A Crack in the Facade and the Whole Building Came Tumbling Down: A Critical Examination of the Central Banks' Response to the Subprime Mortgage Loan Crisis and Global Financial Market Turmoil

Author:Kara M. Westercamp
Position:J.D./M.B.A. Candidate, The University of Iowa College of Law and the Tippie School of Management, May 2009
Pages:03
SUMMARY

I. Introduction. II. The Role of Central Banks. A. Central Banks And Market Stability. B. A Brief History Of The Federal Reserve, Bank Of England, And The European Central Bank. 1. The Federal Reserve. 2. The Bank of England. 3. The European Central Bank. Ill. Long-Term Capital Management : A Primer on the Federal Reserve's Past Efforts to Avert Wide-Scale Market Panic. A. Unique Risks Of Hedge... (see full summary)

 
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J.D./M.B.A. Candidate, The University of Iowa College of Law and the Tippie School of Management, May 2009. For their invaluable feedback and suggestions on this topic, the author would like to thank Professor Enrique Carrasco of The University of Iowa College of Law and Professor Gabriele Camera of The University of Iowa Tippie College of Business. The author also expresses her sincere appreciation to Professor William Buss of The University of Iowa College of Law, for his continued and dedicated mentorship. The views expressed in this article are the author's alone.

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I Introduction

The subprime mortgage loan crisis originating in mid-2007 threatened global financial market stability and presented an interesting question as to the appropriate degree of central bank intervention. In theory, the implosion of the highly-specialized subprime mortgage loan market should have affected only a small portion of actively-traded mortgage-backed securities (MBSs) or collateralized debt obligations (CDOs), but instead, investors panicked and the crisis ballooned as the broader global financial markets felt the contagious effects of the subprime meltdown.1

The subprime mortgage loan crisis began innocently enough. Low interest rates combined with a growing economy fueled a booming housing market, resulting in a supply of homes outpacing demand.2 As home prices appreciated and the supply of available homes increased, lenders became more willing to include aggressive underwriting terms, potentially far beyond the homeowners' ability to pay.3 These "subprime" loans are usually adjustable-rate mortgages (ARMs) that may include a "teaser" or low introductory interest rate, no "ceiling" or cap on the interest rate, limited Page 199 certification of borrowers' income history, and substantial prepayment penalties.4

Banks and other financial institutions then pooled large groups of subprime mortgages and used financial models to predict default rates and other borrowing contingencies.5 The mortgages became the collateral behind different classes (or tranches) of securities. Collateral was based upon each class' cash flow to determine payment prioritization.6 At this point, a single mortgage represented only a miniscule portion of any one CDO's cash flow.7The originators then sold the securities to other investors, thus spreading the risk of default across multiple purchasers.8 In the case of subprime loans, the weak credit history of the borrowers caused a much higher than expected rate of defaults.9

When the value of the mortgage-backed bonds began to plummet, investors panicked and began trying to sell off as much of their holdings as possible.10 Highly-leveraged hedge funds and investors with large exposure to subprime bonds responded by selling broader classes of much safer investments in an effort to mitigate their losses on subprime bonds.11 A liquidity crisis and credit crunch quickly resulted as financial institutions tightened their lending standards and became more risk-averse.12 Due to the interconnected nature of the subprime bond and wider credit markets, the subprime crisis morphed into global panic as "the global financial losses . . . far exceeded even the most pessimistic estimates of the credit losses on these loans."13 Investors lost confidence in the valuation of asset-backed commercial paper, mortgage-backed assets, and the ability to obtain Page 200 funding.14 The substantial infusion of liquidity-or in other words, cash injections-by central banks has only minimally helped the asset-backed securities, which are still "vulnerable to further shocks."15

The beginning sections of this Note introduced and briefly explained the subprime mortgage loan crisis and its effect on global markets. Part II provides an abbreviated background of central banks and their role in providing market stability. There is disagreement about whether central banks should serve as the lenders of last resort (LoLR) for banks that are "too-big-to-fail." There is also ongoing debate as to whether providing market liquidity is a moral hazard of government intervention.

Part Ill provides a brief history of the three central banks that this Note will study in some detail: the Federal Reserve, the Bank of England, and the European Central Bank.16 Although overlap exists in common policies and general purposes, the central banks have divergent means and procedures that may provide an explanation for their reactions to global financial crises.

Part IV examines the collapse of Long-Term Capital Management (LTCM) in 1998 and the Federal Reserve's efforts to contain the crisis. This Part provides basic information about hedge funds as a background to the collapse of LTCM. The well-documented study of LTCM demonstrates both the factors behind the collapse of LTCM and the Federal Reserve's rationale behind its dramatic rescue and bailout of a hedge fund with significant global ramifications.17 The political reaction and subsequent reform of financial markets following LTCM also play pertinent roles in setting the stage for the subprime crisis.18

Part V describes in further detail the growth of the subprime mortgage loan market and its subsequent collapse. From a purely U.S. perspective, the subprime collapse has drawn much attention to the affected homeowners and alleged predatory lending practices. From a global perspective, financial markets are shaky and uncertain after liquidity and access to short-term equity disappeared. This Part highlights the bank failure of England's Northern Rock and several bank failures in France and Germany, as a Page 201 contagious result of the financial panic originating from subprime mortgage loans. Additionally, this Part studies the collapse of Bear Stearns within the u.s. market.

Part VI compares the Federal Reserve's response to the subprime mortgage loan crisis with the European Central Bank and the Bank of England. More specifically, the effects of the Bank of England's "wait and see" approach are compared to the noticeably more proactive interventions of the Federal Reserve and European Central Bank.

Finally, Part VII suggests recommendations for increased financial integration of the central banks and their changing role in the global financial markets. The Federal Reserve, Bank of England, and European Central Bank should harmonize their efforts to provide market liquidity and prevent wide-scale market failures. This Part predicts that collaboration will increase among the central banks as the markets stabilize following the subprime crisis.

II The Role of Central Banks
A Central Banks And Market Stability

Every country has a central bank to facilitate monetary policy goals and to promote the smooth functioning of financial and banking systems.19 Widely recognized goals include: controlling the inflation rate, stimulating the economy, and managing the unemployment rate.20 Central banks are the main determinants of monetary policy worldwide, but they also serve other important functions.

Central banks can absorb "solvency shocks," act as "crisis managers" by coordinating state and non-state affiliated private banks, and reduce the cost of accessing short-term liquid assets.21 Central banks also make emergency loans to distressed financial institutions through a discount window22 as a means of bolstering individual banks with additional short-term credit or cash on an as-needed basis.23 Central banks differ with regard to the collateral that they will accept for the discount window loan and the penalty Page 202 for accessing the emergency loan.24 Banks usually will not borrow from a discount window unless they are in extreme financial distress because such borrowing indicates exhaustion of a bank's regular credit supply.25 Even without direct intervention, central banks can influence and coordinate other creditors to assist in committing private funds.

In the event of a market crisis, central banks may become the "lender of last resort" and can provide liquidity to illiquid-but not insolvent-banks.26By protecting one bank or a class of banks, the central bank can forestall widespread financial disaster and simultaneously stabilize the market.27Market failures can extend like a domino effect based purely on expectations or by interbank credit risk.28 Central banks accordingly function as a financing safety net if funding is unavailable from conventional sources or if a market views a borrower (or...

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