ECONOMICS AND TRADE | Achieving growth through open markets
03 April 2008
U.S. Government Moves to Meet Challenges in Capital Markets
Opaque financial products, complex structures make policymakers cautious
This is the first in a three-part series on the turmoil in the U.S. financial markets and efforts to address it.
Washington -- The U.S. government has taken steps to address major weaknesses revealed by the first major financial crisis in the 21st century.
Turmoil in the capital markets has caused a record number of foreclosures, multibillion-dollar losses at financial institutions and a credit crunch in the United States. It also has challenged perceptions of those markets and assumptions about effective ways to deal with their problems.
The complexity of the financial system, weak understanding of connections among its numerous elements, lack of transparency in many financial dealings and uncertainty about the extent of financial companies’ exposure to bad debt make finding solutions difficult, according to experts.
In the past, commercial banks, which take deposits and extend loans, were the mainstay of the financial system. Today, more borrowing, lending and investing is done through and by investment banks, mutual funds, hedge funds and other financial entities.
Also known as underwriters, investment banks act as intermediaries between corporations issuing new securities and the public. Those types of companies today have about three times more assets than commercial banks, according to the Federal Reserve, the U.S. central banking system.
Nonbank capital markets have expanded mostly through a vast array of innovative financial products that fall into two major categories -- asset-backed securities and credit derivatives.
Asset-backed securities are debt securities, or bonds, created through pooling and repackaging of financial assets such as mortgages, automobile loans or home equity loans. Credit derivatives are bilateral contracts between a buyer and seller in which the seller sells protection against certain events -- such as bankruptcy or default on a loan -- occurring in relation to a third party.
Because these products are not traded on open exchanges and financial companies disclose few details about them, they are difficult to understand and even harder to value. The extent of this challenge is such that former Federal Reserve Vice Chairman Alan Blinder, who holds doctoral degree in economics, admitted recently that he has only a “modest understanding” of complex derivatives.
Anthony Ryan, assistant secretary of the Treasury, said that monitoring of the current crisis has brought to light “many issues to evaluate and address.”
For a long time, innovative financial products were favored by Wall Street companies as their main profit sources and praised by U.S. central bankers. When Alan Greenspan was chairman of the Federal Reserve, he and at least one central bank governor said these products improved risk management and distribution, thereby enhancing market efficiency and resilience.
But asset-backed securities and derivatives, created by loading debt upon debt in intricate ways, have another feature, which became apparent only recently. Although in normal times they produce large profits, during turmoil they increase losses by magnifying the effects of mistakes made in the financial system. That is because these products have linked as counterparties many financial institutions around the globe, which often held these financial instruments off the balance sheet (and away from creditors’ scrutiny) and traded them in a variety of complex, unregulated transactions. Those characteristics have made a chain reaction of failures in the capital markets more likely, according to experts.
The current crisis started when the U.S. real estate market turned downward and homeowners with limited incomes began defaulting on their mortgage payments. Many of these mortgages were underwritten poorly or were created through fraud. When mortgage-backed securities, mostly in the subprime sector, went down, they sent shockwaves through the entire global financial system. Home loans to borrowers who do not qualify for market interest rates because of poor credit history or inability to repay the loan are called subprime mortgages.
Joseph Mason, a finance professor at Drexel University in Philadelphia, says that innovative financial products are neither a silver bullet nor a financial virus. They cannot serve all purposes, particularly if they are untested, he told America.gov. But there are ways to limit the use and trades of the newest ones, so they do not become mainstays of the funding for socially and economically important sectors, such as housing, Mason said.
In March, the President’s Working Group on Financial Markets, chaired by Treasury Secretary Henry Paulson, issued a set of recommendations to address weaknesses of the capital markets. They include strengthening government oversight of mortgage originators, imposing licensing requirements and stronger enforcement standards on mortgage brokers, improving credit rating process and practices as well as transparency throughout the system.
The administration also relaxed rules for the two government-sponsored mortgage financing enterprises -- Fannie Mae and Freddie Mac -- and a dozen regional federal home loan banks, allowing them to purchase more mortgages and mortgage-backed securities.
In addition, U.S. regulators are developing common guidance for financial institutions to address risk management flaws revealed by the crisis, and the Treasury Department has proposed a comprehensive reform of the financial regulatory system designed to reduce the likelihood of financial upheavals in the future.
