The Subprime Crisis and Financial Regulation: International and Comparative Perspectives*
Dam, Kenneth W., Chicago Journal of International Law
The global subprime crisis that erupted in mid-2007 unleashed a torrent of analysis in the US.1 Its impact in some other countries equaled or exceeded that in the US, in part because financial institutions elsewhere in the world purchased securities issued by US-based financial institutions and secured by mortgages on US real estate.2
The spread of the subprime crisis abroad has several implications. The reach and impact of the "made in America" subprime crisis has generated an urgent international issue engaging many central banks and finance ministries, as well as a wide variety of international bodies, especially the Basel-based international institutions, such as the Financial Stability Forum (renamed the Financial Stability Board in 2009) and the Basel Committee on Banking Supervision. The purchasers of these US mortgage securities were not simply victims. Many of the world's most sophisticated banks bought these securities, usually without doing their own investigation and analysis and almost certainly without adequate due diligence. And they did so because, like many US purchasers, they sought higher returns than elsewhere available.
The underlying theme of this paper is thus that an analysis of the subprime crisis and proposed solutions is incomplete if international and comparative perspectives are not brought to bear. Contrary to popular impression, securitization (the pooling of loans, including mortgage loans, into securities) is common throughout the world.3 In Germany, mortgage-backed securities have been common for at least 200 years.4 In Asia, securitization markets are growing, in part because of the underdeveloped state of Asian bond markets.5 Indeed, US authorities have often looked to European precedents for reform. For example, a US Secretary of the Treasury called for adoption of the European institution of "covered bonds" for financing home mortgages.6
As C.A.E. Goodhart has pointed out, the crisis was "an accident waiting and ready to happen"7 based on very low interest rates in the US, UK and the Eurozone; the "Great Moderation" (an unparalleled period of low and stable inflation); and the tendency of the Federal Reserve during the chairmanship of Alan Greenspan to increase liquidity and lower target interest rates prompdy whenever financial markets weakened sharply, also known as the "Greenspan put."8
In many respects, this crisis was foreseen in advance. Almost every central bank which published a Financial Stability Review, and international financial institutions, such as the BIS and IMF, which did the same, had been pointing for some time prior to the middle of 2007 to a serious underpricing of risk. This was characterised by very low risk spreads, with differentials between risky assets and safe assets, having declined to historically low levels. Volatility was unusually low. Leverage was high, as financial institutions sought to add to yield, in the face of very low interest rates. Those same institutions were apparently prepared to move into increasingly risky assets in order to do so, often leveraging themselves several times in pursuit of that objective.
The Goodhart analysis suggests that the subprime crisis would not have occurred if it had not been for very low interest rates, the Great Moderation, and the Greenspan put. But the crisis did occur and it centered on the subprime mortgage market. Perhaps that was because of a factor not discussed by Goodhart: the long period of steadily increasing US housing real estate values that led to a popular view that home prices would continue to appreciate and certainly would not fall. But prices did stop rising, and in fact fell with resulting widespread mortgage defaults.10 But since Goodhart's three factors (minus arguably the Greenspan Put11), as well as steadily rising home prices were, until recently, common in many countries and particularly in Europe, a comparative country analysis of financial regulation is justified. …