LESSONS FROM THE FINANCIAL CRISIS The Robert W. Kolb Series in Finance series provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately 65 volumes covering all major topics and specializations in finance, ranging from investments, to corporate finance, to financial institutions. Each vol- ume in the Kolb Series in Finance consists of new articles especially written for the volume. Each Kolb Series volume is edited by a specialist in a particular area of finance, who develops the volume outline and commissions articles by the world’s experts in that particular field of finance. Each volume includes an editor’s introduction and approximately thirty articles to fully describe the current state of financial research and practice in a particular area of finance. The essays in each volume are intended for practicing finance professionals, grad- uate students, and advanced undergraduate students. The goal of each volume is to encapsulate the current state of knowledge in a particular area of finance so that the reader can quickly achieve a mastery of that special area of finance. LESSONS FROM THE FINANCIAL CRISIS Causes, Consequences, and Our Economic Future Robert W. Kolb The Robert W. Kolb Series in Finance John Wiley & Sons, Inc. Copyright c 2010 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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Contents Acknowledgments xv Editor’s Note xvii Introduction xix PART I Overview of the Crisis 1 1 Leverage and Liberal Democracy 3 George Bragues 2 A Property Economics Explanation of the Global Financial Crisis 9 Gunnar Heinsohn and Frank Decker 3 Of Subprimes and Sundry Symptoms: The Political Economy of the Financial Crisis 17 Ashok Bardhan 4 The Political Economy of the Financial Crisis of 2008 23 Roger D. Congleton 5 The Global Financial Crisis of 2008: What Went Wrong? 31 Hershey H. Friedman and Linda Weiser Friedman 6 The Roots of the Crisis and How to Bring It to a Close 37 James K. Galbraith 7 Enron Rerun: The Credit Crisis in Three Easy Pieces 43 Jonathan C. Lipson 8 The Global Crisis and Its Origins 51 Peter L. Swan vii viii Contents 9 Four Paradoxes of the 2008–2009 Economic and Financial Crisis 59 John E. Marthinsen 10 Understanding the Subprime Financial Crisis 69 Steven L. Schwarcz PART II Causes and Consequences of the Financial Crisis 77 11 The Origins of the Financial Crisis 79 Martin N. Baily, Robert E. Litan, and Matthew S. Johnson 12 Ten Myths about Subprime Mortgages 87 Yuliya Demyanyk 13 The Financial Crisis: How Did We Get Here and Where Do We Go Next? New Evidence on How the Crisis Spread Among Financial Institutions 95 James R. Barth, Tong Li, Lu Wenling, and Glenn H. Yago 14 A Decade of Living Dangerously: The Causes and Consequences of the Mortgage, Financial, and Economic Crises 103 Jon A. Garfinkel and Jarjisu Sa-Aadu 15 Making Sense of the Subprime Crisis 109 Kristopher S. Gerardi, Andreas Lehnert, Shane M. Sherlund, and Paul Willen 16 Miraculous Financial Engineering or Legacy Assets? 119 Ivo Pezzuto 17 The Making and Ending of the Financial Crisis of 2007–2009 125 Austin Murphy 18 The Subprime Mortgage Problem: Causes and Likely Cure 133 Ronald D. Utt 19 Sequence of Asset Bubbles and the Global Financial Crisis 139 Abol Jalilvand and A. G. (Tassos) Malliaris CONTENTS ix PART III Borrowers 147 20 The Past, Present, and Future of Subprime Mortgages 149 Shane M. Sherlund 21 FHA Loans and Policy Responses to Credit Availability 155 Dr. Marsha Courchane, Rajeev Darolia, and Dr. Peter Zorn 22 The Single-Family Mortgage Industry in the Internet Era: Technology Developments and Market Structure 163 Forrest Pafenberg 23 Speed Kills? Mortgage Credit Boom and the Crisis 175 Giovanni Dell’Ariccia, Deniz Igan, and Luc Laeven 24 Subprime Mortgages: What We Have Learned From a New Class of Homeowners 181 Todd J. Zywicki and Satya Thallam 25 Rating Agencies: Facilitators of Predatory Lending in the Subprime Market 191 David J. Reiss PART IV The Process of Securitization 197 26 A Primer on the Role of Securitization in the Credit Market Crisis of 2007 199 John D. Martin 27 Incentives in the Originate-to-Distribute Model of Mortgage Production 209 Robert W. Kolb 28 Did Securitization Lead to Lax Screening? Evidence from Subprime Loans 217 Benjamin J. Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig 29 Tumbling Tower of Babel: Subprime Securitization and the Credit Crisis 225 Bruce I. Jacobs x Contents 30 The Incentives of Mortgage Servicers and Designing Loan Modifications to Address the Mortgage Crisis 231 Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen Mauskopf 31 The Contribution of Structured Finance to the Financial Crisis: An Introductory Overview 239 Adrian A.R.J.M. van Rixtel and Sarai Criado 32 Problematic Practices of Credit Rating Agencies: The Neglected Risks of Mortgage-Backed Securities 247 Phil Hosp 33 Did Asset Complexity Trigger Ratings Bias? 259 Vasiliki Skreta and Laura Veldkamp 34 The Pitfalls of Originate-to-Distribute in Bank Lending 267 Antje Berndt and Anurag Gupta PART V Risk Management and Mismanagement 275 35 Behavioral Basis of the Financial Crisis 277 J. V. Rizzi 36 Risk Management Failures During the Financial Crisis 283 Dr. Michel Crouhy 37 The Outsourcing of Financial Regulation to Risk Models 293 Erik F. Gerding 38 The Future of Risk Modeling 301 Elizabeth Sheedy 39 What Happened to Risk Management During the 2008–2009 Financial Crisis? 307 Michael McAleer, Juan-Angel Jim ´ enez-Martin, and Teodosio P ´ erez-Amaral 40 Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges 317 Jayanth Varma CONTENTS xi PART VI The Problem of Regulation 325 41 Regulation and Financial Stability in the Age of Turbulence 327 David S. Bieri 42 The Financial Crisis of 2007–2009: Missing Financial Regulation or Absentee Regulators? 337 George G. Kaufman and A. G. Malliaris 43 The Demise of the United Kingdom’s Northern Rock and Large U.S. Financial Institutions: Public Policy Lessons 345 Robert A. Eisenbeis and George G. Kaufman 44 Why Securities Regulation Failed to Prevent the CDO Meltdown 355 Richard E. Mendales 45 Curbing Optimism in Managerial Estimates Through Transparent Accounting: The Case of Securitizations 361 Stephen Bryan, Steven Lilien, and Bharat Sarath 46 Basel II Put on Trial: What Role in the Financial Crisis? 369 Francesco Cannata and Mario Quagliariello 47 Credit Rating Organizations, Their Role in the Current Calamity, and Future Prospects for Reform 377 Thomas J. Fitzpatrick IV and Chris Sagers 48 Global Regulation for Global Markets? 383 Michael W. Taylor and Douglas W. Arner 49 Financial Regulation, Behavioral Finance, and the Global Financial Crisis: In Search of a New Regulatory Model 391 Emilios Avgouleas PART VII Institutional Failures 401 50 Why Financial Conglomerates Are at the Center of the Financial Crisis 403 Arthur E. Wilmarth [...]... Causes and Consequences of the Financial Crisis Borrowers The Process of Securitization Risk Management and Mismanagement The Problem of Regulation Institutional Failures The Federal Reserve, Monetary Policy, and the Financial Crisis Implications of the Crisis for our Economic System International Dimensions of the Financial Crisis Financial Solutions and Our Economic Future OVERVIEW OF THE CRISIS The. .. produced and impressionistic accounts that already sit on bookstore shelves Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future aims to bring to the attention of the general public an understanding of the conceptual underpinnings of the issues that lie at the heart of the crisis Objective conceptual studies of the crisis are being produced mainly by academics and economists... risky these securities actually were Beyond the complexity of the securities, the movement from the old simple originate-to-hold model of mortgage production to the originate-to-distribute model had a tremendous effect In the originate-to-hold model, a lender, typically a local bank or savings and loan, would lend to a home buyer and hold the mortgage for the life of the loan By contrast, in the originate-to-distribute... were guaranteed by the federal government The government presumably does not want to operate these firms forever As a consequence, it will need to create a new regulatory structure for these firms that will be more successful than the previous failed system LESSONS FROM THE FINANCIAL CRISIS Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future by Robert W Kolb Copyright © 2010... protect their solvency Both the property of the bank and the property of the borrower remain in the possession and use of the parties during the loan contract Only the immaterial property side, represented by legal rights over the bank property and the borrower’s collateral, are relevant for this transaction If the bank property was farmland, the bank would continue to till the soil and to harvest the. .. harvest the crop The bank money is derived from the fence around the field and not the soil There is no sacrifice from the postponement of consumption involved As long as private banks issue their own money, of course, nobody must remind them to demand interest, because as proprietors liable for their note issue, they need to protect their capital and solvency The proprietor’s property premium and associated... of the Financial Post in Canada His articles have been published in such venues as the Journal of Business Ethics, The Independent Review, History of Philosophy Quarterly, Episteme, and Business Ethics Quarterly Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future by Robert W Kolb Copyright © 2010 John Wiley & Sons, Inc CHAPTER 2 A Property Economics Explanation of the Global... Markets William B Gwinner and Anthony B Sanders 559 xiv Contents PART XI Financial Solutions and Our Economic Future 569 70 571 The Long-Term Cost of the Financial Crisis Murillo Campello, John R Graham, and Campbell R Harvey 71 Coping with the Financial Crisis: Illiquidity and the Role of Government Intervention 579 Bastian Breitenfellner and Niklas Wagner 72 Fiscal Policy for the Crisis 587 Antonio... Overview of the Crisis Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future by Robert W Kolb Copyright © 2010 John Wiley & Sons, Inc CHAPTER 1 Leverage and Liberal Democracy GEORGE BRAGUES University of Guelph-Humber, Toronto, Canada henever something out of the ordinary happens that is destructive and menacing, the search for causes is almost always intense and prolific... borrower is then ordered to perform the following command: go out and harness the natural and human resources at your disposal so as to produce goods and services for which other people will be willing to trade at least enough paper and electronic tokens to pay off your loan Finance has evolved to the point that it does not merely grease the wheels of trade and bring savers and investors together; it . a mastery of that special area of finance. LESSONS FROM THE FINANCIAL CRISIS Causes, Consequences, and Our Economic Future Robert W. Kolb The Robert W. Kolb Series in Finance John Wiley & Sons,. products, visit our Web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Lessons from the financial crisis : causes, consequences, and our economic future / Robert W. Kolb, editor. p than the rapidly produced and impressionistic accounts that already sit on bookstore shelves. Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future aims to bring to the