OECD - The Current Financial Crisis – Causes and Policy Issues (1)

Found an article "The Current Financial Crisis – Causes and Policy Issues" in (OECD)’s website.

Some highlights from the article on causes of the current financial crisis:

Current financial crisis as being caused at two levels:
1. by global macro liquidity policies
2. by a very poor regulatory framework

Global macro liquidity policies that causes global liquidity distortion,s,
including interest rates at 1 per cent in the United States and 0 per cent
in Japan, China's fixed exchange rate, the Sovereign Wealth Funds.

The poor regulatory framework, far from acting as a second line of defence, actually contributed to the crisis in important ways.

Area: mortgage securitisation and off-balance sheet activity

Year of causality: 2004
Things happening in 2004:
1. The Bush Administration ‘American Dream’ zero equity mortgage proposals

2. The Office of Federal Housing Enterprise Oversight (OFHEO) imposed greater capital
requirements and balance sheet controls on Fannie Mae and Freddie Mac,

3. The Basel II accord on international bank regulation was published and opened an arbitrage opportunity for banks that caused them to accelerate off-balance-sheet activity

4. SEC agreed to allow investment banks (IB’s) voluntarily to benefit from regulation changes to manage their risk using capital calculations under the ‘consolidated supervised entities program’; from 15:1 debt to net equity ratio to allowing them to increase their leverage ratio towards 40:1 in some cases.

On Investment Banks:

  • Banks created their own Fannie and Freddie lookalikes: SIVs and CDOs.
  • They move their business model towards equity culture (focus on share price growth, earnings expansion, becoming "growth stocks") and based on securitisation. Compensation evolves to bonuses based on up-front revenue generation, options, employee share participation schemes.

On Basel II:

  • Basel II makes mortgages more attractive (capital weight given to mortgages fell from 50 per cent to 35 per cent, makes greater concentration in low-capital-weighted mortgages improves the overall bank return ).
  • Portfolio invariance (riskiness of an asset like a mortgage is independent of how much of the asset you add to your portfolio) becomes an arbitrage opportunity. To illustrate its points, some case studies are used: Citi, Northern Rock and UBS.

A great read on what happens on these companies.
There is also a corporate governance comparison.

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