The 2007 2009 Financial Crisis: An Erosion of Ethics: A Case Study Journal of Business Ethics

After two years of secrecy, the Federal Reserve Bank of New York is disclosing key details about billions of dollars of financial products it bought while rescuing insurance giant American International Group Inc. and supporting the sale of failed investment bank Bear Stearns Cos. The “Disastrous Effects of the 2007–2009 Financial Crisis” section of the case will catalog the deleterious effects of the financial crisis including unparalleled unemployment, massive declines in gross domestic product (GDP), and the prolonged mortgage foreclosure crisis. On December 19, the George W. Bush administration announces plans to support two of the “Big Three” U.S. automakers, General Motors and Chrysler, with emergency financing totaling more than $17 billion; the third, Ford, avoids a bailout. In February 2009, the companies approach the government again for additional loans of more than $20 billion; by June, both have entered bankruptcy.

By serving as a backup source of liquidity for borrowers, the Fed’s commercial paper facility was aimed at reducing investor and borrower concerns about „rollover risk,“ the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased. Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm.

Tracking Our Toxic Asset

Bernanke explained that between 1996 and 2004, the U.S. current account deficit increased by $650 billion, from 1.5% to 5.8% of GDP. Financing these deficits required the country to borrow large sums from abroad, much of it from countries running trade surpluses. The balance of payments identity requires that a country (such as the US) running a current account deficit also have a capital account (investment) surplus of the same amount. Hence large and growing amounts of foreign funds (capital) flowed into the U.S. to finance its imports. The Federal Reserve and Treasury took action to stabilize AIG because its failure during the financial crisis would have had a devastating impact on our financial system and the economy. TARP helped restart the secondary credit markets which are essential to keeping credit flowing to households and businesses.

For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy.

‘Moral Hazard’ and Lehman’s Collapse

Collateralized Loan Obligations (CLOs), which uses corporate debt instead of mortgages, performed well through the financial crisis; it remains a vibrant market today. Given FASB’s two recent pronouncements on Level 3 assets, there is no question that banks will increasingly value illiquid securities by marking them to model. During the first quarter of 2009, Level 3 assets at the 19 largest U.S. banks increased by 14.3%, as compared with the prior quarter. Because banks are allowed to make reasonable assumptions based on their own estimates for rates of return on subprime loans, mortgage-backed securities, and other troubled assets over several years, mark-to-model valuations will usually be higher than those based on recent trades of similar assets. Marking to model lets banks paint a relatively optimistic picture of their financial condition.

Because prime mortgages had very low default rates and were implicitly guaranteed by the GSEs, investors believed the MBS were safe investments. The risk profile of the security they purchased was inherited directly from the underlying mortgages in the mortgage pool, much like investors purchasing mutual funds (p. 73). Trump signs the Economic Growth, Regulatory Relief, and Consumer Protection Act, the first major financial legislation since Dodd-Frank. The bill, passed with bipartisan support in Congress, keeps the Dodd-Frank framework but exempts many smaller banks from the regulatory scrutiny imposed after the crisis. Now, only financial institutions with more than $250 billion in assets, rather than $50 billion, will be subject to increased federal oversight, though the bill gives the Fed discretion to include smaller banks if it deems necessary. President Barack Obama signs into law a financial reform bill aimed at preventing future financial crises by giving the federal government new powers to regulate Wall Street.

Financial crisis, five years on: trust in banking hits new low

The reformed system also needs to balance national sovereignty and international coordination. All systemically important economies need to be fully engaged, and there needs to be real and rigorous peer review of their systems and mutual assessment of their macroeconomic policies and the potential to contribute to global imbalances. This highlights the importance of designing and implementing rigorous medium-term “exit strategies,” so that the necessary short-term contracyclical policies do not become the source of new global imbalances. It also highlights the need for a better early warning system for imbalances, including asset bubbles, both at the national level and for the international system as a whole. Such an early warning system should take lessons from the last decade, when too much liquidity led to a frantic search for yield, real interest rates were below sustainable levels and risk was systemically underpriced.

• As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy–namely, by setting a target for the federal funds rate.
• Subprime collateralized debt obligations catalyzed the global financial crisis.
• Most important, a bank should disclose enough detail about the assumptions underlying its models to allow investors to trace how it reached valuations.
• It needed to buy them so banks like Goldman Sachs Group Inc. and Societe Generale would cancel AIG’s insurance obligations.
• However, even under historical accounting, current market values are factored into financial statements.

The crisis began in early August 2007, and a bank run led to Northern Rock’s collapse in mid-September. The Bank of England wanted urgently to supply liquidity to banks and was therefore willing to accept a wider-than-usual range of collateral, but it wanted a correspondingly higher interest rate against any weaker collateral it took. House of Representatives pass the Financial CHOICE Act, which would largely dismantle the Dodd-Frank reforms. Provisions include exempting many banks from stress tests, repealing the Volcker Rule, stripping the Consumer Financial Protection Bureau of much of its power, and easing many other regulations on financial institutions. The Treasury sells its remaining shares in Ally Financial, formerly the financing arm of General Motors, offloading its last major investment from the Troubled Asset Relief Program.

Unprecedented Rescue Efforts

Forced by its auditors, PricewaterhouseCoopers, to disclose it had no reliable methodology to estimate movement in the value of the securities on which it wrote its CDS, the ratings agencies downgraded AIG’s credit rating, triggering a massive demand that AIG post significant collateral to secure its CDS. Soon afterward, AIG began reporting substantial declines in the value of MBS and CDO on which it had written CDS, triggering an ensuing series of calls for increased collateral. AIG simply could not keep up, and, unable to borrow funds Global Financial Crisis and Toxic Assets or raise capital, AIG turned to and was rescued by the Federal Reserve. The mortgage pools, sometimes combined with other types of loans, were divided into multiple tranches which would absorb in ascending order the losses stemming from the mortgage or loan defaults. The equity tranches, having the highest level of risk, paid the highest interest rates; the mezzanine tranches paid lower interest rates; and the senior tranches, possessing the least risk, paid the lowest interest rates (Blinder 2013 p. 75 and FCI Report 2011, p. 71).

Both could be accommodated if banks were required to fully disclose the results under fair value accounting but not to reduce their regulatory capital by the fully disclosed amounts. As explained before, if a bank holds bonds in the available-for-sale category, they must be marked to market each quarter—yet unrealized gains or losses on such bonds do not affect the bank’s regulatory capital. Accounting and capital requirements could be unlinked in other areas, too, as long as banks fully disclosed the different methodologies.

As a result, the share of subprime mortgages among all home loans increased from about 2.5 percent to nearly 15 percent per year from the late 1990s to 2004–07. Banks sold their mortgage loans to their structured investment vehicles (SIV); the SIV borrowed money in the commercial paper market to pay for the mortgages; and the banks used the sales proceeds to make more loans. Because their balance sheet did not change, banks avoided additional reserve requirements; because the banks did not have to report the loans on their balance sheet, the significant debt incurred by the SIV was hidden from view. Likewise, as noted above, camouflaging the banks’ level of debt was a substantial cause of the financial crisis, caused more harm than good to those affected, and constitutes a lousy universal practice. Hence banks’ hiding debt in SIV can be deemed immoral under both Act and Rule Utilitarianism. Banks and other lenders practically tossed money at prospective new homeowners and existing homeowners who wished to refinance at lower rates (p. 38).

This IASB amendment had an immediate impact on the financial statements of European banks. In the third quarter of 2008, Deutsche Bank avoided more than €800 million in losses from write-downs in its bond and marketable loan portfolios by shifting assets to a more favorable category. Through the magic of relabeling, Deutsche Bank reported a third quarter profit of €93 million, instead of a loss of more than €700 million. More generally, European banks shifted half a trillion dollars from other categories to held to maturity—boosting their profits by an estimated $29 billion in total for 2008. Some critics asked, How could actively traded bonds now be accounted for at historical cost if they were not purchased with the intent to hold them to maturity?

None of those, says Steve Forbes, chairman of Forbes Media and sometime political candidate. In his view, mark-to-market accounting was “the principal reason” that the U.S. financial system melted down in 2008. In this article, Pozen, the chairman of MFS Investment Management, dispels the myths about fair value accounting. For example, it’s untrue that most bank assets are marked to market—in 2008 just a third were.

Such was the case with the spectacular 2000–2009 housing bubble “of historic proportions (p. 35).” The history of relative house prices (i.e., compared to the prices of other things consumers buy) from 1890 to 1997 barely changed (p. 32).Footnote 6 Suddenly, beginning in 1997, things altered radically. The final approach that is sometimes used is the simultaneous multiple round auction – the multi-stage auction in which bidders take turns bidding on multiple assets until no one wants to bid again on any asset. My product-mix auction yields similar outcomes but is more robust against collusion and other abuses of market-power. Furthermore a simultaneous multiple round auction is often infeasible – especially in financial markets – because of transaction costs, the time required to run it, or because its complexity is too off-putting to bidders. And the re-remic structure itself could make it difficult to break down the Maiden Lane III CDOs to get at the underlying assets most coveted by investors — securities backed by bundles of mortgages, known as CMBS, and many of which remain AAA-rated.