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Capital Markets, Derivatives, and the LawPositivity and Preparation$

Alan N. Rechtschaffen

Print publication date: 2019

Print ISBN-13: 9780190879631

Published to Oxford Scholarship Online: May 2019

DOI: 10.1093/oso/9780190879631.001.0001

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PRINTED FROM OXFORD SCHOLARSHIP ONLINE (www.oxfordscholarship.com). (c) Copyright Oxford University Press, 2019. All Rights Reserved. An individual user may print out a PDF of a single chapter of a monograph in OSO for personal use. date: 17 October 2019

The Financial Crisis

The Financial Crisis

The Seeds of New Regulation

(p.1) 1 The Financial Crisis
Capital Markets, Derivatives, and the Law

Alan N. Rechtschaffen

Oxford University Press

Abstract and Keywords

This chapter discusses the origins of the 2007 financial crisis, subprime lending, and government-sponsored entities. It argues that the events driving financial markets to the precipice of collapse during the global financial meltdown gave rise to a regulatory framework that may have been a rational response to a market in free fall, but need to be reassessed in an era of recovery. In 2018, the U.S. economy may be, by many measures, viewed as wholly recovered from the economic impact of the crisis. The stock market is trading at record highs, having erased all the losses of the crisis period and then some. With this recovery, the Trump administration seeks to restrain the regulatory burden imposed during the crisis.

Keywords:   financial crisis, subprime lending, government-sponsored entities, financial regulation, economic crisis

ON NOVEMBER 8, 2016 Donald Trump was elected the 45th president of the United States. After many years of financial crisis, and several years of modest recovery, the American electorate chose a president advocating less regulation as a means to greater growth.

The reaction of the stock market the night that the votes were cast was quite dramatic. The stock market futures sold off dramatically and then, over the next 48 hours, recovered to levels that would remain the low price for years to come. It seems the markets bought into the notion that light touch regulation and a focus on business would be better for the American economy.

The idea of less regulation was anchored in a notion that part of what was holding back domestic growth was an overreaction by regulators to the global financial (p.2) crisis. Indeed, beyond the financial realm, candidate Trump declared that regulatory burden stymies growth across a multitude of industries.

President Trump makes clear that deregulation is a focus of his administration. He declared, “We’re here . . . to cut the red tape of regulation. For many decades, an ever-growing maze of regulations, rules, restrictions have cost our country trillions and trillions of dollars, millions of jobs, countless American factories, and devastated many industries.”1

In Executive Order 13789, identifying and reducing regulatory tax burdens, he expressed the view that “numerous tax regulations issued over the last several years have effectively increased tax burdens, impeded economic growth, and saddled American businesses with onerous fines, complicated forms, and frustration.”2 This viewpoint is consistent with his view of financial regulation under the Dodd–Frank Act that “regulation is stealth taxation.”3

President Trump established a set of core principles to be used to regulate the U.S. financial system via Executive Order 13772. These principles are to (1) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; (2) prevent taxpayer-funded bailouts; (3) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; (4) enable American companies to be competitive with foreign firms in domestic and foreign markets; (5) advance American interests in international financial regulatory negotiations and meetings; (6) make regulation efficient and effective, while ensuring that it is appropriately tailored; and (7) restore public accountability within the federal financial regulatory agencies, while rationalizing the federal financial regulatory framework.4

In operationalizing Executive Order 13772, the Treasury Department provides a review of the financial system through a series of reports covering:

  • The depository system, including banks, savings associations, and credit unions of all sizes, types, and regulatory charters;

  • Capital markets: debt, equity, commodities and derivatives markets, central clearing, and other operational functions;

  • (p.3) The asset management and insurance industries and retail and institutional investment products and vehicles; and

  • Nonbank financial institutions, financial technology, and financial innovation (unpublished).

The events driving financial markets to the precipice of collapse during the global financial meltdown gave rise to a regulatory framework that may have been a rational response to a market in free fall. The Trump administration seeks to restrain that regulatory burden now that the economy is recovered.

Beginning in 2007, the world witnessed dramatic events affecting the global economy. Failures in individual markets and institutions rapidly devolved into global financial recession. Financial markets and regulators the world over scrambled to navigate systemic imbalances and avoid stagnation as unemployment, debt crises, and recessions fostered political, social, and economic unrest. In response, the United States passed a host of legislative acts that completely reshaped the regulatory landscape.

Since the darkest days of the financial crisis we have seen an unemployment rate that has more than halved and economic growth that has more than doubled. We are near or beyond full employment.5

As an emergency measure, it is certainly plausible that the slew of crisis reactionary regulation contributed to order and confidence in the financial markets. Their utility, now that the economy is quite robust, is less clear.

To better understand the current state of financial market regulation, it is necessary to review the systemic vulnerabilities that led to the Great Recession. The financial crisis arose in large part as a result of “the complexity and sophistication of . . . financial institutions and instruments and the remarkable degree of global financial integration that allows financial shocks to be transmitted around the world at the speed of light.”6 As the financial markets evolved up until the crisis, financial instruments took on dynamic and sophisticated structures allowing returns to investors, contingent on variables other than credit. For example, mortgage-backed bonds, backed by the cash flow of underlying mortgages, were particularly vulnerable to the macroeconomic imbalances that existed at the onset of the crisis.

(p.4) Adair Turner, chairman of the U.K.’s Financial Services Authority during the crisis,7 explained that “[a]t the core of the crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10–15 years [prior to the crisis] and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances.”8 Chairman Turner explained that very large current account surpluses piling up in the oil exporting countries and corresponding deficits in the United States and other countries led to a dramatic “reduction in real risk free rates of interest to historically low levels.”9 Two effects of extremely low interest rates were “[a] rapid growth of credit extension . . . particularly but not exclusively for residential mortgages . . . and . . . a ferocious search for yield.”10

In part, as a result of low interest rates and legislative incentives to own a home, the U.S. real estate market saw enormous gains in the decades leading up to the crisis. When the real estate market reversed, it carried securitized debt with it. Prices of securities that were purchased to enhance yield tumbled, and the dramatic reversal proved devastating for market participants who created and invested in mortgage-linked debt. As a result of the implosion of the real estate and credit markets, companies such as Lehman declined from positions of financial supremacy to illiquidity in a matter of days. Firms that took on the credit default risk of others, such as American International Group (AIG), were subsequently devastated.

In 2019, the U.S. economy is viewed by many as wholly recovered from the economic impact of the crisis. At the time of the writing of this work, the U.S. stock market is trading at record highs, having erased all the losses of the crisis period and then some. Indeed, the Federal Open Market Committee (FOMC) in commenting on the accomplishments of the economy recently observed:

Information received since the Federal Open Market Committee met in March indicates that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Recent data suggest that growth of household spending moderated from its strong fourth-quarter pace, while business fixed investment continued to grow (p.5) strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.11

While the economy may be approaching full recovery and robust growth, the long-lasting effects of the crisis continue to be felt throughout the global regulatory systems, and it remains to be seen what the impact will be of a reduction in those constructs.

I. Origins of the Great Recession

After years of robust growth in the American real estate markets, prices began to decline in the second half of 2007. The decline in real estate prices had a direct impact on the prices of financial instruments linked to the mortgages on those properties. In addition, the prices and market for instruments deriving their values directly or synthetically from mortgages rapidly declined. Systemically important financial institutions owned these securities, while others such as AIG “insured” the financial health of the security holders.

Mortgage-backed securities are financial instruments that derive their cash flow and/or value from pools of mortgages; they include mortgage-backed bonds. The ripple effect caused by a downdraft in the value of mortgage-backed securities resulted in diminished liquidity at financial institutions and systemic threats to the broader capital markets. The undertow created by mortgage foreclosures and deficiencies rocked the financial world and changed the essential functioning of financial institutions in the global economy. Ben S. Bernanke, the chairman of the Board of Governors of the Federal Reserve System at the time, explained that:

Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress. The unwinding of these developments, including a sharp deleveraging and a headlong retreat from credit risk, led to highly strained conditions in financial markets and a tightening of credit that has hamstrung economic growth.12

(p.6) II. Subprime Lending

In 2007 and 2008, the high levels of delinquencies, defaults, and foreclosures among subprime borrowers led to the undoing of the broader capital markets, the shock waves of which were felt throughout the global economy. The effects of mortgage lending on the broader capital markets demonstrate both how global banking systems and international economies are increasingly interconnected and the effect that a unique capital market disruption has on the broader U.S. economy. Today more than ever before, improvements in communication and financial innovation have increased the effects of market disruptions anywhere in the world on the global capital marketplace.

The rise in real estate prices in the 10 years prior to the crisis was encouraged, in large part, by low interest rates facilitating the purchase of homes and investment properties, mortgage brokers on commission, and federal policies encouraging home ownership. This increase in real estate activity, combined with easy access to funding, allowed borrowers to access equity contained in their homes and allowed speculators to make investments in property that would never have been possible without the availability of cheap money.

Borrowers take on debt for many purposes including the funding of long-term purchases such as a home. In the years leading up to the mortgage meltdown, banks aggressively pumped capital into the economy by making loans, advantaging themselves of the spreads between the rates at which banks borrow money and the mortgage rates they charge their customers. Cash was readily available to banks to lend to their customers, since the loans they created were resold in the form of mortgage-backed securities.

The concept of financing mortgages by issuing securities backed by the revenue stream generated from those mortgages was not new. Indeed, the federal government sponsored the establishment of several enterprises specifically designed to provide liquidity to banks participating in the mortgage markets.

III. Government-Sponsored Entities

There are several entities that are sponsored by the federal government to refinance mortgages. Federal agencies are direct arms of the U.S. government, while federally sponsored agencies were historically privately owned and publicly chartered organizations that were created by acts of Congress to support a specific public purpose (also referred to as government-sponsored entities or GSEs). Until the (p.7) changes resulting from the crisis, several executive branches had overseen GSEs. The Department of Housing and Urban Development (HUD) monitored the activities of Fannie Mae and Freddie Mac.13

During the financial crisis, the Housing and Economic Recovery Act of 2008 (HERA) established the Federal Housing Finance Agency (FHFA) as the overseer of Fannie Mae, Freddie Mac (the Enterprises), and the Federal Home Loan Bank System (which includes the 11 Federal Home Loan Banks and the Office of Finance). Since 2008, FHFA has also served as conservator of Fannie Mae and Freddie Mac.14

In 2008, Fannie Mae and Freddie Mac experienced large losses related to the plummeting real estate market in the United States. As a result, the U.S. government placed these two leading mortgage lenders into conservatorship. This action blurred the distinction between government and government agency beyond an implicit guaranty for survivorship. This action was taken to avoid unacceptably large dislocations in the mortgage markets and the economy as a whole.

The U.S. Treasury, drawing on authorities granted by Congress, made financial support available to the housing agencies. As the recovery unfolded, we witnessed a recovering credit market and a more robust mortgage lending market. As housing prices recovered, Fannie Mae and Freddie Mac returned to profitability after teetering on the edge of collapse. In May 2013, Fannie Mae announced a record profit and the return of $59.4 billion to the government that bailed it out:

WASHINGTON, DC—Fannie Mae (FNMA/OTC) reported pre-tax income of $8.1 billion for the first quarter of 2013, compared with pre-tax income of $2.7 billion in the first quarter of 2012 and pre-tax income of $7.6 billion in the fourth quarter of 2012. Fannie Mae’s pre-tax income for the first quarter of 2013 was the largest quarterly pre-tax income in the company’s history. The improvement in the company’s results in the first quarter of 2013 compared with the first quarter of 2012 was due primarily to strong credit results driven by an increase in home prices, including higher average sales prices on Fannie Mae-owned properties, a decline in the number of delinquent loans and the company’s resolution agreement with Bank of America. Including Fannie Mae’s release of the valuation allowance on its deferred tax assets, the company reported quarterly net income of $58.7 billion for the first quarter of 2013. Fannie Mae reported comprehensive income of $59.3 billion in the first (p.8) quarter of 2013, compared with comprehensive income of $3.1 billion for the first quarter of 2012.

As a result of actions to strengthen its financial performance and continued improvement in the housing market, Fannie Mae’s financial results have improved significantly over the past five quarters. Based on analysis of all relevant factors, Fannie Mae determined that release of the valuation allowance on its deferred tax assets was appropriate under generally accepted accounting principles (“GAAP”), which resulted in a benefit for federal income taxes of $50.6 billion. The release of the valuation allowance in addition to operating income and comprehensive income for the first quarter of 2013 will result in a dividend payment to taxpayers of $59.4 billion in the second quarter of 2013.15

In August 2012, before the announcement of record profits, Treasury and FHFA amended the Senior Preferred Stock Purchase Agreements (the so-called “Third Amendment”) that facilitated the bailout of Fannie Mae and Freddie Mac during the height of the crisis to include significantly more favorable terms for the government. In addition to requiring a faster wind-down of their portfolios, the 10 percent fixed-rate dividend that was to be paid to the government on “bailout” contributions was replaced with a variable structure directing all net income earned by the Agencies to be paid to the Treasury.

According to the FHFA, “replacing the current fixed dividend in the agreements with a variable dividend based on net worth helps ensure stability, fully captures financial benefits for taxpayers, and eliminates the need for Fannie Mae and Freddie Mac to borrow from the Treasury Department to pay dividends.”16

While the Treasury continues, at the time of the writing of this book, to collect profits from the GSEs, the shareholders of the GSEs are restless about the dividend distribution scheme, which does not allow them to receive any dividend return on their GSE investments. The Third Amendment has resulted in approximately 20 lawsuits by various classes of shareholders in the GSEs. These litigations all spring from the same set of facts and have taken a number of different approaches to attacking the validity of the Third Amendment.17

The Appellate Court held that HERA’s Succession Clause18 allowed FHFA to succeed to all rights, titles, powers, and privileges of the GSEs’ shareholders as (p.9) conservator and barred plaintiffs from bringing a derivative claim on behalf of the GSEs during a conservatorship. In rejecting petitioners’ assertion that the Succession Clause included a “manifest conflict of interest” exception that permitted shareholders to sue on behalf of the enterprises to challenge FHFA’s decisions, the Appellate Court recognized a limited conflict-of-interest exception in interpreting an analogous FIRREA provision, and declined to extend that rationale to HERA. However, the Appellate Court held that stockholders retained the right to bring direct claims against FHFA during a conservatorship, and subsequently determined that plaintiffs’ breach-of-contract claims were direct and remanded the issue to the District Court for further proceedings, the only relief the plaintiffs secured in their appeal. The plaintiff shareholders’ appealed to the Supreme Court of United States for the reversal of the order passed by the Appellate Court by filing a petition for a writ of certiorari in January 2018. The Supreme Court declined the plaintiff shareholders’ petition.

IV. Legislative Reforms

GSEs enjoy lower operating and funding costs, a line-of-credit with the U.S. Treasury and issue debt and mortgage-backed securities at lower yields than comparable corporate entities due to their government-sponsored status. The credit rating of many GSEs is AA+. The credit spread between GSEs and Treasury securities is small. While the mortgages purchased by Fannie Mae and Freddie Mac are not “government- insured,” a perception had always existed that they “carry an implicit government guarantee [because] the companies are so large that the government would never let them fail.”19

The biggest criticism for bailout of GSEs was the notion of privatization of gains and socialization of losses. The use of $400 billion of taxpayers’ money to bailout private GSEs was a hot topic in the legislature. In order to shape the post-crisis world, the regulatory focus has shifted to the taxpayer protections with respect to government sponsored entities especially in the light of GSE’s federal government conservatorship. Equity holders initially suffered under federal conservatorship. However, in 2013, as investors considered the robust profits at the agency, the future of GSEs generally, and the potential outcome of shareholder lawsuits, the stock of Fannie Mae rose from 25 cents to over three dollars. As of this writing the shares are trading at about $1.50.

(p.10) Bondholders immediately benefited from the federal government’s new and active role in overseeing Fannie Mae and Freddie Mac. Indeed, after Fannie Mae and Freddie Mac were placed into federal conservatorship, investors’ moral obligation inference seems to have been well placed as credit spreads tightened in the wake of government intervention into the ownership and operation of these entities.

GSEs were created to ensure adequate credit flows. They were deemed necessary because of the types of loans they facilitated. The aggregate amount of GSE loans is in the trillions of dollars. Much of the loans outstanding represent growth in the issuance of mortgage-backed securities by home-lending GSEs. Mortgage-backed securities are supported by mortgages the GSE purchases. Fannie Mae and Freddie Mac also purchase loans from banks and repackage the loans into debt securities called residential mortgage-backed securities (collateralized mortgage obligations or CMOs). The GSEs enhanced liquidity by affording homeowners the opportunity to borrow money to spend in the economy.

There is a long line of housing finance reforms proposals made by various policymakers since the financial crisis of 2008. At their core these policies differ on two conceptual issues: (1) whether to keep the GSEs or dissolve them, and (2) whether we continue affording federal guarantee to refinancing agencies. The best way to analyze the legislative reforms surrounding the housing finance market would be to examine two different models that propose different solutions for these questions.20 One of the models is the Corker-Warner “multiple guarantor model” (“Multiple Guarantor Model”) and the second is DeMarco-Bright-Hensarling “multiple issuer model” (“Multiple Insurer Model”).

A. Multiple Guarantor Model

The model proposes the creation of additional market competition and dissolution of the GSEs. The new system would allow new guarantor firms (“Guarantor Firms”) to purchase mortgages from originators and then bundle them into mortgage backed securities (MBS). The qualified MBS shall have a federal guarantee that can only be invoked where private capital arranged by Guarantor Firms takes considerable losses. The model also proposes the creation of a single government agency, the Federal Mortgage Insurance Corporation (FMIC) that would, among other things, provide a common securitization platform, develop standard form risk-sharing mechanisms, expand access to credit, impose disclosure requirements (p.11) in collaboration with the Securities Exchange Commission (SEC), provide insurance on principal and interest for qualified MBS when Guarantor Firms suffer catastrophic losses, and charge fees in exchange for providing this insurance.

All resources and functions of FHFA would be transferred to FMIC. Once fully functional, the GSEs charters will be repealed, except that provisions of the charters will continue to apply with respect to mortgage-backed securities guaranteed by the GSEs, as well as outstanding debt obligations, bonds, debentures, notes, and other similar instruments, and the full faith and credit of the U.S. government would continue to apply to them.

The idea behind the model appears to increase competition in the market so that the status of Fannie Mae and Freddie Mac can be reduced as systemically important and also reduce the scope of the federal guarantee.

The deficiencies of the model revolve around the federal guarantee that it proposes. The model would make the implicit federal guarantee into an explicit one. Considering the explicit federal guarantee, the model also flusters on the design of capital loss of the Guarantor Firms that would trigger the federal guarantees and pricing of the guarantees.21 A separate issue triggered by the model is the introduction of competition in the refinancing market. With too many Guarantor Firms and high level of competition we might end up in a similar situation as the housing bubble of 2008.

B. Multiple Insurer Model

The model proposes to end the receivership and reconstruct the GSEs (Fannie Mae, Freddie Mac, and Ginnie Mae22) by amending their charters and dissolving their investment portfolio. The GSEs will be turned into lender-owned mutuals. They would continue to provide credit enhancement by syndicating mortgage credit risk through a variety of credit risk transfer structures and provide access to small and mid-sized lenders to sell mortgages for cash. Other than being approved by the FHFA as a credit enhancer, the GSEs would no longer have any government role. Ginnie Mae would be reconstructed to become a stand-alone government entity providing guarantees on MBS issued by newly reconstituted GSEs.

FHFA shall continue to exist and would regulate the securitization and the quantity and quality of private capital with respect to government guarantee. FHFA (p.12) would also be responsible for setting standards for private credit enhancement and overseeing the winding down of the conservatorships, including managing the outstanding securities issued by Fannie Mae and Freddie Mac backed by the Treasury. The model, like in the case of multiple guarantor model, promotes standardization across the housing finance market with regard to disclosure requirements and market systems.

A major concern with the proposal is whether such mutual ownership of potentially systemic financial institutions can survive a financial crisis such as the one in 2008. Just like the Multiple Guarantor Model, this model is unclear on the pricing of government guarantees by Ginnie Mae and the extent to which it can or should take risk, to avoid looking increasingly like the previous GSEs.

On January 16, 2018, FHFA Director Mel Watt provided his views on housing finance reforms in a letter and supporting report23 to the Senate Banking Committee chairman, Mike Crapo, and Senator Sherrod Brown. Both the previous models recommend the retention of FHFA, but FHFA leans more toward the Multiple Guarantor Model.

Watt’s term as FHFA director ended on January 6, 2019. As of the writing of this book, the FHFA is led by Comptroller of the Currency Joseph Otting, who was picked by President Donald Trump to serve as acting director of the FHFA while Mark Calabria, the President’s nominee for permanent Director awaits Senate confirmation.


(1) Remarks by President Trump on Deregulation (December 14, 2017), https://www.whitehouse.gov/briefings-statements/remarks-president-trump-deregulation/.

(2) Exec. Order No. 13,789, 82 Fed. Reg. 19317 (Apr. 26, 2017).

(3) Supra note 1.

(4) Exec. Order No. 13,258, 82 Fed. Reg. 9965 (Feb. 8, 2017).

(5) Monetary Policy Report, Board of Governors of the Federal Reserve System (Feb. 23, 2018), at https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf.

(7) The Financial Services Authority (FSA) is an independent non governmental body in the United Kingdom, given statutory powers by the Financial Services and Markets Act 2000. The U.K. Treasury appoints the FSA Board. The FSA is accountable to Treasury Ministers and through them to Parliament. It is operationally independent of government and is funded entirely by the firms it regulates.

(8) Adair Turner, chairman of the FSA, The Economist’s Inaugural City Lecture (Jan. 21, 2009).

(9) Id.

(10) Id.

(12) Id.

(13) Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Fannie Mae and Freddie Mac are subject to supervision by a newly created regulator within HUD, called the Office of Federal Housing Enterprise Oversight (OFHEO).

(14) https://www.fhfa.gov/AboutUs (last visited June 30, 2018).

(17) Altering the Deal: The Importance of GSE Shareholder Litigation, 19 N.C. BANKING INST. 109.

(18) HERA, 12 U.S.C. 4617(b)(2)(A)(i).

(19) Ally Coll Steele, Fannie, Freddie, and Fairness: Judicial Review of Federal Conservators, 53 HARV. J. ON LEGISLATION 417, 420.

(20) Eric Kaplan, Michael A. Stegman, Phillip Swagel & Theodore W. Tozer, Bringing Housing Finance Reform over the Finish Line, Milken Institute (Jan. 2018), available at http://assets1b.milkeninstitute.org/assets/Publication/Viewpoint/PDF/FINAL-Housing-Finance-Reform-Proposals-to-Legislation-2.pdf.

(21) David Scharfstein & Phillip Swagel, Legislative Approaches to Housing Reform, p. 7, (2016), available at http://assets1b.milkeninstitute.org/assets/Publication/Viewpoint/PDF/Legislative-Approaches-to-Housing-Finance-Reform-Oct16.pdf.

(22) For the purpose of this chapter we will only focus on Fannie Mae and Freddie Mac.