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The following OECD assessment and recommendations summarise chapter 2 of the Economic survey of the United States published on 9 December 2008.
The housing downturn triggered the financial crisis
The trigger for the financial crisis was the wave of subprime mortgage defaults, following sharp falls of house prices from unsustainably high levels. These events caused large losses on mortgage backed securities, which were often highly rated and therefore thought to be safe, but turned out to be much riskier than expected. Mortgage defaults and foreclosures have soared in the non-prime market, adding to the inventory of unsold houses, crowding out regular house sales and putting market prices under further downward pressure. Measures have been taken to help distressed borrowers, such as two new programmes to prevent avoidable foreclosures. In addition, the Federal Housing Administration (FHA) has been authorised to guarantee up to $300 billion in refinanced mortgages, provided that lenders agree to write down significantly the amount of the loan. While the FHA programme is estimated to help up to 400 000 borrowers (out of some 2.2 million mortgage loans that may enter foreclosure by 2011), it is likely to be too small to solve the housing crisis. Further action could be needed to prevent avoidable foreclosures and ensure that the fall in house prices does not become excessive.
Supervision of mortgage lenders should be tightened
The wave of defaults on subprime and Alt-A mortgages shows that the process of originating these loans was often inadequate. Lending standards eroded across the entire funding chain, from mortgage origination to final distribution. While securitisation is likely to remain an important part of the financial landscape, stronger supervision is needed at all levels, including underwriters and credit rating agencies, which faced conflicts of interest between the process of rating instruments and the advice provided to the issuers of and investors in these instruments. Investors’ due diligence also needs to be reinvigorated. A good place to start is where mortgage loans are originated and, in this respect, the new rules issued by the Federal Reserve to protect borrowers from predatory lending practices are welcome. As well, legislation has established a federal register for mortgage brokers and developed stronger licensing standards, so as to ensure that mortgage brokers are qualified and properly screened and that prospective borrowers can easily look up a broker's employment history, violations, complaints, and other information. These rules should be rapidly implemented.
Housing finance needs to be reformed
The government took over Fannie Mae and Freddie Mac to safeguard financial stability and support the mortgage market. Over time, it will be necessary to overhaul the structure of the market for housing financing. If the government were to continue to play a role in it, public support should be explicit to avoid the ambiguities present in the charters of Fannie Mae and Freddie Mac. Fundamentally, however, it would be preferable to leave the securitisation of mortgages, especially prime ones, entirely to the private sector, as in most other countries. In order to foster competition and reduce moral hazard, the two government-sponsored enterprises should no longer have access to preferential lending facilities with the federal government; be more tightly regulated and subject to the same regulation and supervision (including capital adequacy requirements) as other issuers of mortgage-backed securities; and divided into smaller companies that are not too big to fail. This would imply that, in due time, new debts issued by privatized GSEs would be explicitly not guaranteed.
Financial markets remain severely disrupted
Fallout from the financial crisis that started in mid 2007 intensified in late 2008. The financial sector is still experiencing severe problems of confidence, credit availability is restricted in some major markets, liquidity is still lacking and credit spreads are abnormally high. The first phase of the crisis was confined to the subprime mortgage market and associated leveraged products, but events have been progressing to the broader economy. In the current second phase, some prime borrowers have felt the hit from slowing economic conditions and defaulted on their mortgages. Credit spreads are widening on other markets, such as student loans, and severe liquidity difficulties have hurt auction-rated securities. As the real economy weakens, in particular in energy sensitive industries such as cars and airlines, a negative feedback loop between the real economy and the financial sector could intensify. The banking system has reacted to asset write-downs by raising fresh capital, but doing so is expensive and difficult in the current environment. Thus, a significant amount of deleveraging is underway, with a severe impact on the supply of credit. The government has responded to these developments by establishing a plan to inject capital into distressed financial institutions and to purchase troubled assets in order to provide the funds needed to normalise conditions.
Gaps in regulatory oversight contributed to the crisis
There is wide agreement that gaps in regulatory oversight are at least partly to blame for the crisis. Many of these gaps were caused by the fragmented structure of regulation, which maintains specialized regulatory agencies across segregated lines of services, such as banking, insurance, securities and futures. While this arrangement may have worked in the past, it is not well suited to the modern financial system. The traditional components of financial services have converged over the past decade and most financial providers now operate across regulatory boundaries. Also, at present in the United States, no single regulator possesses all the information and authority necessary to monitor overall market stability, although there is an increased potential for events triggering a series of defaults affecting the whole financial system and the real economy. Finally, the conduct of business regulation proved weak in the run up to the crisis, enabling the decline in lending standards and, in some instances, deceptive practices. The risks associated with this inadequate regulatory structure have been heightened by the recent shoring up of individual financial institutions, which has increased moral hazard risks. Without tighter prudential standards, the authorities’ financial support to failing institutions will encourage imprudent behaviour of market participants in the hope that their losses would be absorbed by the taxpayer in case of failure. Combating moral hazard costs more effectively should be a major objective of reform to financial supervision and regulation.
Supervision should be more unified and comprehensive, reflecting financial sector developments
The Treasury blueprint provides a sensible starting point for addressing these weaknesses, with a proposal to consolidate the current system around three regulators: a market stability regulator responsible for overall financial risks potentially impacting the real economy; a prudential financial regulator responsible for the supervision of individual institutions, notably those benefiting from a form of government guarantee and therefore prone to moral hazard; and a business conduct regulator responsible for enforcing business related rules, notably protecting consumer interests. However, the framework does not address explicitly whether it would be desirable to regulate financial institutions that are currently subject to no, or less demanding requirements, but may be or may become systematically important, notably hedge funds and private equity firms. The prudential supervisor needs to have authority over all systematically important institutions and all institutions that have access to the central bank’s credit facilities. The market stability supervisor, if it is separate from the prudential supervisor as the Treasury blueprint proposes, needs extensive access to financial sector data to be able to arrive at an independent judgment regarding systemic risks. A number of different institutional arrangements would be consistent with these principles, including the tri partite approach proposed by Treasury and a “Twin Peaks” model. In the latter case, the market stability and the prudential regulators could be unified within the central bank (as in the Netherlands) which already has considerable responsibility in this area through monetary policy and as lender of last resort to the financial system. An argument can also be made for an independent market stability supervisor (as in Australia or the United Kingdom) to ensure focus on supervisory issues and avoid possible conflicts between monetary policy and prudential concerns. The credit crisis has thrown into sharp focus the need for a substantial overhaul of US financial supervision. While some progress has been made through informal and incremental cooperation agreements (memoranda of understanding) among regulators, in the longer term a more formal and dramatic process, such as that outlined in the Treasury blueprint, is likely to be necessary. The new regulatory structure should feature unified supervision in line with the current business model adopted by financial conglomerates. The market stability supervisor, whether a separate institution or not, should have access to sufficient information to assess macroeconomic risks and have the tools to promote corrective action if needed.
Capital requirements should be reconsidered and probably tightened
Many financial institutions, including several large banks, took more risk than was compatible with their capital holdings. Lehman Brothers was one of those, and finally had to file for bankruptcy. Risk-based capital standards should be re-assessed, and tightened where needed to discourage these practices. Financial institutions should hold capital against off balance sheet risks and assets held in so-called trading accounts. The financial crisis has also revealed major risk with the investment banks’ highly leveraged business model and the regulatory framework to which they were subjected. The remaining two large investment banks, Goldman Sachs and Morgan Stanley, have become bank holding companies, which puts them under the Federal Reserve’s regulatory umbrella and gives them greater access to the Federal Reserve’s credit facilities. However, regulatory overreaction should be avoided, as this could encourage the shift of certain financial activities into segments of the financial markets where they would be even further away from the reach of regulators (e.g. hedge funds or offshore). These and other suggestions to overhaul financial supervision and regulation will be important to increase the robustness of the financial system against future stresses. Introducing a greater degree of regulatory enforcement would go a long way towards preventing the recurrence of financial crises and averting their detrimental effect on economic stability. Once repaired, the US financial system will once again play its key role of efficiently intermediating between savers and investors and contributing to economic growth.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.The complete edition of the Economic survey of the United States 2008 is available from:
For further information please contact the United States Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by David Carey and Andrea de Michelis under the supervision of Patrick Lenain. Research assistance was provided by Laure Meuro and Roselyn Jamin.