Chapter 6: Executive Summary – Hedge Funds in the Aftermath of the Financial Crisis

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section II: Financial Institutions

Background

The available data show a remarkable diversity of management styles under the “hedge fund” banner.  Hedge funds are major participants in the so-called shadow banking system, which runs parallel to the more standard banking system.  Hedge funds have the ability to short sell assets, which allows them to use leverage, and leverage means that their equity value, absent limited liability, can go negative.  Hedge funds add value to the financial system in a number of ways: (i) by providing liquidity to the market; (ii) by correcting fundamental mispricing in the market; (iii) through their trading, by increasing price discovery; and (iv) by providing investors access to leverage and to investment strategies that perform well.

Chapter 4: Executive Summary – What to Do About the Government Sponsored Enterprises

From the book “Restoring Financial Stability: How to Repair a Failed System”.

Section II: Financial Institutions

Background

The primary function of the two government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, is to purchase and securitize mortgages. The securitized mortgages are sold off to outside investors with a guarantee of full payment of principal and interest. In addition, the GSEs hold some of the purchased mortgages as investments, and, in theory, help provide liquidity to the secondary market by repurchasing the mortgage-backed securities (MBS). They are major enterprises and play an unquestionably important role in the market for residential mortgages. The residential mortgage market is approximately 10 trillion dollars in size, 55% of which is securitized.  The GSEs retain a mortgage portfolio of $1.5 trillion and have securitized (and thus guaranteed the defaults of) $3.8 trillion of existing mortgages. Though private institutions, the GSEs accept some regulatory oversight in return for an implicit government guarantee of support. As a result, the GSEs’ activities are funded through “cheap” credit made available in capital markets under the presumed guarantee. The structure of the GSEs leads to the classic moral hazard problem in which the lack of capital market discipline and cheap credit provides an incentive for excessive risk taking. In fact, even though the GSEs’ portfolio contained a variety of risks, including nonprime mortgages and long-maturity prime ones, the GSEs had leverage ratios of the order of 25 to 1.

Chapter 3: Executive Summary – The Rating Agencies: Is Regulation the Answer?

From the book “Restoring Financial Stability: How to Repair a Failed System”.

Section 1: Causes of the Financial Crisis of 2007-2008

Background

Credit rating agencies — the three major ones being Moody’s, Standard & Poor’s, and Fitch—are firms that offer judgments about the creditworthiness of bonds. Specifically, the agencies measure the likelihood of default on debt issued by various kinds of entities, such as corporations, governments, and (most recently) securitizers of mortgages and other loan obligations.  The lenders in credit markets, including investors in bonds, are always trying to ascertain the creditworthiness of borrowers.  Credit rating agencies are one potential source of such information—but they are far from the only potential source. Starting in the 1930s, financial regulators have required that their financial institutions heed the judgments of the rating agencies with respect to these institutions’ bond investments. These regulations, motivated by the desire for safety in bond portfolios, have played a major role in thrusting the agencies into the center of the bond markets.  By creating a category (“nationally recognized statistical rating organization”, or NRSRO; in 1975) of rating agency that had to be heeded, and then subsequently maintaining a barrier to entry into the category, the Securities and Exchange Commission (SEC) further enhanced the importance of the three major rating agencies.

Chapter 1: Executive Summary – Mortgage Origination and Securitization in the Financial Crisis

From the book “Restoring Financial Stability: How to Repair a Failed System”.

Section 1: Causes of the Financial Crisis of 2007-2008

Background

One of major catalysts for the current financial crisis was the spate of defaults and foreclosures in 2007 and 2008, which also generated considerable dead weight costs in their own right.  Two big reasons for all the defaults and foreclosures were the downturn in house prices, coupled with a dramatic decline in the quality of mortgage loans. Several factors in the mortgage market contributed to this latter reason:

Formula For Fiscal Fitness

The instant he takes office, President Obama’s imme diate priority must be to fix the economy, which is spiraling downward rapidly in the worst financial crisis since the 1930s. The clear answer is a combination of government spending (the “stimulus package”) and financial restructuring – and the latter is the more important.