Lessons from the Financial Crisis

ROBERT W. KOLB is the Frank W. Considine Chair of Applied Ethics and Professor of Finance at Loyola University, Chicago. Before this, he was the assistant dean, Business and Society, and director, Center for Business and Society, at the University of Colorado at Boulder and department chairman at the University of Miami. Kolb has authored over twenty books on finance, derivatives, and futures, as well as numerous articles in leading finance journals.

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: WhatWent 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

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 SubprimeMortgages 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 theMortgage, 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 TheMaking and Ending of the Financial Crisis of 2007–2009 125
Austin Murphy

18 The SubprimeMortgage 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

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 SubprimeMortgages: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 SubprimeMarket 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-DistributeModel 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

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 ofMortgage-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 RiskManagement 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

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 GlobalMarkets? 383
Michael W. Taylor and Douglas W. Arner

49 Financial Regulation, Behavioral Finance, and the Global Financial Crisis: In Search of a New RegulatoryModel 391
Emilios Avgouleas

PART VII Institutional Failures 401

50 Why Financial Conglomerates Are at the Center of the Financial Crisis 403
Arthur E. Wilmarth

51 Corporate Governance and the Financial Crisis: A Case Study from the S&P 500 411
Brian R. Cheffins

52 Secondary-Management Conflicts 419
Steven L. Schwarcz

53 The Financial Crisis and the Systemic Failure of Academic Economics 427
David Colander, Michael Goldberg, Armin Haas, Alan Kirman, Katarina Juselius, Brigitte Sloth, and Thomas Lux

54 FannieMae and FreddieMac: Privatizing Profit and Socializing Loss 437
David Reiss

55 Disclosure’s Failure in the SubprimeMortgage Crisis 443
Steven L. Schwarcz

PART VIII The Federal Reserve, Monetary Policy, and the Financial Crisis 451

56 Federal Reserve Policy and the Housing Bubble 453
Lawrence H. White

57 The Greenspan and Bernanke Federal Reserve Roles in the Financial Crisis 461
John Ryan

58 The Risk Management Approach to Monetary Policy: Lessons from the Financial Crisis of 2007–2009 467
Marc D. Hayford and A. G. Malliaris

59 Reawakening the Inflationary Monster: U.S. Monetary Policy and the Federal Reserve 475
Kevin Dowd and Martin Hutchinson

60 The Transformation of the Federal Reserve System Balance Sheet and Its Implications 483
Peter Stella

PART IX Implications of the Crisis for Our Economic Systems 493

61 Systemic Risk and Markets 495
Steven L. Schwarcz

62 The Transmission of Liquidity Shocks During the Crisis: Ongoing Research into the Transmission of Liquidity Shock Suggests the Emergence of a Range of New Channels During the Credit Crisis 501
Nathaniel Frank, Brenda Gonz´alez-Hermosillo, and Heiko Hesse

63 Credit Contagion From Counterparty Risk 509
Philippe Jorion and Gaiyan Zhang

PART X International Dimensions of the Financial Crisis 517

64 Only in America? When Housing Boom Turns to Bust 519
Luci Ellis

65 The Equity Risk Premium Amid a Global Financial Crisis 525
John R. Graham and Campbell R. Harvey

66 Australia’s Experience in the Global Financial Crisis 537
Christine Brown and Kevin Davis

67 Collapse of a Financial System: An Icelandic Saga 545
Tryggvi Thor Herbertsson

68 Iceland’s Banking Sector and the Political Economy of Crisis 551
James A. H. S. Hine and Ian Ashman

69 The Subprime Crisis: Implications for Emerging Markets 559
William B. Gwinner and Anthony B. Sanders

PART XI Financial Solutions and Our Economic Future 569

70 The Long-Term Cost of the Financial Crisis 571
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 Spilimbergo, Steven Symansky, Olivier Blanchard, and Carlo Cottarelli

73 The Future of Securitization 595
Steven L. Schwarcz

74 Modification ofMortgages in Bankruptcy 601
dam J. Levitin

75 The Shadow Bankruptcy System 609
Jonathan C. Lipson

76 Reregulating FannieMae and FreddieMac 617
Dwight M. Jaffee

77 Would Greater Regulation of Hedge Funds Reduce Systemic Risk? 625
Michael R. King and Philipp Maier

78 Regulating Credit Default Swaps 633
Houman B. Shadab

Index 641