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It is hard to predict what could have happen if government regulation did not get in the way of
financial markets in the current crises. Nor is it possible to predict what could have happen if the
government did not get involved during the Great Depression. The only thing that is certain is facts and
statistics that we can look at to draw our own conclusions. To compare two scenarios where financial
markets are regulated versus unregulated, we have to look at the facts. An unregulated financial market
is one in which banks and other financial institutions are free to make loans to whomever they please
and under any terms that are mutually agreeable between them and the borrower. The government
also doesn’t get involved if a bank and other financial institution makes bad loans and loses money. A
regulated financial market is one in which the government gets involved by setting policies and passing
acts and other legislation to mandate the bank to take certain actions that it otherwise would not take.
As “The Housing Boom and Bust” by Thomas Sowell puts it, congress passed legislation to subsidize or
guarantee loans made under lower standards.
The unregulated financial markets produce the most efficient allocation of investible funds.
Banks are allowed to make loans to whomever they choose. Banks in an unregulated market, and any
other market for that matter, will try to maximize profit. To that end, in an unregulated market, Banks
will try to make the least risky loans in an attempt to assure that the borrower is able to repay the loan.
On the other hand, banks would not make subprime loans with borrowers who show signs that they are
not able to repay the loan. Furthermore, banks would not negotiate with these borrowers to make
“creative” loans such as giving out low introductory “teaser” interest rates, and adjustable-rate
mortgages, known as ARMs, in which the borrower had the option to pay less than the amount of the
interest in some months during the interest-only period. “While convenient for dealing with temporary
financial problems, these option ARMs meant that paying less than the interest in some months meant
that the unpaid interest was added to the principal, so that the home buyer who used that option could
end up owing more than the original amount of the mortgage.” (p. 19)
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The unregulated financial market is the best solution for financial institutions; however, I would
argue that some regulation, which is not politically motivated, is the best possible solution. The whole
notion that unregulated financial institutions will make the best possible risk-free decisions based on the
fact that there will be no one to bail them out if they fail is absurd. Banks are run by humans. Humans
gamble. Gambling involves taking risks. Banks should not be bailed out. Bank CEOs should be aware at
all times that their decisions could lead to a bank failure. However, I also believe that there should be a
system in place to prevent over-the-top risky decisions. One can call this minimalistic regulation in which
the government has no say in which group of people deserves to buy a house even if they can’t afford it.
In general, the nature of regulation upsets the normal operation of the market, and creates problems
which can be very costly to the tax payer, and can cause problems to the overall stability of the
economy. The FDIC is one example where the government stepped in to prevent bank panics. Although
the FDIC is an entity that guarantees the money deposited in a bank, it is still a form of regulation.
Furthermore, although the FDIC was designed to prevent bank panics, it creates moral hazard and
asymmetric information problems. Because the government will step in and cover any losses, the
normal incentives the owners of any business face are now perverse incentives. With FDIC in place, bank
management is rewarded if they gamble more than they usually would. Eventually, the government
places so much regulation on top of banks and other financial institutions, that in the end we are faced
with the current financial crises.
The unregulated financial market is the best scenario for borrowers and potential homeowners.
Although one can argue that regulated financial markets are better because government can make all
sorts of guarantees and incentives for banks to redistribute incomes and engage in social engineering, is
in fact the opposite that is true. In a regulated market, a low income family can indeed more easily get
into a low monthly payment mortgage. But what good is that mortgage if you cannot afford to make the
payments after the initial teaser rate expires and you end up on the streets? “In 2004, Josh Rosner, an
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analyst at Medley Global Advisors in New York, said, ‘The move to push home ownership on people that
historically would not have had the finances or credit to qualify could conceivably and ultimately turn
Fannie Mae’s American dream of homeownership into the American nightmare of homeownership
where people are trapped in their homes.’ He added: ‘If incomes don’t rise or home values don’t keep
rising, or if interest rates rose considerably, you could quickly end up with significantly more people
underwater with their mortgages and unable to pay.’” (p. 46)
In “The Big Short” by Michael Lewis, tells a story of people who made a ton of money during the
subprime mortgage crisis. These people found wealth in tricky ways by realizing facts that no one else
was able to see. The subprime mortgage crisis was a result of many poor decisions starting with the
government and its lax policies towards lending and homeownership. They even had a name for it – “the
interest-only negative-amortizing adjustable-rate subprime mortgage. You, the home buyer, actually
were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a
higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one
with no income.” (p.37) It was rather clear why Banks were making such loans. They weren’t keeping
them. They sold them to Goldman Sachs and Morgan Stanely and Wells Fargo and the rest, which
packaged them into bonds and sold them off. The subprime mortgage bonds had various floors, or
tranches. There were the riskiest floors, or the ones that would flood first, and then there were the
higher floors which were made of triple-A bonds. Big banks and other financial institutions would take
the lower level bonds and repackage them into CDOs – Collateral Dept Obligations which were rated by
Moody’s and Standard & Poor as triple-A.
The people in “The Big Short” were able to identify certain attributes about these bonds, the
fact that the rating agencies were not aware of the underlying foundation of these bonds. That these
bonds were, at the end of the day, made up of crappy mortgage loans that would soon default. Michael
Burry, a market investor, got an idea: credit default swaps on subprime mortgage bonds. “A credit
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default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy,
typically on a corporate bond, with semiannual premium payments and a fixed term.” (p.38) At first it
was difficult to find sellers of this type of insurance, but in the end the sellers that he did find, mainly
Goldman Sachs not only sold him insurance on the pool of bad loans, but sent him a little note
“congratulating him on being the first person” to buy insurance on this type of item. Goldman Sachs had
made it clear to Burry that it wasn’t the ultimate seller. It turned out that the party on the other side of
Burry’s bets against subprime mortgage bonds was a triple-A-rated insurance company AIG – American
International Group, Inc.
One of the big problems that led to the current financial crises was that banks and other
financial institutions were making bets against bonds that had good ratings. Why should these subprime
mortgage bonds default? So what if the foundation, or the bottom floor, trenches defaulted. The rest of
the bond, especially the higher floors were all triple-A. What most of these banks did not know was that
Moody’s and S&P did a horrible job rating these bonds. “Moody’s and S&P asked the loan packagers not
for a list of the FICO scores of all the borrowers but for the average FICO score of the pool.” (p. 94) To
give an accurate rating, you need to know all the FICO scores not the average. If you have a pool of FICO
scores with half being 550 and the other half 680 averaging out at 615, it would be more likely to default
than a pool of all FICO scores at 615. Each CDO contained pieces of a hundred different mortgage bonds
which in turn held thousands of different loans. It was impossible to find out which pieces belonged
where. Even the rating agencies, that were supposed to be the most informed sources, hadn’t a clue.
Since the banks were making bets based on the ratings of Moody’s and S&P, at the end of the
day, it was the rating agencies to blame for this financial crisis. The rating agency people were all
underpaid. “The smart ones leave for Wall Street firms so they can help manipulate the companies they
used to work for. There should be no greater thing you can do as an analyst than to be the Moody’s
analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if
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Goldman likes General Electric paper. If Moody’s downgrades GE paper, it is a big deal. So why does the
guy at Moody’s want to work at Goldman Sachs? The guy who is the bank analyst at Goldman Sachs
should want to go to Moody’s. It should be that elite.” (p. 139) The credit agencies were the prime
reason behind bad decisions on the bank’s end. The whole system behind bonds is so convoluted that
no bank analyst would ever even look into what a CDO was made of. They all relied on the rating
agencies to provide solid and sound ratings.
The people in “The Big Short” all got rich because they identified a major flaw in the American
financial system. They identified the fact that they can buy highly insurance on highly rated CDOs that
looked bullet proof but in reality were worthless. They identified the fact that these CDOs, in its
fundamental state, were all simply bad subprime mortgage loans that were doomed from the start.
They all knew that when the teaser rates expired at the end of the 2 year period, the borrowers would
default causing the collapse of the entire market. It was then that they can cash in on their insurance
(credit default swaps on subprime mortgage bonds) that they knew from the start would pay off sooner
or later.