Smith Faculty Opinion Article

By Dr. John A. Haslem, Professor Emeritus of Finance E-MAIL WEB SITE

The 30 Seconds Outlook
May 1, 2009

In the prior Outlook, it was stated that regulation of financial markets and institutions should favor transparency more so than regulation, unless proved wrong. However, the current financial crisis was accompanied by failures of both, including too much deregulation, failures of enforcement, political pressures on supervision, poor risk management of financial institutions, and lack of effective transparency in financial institutions and markets. As a result, the way to prevent another financial crisis must focus on effective regulation, rather than any hope that real and complete transparency alone would be sufficient.
 
The need for effective regulation has been demonstrated by failures in financial legislation across the board. In what was arguably the primary failure, Congress deregulated (1990s and 2000) the large secondary markets for mortgage instruments and thus ignited demand for new types of private-label mortgages. These mortgages were bundled into "collateralized debt obligations" (CDOs) and sold on the private-label market. “Jumbo” mortgages had heterogeneous terms, which made trading difficult and illiquid. Issuers of CDOs did not bear the credit risk and these securities were not market priced for risk. Risk was assessed by credit rating agencies, but they assumed incorrectly, for example, that senior CDO tranches (“slices”) had virtually no risk.
 
Development of the private-label market for subprime mortgages was facilitated by automated underwriting that incorrectly determined that the risk of loans to subprime borrowers was limited.
 
The private-label market greatly increased demand for housing and housing prices responded. But, once the credit easing of subprime mortgages reached its limits, housing prices began their “big fall” in late 2006. As loan defaults became systemic, investors fled the private-label markets and the sub-prime mortgage market collapsed. This market failure spread worldwide and gave impetus to the “credit squeeze” that engendered the current financial crisis and depression.
 
Issuance of CDOs and their rapid growth without regulation was unsustainable and ultimately became the systemic risk that brought the financial markets and the economy to crisis. It is amazing, but sad, what the lack of regulation and resultant lack of real transparency and pricing of risk in well-functioning markets has done to so many citizens and their futures.

John A. Haslem