Table of Contents Economic Policy Causes and Consequences of the Subprime Crisis Brendan Dowling 11

Shannon Burke ’15, Forrest Robinette ’15, Elaina Rollins ‘15

with support by Jessica Henning and Tennyson O’Donnell
Table of Contents

1. Economic Policy Causes and Consequences of the Subprime Crisis - Brendan Dowling
11. Objectivity Created from Created Subjectivities - Caroline Howell
17. Revisiting Educational Inequality in the 21^st Century -Elaina Rollins
30. Crossing the Line: Barriers in War and Peace - Emily Turner
38. The Biogeography of Crassitegula C.W. Schneid., C.E. Lane et G.W. Saunders (Sebdeniales, Rhodophyta)

–Erica Quinones

Nineteenth Century America - Madeline Burns

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To say that causes and consequences of the Great Recession are at the forefront of economic discussion is a gross understatement. Even 6 years removed from the largest destruction of wealth since the Great Depression, economists, regulators, and even the average citizen are analyzing what caused the crisis, and to what extent economic policymakers reacted effectively to mitigate its effects. As with anything in economics, it is difficult to pinpoint exactly one catalyst. As one might imagine for a financial collapse with the international scope and totality of the Great Recession, there are several policy culprits. Decades-old legislation aimed at encouraging innovation and growth have been proven irresponsible, a rather lax approach to monetary policy helped fuel a massive bubble, and a those tasked with protecting investors did the opposite for many years.

In the aftermath of financial collapse in such fantastic fashion one might expect that regulators and businesses pursued wide reaching overhaul. One would assume that firms in the financial services industry, particularly those that are levered, would face more stringent regulation reflecting their systemic importance. Unfortunately, though, in many respects the financial crisis is a missed opportunity. Much of the policy consequences are either making an implicit goal explicit or half-measures. In this paper we will examine the economic policies that led up to the crisis, and we will also analyze the extent to which the Great Recession has had policy consequences.

The Glass-Steagall Act was legislation that emerged out of the Great Depression in an attempt to make the financial sector safer. It legally required that commercial and investment banks operate as separate entities. These two categories of financial institutions perform vastly different tasks; commercial banks accept savings and loan them out in the form of instruments such as mortgages or loans to businesses. This was traditionally a stable business, especially after the introduction of the Federal Deposit Insurance Commission, as long as the banks made responsible decisions with their loan portfolios. Conversely, investment banks engage in riskier activities such as market making to facilitate trading securities, underwriting new securities and engaging in innovative financing structures such as collateralized debt obligations. Separating these two types of institutions was an important step in promoting financial stability, and it also made the job easier for regulators. By classifying a firm as either an investment or commercial bank, it was much more clear who should do the regulating and to what extent that regulation should take place.

Enter 1999, during the Clinton administration when Glass-Steagall was repealed. This meant “…commercial banks (could) engage with risky new financial instruments such as derivatives that ultimately undermined their solvency” (Allington 2009). While perhaps it was permissible for financial behemoths to exist as long as they engaged in less risky, “thrift”, activities, what followed was consolidation between investment and commercial banks. Rather than thrifts following the satirical 3-6-3 rule (borrow at 3%, loan at 6%, on the golf course by 3:00pm from Liar’s Poker by Michael Lewis), these behemoths were engaging in derivative speculation, using off-balance sheet special purpose vehicles to hide risk from their books and selling securitized products collateralized by the very loans they underwrote. Massive financial institutions became much more risky.

Adding even more risk to the situation was the fact that the regulatory landscape was murky at best. As Hank Paulson, former Goldman Sachs CEO and Secretary of the Treasury, stated after the crisis unfolded and he retired from public service, “we still have five regulators falling all over themselves, competing with each other, with no clear message” (Paulson 2013). These enormous institutions, wielding trillions of dollars on their balance sheets, went lightly regulated because there were so many different regulators that nobody knew who should regulate which part of the business. Take a firm like JP Morgan Chase, which is the largest bank in the United States. It is involved in so many different businesses from securitization to advisory to traditional savings and loans, and no regulatory body in history has the tools or resources to monitor all of that activity on its own. This means that the Federal Reserve, Securities and Exchange Commission, Federal Deposit Insurance Commission and an alphabet soup of other institutions all regulate the business of this one firm. Each of these regulators competes with each other for work, and as a result there is a race to the bottom. They rely on work to maintain their levels of funding, so to get the banks to agree to let the FDIC regulate part of their business instead of the CFTC, for example, the FDIC might agree to look the other way or take it easier. This greatly undermines regulation’s purpose.

To make matters worse, financial regulation is constantly taking place and in a search for profits and products that meet investor needs, investment banks are constantly bringing new securities to market. Because there is so much ambiguity towards the role of each regulator, it is often unclear which institution should regulate which market and which new product. In the context of the financial crisis, the mortgage backed securities and derivatives markets became so large and complex that regulation was grossly underprepared. The lackluster (at best) regulatory policy left the system vulnerable for the kind of bubble that had the potential to destroy the global economy.

Similar to the conflict of interest in terms of the regulatory race to the bottom, credit agencies, another group of critical importance, had motives that did not align with society’s best interest. Just as regulators make money regulating, credit rating agencies make money by rating credit. In a rather simplistic line of logic, more credit products means that the rating agencies will rate more paper, and higher ratings mean more issuances. If ratings agencies awarded higher ratings, they would have the opportunity to rate even more products and make more money, and it became a vicious cycle. Obviously this isn’t efficient or productive, but this was the state of affairs that led up to the crisis. Lack of credit rating regulation meant that low-quality products “earned” high-quality ratings, and led investors to believe that risky products were unlikely to default, and were on the conservative side of the risk spectrum.

At this stage we understand that regulators and rating agencies failed to promote stability and responsible behavior by the newly created financial behemoths that permeated every avenue of financial services. Surely the Federal Reserve, behind its legendary leader Alan Greenspan, would be the savior and behave responsibly. This storied institution filled with the brightest minds in economics must exhibit the sanity needed to restore stability. Unfortunately, as Taylor analyzes in great detail, this was yet another area of policy failure. The chart below shows that the Federal Reserve kept interest rates extremely low for too long following the dotcom bubble and all the way up to 2006.

Low interest rates encourage businesses and individuals to borrow and invest, and the Taylor Rule has long stood as an unofficial guideline for interest rate adjustment. The idea is that by following the Taylor Rule, the Fed can maintain steady and stable inflation, growth and unemployment. A rate higher than the Taylor rule would suggest that policy is too tight, and a lower rate signals that policy is too loose. Clearly, from the above graph, the Fed was loose for too long. With historically cheap borrowing, businesses and individuals went on a borrowing spree. Asset managers like hedge funds saw cheap leverage at every turn and used this tool to maximize exposure while individuals saw this as an opportunity to purchase their dream home at a very low interest rate. The problem is that for many, if not most, dream homes are dreams for a reason: they’re too expensive. Enticed by teaser low rates that would eventually skyrocket, consumers bought homes en masse for living and speculative purposes, and the housing bubble gained steam. Without the Federal Reserve’s low interest rates, this bubble would not have grown to its systemically risky size.

Again, there are other policies that exacerbated this effect. The Community Reinvestment Act in place during this time “…required that financial institutions lend more to this (risky) sector, mainly blacks and Hispanics to create a more inclusive property-owning democracy” (Allington 2009). This means that the federal government in the United States incentivized lending to risky borrowers. The government literally rewarded banks for issuing riskier loans.

In an attempt to gather the information discussed so far, we can state that banks got much larger and pursued riskier businesses while credit rating agencies conveyed a false sense of safety and regulators stepped all over each other. Simultaneously, the Fed kept interest rates irresponsibly low while the government incentivized banks to lend to risker borrowers, encouraging the very loans that the risker banks would securitize after getting a synthetically high rating from the credit agencies. Economic and financial policy certainly failed in preventing crisis, and with these facts in mind it is not difficult to believe that policy actually made the crisis inevitable.

As the meltdown unfolded, governments around the world were called to action in order to prevent the Great Depression, particularly in the United States. The Treasury enacted the Toxic Asset Relief Program as a means to inject quality capital into banks, the Federal Reserve has pursued three different rounds of quantitative easing so far in an effort to inject capital into the economy, and the Fed finally adopted an explicit 2% inflation target as part of a policy of increased transparency. A liberal executive branch extended unemployment insurance to cover those out of work for an unprecedented tenor, and various institutions were either bailed out or left to fail. Policy makers called upon creativity and experience to prevent the crisis from getting any worse, and many hoped that they would use those same traits to enact measures preventing another crisis. Let us now examine the extent to which this occurred.

Without question, financial institutions taking excessive risk using leverage need to be closely monitored. Interconnectedness makes the financial sector systemically important and these firms need to be regulated as such. After the crisis, these companies undergo periodic “stress tests” to determine if they are adequately capitalized for another crisis. Conducted by the Fed, these evaluations continue to increase in terms of difficulty, and offer not only regulators but also investors a better understanding of each bank’s financial condition.

Basel III, a set of rules and regulations for the global financial community, is another important measure to promote stability. The key aspect of Basel is that it forces banks to maintain liquid assets at a higher level than before. The idea is that with a larger buffer zone, banks will be able to withstand a drop in the value of assets that are less risky.

While both of these policies are important in promoting stability, they both seem to be measures to protect the system after a crisis occurs. It is doubtful that there will be any point in the future when crisis is no longer a worry, but surely as much, if not more, attention should be paid to preventing crisis. Banks still engage in risky securitization and trade opaque derivatives. Asset managers, particularly hedge funds, use leverage to maximize returns at the cost of increasing risk. High-speed traders using secretive dark pools trade securities at lightening speed and subject the system to “flash crashes”. Even after the crisis, this behavior takes place behind regulators’ backs, or perhaps a more appropriate metaphor, in their faces while they argue amongst themselves whose responsibility it is to prevent the behavior in front of their eyes.

Furthermore, that almost every single financial institution facing a liquidity crisis was bailed out introduces a dangerous amount of moral hazard. If firms like Bear Sterns and American International Group can engage in risky investments with far too little capital and still get saved by the government, then surely I can do the same without serious repercussion. Many of the people engaging in this risky behavior earn such high salaries and bonuses while they introduce the risk that the fear of insolvency isn’t a deterrent. Credit rating agencies, whose ratings are treated as the final say in many investment decisions, need some sort of mechanism to ensure accuracy. Regulators need to make significant strides that prevent unnecessary risk taking, ensure that risk is being taken only by those who can afford it, and make credit ratings systematic decisions rather than “opinions”. Regulatory policy has a long way to go before the economic community can consider the changes a positive consequence of the crisis.

An interesting and little-discussed aspect of radical policies in the wake of crisis is the extent to which this abnormal economic environment will play a part in future leaders’ decision making. My generation has become socially, academically and intellectually aware in an age of zero interest rates, billion-dollar stimulus packages, quantitative easing, forward guidance and almost routine debt crises. In several decades when thinkers from the Great Recession years are in charge, perhaps quantitative easing and forward guidance will be traditional policy tools. Perhaps a President who admired Hank Paulson’s rescue of the financial industry will be more likely to inject capital into investment and commercial banks. To those my age and with in a band of about four years older and younger, low interest rates and a fed funds rate of 25 basis points are normal. It is certainly possible that rates will be abnormally low going forward, because to my generation, low is normal. This is a policy consequence that will not come into fruition for many years, but will certainly be interesting to track.

With the benefit of hindsight it is easy to paint economic policy as one of the causes of the Great Recession. The federal government encouraged banks to make risky loans at the same time it encouraged consolidation, the regulators couldn’t decide who should actually regulate, and credit rating agencies, acting essentially freely, falsified ratings and did not do anywhere near the necessary analysis when deeming speculative grade products as creditworthy. Moreover, the Fed kept interest rates low for far too long, facilitating leverage and even more risk taking. When the crisis unfolded, the government took steps to prevent the economy from falling off a cliff but introduced even more moral hazard in the process. While stress tests and Basel III are significant improvements to stability, the regulatory framework remains far from efficient. Moving forward, decision makers need to use lessons from the past to prevent a similar crisis from happening again.

Works Cited

Allington, N. F. B. (2009), “The American Sub-Prime Crisis and Its Consequences”, Downing College Alumni Journal
Taylor, J. B. (2009), “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, National Bureau for Economic Research, Working Paper W14631
Lopez, Linette. "HANK PAULSON: We're Sowing The Seeds For Another Major Problem." Business Insider. Business Insider, Inc, 28 Jan. 2014. Web. 01 Apr. 2015.