5. Governments response to the financial crisis
5.5 Government control on the Credit Agencies
5.4 Reorganizations of financial institutions. A standard remedy when liabilities exceed assets in a firm is for the firm to file for bankruptcy. The government steps in and reorganizes the firm if possible so that it can resume its business. The essential way the reorganization works is as follows. Equity (net worth) is already zero or even negative, so the stockholders have lost their entire investment. Debt is then reorganized in to new equity claims. That is, debt is written down to zero and the former debt holders are given equity claims in the newly reorganized firm. Essentially, the value of the debt at the time of bankruptcy becomes the new equity in the new firm. In the context of the financial crisis, this last option has a number of appealing features. First, the stockholders and bondholders in the financial firms that have magnified the crisis bear the brunt of the cost of putting the financial institutions back on their feet; there is no cost to taxpayers. Second, the banks are recapitalized and should emerge with willingness an ability to lend.
5.5 Government Control on the Credit Agencies
Why does the credit rating system exist? It arose in the 1970s when the SEC looked for a way to ensure that the brokers it regulated had enough capital. It was much easier for the commission to accept the opinions of a few agencies than to research every single bond itself, and it also saved money (and regulatory risk) for the brokers the act was known as Nationally Recognized Statistical Rating Organizations, or NRSROs.
At the same time, those rating agencies have earned huge sums in the past ten years offering opinions on the creditworthiness of an alphabet soup of mortgage-related securities created by over-eager banks. As the market blossomed, so did the agencies’ profits. Moody’s net income rose from $289m in 2002 to $754m last year <11>.
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“The events of recent months have had a profound effect on our economy and our markets, and they have galvanized regulators and policymakers not only in this country but around the world to re-examine every aspect of the regulatory framework governing credit rating agencies,” said SEC Chairman Christopher Cox.
The agencies feel harmed at the criticism. S&P says it has downgraded just 1% of subprime residential mortgage-backed securities, and that none of those downgrades affected the triple-A bonds. So far, defaults have hit only three of the mortgage tranches it has rated. Of more complex products, collateralized-debt obligations (CDOs) downgrades have affected just 1% of securities by value (*13).
Analyst might retort that the agencies are behind the times; market prices for
subprime-related bonds suggest many are in deep trouble. But the agencies argue that their ratings are designed to measure the probability of default, not to recommend the purchase of individual securities or to predict market prices. And they say their long-term record is good;
the average five-year default rate for investment grade (BBB and above) structured securities is less than 1%. Which implied that their rating will still be accurate only if no crisis will be happen in the future. Which is a question no one can be sure about the answer.
Any set of rules creates incentives for participants to game the system. And that seems to have happened with ratings. After all, CDOs repackage existing securities and charge hefty fees for doing so. There must be a substantial exception in the system to make such
activities worthwhile; the most likely source is the way ratings are treated.
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.
On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of
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interest between rating agencies and issuers of structured securities. On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found “significant weaknesses in ratings practices,” including conflicts of interest <12>.
The regulatory program established by Congress through the Credit Rating Agency Reform Act allows the SEC to promulgate rules regarding public disclosure, recordkeeping and financial reporting, and substantive requirements designed to ensure their activities with integrity and impartiality. These additional proposed rules supplement initial rules
implemented by the Commission under the Act in June 2007. The detail regulatory program is summarized as below.
Create more agencies: A view that partly inspired the Credit Rating Agency Reform Act passed by Congress at 2008. The negative is, perhaps the existence of more agencies would encourage issuers to shop around for the firm with the weakest standards. Although the agencies’ models make it clear what rating they will give a bond on issue, it is less clear what will cause them to downgrade it later on.
Make the agencies legally liable for their views
The courts may do this of their own volition. The negative is the potential damage claim for making a rating would be so large that agencies might either be driven out of business or made excessively cautious by the threat of legal action.
Perhaps the best approach would be to make the regulations less dependent on ratings, and market values could be used instead. However, prices can be very volatile, as they have been in recent weeks; that might require banks to hold more reserves as a cushion against
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price moves, an inefficient use of their capital which is the price we have to pay for the change. Improve investor understanding of credit rating: There was a new proposal from SEC in regard to the Credit agency issue for the recent financial crisis. The aims of the act are to enhance disclosure of NRSRO methods and performance data, and to promote investor confidence in credit ratings by minimizing the gap. The Commission’s rule proposal summarized as below:
Maintain the independency. Prohibit a credit rating agency from issuing a rating on a structured product unless information on assets underlying the product was available.
Constrain credit rating agencies from structuring the same products that they rate. Attack the practice of buying favorable ratings by prohibiting anyone who participates in
determining a credit rating from negotiating the fee that the issuer pays for it.
All information should be announced and can be easily compared through a standardized platform. Require credit rating agencies to make all of their ratings and subsequent rating actions publicly available. This data would be required to be provided in a way that will facilitate comparisons of each credit rating agency’s performance.
Disclose the methodology and risk composition in detail: Require disclosure by the rating agencies of the way they rely on the due diligence of others to verify the assets underlying a structured product. Require disclosure of how frequently credit ratings are reviewed;
whether different models are used for ratings surveillance than for initial ratings; and whether changes made to models are applied retroactively to existing ratings. Require credit rating agencies to make an annual report of the number of ratings actions they took in each ratings class, and require the maintenance of an XBRL database of all rating actions on the rating agency’s Web site. That would permit easy analysis of both initial ratings and
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ratings change data. Require the public disclosure of the information a credit rating agency uses to determine a rating on a structured product, including information on the underlying assets. That would permit broad market scrutiny, as well as competitive analysis by other rating agencies that are not paid by the issuer to rate the product.
Differentiate the rating across product type. Require credit rating agencies to
differentiate the ratings they issue on structured products from those they issue on bonds, either through the use of different symbols, such as attaching an identifier to the rating, or by issuing a report disclosing the differences between ratings of structured products and other securities.
Declaration of the track record of Credit agency performance: require credit rating agencies to publish performance statistics for 1, 3, and 10 years within each rating category, in a way that facilitates comparison with their competitors in the industry.
5.6 Balance of Advantage
Bigger is not necessarily to be better. To a degree, the financial crisis is responsible. It has devastated the venture-capital market, the lifeblood of many young firms. Governments have been rescuing companies they consider too big to fail, such as Citigroup and general motors. Recession is squeezing out smaller and less well connected firms. But there are other reasons too, which are giving big companies a self-confidence they have not displayed for decades. A health economic ecosystem should be contained a variety of big and small companies. The return of the giants could well be a boon for the world economy-but only if business people and policymakers avoid certain pitfalls. Business should not largely focus on the company size, and thereafter to diversifying into a lot of unrelated areas. The most successful big firms should focus on their core businesses.
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The best use of the government’s energies is to remove the barriers which prevent
entrepreneurs from starting businesses and turning small companies into big ones, instead of making a big company to be the future giant.
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6. Consumer response to the financial crisis Understand your investment
As talk on the above page, investors should be able to identify the possible risk on your target investment before you step in the market. Of course consultation with a professional is always the best way to capture more information that we can get from ourselves. But we are the only person who makes the investment decision. Your financial consultant will not responsible for your living if you are not their customer.
Don’t be fooled by the product name
There is no free lunch in the world, at least in the investment world. Even a large financial institute, they launched products like “Premium Deposit” but they are actually not 100%
deposit. The most common way will be to use the interest piece or part of your principle to link with the derivative product. Some of them are principle product, some of them are not.
Make sure you fully understand the terms and conditions of the product. The product name could be difference from what they going to sell.
Personal Financial Crisis
The best way to avoid a financial crisis is to spend less than you earn. You'll be better prepared for unexpected expenses or life-changing events that might dramatically reduce your income or increase your expenses. It also enables you to have the freedom to make personal choices about your job, where you live, and in many other areas of your life.
Recognizing the causes of financial crisis will help you know what to avoid. Below is a list of major circumstances that could put you deeply in debt. When one or more of these happens, it can be overwhelming. If you plan for the unexpected, you will be in a much better financial situation. Part of the reason of the current financial situation is some people
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pay more mortgage payment than they can actually afford. The worst things is that the bank supports this kind of mortgage loan application.
Education
We are facing the most severe economic crisis since the Great Depression. There is plenty of blame to go around. But as suppliers of ideas and talent to the business community, schools education needs to accept some responsibility. Exotic financial instruments, poorly designed compensation plans, models of corporate leadership that value leaders’ charisma over substance. Maybe it is the time for the school faculties to make the most of this opportunity to consider how they can contribute to the creation of a business culture that better serves the American economy and society. We must define business leadership in terms of value creation, not value extraction. This would be an important first step toward restoring society’s faith in our future business leaders.
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The current recession is different. It is now in global scope. The advanced countries like Japan, Germany, the U.K., and France are all in or headed for a deep recession. I can say that it is a balance sheet crisis; both on the firm side and on the household side want to take advantage of the risk transfer market and leverage to get the most fortune out of the market. The investment is a zero sum game; no one can get an extra one dollar from the market. Someone will ask the question, where has money gone. The answer is simple, the investor who uses the leverage and the money is from the bank. They can earn many times return from the original
investment, which depends on your bargaining power to get the fund. At the same time, when the market goes down, investors will loss many times the original investment which depends on the leverage level. In the normal situation, investors will absorb the loss until they go bankrupt. The bank will take over the loss until the bank goes bankrupt. Then, the
government/ Central bank will take over the loss. If the government takes over too much toxic asset like Iceland. They will go bankrupts too. Macroeconomic performance over the next few years is very challenge. The Great Depression was extraordinary by all measures, with unemployment peaking in 1933 at an astounding rate of 25%<13>. No economist expects an outcome that even approaches this magnitude. But an unemployment rate of half that amount is a distinct possibility, something no economist would have expected just two years ago.
Also, there will be some drawback for the government action to purchase toxic assets or direct injection to the financial institute as we can see on the current financial market.
These policies can lead financial institutions to undertake excessively risky investments in the future. This is no doubt that this is a valid concern and a cost of intervention. The
government’s position is that the costs of intervention thus far have been significantly lower that the cost of not intervening which would cause an even more serious financial crisis that could happen in the future.
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<1> Andreas A. Jobst. (2003). Collateralized Loan Obligations, A primer.
The Securitization Conduit, Vol. 6, 1-14.
<2> Henry CK. Liu. (2008). Treasury’s Troubled Assets Relief Program in Trouble.
Free Market fundamentalism to State Capitalism.
<3> Sherman L. Lewis. (1986). Capital Investments, Corporations Finance.
Evaluating Corporate Investment and Financing Opportunities: A Handbook and Guide to Selected Methods for Managers and Finance Professionals, 5-8.
<4> Nicos A. Scordis. (2000). The Journal of Risk and Insurance. American Risk and Insurance Association Vol. 67, No. 4. 667-668.
<5> Davis Wesse. (2009). Financial Crisis: the Fed. Wall Street Journal.
<6> Floyd Norris. (2008). Auctions Yield Chaos for Bonds. The New York Times.
<7> Marie Leone. (2005). Auction-Rate Securities: Hold That Gavel. CFO publishing. 1-2
<8> Jeremy R. Cooke. (2008). Florida Schools, California Convert Auction-Rate Debt.
Bloomberg.
<9> Macon Phillips. (2009). Signed, sealed, delivered: ARRA. The Recovery Act of the White House
<10> Kimberly Amadeo. (2009). Stimulus Is Working as Planned. Guide to US Economy at About.com
<11> Frank Partnoy. (2006). How and Why Credit Rating Agencies Are Not Like Other Gatekeepers. San Diego Legal Studies Paper. No. 07-46.
<12> Florence E. Harmon. (2008). SEC Proposes Comprehensive Reforms to Bring Increased Transparency to Credit Rating Process 2008. U.S. Securities and Exchange Commission 2008. Immediate Release 2008-110.
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<13> Robert VanGiezen and Albert E. Schwenk. (2003). Compensation from before world war I through the great depression. Compensation and Working Conditions of Bureau of Labor Statistics.
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Appendix 1: Working model of securitization
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Appendix 2: CDO Flow Chart
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Appendix 3: Value Maximization Relationship (Erik Banks, Alternative risk transfer. Wiley finance/ Investment)
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Appendix 4: Cost of loss Control/ Loss Financing & Risk Reduction