Question

Please explain in extensive detail:

What are 5 financial innovations and deregulations that led to the financial crisis in 2008? What are 5 policy responses by the Federal Reserve and the U.S. Government and Treasury department that helped us to get out of the financial crisis? Who are the winners and losers?

Answer 1

1- Special Purpose Vehicles: entity that is created by a sponsoring firm. This entity could take the form of a limited liability company, a corporation, trust or partnership. The most important functions of SPVs is securitization. Commercial banks that create SPVs enlarge their balance sheets and this creates more possibilities for a bank to lend money to the public. SPVs, in the period between 2002 and 2006, were mainly concerned with the securitization of subprime mortgages, which were mortgages that lost their value during the financial crisis

2- Mortgage Backed Securities: described as credit risk-shifting instruments. MBS are securities that are created from pools of mortgage loans. MBS that are made of subprime mortgages called subprime MBS. When households began to default on their mortgages the value of subprime MBS decreased rapidly which had great consequences for the investments of financial institutions and investors in these securities.

3- Residential Mortgage Backed Securities: are products that are designed by sold pools of residential mortgages by special purpose vehicles. The originator of residential mortgages are commercial banks, thrifts and mortgage banks. SPVs are securitization entities that pool many residential mortgages for the creation of RMBSs to get benefits of diversification. RMBS that were based on subprime mortgages contributed to the financial crisis of 2007 and 2008

4- Collateralized Debt Obligation: A security that is backed by one or a pool of diversified debt obligations is called a collateralized debt obligation (CDO). A CDO is backed by tranches, that is, the underlying debt obligations of a CDO are called tranches or one could say bond classes. There are several tranches: senior, mezzanine and equity or subordinated tranches. CDOs were responsible for huge write downs at large financial firms like investment banks that invested heavily in these credit risk-shifting instruments. The reason was that these products were partly based on RMBS and RMBS was mainly made of subprime MBS. When the subprime mortgage market collapsed CDOs lost a lot of their value

5- Credit Default Swap: A CDS transfers credit risks of reference entities and it provides protection to buyers of assets against unexpected credit events of the reference entities in the case of default risks. CDS are traded unregulated which means that no supervisory entity that supervises and regulates the financial markets had insight in the risks that were involved in these markets.

Deregulation:

1- The Landmark act allowing banks to expand into financial activities, like investment banking and insurance.

2- Gramm-Leach-Bliley Act repealed the Glass-Steagall Act of 1933. The repeal allowed banks to use deposits to invest in derivatives.

3- Commodity Futures Modernization Act exempted credit default swaps and other derivatives from regulations.

4- Deregulation of Derivative Markets

5- Deregulation allowed financial conglomerates to become so large and complex that neither insiders nor outsiders could accurately evaluate their risk.

Policy Response:-

1- large investment banks to borrow directly at the Federal Reserve.

2-  Fed bought long-term treasury securities, agency issues, and mortgage-backed securities to try to invigorate the housing market.

3- Injected equity capital in banks; taking over Fannie Mae and Freddie Mac; increasing deposit insurance from $100,000 to $250,000

4- Dodd-Frank Act

5- CCAR and Basel reguations on Banks