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Financial Innovation And Financial Stability Finance Essay

The recent economic environment and the continuous volatility of the financial markets due to the credit crunch emerged several issues for deeper thinking and discussion. Many approaches of the major reasons that lead to the economic meltdown are widely cited in the updated scientific journals and articles. This paper’s aim is to clarify why and how securitization affected the financial industry.

Additionally will present the reasons of the recent financial crisis related to subprime lending in U.S and what was the role and contribution of the securitization. Also the issue of securitization will be observed from several perspectives in order to point out the lesson that market participants and policy makers have learned and what should be the potential measures that have to be taken in order to escape from the vortex which will lead to the destruction of the edifice of the well functioning free markets.

Introduction

Financing with bonds guaranteed by asset backed finance or securitization is a financing technique that was known in the 1970’s home mortgage industry and has since become the cause for changing the financial market and most specifically of debt issuing products. Quite simply, “securitization involves the pooling of a set of loans or debt securities whose purchase is financed by issuing new debt titles. The new titles get different names depending on the format of the assets of the pool in which they correspond” (Blundell-Wignall & Atkinson, 200:32). “A CLO is issued in relation with the securitization of corporate bonds, whereas collateralized bond obligations (CBO) are issued when a portfolio of corporate bonds is included in the securitization. Cash flows generate the payments of capital and interest on securities that are created by the process of securitization . These cash flows are generated by a pool of assets (Chinloy & MacDonald, 2005)

Credit is extended to individuals and businesses, e.g. consumer and business loans. For the purposes of securitization consumer credit is typically divided into two types of credit: in mortgage loans and other forms of consumer credit. During securitization of mortgage loans, the entity which carries the securitization issues RMBS. The RMBS is one of the two subcategories of MBS (Mortgage-backed securities), the other is the subcategory is CMBS (commercial mortgage-backed securities), depending on the nature of the underlying asset. During the securitization of credit cards or other forms of consumer credit, the titles issued, facing those who are concentrated in the loan pools, are called Asset-backed securities (ABS). In 2007, ABS titles amounted to 3.455 billion U.S. dollars in the U.S. and 652 billion U.S. dollars in Europe (Security Exchange Commission, 2008).

The term collateralized debt obligation (CDO) is used several times as a more general term that includes most forms of securities issued during securitization, including debt. CDOs are structured titles which have as a subject other structured titles and various series of titles by having some investors in payment priority. In 2007, CDOs amounted to 481.6 billion U.S. dollars worldwide, followed by a steep drop in 2008 to 61.9 billion U.S. dollars (Pagano & Volpin, 2009).

Securitization categories

The RMBS issued during the securitization of mortgage loans is made subject to a second series of securitization where CMOs (Collateralized mortgage obligations) issue. The CMOs are titles covered by mortgages on real estate and usually by RMBS or CMBS. In other words, CDOs are not used exclusively for the securitization of business lending and ABSs are not only used in the securitization of consumer credit. Finally, the CDO securities (titles) have been at times bought and collected (pooled) in entities which issue new requirements on CDO (they are referred as CDO2 or CDO-squared) (Chinloy & MacDonald, 2005).

An important observation here has to do with the fact that securitization has been greatly developed and includes increasingly specialized and complex securitization structures, making difficult if not impossible, to estimate the risk of a particular title. There are thousands of types and stages of debt associated with this title, for example, with a mortgage loan, the requirements of a credit card or by issuing a corporate bond or loan.

First, consumer and corporate debt issued by the lender is distributed to the investors in capital markets. Given the fact that the loans were previously left in the possession of the lender till repayment, through securitization, these loans are concentrated in a pool and claims on their cash flows are sold to investors around the world. Consequently, the problems arising from the credit are no longer confined to the sponsor of the loan, but are spread through financial markets (Couchrane et al., 2004).

Second, credits are securitized in pools with the simultaneous issuance of new securities on tranches that have claims on the cash of the credit pool. This means that these requirements have no direct claim on a specific loan or credit. This fact makes very difficult to separate the claims in the event of default by the borrower (Pennington-Cross, 2002).

Securitization and Structured Bonds

In order for banks to raise more and more liquidity, and thus the potential for more loans, they began to securitize mortgage loans they had granted and to create bonds, which they sold afterwards. The securitization took its name from the fact that the financial tools used for raising funds, are debt instruments. The securitization of loans is a complex financial process (a practice that was used in the U.S. since 1939, and was introduced in Europe in 1999 (Kutner, 2007).It includes the bundling of different categories of loans and their rebuilding into complex investment tools to a broader portfolio of Asset Backed Securities-ABS.

Securitisation changed the funding framework of financial institutions due to the transition from traditional lending (borrowing, holding loans) into the new way of funding (grant, rebuilding, and sale), it helped the banks to exempt from the risk and created increased and uncontrolled liquidity which raised the possibility of lending.

The bonds created, the Colaterized Debt Obligations (CDOs), were based on “guaranteed debt obligations." In other words, they were based on the expectation of receiving loan debts that would generate high profit. At the same time, they incorporated all forms of risk posed by the loans that were given, and emanating from. The CDOs certainly contained a large proportion of low risk bonds, so that they could be evaluated as high reliability (Class AAA) bonds by the rating agencies. So CDOs fuelled the market with liquidity. The portfolio of these bonds (CDO) is a synthesis of three categories of debts, different risk and return (Immergluck, 2007):

a) The senior tranche, with less risk (and lower yield), but with the highest rating and priority regarding the realization of payments to investors.

b) The mezzanine tranche, with greater risk (and return), but lower evaluation.

c) The equity tranche has the highest risk (and higher performance) and is not usually credit evaluated, i.e. has no interest. Those investors buying bonds of this category, are only paid when the demands of the above two categories of bonds are met. Consequently, this category first suffered the consequences of problems that appeared and concerned the difficulties in paying the interest rates of low collateral loan.

Each category of bonds is addressed at different investor categories. In the bonds category of equity tranche primarily hedge funds are invested, i.e. international speculative capital seeking high returns on investment oblivious to the risk. More specifically, the process of securitization is as follows: In the first stage lenders (Asset originators: commercial banks, investment banks) were granting loans of each kind (mortgage, consumer, credit cards, corporate) to borrowers.

In most cases of lending, specialized mortgage brokers, which were coming into contact and were evaluating the credit of borrowers, but they were also involved with the loan applications to lenders. The collection of payments (principal and interest) of borrowers, and generally the recording and servicing of the loan from the borrower assumed by the servicer, who was paid by the lender for his role in the collection of debts. Then, the lenders were establishing (for accounting and tax purposes) an independent, offshore financial entity (offshore Special Purpose Vehicles-SPV), which was the issuer of the negotiable ABSs. This "entity" was buying the packaged loans from lenders and transformed them into structured marketable securities (CDOs). The Credit Rating Agencies were evaluating the credit of investment securities CDOs, and the companies of insuring mortgage debt (Mortgage insurers, Bond insurers), provided guarantees on periodic payments of interest and principal due (Glaister & Lockhart, 2008). The issued titles were separated in three different debt categories mentioned above (Tranches), bought by an investment bank, which undertook to determine the price at which the securities will be promoted in investment market and sold to investors (insurance companies, pension funds, hedge funds), as well as the holding of securities up to their sale. The monthly salary of investors (who had bought these titles) was provided by the servicer (mentioned above).

In other words, the banks did not hold mortgages in their portfolios, but promoted them to companies-brokers, who were converting the bonds into CDOs, which were sold to institutional investors. The securitization of mortgage reduced the risk of the mortgages originated from loans provided by the banks. In essence, this risk is transferred from financial institutions that knew it to others who did not know it (Crouch, 2008). At this point, it should be emphasized that the main driving force of the whole securitizations and sales securities system were the high commissions reaped those by involved in the process (Pennington-Cross, 2002). An important factor is also the fact that the various intermediaries involved in the whole process, from obtaining of loans to the creation and sale of CDOs, did not take risks. The securitization of all kinds of loans and commitments in general, was a consistent, if not compulsory tactic of regular lenders. New mechanisms were made for the production of secondary CDOs: the initial CDOs were broken and new ones were created by mixing the components of the first and resold. Finally, even those securities that had low evaluation were "restructured" and reassessed as products of higher reliability. CDOs enabled their buyers to earn from spreads (Crew Cutts & Van Order, 2005).

In addition, CDO bonds have enabled financial institutions to gain market access in some states of the U.S., since they could buy structured bonds containing loans given in the specific state, without having to open up a branch in the state in order to give loans. So, these bonds were finding owners in every corner of the U.S. and the entire world. This way, most of the banks in the developed world's financial centres were involved in the mechanisms of the CDO market.

According to official figures, the last 3-4 years before the onset of crisis, most of the mortgage loans in the U.S. were produced by legal autonomous private mortgage financing offshore companies, i.e. companies were not controlled by a commercial or investment bank and had their headquarters in a tax haven state (egg Fiji). The companies, since they were not operating as commercial banks and did not accept deposits and there had very small (or zero) part of their own funds in credit safety and used basically borrowed funds (Kuttner, 2007).

Apart from the bond market, a huge market of Credit Default Swaps (CDS) on the CDO was created. It was a creation of insurance policy against the credit risk of CDO. These contracts were traded, even without the knowledge of the original issuer of the CDOs, and essentially they transferred the risk of a loan to another i.e. the insurance market. It is usually the product of a collaboration between a bank that transferred the CDO credit risk for a time period to another, against an agreed annual salary, commensurate with the size of this risk, but certainly very high (Elliehausen and Staten, 2004). Very often, hedge funds took the position of the insurer. As it happens in the CDO market, the profits of the intermediaries of these transactions were extremely high.

The theory of efficient markets

The efficiency of markets is an assumption which describes how the markets react to the information provided. This does not imply that markets promote economic efficiency in the broader sense of the concept. As a matter of fact, these two concepts of efficiency seem to be related. People of the markets supported that when the markets are efficient, the interventions in the markets are counterproductive and more markets mean greater efficiency (Schwartz, 2008).

As anyone who studied economics knows, there are three types of efficient markets. The strong type supports that everything is known about the value of a financial title/product is included "in the price" (Minsky, 1986). This type is closely related with the concept of rational expectations, whose effects were dominant in the macroeconomic theory for 30 years. According to this type policy interventions are useless, monetary policy should have clear and rigid rules, market prices are nothing more than a reflection of fundamentals and obviously there can be no bubble values.

  These claims are not only empirically wrong, but they include several internal contradictions. If prices show all available information, then why should anyone be look for information? If markets are efficient, why people who think in a different way about the future continue to have transactions? If the theory is true, the activities it seeks to explain simply would not exist.

  The theory of efficient markets is not true, but it is enlightening. The vague issues that rational expectations include, are based on the envy of many economists to physics, which leads them to take random inspirations as universal truths. Economic models are exemplary illustrations and cannot give detailed descriptions of the world they describe.

The weak version of the theory of efficient markets suggests that past prices are not a guide on what to do with the prices of securities in the future (Schwartz, 2008). This claim is supported by much empirical data. However, there are other empirical data that show that short-term price movements continue for some time in the same direction - when there is a trend in the market.

And the intermediate version of the theory claims that markets show the information needed about securities. Suggestions like "General Electric has a very good management" or "Britain has a very large deficit" are quite vague and not particularly useful to investors. However, the internal information or the original analysis can add value.

The strong type of the efficient markets theory is popular because it describes a world that has no socio political and/or cultural influences. However, if the reality is formed by people’s beliefs about the world, it should be investigated not only how these beliefs are formed and what their influence is - something that economists do not wish to do – but also how the models and their subsequent predictions depend on these beliefs. Because models and projections are also possible, and it is necessary to understand how beliefs affect them. In the subprime crisis, however, the role of securitization and structured bonds was a key one and proved that the word is far away from efficient markets.

The crisis of 2008-9

The sub-prime market crisis and its effects

It is now widely accepted that this financial crisis derived from the weaknesses of the USA sub-prime market. During 2007, the obligations in this market rose sharply, despite the expectation that this would create problems. This fact had a much larger than expected impact on international markets.

Admittedly, the connection between a default in fulfilling obligations in Chicago and the panic of withdrawal of deposits from credit institutions in Europe and Asia is complex. In its simplest form, this association included the creation of packets of sub-prime loans in the U.S., which were sold at wholesale and retail investors, the revenues of which were then used for new loans (Greenspan, 2008), avoiding this way existing regulatory capital requirements. The reduction of the original valuation of initial securitized claims following the surge of failures to fulfil underlying obligations resulted in a decrease in market value and therefore, of the total value of portfolios of financial institutions around the world. Facing the need of replacing their own capital, these institutions cut their lending activity, especially in the interbank market that provides the greatest part of short-term liquidity, which keeps alive the financial sector of the economy. The formation of a new, more careful approach to investment risk resulted in increased costs of allocated funds, namely the increase of interest rates in the interbank market.

The crisis was of a highly contagious nature. The widespread impact of development to a segment of the U.S. sub-prime market on a wide range of financial markets is due to the characteristics of the complex financial instruments. Sub-prime loans are a type of loan that banks (Wade, 2008) have restructured and packaged into securities that generate income based on cash import flows from these loans, a process known as securitization of requirements. These securities are typically characterized by long-

term duration, high yield but relatively low liquidity and transparency, were sold by investment banks to investors as well as to special investment organizations, many of which were set up by the same investment banks and other entities which funded further the market of re-securitization requirements by issuing short-term credit titles.

Securitization of requirements is a process that demands a distinction between information held by the issuers of loans than information of those exposed to counterparty risk. The unexpected and ongoing capital losses on investment securities resulted as restructuring and sub-prime loan [1] products traded in markets with limited liquidity highlighted the potential cost to investors of the uncertainty surrounding the different types of underlying loans that they were indirectly purchasing. Pursuant to the capital losses, the markets for these securities finally faced a major contraction of liquidity, or they stopped. Specific investment organizations that issued short-term corporate bonds for financing the purchase of long-term sub-prime loans were finally found to possess assets, which could not further sell to liquid markets. That means that they were found in a situation where they had borrowed short term to invest long term facing an immediate problem of refinancing.

Pursuant to this mismatch, the gap between the time borrowing and investment, the special investment organizations have difficulties in gaining re-financing by issuing equity short-term securities. The markets withdrew short – term, in a process resembling with past panic situations of withdrawing bank deposits.

Many investment organizations were forced to shorten the time duration of their issued short-term securities to a more short- term borrowing, which led to a vicious cycle of increasing mismatch between the time duration of short-term borrowing and long-term investment, which ultimately took the form of an international financial crisis.

The increased demand for highly liquidity investment securities during the adjustment period was a key reason for reducing the yields of those securities in all the major economies, such as state titles, and provides the basis for understanding the large increase in the required by the banks' fee for providing liquidity to other banks for a period of more than one night, and the high concentration volume of interbank lending securities in titles of limited duration. Since early August 2008, the difference between 3-month term interest rates in interbank market from the base rate of the central bank for the same period was increased in all major economies. This is the natural financial effect of the change in the expectations of the banks regarding the composition of the assets they wish to declare in their balance sheets.

The most significant developments in the financial crisis in 2008 occurred in the second half of the year. Concerns about financial stability were the focus of the period August-December. Following the bankruptcy of the investment bank Lehman Brothers in the U.S. in September, the international financial markets came to a deeper state of crisis. As initially the money market funds and other investors had to write off the interconnected with Lehman Brothers investments, concerns about the increased risk of the contractor were multiplied, resulting in large-scale liquidations, which swept even the safest investments and led major parts of the international financial system to malfunction. By effective freezing of credit and money markets and the large reduction of stock prices (Mooslechner et al., 2006), banks and other financial institutions saw their access to financing to be limited and their capital base to shrink due to accumulated losses of decreasing value current prices. The difference (spread) in the cost of giving credit rose to record levels, the prices of the shares marked a historical decline, and volatility was increased in all markets, leading to extreme market gridlock. The concerns about the upcoming economic decline and increased capital flows to safe havens offset the positive impact from the expected to the economy increases in public deficits, leading to reduced yields of government bonds. Simultaneously, the performance curves were moved, reflecting the continuous downward movements in interest rates.

The emerging financial markets were also characterized by price reductions, since the rising risk aversion and related pressures in the developed world extended to them, leading to an outflow of capital. The shrinking expectations regarding the viability of significant parts of the international banking system led the relevant supervisory authorities in many countries to take political initiatives to reduce the price cut and the systemic risk.

The international market developments during the second half of 2008 were characterized by four more or less distinct phases. The first phase included the bankruptcy of the investment bank Lehman Brothers in the middle of September and the State acquisition of two large housing financial institutions in the U.S. The second phase contained the direct consequences of the bankruptcy of Lehman Brothers in the markets and the widespread crisis of confidence caused by it. The third phase, began in late September, and was characterized by rapid and broad political action in response to the crisis that evolved. This action concerned the adoption of a more systemic international approach. In the fourth phase, which began in the middle of October, stock market valuations began to be dominated by growing fears of recession in the economies, whereas the behaviour of the markets continued to be influenced by uncertainty about the effectiveness of the newly-taken policy measures. In September the financial markets, were characterized by intermingling expectations about a cyclical deterioration. The investment prices had begun to follow a downward trend even during the summer since the markets readjusted their attitude towards perspectives of reducing corporate earnings, increased cases of failure of fulfilling demands, and increasing capital losses. The expectations of stabilizing property prices in the U.S. were not confirmed (Stiglitz et al., 2006) and the ongoing capital losses in the sub-prime market led to a sharp drop in the market activity of securitization demands. This contributed to further loss of confidence in the markets, despite the intervention of the U.S. government to obtain the bankrupted mortgage organizations Fannie Mae [2] and Freddie Mac [3] on September 7.

This move was widely expected and the rehabilitation of the guarantees of the two organizations contributed significantly to reduce the credit risk of high collateral securities issued by them. The performance deviations of the securitized versions of these organizations were decreased. In contrast, the participation value of investors in these organizations shrunk dramatically due to the increased state participation in the form of privileged shares, resulting in great losses to the regional U.S. banks and shareholders of these organizations.

The relief provided by these measures proved to be limited. The expectations of any further capital losses and writing off of 'toxic' financial assets and investments continued to affect negatively the financial sector. As the macroeconomic perspectives deteriorated, the total actual capital losses worldwide related to the credit crisis were more than half a trillion dollars by the end of August 2008 continued to grow. Even when the focus shifted away from the U.S., the momentum of development was so intense that led to further deviation of credit costs in other markets and reduction of stock prices in the markets. The weakness in international markets made imperative the problem of capital replacement of the affected institutions and the need of continuous refinancing to meet their immediate needs. The problem was particularly acute in those institutions and participants in the market who were dependent on the wholesale markets to obtain financing, and were known to be exposed to problematic investment.

The financial turmoil intensified and quickly spread to both credit and stock markets and to the global financial system in general. The expectation of rising counterparty risk led to a large and sudden increase in the risk premium, as expressed in the price of credit default swaps (CDS), and the deviation in the cost of credit in USA. These developments were expanded into other international markets, whose path followed largely one of the U.S. markets for the remainder of the season [4] . As a result, the spread of high-performance CDS in the U.S. reached its highest level up to 500 unit’s base over the corresponding deviations in cash that were observed during the burst of the 'bubble' prices of the IT and telecommunications companies in September 2002. The bankruptcy of Lehman Brothers led stock prices to a daily reduction of about 4% in the U.S., European, and other stock markets. The long- term yields of government bonds also fell and carry trades were inflated as the reduction in confidence in the markets led to a new flow of funds to low-risk securities (Montgomerie, 2008). The volatility of prices in all markets increased even more in coming weeks as investors progressed continuously to sell off their investments.

Why incomplete assessments supported the expansion of the structured debt market

First, the ratings published by S & P and Fitch mirrored theirr estimates on default probability of a title or a tranche. Of course, default probability can find only one side of default risk. It does not reveal the size of loss given default, which is critical in assessing the risk of a security or a tranche. In contrast, Moody's ratings show the evaluation of the expected default loss. Although it is a better measurement of default risk, it does not suffice to evaluate the risk of a debt structured product. Indeed, Brennan et al. (2008) show that the wrong evaluation occurs even if the pricing of structured products is based on assessments which are based on estimates of expected default and loss not just default probability.

A more complete assessment of the risk of such securities would need information regarding the covariance between default probability and the marginal utility consumption as reported by Coval et al. (2008). These authors examine the pricing error that occurs when the evaluation is taken into account only in the probability of default but fails to reveal whether the breach is likely to occur in high marginal utility situations. They also note that, in chopped CDOs, “the allocation of risk among the different tranches is very sensitive to the assumptions made by the rating agency regarding the structure of the correlation of defaults in the underlying portfolio, which seems to be one of the weaknesses of the methodology used by rating agencies” (p. 120). For example, S & P simply assumes that the correlation between two corporate bonds is 15 percent if they are within the same industry and 5 percent if they belong to different sectors, regardless of the overall state of the economy (Benmelech and Dlugosz, 2008). The correlation of defaults, however, is much more pronounced in economic downturns than in boom times, which probably contributes significantly to the explanation of the massive failure of ratings of structured securities in the current financial crisis.

From another perspective, the lack of completeness of the assessments shows the restricted amount of detailed data at loan-level used by rating agencies in their models for measuring the risk of the underlying portfolio. In early 2007, Moody's announced its intention to demand more information and detailed data from loans issuers who issued for the first time since 2002, including data originally thought as "primary" such as the level of loans to borrower's income (debt-to-income - DTI), the evaluation process and the identity of the lender who issued the loan. As noted by Mason and Rosner (2007), it is noteworthy that such data were not collected from them in the past, considering that "traditionally the loan to value ratio (LTV), the FICO score and the ratio of debt to the borrower's income (DTI) are the three most important measures of credit risk on a mortgage loan "(p. 24). The same surprise is caused by the fact that the models used by the rating agencies were unaware of who the lender was that issued the loan, assuming that this piece of information turns out to be very important for its prediction.

Obviously, in order to effectively deliver all this information about the risk of MBSs, CDOs and the resulting tranches deriving from these, the rating agencies would have to make assessments with many dimensions and also to show statistics about the vulnerability of assessments in the major assumptions of their models, as is , for example, the relation between loan defaults in the existing portfolio. This, however, would probably make their assessments much more obscure and difficult to interpret from the perspective of investors that would lead to a reduction of structured debt publications, refuting the role ascribed to the rating agencies themselves, the one of market development (Partnoy, 2006).

This reluctance to notify is found by the model of Pagano and Volpin (2008), where publishers may not want to publish information about complicated structured bonds, because few potential buyers have enough knowledge to understand the consequences of such information on the pricing. Therefore, by publishing them it would cause the phenomenon of 'winner's curse » (winner's curse problem) for non-knowledgeable investors and would restrict the size and liquidity of primary markets. The argument that disclosure of information about the securitized assets may limit their liquidity has come from Woodward (2003) and Holmstrom (2008).

This forecast is supported by the attempt to restrict information regarding the location of the exact position of the mortgage securitization incurred by public agencies in the U.S. In 1970, when the Government National Mortgage Association (GNMA or Ginnie Mae) paved new roads in securitized loans insured by the Federal Housing Administration (FHA), its management announced that no information will be communicated on the pool of underlying loans other than the publishing rate. The explanation given for this decision was that the advances, although they are directly dependent on the interest rate, they depend to some extent on the geographic composition of the loans pools. The GNMA prohibited information about the location and thereby the ability of investors to prepayment risk was weakened. This policy was adopted by the other two public entities securitising mortgage loans, while insuring against the risk of default, Freddie Mac (Federal Home Loan Mortgage Corporation) and Fannie Mae (Federal National Mortgage Association).

However, in the decade of 1990, Freddie Mac succumbed to pressures to disclose more information about the loan pools of loans and communicates regularly geographic information about them. Thereafter, the pools of Freddie Mac were traded consistently in higher yields than the respective loan pools of Fannie Mae in the period 1998 to 2008, although the securities of Fannie Mae made payments a few days earlier (it would, therefore, have to pay lower interest rates). The difference was 3.05 basis points for ten years, reaching 4.8 points in the problematic period (July 2007 - October 2008). So, there is an example of nearly similar titles, which differ mainly in the details of information provided by the issuer which affect the price. The market assesses more titles with less information, for which specialized investors can reap fewer trading profits and speculation at the expense of the less specialized.

While on the one hand the sparingness in communicating information affecting the liquidity of primary markets, on the other hand, it can reduce the liquidity in the secondary market or even immobilize it. This is because the information that was not disclosed in the adoption process can be detected by specialized investors at a later stage, especially if it enables them to reap substantial profits on transactions in the secondary market. Thus, by limiting transparency in the stage of issuance, the adverse selection problem in the secondary market is postponed. In selecting the degree of transparency evaluation, the issuers in fact encounter a trade-off between the liquidity of the primary and secondary market.

As supported by Pagano and Volpin (2008), the selection of transparency on the part of issuers will directly depend on the exchange ratio between the liquidity and the primary and secondary market. As also noted above, insufficient information reinforces the first, but endangers the second. The key-parameters to this relationship are the value investors attach to the liquidity of secondary markets and also the severity of the problem of adverse selection in the primary market. If the secondary market liquidity is valuable and / or adverse selection does not seriously affect the liquidity of the primary market, then the issuers will select the assessments to be transparent and informative, even with the cost of limiting the liquidity of primary markets. On the other hand, if investors have little liquidity in the secondary market and / or adverse selection deteriorates significantly the liquidity of the primary market, then publishers will resort to inadequate and non-informative assessments.

The degree of transparency of assessments chosen by the editors, however, is lower than the socially optimal whenever the lack of liquidity in the secondary market is more costly to society in general than for issuers of securitized assets. This can happen, for example, if the freezing of the secondary market causes massive bankruptcies and liquidation of assets in the economy because, for example, banks that have open positions in debts and credits and would want to close them, creating a phenomenon of "traffic jam" in the market. Therefore, the degree of transparency in assessments that is optimal for society supersedes the one chosen by the issuers of structured bonds.

This creates a pretext for regulating authorities to impose a degree of transparency to the issuers of such securities. However, it should be acknowledged that such an arrangement would have cost in terms of liquidity or limited market size in the issuing stage. That is, by imposing a greater intensity in foreclosure in the market of MBS, its size will most probably be reduced in size compared to pre-crisis record-size and will very likely prompt investors to demand higher returns even if the market situation has returned to normal levels, as evidenced by the example of comparison of Freddie Mac and Fannie Mae.

Many researchers suggested that the 2008 crisis was systemic and was created by and hit mainly the financial system, particularly the banking the system.

The increased bank liquidity combined with the deleveraging of the economy and strengthens of their regulatory capital, is a key prerequisite for the restoration of the normal operation of the banking system. For now, these policies that have largely restored equilibrium in the balance sheets of the banks have not led to increased credit expansion and financing of the real economy. This is because recession reduces demand for banking products, increases lending risks, loans are delayed in loans, the number of non-served loans is also increased and as a result the profitability of banks is influenced negatively. So, the interest rates of loans remain relatively high despite the extremely loose monetary policy (in practice zero interest rate policy). However, ssooner or later, the actual funding of the real economy will move forward and then central banks will be invited to check the potentially explosive growth of the key monetary aggregates. This development poses, of course the risk of inflation and destabilization (Wade, 2008).

However, the central banks have the ability to limit both the unconventional and the conventional measures of aiding liquidity (e.g. higher interest rates), it is questionable whether some of them will seek it really. For example, the motive for deleveraging and reducing real US debt is served through inflation. This, of course, will apply insofar as the dollar continues to remain the main hoarding currency. The reaction of almost all governments to the crisis was expansionary fiscal policy, the creation of substantial deficits and rising debt as a percentage of GDP (Watson, 2008).

Although deficits are generally effective to stimulate aggregate demand, short term they either derive from public spending or tax cutting, they have negative results in medium term. This is because, beyond the known effects of the multiplier, the crowding out is activated and the Ricardian Equivalence Principle. The former partly replaces the potential private investments that promote the exit from recession and development in a more permanent basis, whereas the forces of Ricardian Equivalence tend to increase savings in anticipation of higher taxes for repayment of debt over time (Benmelech & Dlugosz, 2009). The phenomena will be stronger in countries like Greece, where there were structural deficits and high debt even before the crisis. In addition, in the case of these countries, it is doubtful whether the deficits can act in a stabilizing way even in short term.

Regarding the reduction of the likelihood of recurrence a similar crisis in future, the causes should be eliminated or at least limited. Concerning the issue of global macroeconomic imbalances is obvious that China and other Asian countries must find ways to reduce the gigantic surpluses of their current balance account. For example, China could have overestimated the Yuan against the dollar and strengthen with fiscal and structural measures (social protection and insurance) domestic demand.

The issue of leverage is treated correctly in our opinion by central banks, both by increasing banks’ capital adequacy and other investment entities as well as with the pressure to reduce their short-term financing. In these measures, there will probably be measures when real economies emerge from recession, to enhance banks’ liquidity ratios and measures for countercyclical estimates for the non-performing loans (macro-policies). In the post-crisis era, many economists have recognized that in the pre-crisis era, the term "Free market" is mistakenly identified with the term "Deregulated market." (Spatt et al., 2009). The new arrangements that will be applied are largely still in the planning stage.

In an excellent article in the newspaper Financial Times (2008), the author concludes that there have not been set substantial restrictions on derivatives and in hedge funds in the U.S. but adequate measures have been taken to protect consumers from banks abusive practices. The issues of corporate governance and transparency are also discussed, beyond the public representatives, on the boards of the banks that received capital from the state, significant new policies do not seem to exist.

In many countries, constraints have been set on bonuses both in amount and as to their connection with short-term goals. In addition, the Fed has proposed linking the amount of bonuses to the risk undertaken (Froud & Williams, 2007). Moreover, in some European countries, the time horizon for the payment of bonuses has been extended.

In the European Union a serious effort is made to strengthen the supervisory framework of the financial system by creating a macro and micro supervisory system (Skreat & Veldkamp, 2008).The first will monitor and assess the possible threats to financial stability stemming from macroeconomic developments and systemic risks. In this system, the central banks will have a key role.

The second will be comprised by a network of national surveillance authorities that will work alongside with other supervisory authorities at the level of individual financial institutions and the protection of consumers. By doing this, a mechanism of producing legal provisions for the coordinated oversight of the financial system will be set up.

Suggestions for effective evaluation

Rating agencies should be rewarded by investors rather than issuers.

Once the ratings of rating agencies are lenient and rely on inadequate information by distorting information about the credit risk of the rated securities, the umbilical cord among issuers and rating agencies should be cut. The system “the issuer pays" should be cut and there should be a transfer to a system where "investor pays", as was done before 1970. Something like that happens with financial analysts, where the analyses and their recommendations are sold on a permanent basis to investors or combined and sold together with other financial services from the big banks and investment firms. There could, certainly, be the possibility for investors to push the rating agencies to delay the downgrading of the securities they hold. The possibility, however, may not be possible so it unlikely an investor to have such bargaining power to influence the scores of all the rating agencies. In addition, the indirect transactions and payments by issuers to rating agencies should be avoided. This can be done by eliminating or weakening the bodies or regulating authorities that give power to rating agencies.

The coordinators and service providers should disclose all data of each individual loan or bond that is subject to structured products.

It is appropriate to disclose all information made available to arrangers and service providers (servicers), regarding the version of each individual loan. The information currently provided against remuneration by information providers (such as the Loan Performance in the U.S.) will be provided free of charge to investors. This will enable investors to make their own assessments of the credit risk of every securitized security. This form of communication reduces the risk of fixation of the secondary market and potential conflict of interest among issuers and the rating agency. It is worth noting that the imposition of the requirement for information disclosure to publishers is preferable to the imposition in the rating agencies although this policy will turn rating agencies to be more accountable to investors public, it will also reduce their incentive to invest in improving better risk assessment models. In addition,r model evaluation transparency could lead to greater conflict with publisher. S&P was so transparent about the CDO Evaluator Manual that issuers could forecast perfectly the graduation they would receive and adapted accordingly, the structure of the securities in order to receive AAA credit rating. As already noted in the previous paragraph, the policy proposed here will lead to a reduction in the price of securitized assets in the adoption process and thus reduce the degree for marketable structured debt products, compared with the pre-crisis period. The market, however, will be based on more secure foundations.

Notification of performance of comparable CRAs.

The rating agencies should publish verifiable and quantifiable information about the performance of their assessments in a format that facilitates the ability of investors to compare the performance of various CRAs. More specifically, the CRAs should publish a minimum and transparent level of historical movements (concerning the degree of credit) and performance on the default rate per asset class in a directly comparable basis.

Distinction among traditional services and advisory services of CRAs

The rating agencies that have been accused from a large part of the market to work with the issuers of securitized products to regain investors’ confidence, should disengage from consultancy services to customers whose products evaluate. Therefore, they must provide such as:

• The scoring and monitoring of public and private placements.

• Estimates on new credit and speculative assessments.

• Services related to the valuation of hybrid securities.

• Internal evaluations.

• Press Releases and Report evaluations.

• Publications of researches, including the methodologies, models, newsletters and comments.

Disclosure of the remuneration of CRAs

It is a strong sense that there is an inherent conflict of interests in the process of credit rating because many people receive the bulk of their revenue from the issuers they evaluate. Therefore, CRAs should disclose the remuneration they receive to each regulatory authority aiming at conducting a control of the commission received by each issuer, investor or any other participant in the evaluation process.

Consistent ratings

Investor confidence in the ratings of structured products has been worn due to the recent experience and sharp deterioration of certain structured products (mostly RMBS and CDOs covered with RMBS). Each marking symbol should be clearly defined in the magnitude of the changes among these products and other such common corporate bonds and be applied consistently for all types of products to which the symbol is assigned.

Common framework of the regulating authorities worldwide

The evaluations have a global dimension and would require a more harmonious and consistent approach to legislating, regulations, best practices and agreements. This way, the duties and responsibilities of CRAs, investors, issuers, underwriters and all other participants would be defined and an orderly, transparent and orderly functioning of the global financial market would be maintained. It is necessary for the participants in the market- worldwide - to provide with prompt, firm and coordinated manner, specialized opinions and advice to relevant regulating authorities, lawmakers and to participants in the global market, matters associated with the credit assessments.

Conclusions

The financial crisis in the U.S. was made to happen. The reasons why it is believed that the crisis was inevitable are the following:

From the available statistics derives the result that in recent decades, the U.S. became a debtor country. This means that they spend on products and services more than they produce. This finding would have no impact if the external debt increased due to imports of capital equipment. In contrast, the increase comes from increased imports for consumption. Indeed, due to the energy crisis, in recent years the balance of payments deficit accelerated dramatically, with obvious consequences for the devaluation of the dollar and a loss of confidence in the leadership capabilities of the U.S.

During the second four years of William Clinton, serious efforts were made and the public deficit turned into surplus. However, from 2000 onwards, the budget surplus turned into a growing deficit, and the public debt was inflated.

In light of the above any decent economist would constitute the central bank to raise interest rates and the government to either cut spending or raise taxes. In the U.S. authorities did exactly the opposite. The government increased public spending while lowering taxes, while the Federal Reserve kept interest rates at very low levels to avoid slowing down economic activity. This was that an openly provocative economic policy, which could not have evolved into a crisis if the bubble of real estate that was its creature, did not evolve.

The real estate bubble that was a creature of the intervention of the political system in the U.S. housing market, which was manifested through two wholly-owned by the government semi-government organizations, Fannie Mae and Freddie Mac, which hold or guarantee nearly four trillion U.S. dollars of household debts in the USA. Their agency bonds attracted investors’ interest because they provided a state guarantee on the incorporated debt, while ensuring higher returns than those of their private competitors. The actions of these two organizations in the derivatives market with the guarantee of the U.S. government created enormous effects on competition fostered an unjustified confidence in investors, and they largely eroded confidence in the international money markets and capital.

The failure of the process of evaluation is one of the main causes of the observed lack of liquidity that hit the market of securitized versions since the crisis erupted. Once housing prices stopped increasing, and defaults in the repayment of loans started to increase, those involved in the market realized that the analytical and detailed information needed for identifying "toxic loans" were simply lost in the process of mass securitization of structured debt and the ratings provided to them were proved an insufficient guide for their identification.

Based on the above, it is believed that the economic crisis of 2008-9 is due, first, to the fiscal and monetary policies followed by the U.S., and, secondly, the supervisory authorities who failed miserably in their crucial role. So, the markets were largely inefficient and there is an immediate need to improve processes in order to avoid any future crises of this extent.


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