ability to sell off loans in mortgage back securities, insurance effectively
increased the willingness for banks to take risks and decreased their need to monitor loans
because their losses would be covered by the insurer (Stulz). What made this operation
extremely risky was that “the provider of protection [CDSs] didn’t put up collateral” (Cassidy
282). As a result, the demand for CDSs was artificially raised because the risks associated with
them being uncovered by capital reserves, poorly monitored, and improperly appraised was too
opaque for accurate investor evaluation (Gennaioli).
Not only did CDSs increase the rate of loans, but insufficient regulation also enabled
them to vastly increase the scope of the subprime crisis. With CDS rates too low and no
minimum collateral levels to insure against the loss of CDS value (the Graham Leach – Bliley
act had removed minimum collateral requirements) AIG and other insurers didn’t garner enough
profits or reserve sufficient capital before default to cover their insurance obligations (Stulz).
When it was discovered during the crisis that risk had been underestimated and that AIG could
not fulfill its insurance contracts, holdings of companies came into high risk of bankruptcy
(Krishnamurthy, 2009). Since the derivatives insurance market was worth approximately the
world’s real economic output, the risk of default was spread into diverse holdings (Stulz, 2010;
Tolios, 2010). This greatly increased uncertainty over which institutions were trustworthy, which
would be forced to compensate for CDS contracts, and which would lack funding because other
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institutions could not meet the required CDS payouts (Stulz, Gennaioli).. The risk of default was
so severe that the US government was forced to bail out AIG in order to reduce the possibility of
bankruptcy (Krishnamurthy, 2010).
While CDSs were designed as insurance, they could also be thought of as a way of
selling short on an Asset Backed Security, with the short seller being the insuring company
(AIG, for example) and the cost of selling short being the insurance premium (Stulz). While at
times short selling can help properly value assets, in this market the ability to sell short was
potentially destabilizing (Stulz). This was partly because individuals who did not own securities
could purchase CDSs on them, so there could be an incentive for them to see the market value of
a company’s share drop (Stulz). When a security defaulted and a company lost funding,
individuals with CDS and no holdings in securities would also more inclined to see the company
fail in order to collect the payout from the insurer (Stulz). This distorts incentives so that there
would be an underestimation of risk from analysis tools that only used data from prior markets
that did not rely heavily on CDSs.
Furthermore, the short selling effect was compounded by the creation of ABX indices,
which rated the probability for subprime mortgages to default (Stulz). The nature of these indices
increased risk because for two major reasons: individuals not in the subprime market could take
views on the likelihood for subprime mortgage collapse; investors could “take more exposure to
subprime mortgages than there were such mortgages” (Sutlz). Since CDS’s were more liquid
than subprime mortgage securities themselves (Krishnamurthy), the ABX indices would also
reflect changes in the perception of the subprime market with greater immediacy. Thus, these
indices have been credited with an overreaction to changes in the confidence of market
valuations of subprime mortgages (Stulz). For example, when BNP Paribas halted its valuation
of subprime mortgage investments, there was a sharp decline in ABX indices and money market
participants promptly became unwilling to lend to each other (Brunnermeier). Although it is
generally impossible to show direct cause and effect, the close proximity of these events suggests
a strong economic correlation.
The sharp decline of index ratings, which occurred in part due to market overreaction,
was limited to poorly rated mortgages at the beginning of crisis (Brunnermeier, 2009). However,
since consumer sentiment was such an integral element in the make-up of these ratings,
uncertainty in the market caused ABX indices drop substantially; those rated less than AAA
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dropped 95% of their January 2007 value and even AAA securities dropped 75% in value by the
beginning of 2009 (Brunnermeier). Since these precipitous falls represent an increase in the
likelihood of mortgage default, the rapid fluctuation of ABX indices played an indirect role in
the Moody’s decision to downgrade 62 tranches of subprime securities. Moody’s action
consequently caused a wide ripple in the commercial credit market and was involved in Bear
Stearns’ hedge funds being unable to meet funding requirements (Brunnermeier). Since Bear
Stearns failed later in that year, the potentially overeactive devaluation of ABX indices seem
likely to have amplified the crisis and caused the failure of at least one important financial
institution.
The issuance of commercial paper and similar asset backed securities within the shadow
banking system also played a large role in expanding the subprime crisis (Kacperczyk and
Schnabl). Since 92% of the $1.97 trillion dollar market of commercial paper was issued by
financial institutions, a decline in its value would result in a significant loss of funding for many
financial institutions (Kacperczyk and Schnabl). For years trading in CP had been occurring in
such a high volume that it had become an ingrained source of funding for structured investment
vehicles. As a result, SIVs held an almost continuous amount of commercial paper debt on their
books, with an especially large amount in asset back commercial paper (Kacperczyk and
Schnabl). In the middle of the financial crisis, valuations of subprime mortgage backed financial
derivatives began to come into question; the price of ABCP concurrently decreased, while
regular CP maintained its value (Brunnermeier). Since ABCP but not CP declined in value, there
is the indication that it was the subprime crisis fueling the loss of wealth (Brunnermeier). This
decline in ABCP value thus resulted in a massive decline in funding sources for financial
institutions (Brunnermeier). For example, the SIV for the German bank IKB was the first to be
hit by the subprime crisis; when its ABCP lost its value, IKB was forced to inject funds in order
to prevent a loss of confidence. As similar funding losses spread throughout the US, the decline
in value of commercial paper contributed to an additional $400 billion dollar loss in the US
markets while ABCP lost a quarter of its value between July and October of 2007 (Marcin
Kacperczyk and Philipp Schnabl). Not only was there a loss funding, but the uncertainty which
accompanied this loss of equity caused companies to become reluctant to lend to each other
(Brunnermeier). This reluctance to lend has been one of the most prolonged effects of the crisis
and has greatly retarded the economic recovery.
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The ABX indices, CDSs, and commercial paper issued before the crisis have resulted in
an amplification of the original credit shock, similar to the 1998 crisis, which originated with a
devaluation of the Russian Ruble and ended with subprime defaults in the US (Krishnamurthy).
This is primarily due to a high level of uncertainty associated with the rating mechanisms
(Krishnamurthy). In the 2007 credit crisis, investors had limited experience with the CDSs and
commercial paper. “When AAA subprime tranches suffered losses, investors realized that they
had not understood the securitized credit structures they had purchased” (Krishnamurthy). As a
result, consumers of securities and CDSs were faced with Knightian uncertainty, where the risks
which their investments were exposed to were unknown and incalculable. Since investors
displayed an “excessive reliance on external ratings systems” (Incentive Structure 2008), when
the sharp decrease in CDO prices occurred, the ABX ratings caused the market price to shift
even more dramatically than was necessary (Stulz). Investors were surprised by this collapse of
AAA rated CDSs, further devaluing the market for commercial paper and CDSs (Gennaioli).
With this loss of value, these financial derivatives became less liquid and prevented proper
market prices (Krishnamurth, 2009). This negative shock had a positive feedback mechanism
causing liquidity to evaporate because the asset losses “worsen balance sheets, reducing asset
prices, which then fed back into balance sheets, and so on” (Krishnamurthy, 2009).
Not only did the financial innovations of the last two decades cause a glut in the housing
market, but an increase in maturity mismatch of assets increased the systemic risk of an overfed
mortgage system (Brunnermeier, 2009). Although banks operate by owning long term assets
(loans) and dealing in short term assets, the growth of the shadow banking system allowed this
system to evolve into a much more dangerous beast. Structured investment vehicles, for
example, permitted banks to transfer the funding market for short and medium term asset back
commercial paper off their balance sheets (Brunnermeier, 2009). Banks still provided a line of
credit to these SIV’s, however, so that in the case of default of the ABCP, they would still be
responsible (Incentive Structure, 2008). Since there were no capital requirements, and additional
sales of commercial paper were made for increased funding, this increased the possible amount
of leverage (Incentive Structure, 2008). When the value of ABCP began to fall (as was
previously explained) investors became much less willing to purchase ABCP. Thus, the banks’
debt could not be ‘rolled over’ because they lacked a very important funding source. In order to
maintain sufficient funds, banks were forced to sell assets that were already declining in prices.
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In such a market, funding liquidity dries up because neither ABCP is being bought, and assets
can only be sold for very low prices, if at all (Brunnermeier). This lack of funding liquidity
stresses the financial system (Brunnermeier). Since the ‘shadow banking system’ played a role in
causing a fire sale of subprime mortgage assets, similar constructs should be considered
dangerous financial practices that necessitate regulation.
Although many might simply point to excessive subprime mortgages or an irresponsible
Fed, the current depression clearly had a wide variety of causes. Even recent market booms and
busts which occurred during the ‘deregulatory snowball’ have had comparably negligible effects:
the dotcom bust, for example, resulted in over $5 trillion in lost wealth (Gaither, 2006) but was
overcome quickly to see significant growth prior to 2007. For only $500 billion in wealth to have
decimated the world’s economy, not only did initial investments need to be risky, but
innovations had to concurrently cause the financial system to be extremely highly leveraged, to
have assets that would rapidly lose liquidity, and to be so intricately woven together that one
failure could unwind the entire economy.
In order for economic regulation to have regressed so far, it was claimed that
deregulation was merely following its natural course by addressing new innovations and meeting
the needs of the financial industry. Unfortunately, disaster myopia allowed it to progress
unchecked and without consideration for potential ramifications. The DIDMCA and the Garn-St.
Germain Depository Act, for example, granted thrifts the ability to make an extremely wide array
of loans and savings products without sufficient regulatory oversight (Hammond and Knott).
This met demand for diverse financial products, but deepened the crisis in the s&l industry
(Hammond and Knott). Deregulation had encouraged growth by “decreasing the transactions
costs of investing, expanding access to capital, allowing more diverse opinions to be expressed in
the marketplace, and allowing better risk sharing” (Rajan, 2006). But like a bad case of
dysentery, while deregulation liquified market obstructions, it allowed the competitive creativity
of financiers to flow a bit too freely. Even in 2006, economists recognized that Wall Street had
excreted a mound of innovations that consisted of: assets which would decline in liquidity during
a crisis; financial derivatives that concealed risk with opacity; and investments with high(er)
probabilities of large tail risks (Rajan, 2006).
Addressing all the dangerous innovations that played a role in developing this past crisis
would be impossible. Regulating innovations which were strongly correlated to the collapse,
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however, could help defuse the deadly combination of risks that detonated the economy in 2007.
Since uncertainty in the market caused by the opacity of ABX indices and CDSs massively
devalued asset worth, legal documentation of securitization should be required in order to
provide consumers with proper information (Incentive Structure, 2008). The use of this
additional information could be encouraged if authorities also limited the use of ratings in
oversight regimes (Lucchetti, et al, 2008). Increased knowledge of and familiarity with
purchased goods could prevent the fire sale of safe securities that occurred when individuals
based their decisions solely off ratings (Incentive Structure, 2008). Mandating an ownership
stake in securitization transactions could also give an “incentive to maintain or maximise the
value of the securitized asset pool” (Incentive structure, 2008). Ownership requirements could
decrease CDS issuance that had outstripped the size of the actual mortgage market pool to create
excessive potential losses. Regulations such as these could have prevented and could still prevent
a financial crisis in the vein of the credit debacle of 2007.
Although these measures are all well and good, the financial market is continually
evolving and any regulation put in place is subject to change or nullification. Bubbles will form
because Wall Street is a capitalistic system based on profitable risk taking. The only way to
completely prevent a crisis would be to squelch innovation and disincentivize profit. These are
illogical choices, however safe they might make the market; the only hope for preventing future
meltdowns is for regulators and economists to remain clear sighted and make informed choices
for the safety of the economy.
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