Financial Instruments & Institutions – ECON 304
Financial Crisis and the Dodd Frank Act
After the 2007 Financial crisis, confidence in free markets was at an all time low: the public was increasingly skeptical about the ability of governments and regulatory institutions to improve market conditions. In an attempt to restore financial stability and improve investor confidence, the Obama administration enacted the Dodd–Frank Wall Street Reform and Consumer Protection Act. Easily one of the most controversial pieces of legislation passed by the US government, this act was met with extremely varied reactions from the public, from fierce opposition to straight adulation. While the lack of hindsight prevents us from giving a fair assessment of the act’s outcome and efficiency, a few questions can be formulated: what prompted the US government to pass the Dodd Frank act? What kind of changes did it implement and how did this modify the already existing regulatory architecture? What were the main criticisms? To answer these questions, we will first examine the background of the financial crisis, how these changed the regulatory architecture and finally expose the differing views on the Dodd Frank act. The 2008 global financial crisis resulted from the creation of massive fictitious financial wealth, which is disconnected from the production of goods and services (Bresser-Pereira, 2013). The financial system in the United States was designed to generate profit as leveraged capital, cycled from homeowners to investors. Capital began in the hands of homeowners, who borrowed from commercial banks in the form of a mortgage. The commercial banks profited from interest payments on the mortgages. Investment banks raised millions of dollars to buy mortgages then packaged the mortgages to sell them as financial instruments called collateralized debt obligations (CDO). Rating agencies are hired by the investment banks to rank the quality of the CDOs. These ratings take into account the credit risk evaluation of collateral assets based on the probability of default and other modeling assumptions (Fender, 2004). To compensate for their higher risk, speculative CDOs pay a higher rate of return and safer CDOs pay a lower rate of return. Increasing demand for CDOs caused commercial banks to start lowering their lending standards and approving loans to less credit-worthy homeowners. These subprime mortgages often required payments only on the accrued interest for the first several years. This made monthly payments achievable for low-income borrowers. Subprime mortgages were then sold by commercial banks to investment banks and the heightened default risks associated were transferred as a result. When investment banks packaged the subprime mortgages into CDOs, many of the CDOs failed to pay their returns because of defaulting subprime homeowners. Prudent investors and cynical speculators took notice, and began to guarantee their investments through insurances companies (Desmond, 08). These insured investments, called credit default swaps, transferred an incredible amount of risk to insurance companies like AIG. With the purchase of a credit default swap, the buyers received credit protection, making the seller of the swap guarantee the credit worthiness of the debt security. In doing so, the risk of default was transferred from the holder of the fixed income security to the seller of the swap (Investopedia, 2013). When subprime borrowers needed to begin payments on the primary in addition to the accrued interest on their mortgages, the increased monthly payments became impossible to pay. The subprime borrowers consequently began defaulting in large numbers, thereby harming investments higher up the chain. CDOs became worthless to investment banks, who ceased purchasing them from commercial banks. As a result of the frozen debt security market, the commercial banks stopped lending. The credit default swaps...
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