The global financial crisis in 2007-2008 was caused not by one singular factor, but
rather as a result of the aggregate effect of many different circumstances.
This post i will examine the pivotal decisions and circumstances which lead to
the collapse of the housing market in 2007. It will also consider how the
housing market was intertwined with securitisation and the implications caused
by lax risk management and poor understanding of securitisation in banking.
Finally it will observe the implications of new regulatory reforms designed to
reduce the probability of a similar crisis reoccurring.

The single most substantial event which leads to the financial crisis of 2007-2008
was the collapse in house prices in the US in 2007. This did not happen of its
own accord, there were many elements that lead to the fall in property prices. If you consider the housing market in the US, historically house prices had stayed consistent 1953 to 1995 when accounting for inflation (Baker, 2008). However from 1995-2002 house prices had risen 30 percent above inflation (Baker, 2008). This was then only compounded by the low interest rates of the early 2000′s brought on by a US government trying to re-stimulate the economy after the recession caused by the end of the Internet driven boom. Mortgage rates followed the trend of interestrate and dipped to a 50 year low (Baker, 2008), these were then coupled with new zero or low equity mortgages that banks were able to offer. This is especially after tighter restrictions on Fannie Mae and Freddie Mac allowed banks a greater opportunity in the mortgage market (Blundell-Wignall et al, 2008). Lower mortgages rates and no deposit required meant there was a serge in subprime mortgages.

The surge in the subprime mortgages came from first time buyers
and those unable to get mortgages before who were looking to taking advantage
of the opportunity to get into the property market. Unfortunately, with the
influx of new potential customers, mistakes were made both sides. Banks
offering mortgages often relaxed their vetting procedures for new mortgages,
this was taken advantage of by many as figures suggest that up to 70 percent of
all defaulted subprime mortgages had misinformation on the application (Bianco,
2008, pp10). This was a serious error from the banks, how can a bank truly
understand the credit risk it is undertaking, if the information it is using to
make the decision is wrong?  Banks relaxing their vetting for applications shows their greed for short term gains.

The overvalued housing prices could not be sustained, and with 17
interest rate rises between 2004 and 2006 from 1 percent to 5.25 percent the
housing market was undermined and mortgage rates raised to match interest rates
causing house prices to drop on average 15 percent by the end of 2007 with many
experiencing over 20 percent drop (Bianco, 2008, pp5) (Baker, 2008). The
raising in the mortgage rates caused the first wave of defaults as variable
rate mortgage defaulted at the higher rate. Later on more defaults were caused
as people with zero or low equity mortgages saw they owed more than the value
of their house and so it made sense for them to default.

Alan Greenspan, the former Chairman of the Federal Reserve,
acknowledges that he did not spot the housing market over valuation until too
late even though there was a lot to data to suggest the housing market was overvalued
(Baker, 2008) (Bianco, 2008, pp3). The reason that Greenspan and others might
not have seen the problem is because the theory about financial markets is that
they are efficient and market values should reflect all possible information
available. Also, that even if markets are not efficient, it is difficult to
know how much by and so market intervention is not possible (Turner, 2009).
This means it is very hard to calculate the market risk when valuing a
mortgage. Invariably banks did not accommodate sufficiently for the real market
risk.

The crash of the housing market in the US itself would not usually
cause a global financial crisis, it was the fact that banks had tied together
and sold off these mortgages all over the world in the form of mortgage backed
securities (MBS) that lead to the crisis (Bianco, 2008 pp8). The attraction of
these mortgage backed securities for banks holding subprime mortgages is that
they could repackage them into MBS and sell them with often high investment
grade ratings thus transferring their risk. Many companies, including many
banks, and then bought them based on the credit agency ratings. These
securities then dropped in value when the housing market declined and default
levels climbed. This left many banks with lots of toxic assets on the balance
sheets, lowering the total value of their assets.

The loss in asset value lead to real liquidity issues within the
banks for a couple of reasons, firstly securities were no longer readily
available to turn into liquidity as their value had fallen and very few people
were willing to trade for them. Liquidity also quickly became an issue because
the subprime mortgage crisis and the drop in the value of mortgaged based
securities had led banks to stop lending money due to lacking trust in other
banks. This raised the interest rates within the wholesale markets for interbank
lending, this being a key market to gain finance and available cheap liquidity.
A good example of this liquidity problem is Northern Rock who borrowed higher
than average amounts from the wholesale market and had money in securities and
could not raise the liquidity to pay of loans and had to be bailed out by the
Bank of England. This highlights how the problem spread across from the US, and
shows the risks of excessive leverage (Ringshaw and Smith, 2007) (Carmassi et
al, 2009)

Despite having to be bailed out, Northern Rock were publicly
declared solvent. They had the assets to exceed the repayments needed, but it
was their focus on solvency over liquidity which was the main downfall. This is
the case in many of the banking failures, companies failed to have an adequate
capital base to account for the risks it was taking.(BIS, 2008, pp1).

There were numerous reasons why banks ran this liquidity risk.
Firstly, some banks had inadequate liquidity risk management procedures. They
did not do relevant stress testing regarding their assets and they did not
plausibly see severe or elongated periods where liquidity would be difficult to
obtain (BIS, 2008, pp1). Also assets were inadequately measured; firstly,
credit rating agencies over rated securities without fully understanding the
complexities of them meaning that buyers of these well rated assets were
potentially buying something a lot more volatile than suggested (Bianco, 2008,
pp9). Secondly, Banks themselves used a sophisticated mathematical tool called
Value at Risk (VaR) to rate the risk on a security. VaR is an accepted method
of valuation by regulators for the risk and weighting of capital needed for an
investment. The biggest flaw with VaR is that it uses  short term data, not data over a whole product cycle, this mean that in good times it under estimates risks and in bad times it over estimates risk. This leads to a pro-cyclicality which only goes to escalate problems when times are bad. (Turner, 2009, pp22) (Blundell-Wignall, Atkinson, 2010, pp5). In hindsight, using the VaR model the way banks did could be considered the
greatest operational risk of the financial crisis.

The fact that the financial crisis happened to the extent of which
it did shows there were flaws in the regulations such as Basel II. New
regulations are being drawn up to try and learn from the mistakes ensuring it
does not happen again.

One of the first responses that have already come into force is EU
regulation on bankers bonuses. This regulation will limit bonuses so only 20-30
percent is paid in cash straight away, with the rest being paid in shares, or
in 3-5 years time. What this hopes to achieve is a shift in the short term
culture so that long term gains are the aim of bankers (BBC, 2010). This will
reduce the pro-cyclicality of using short term measurement tools such as VaR as
you will look at longer periods and more of a products cycle. Longer term
investments also tend to have lower credit risks. Implications of this
regulation though are  that it may cause bankers to leave banks within EU nations for countries with more favourable bonuses such as Switzerland. Also if bonuses are lover attracting bankers to the profession with get harder.

As well as EU regulations, there is a new Basel III Accord being
drawn up. The main aim of this is to propose a new approach to capital in
banking (Blundell-Wignall and Atkinson, 2010. pp9).

Firstly, it will look at core capital levels setting tier 1 and tier 2 capital levels for risk weighted assets. Tier one will be mainly common shares and retained earnings and will be required to rise to 6 percent by 2019. (Blundell-Wignall and Atkinson, 2010. pp9)

Secondly, there will be a stronger guideline on risk management
for risk weighted assets. Enabling companies have a greater understanding and
guidance on credit risk of assets (Blundell-Wignall and Atkinson, 2010. pp9).

Thirdly, there will be the use of a leverage ratio, this is in
place to stop excess build up of leverage in the financial system.(Walter,
2010)

Finally, pro-cyclicality will be addressed. It is suggesting banks
hold buffers above the minimum requirements as to protect against down turns in
the economy. The buffer would be part of a system which rose and fell depending
on whether growth was seen to be excessive so it would act as counter-cyclical.
(Blundell-Wignall and Atkinson, 2010. pp10)

These in theory make perfect sense as a solution to the crisis, as
in 2008 a survey pointed out that credit risk and liquidity were the two main
concerns in banking (Lascelles, 2008). The higher capital requirements are to
help in case of increased credit risk, and to make sure there is always
liquidity. The decision to increasing the capital base is also backed up as
companies with higher capital base saw greater stock performance during the
recession (Demirgüç-Kunt, et al, 2010). Finally, in a small survey of top banks
it can be seen that there is a trend for banks who have better risk management
approach such as sharing qualitative and quantitative data well within the
company and more critical judgement of its holding tended to do better during a
crisis.(Senior Supervisors Group, 2008)

Basel III also has adverse implications, the higher equity demands
on companies could mean they will have to work harder to make profits, and in
fact, this could lead to more risks being taken to try and achieve profits
(Triana, 2010). Banks in the US also look to have a shortfall in available
equity of a combined $100bn (Masters & Baer, 2010). To raise this equity a
lot of assets might have to be sold, compromising the ability for banks to make
profits, which are essential to restore the industry after the crisis. Basel
III makes it even harder for emerging economies to compete, as they need fast
growth to help support their increasing populations, but the Basel III accord would
stunt that growth with requirements on capital (Taylor, 2010). Finally,
worldwide collaboration between nations is needed especially in times of
crisis. This can be hard to achieve automatically and often very time consuming
(Pauly, 2011).

In conclusion, the financial crisis was caused by the unforeseen
market risks in the housing market that lead to credit risks when valuing
mortgage based securities. When mortgages defaulted as the housing market
decline banks assets such as securitisations decreased and liquidity dried up
leaving banks unable to pay debts. The new proposed Basel III accord does go
some way to ensuring that a similar scale crisis should not happen as
counter-cyclical buffers should make banking more consistent, greater risk management emphasis should see that banks have a better understanding of their assets and their inherent risks. Also it improves transparency meaning over valuations in markets should happen less and be smaller. This coupled with EU regulation to
try and counteract the short sightedness of banking means returns in the long
run should be better. Even with new regulation if there is still no strong
valuation method for complex securities and derivatives there is always a
chance of the problem repeating itself, maybe just not on the same scale.