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Timeline#

7 Years.flac

The Young Pope (Original Series Soundtrack)

I. Where Did the Dry Kindling of the Financial Crisis Come From?#

One unique aspect of this book is that it describes the financial crisis as a fire. Therefore, when the three firefighters reflect on this crisis a decade later, the first thing they need to analyze is where the dry kindling of the financial crisis came from.

0x1: The Origin of the Subprime Mortgage Crisis
The three authors believe that the trigger for the 2008 financial crisis was not a problem within the banking system, but rather the irresponsible lending practices of the U.S. subprime mortgage industry.

It replayed the inherent pattern of previous financial crises: from frenzy to panic, and then to collapse. The difference is that modern markets are more complex, and financial panic is harder to predict. There are also some deeper underlying factors behind this crisis.

First, lending was extremely reckless.
It can be said that this crisis began with reckless borrowing. From 2001 to 2007, borrowers continuously took out large loans, and lenders continuously issued large amounts of credit.

During the boom in the financial market, it seemed that everyone's behavior was rational. Whether borrowing or lending more, there was money to be made, and there were no risks. However, once there was a disturbance, confidence would waver, quickly manifesting as market panic or even collapse.

The second factor is that leverage was too high.#

Before this crisis began, due to continuous oversized lending and insufficient collateral, both policy-based and commercial financial companies were actually in a high-leverage state, posing extreme risks. The most troublesome aspect was that most leveraged loans existed in the form of highly liquid short-term debt.

Why is this troublesome? It involves the vulnerability of the traditional deposit-loan model. If everyone deposits money in the bank as demand deposits that can be withdrawn at any time, but the bank uses those deposits for medium- to long-term loans, once depositors rush to withdraw their funds, the bank may not have enough available cash, leading to a bank run.

This is the same for other fund companies and lending institutions. The entire financial industry has always been wary of "short-term deposits and long-term loans." Therefore, a more prudent capital operation is to manage the "term transformation" between various funds and loans, reasonably allocating funds for investment and loans to maximize returns while controlling risks.

So how do traditional banks avoid bank runs? Like the U.S. and most countries, there are various regulatory requirements to limit banking risks.

For example, the capital adequacy ratio of a bank's own capital is required to be between 8% and 10%. If the capital is insufficient, they cannot engage in more deposit-loan business.
Additionally, the government established a deposit insurance system to ensure that depositors do not suffer losses.
Unfortunately, before the 2008 financial crisis, driven by profits, many financial institutions on Wall Street, especially non-bank financial institutions, exploited regulatory loopholes to issue large amounts of high-risk subprime mortgages.

This leads to the third point: regulatory failure.
Logically, when these abnormal lending behaviors that violate financial common sense began to emerge, if financial regulatory agencies were sensitive enough and acted promptly, such financial risks could actually be regulated. However, traditional commercial banks found it difficult to do so.

Regrettably, before 2008, Wall Street, through various financial innovations, packaged these high-risk subprime loans into financial derivatives, obscuring the financial risks within subprime loans.

This is what later sparked huge controversy over the "shadow banking" issue. In this field, relevant regulatory legislation was severely lacking, and no one dared to intervene to curb this rampant financial innovation.

The authors analyze that a key factor is the formation of a subprime loan debt chain around residential real estate loans among low- to middle-income groups. These subprime loans, through layers of financial innovation, ultimately transformed into a massive amount of "toxic assets."

What are subprime loans? They usually refer to "subprime mortgages," which are loans provided by lending institutions to borrowers with poor credit and low income levels. In simple terms, these are loans obtained by low- to middle-income individuals for home purchases or consumption, with less stringent approval processes.

Why did such higher-risk loans emerge in large numbers in the U.S. before 2008? This is related to the bursting of the U.S. internet bubble in 2000. In 2001, the U.S. economy experienced a significant recession, prompting the Federal Reserve to continuously lower interest rates in hopes of stimulating economic growth.

As a result, the U.S. economy began to recover, but the housing market became even more active, experiencing a new boom under historically low interest rates. Note that this did not mean that Americans suddenly became wealthier; rather, there was a significant change in U.S. real estate credit.

A large number of low- to middle-income Americans gained the opportunity to buy homes with low down payments, and with low mortgage rates and easy approvals, this led to a massive increase in subprime loans.

The biggest change was the continuous decline in down payment ratios. Initially, the down payment was 20%, then reduced to 10%, 5%, and even later to zero down payment. A large number of individuals with insufficient credit only needed to repay a loan equivalent to their rent each month to live in their own homes. Sounds good, right?

Many low- to middle-income families with unstable future income, once faced with reduced income or unemployment, would have to stop making repayments.

0x3: How Lending Institutions Shifted Risks#

Originally, these lending institutions had already shifted the risks away. They had an expectation that the U.S. real estate market would continue to prosper. When issuing loans, these lending institutions used the homes purchased by borrowers as collateral. Therefore, as long as they expected that home prices would not drop immediately, even if borrowers defaulted, the lending institutions could sell the mortgaged homes to repay the loans, making the risk essentially zero.

At that time, lending institutions also took action by immediately repackaging the mortgages after issuing loans, designing them as a type of financial derivative that could be traded in the market.

These financial derivatives had excellent short-term investment returns and were very popular in the market. Therefore, for lending institutions, the more subprime mortgages they issued, the more tradable derivatives they could package.

If the problem had stopped there, the subsequent troubles would not have been so severe. As the trading of these derivatives boomed, even more complex financial derivatives emerged, gaining even more popularity.

If the U.S. real estate market continued to prosper, this cycle could operate positively. But the facts show that starting in 2001, years of real estate prosperity not only attracted low- to middle-income Americans to unrealistically borrow to buy homes, but also led mortgage brokers and Wall Street bankers to invest their own money in real estate.

At this point, the U.S. was effectively caught in a speculative frenzy, with market rationality lost; it only took a spark for the dry tinder in the market to ignite.

Sure enough, on July 9, 2007, the first spark came: BNP Paribas announced the freezing of three funds holding U.S. subprime mortgage-backed securities.

This news immediately caused market unease, indicating that subprime mortgage-backed securities were depreciating, and banks began hoarding cash.

Some panicked investors thought the first thing to do was to redeem their investments in funds holding subprime loan securities, and bank runs began to appear. More funds had to freeze redemptions, which triggered new panic, marking the first flame of this massive financial crisis.

[!IMPORTANT]

It can be said that the 2008 financial crisis was essentially a confidence crisis triggered by a large-scale bank run that spread throughout the entire system. The bank runs were due to panic, and the panic stemmed from the irrational rise of the real estate market, but it was ultimately unsustainable.

0x4: Summary#

[!WARNING]

1. The trigger for the 2008 financial crisis was not a problem within the banking system, but rather the irresponsible lending practices of the U.S. subprime mortgage industry. Under reckless borrowing, high leverage, and regulatory failure, the roots of disaster were planted.

2. Before the crisis fully erupted, U.S. debt rapidly increased, especially the sharp rise in ordinary household debt, primarily due to soaring mortgage debt from home purchases.

3. From relaxing loan conditions and issuing large amounts of subprime loans to designing complex securities and financial derivatives, a large amount of risk accumulated layer by layer, and a single spark could ignite a towering inferno.

4. How Did the Subprime Flame Spread into a Financial Inferno?
   Combining the three authors' analysis, this financial crisis can be divided into three stages from the appearance of the first flame to the spread of the fire, culminating in a raging inferno, spanning from August 2007 to October 2008.

So how did the subprime flame spread into a financial inferno throughout this process? What key turning points should we be wary of? Why were U.S. regulators unable to prevent the disaster from escalating at critical moments?

0x1: Ignition Period: The Outbreak of the Subprime Crisis#

Let's first look at the first stage, the ignition period, which lasted from August 2007 to March 2008.

During this stage, the risks triggered by subprime loans began to erupt, but many people were unaware that the disaster had already begun, and the U.S. government did not intervene in a timely manner.

Yesterday we discussed that from 2001 to 2007, the U.S. real estate market was overheated, and a series of financial derivatives related to subprime mortgages were highly sought after on Wall Street, but systemic risks gradually became apparent.

On July 9, 2007, BNP Paribas announced the freezing of three funds holding some financial derivatives related to the U.S., temporarily preventing investors from redeeming their investments. This was because the bank saw the prices of derivative trades falling, and the value of the funds holding these financial derivatives was also significantly shrinking, leading to a large number of investor redemptions.

This significant action by BNP Paribas raised concerns among some investors, but it did not immediately trigger government intervention. The authors explain that this is because if there is a hint of danger, the government habitually intervenes, which not only poses moral hazard but may also encourage more speculative behavior.

However, the authors also point out that historically, insufficient early government intervention has greater costs and dangers than overreacting.

What Bernanke referred to is actually a consensus formed among central banks in Europe and America since the late 19th century:

At that time, the three of them did not act at the beginning of the crisis because they did not want to convey the message that the government would support any large company in trouble.
[!IMPORTANT]
However, unexpectedly, as the demand for subprime mortgage derivatives waned, Wall Street began to experience a "E. coli effect." Just as someone gets infected with E. coli after eating meat, everyone stopped eating meat, or even stopped eating anything at all. At that time, both investors and creditors were doing just that, avoiding all categories of financial products, regardless of whether they were related to subprime mortgages.

But that's how financial markets work; when panic begins to spread, it quickly ferments. These scattered sparks of financial risk quickly ignited. Meanwhile, the controversy over regulation continued.

0x2: Spread Period: The Collapse of Bear Stearns, Fannie Mae and Freddie Mac in Crisis
Then we entered the second stage, the spread period, from March 2008 to September 2008. The first typical sign was the collapse of investment bank Bear Stearns.

In March 2008, panic in the financial markets forced President Bush to speak out, trying to restore public confidence. However, Paulson still advised Bush not to disclose any emergency rescue plans, as some institutions might not need rescuing and might not be salvageable.

Indeed, on March 14, 2008, Bear Stearns, the fifth-largest investment bank on Wall Street with an 85-year history and assets of $400 billion, announced its collapse. This was the first major financial institution to fall during the 2008 financial crisis, shocking the world.

However, in the view of the three authors, Bear Stearns brought this upon itself. This institution had long disregarded the rules that restricted commercial banks, operating with high leverage for an extended period, and the warning signs of significant problems had appeared as early as August 1, 2007.

At this point, the principle of controlling systemic risk began to take effect. The Federal Reserve tolerated the collapse of Bear Stearns but did not dare to completely ignore it.

Thus, the Federal Reserve intervened, persuading Wall Street giant JPMorgan Chase to acquire Bear Stearns at a price of $2 per share, totaling $236 million. At the same time, the Federal Reserve provided a $30 billion loan to address Bear Stearns' ongoing operations and debt issues.

It turned out that the Federal Reserve's intervention in Bear Stearns' bankruptcy restructuring temporarily calmed the market. Although this move was controversial at the time, the ultimate beneficiary was the U.S. government, while Bear Stearns did not benefit from it.

But before they could catch their breath, a bigger problem arose, which was the second significant event of this period. Fannie Mae and Freddie Mac, two government-sponsored enterprises, were in crisis.

By July 2008, these two institutions held and guaranteed mortgage debt exceeding $5 trillion, and their asset scale was several times that of Bear Stearns. If they also collapsed, the Wall Street financial system would inevitably collapse.

Therefore, rescuing them was non-negotiable. However, the method of rescue could be discussed: direct loans were one way; government capital injection and takeover were another.

Ultimately, Paulson proposed a plan for government capital injection and takeover, which would alleviate the funding pressure on these two institutions while restructuring their operations and enforcing strict regulation.

0x3: Inferno Period: The Collapse of Lehman Brothers
The first two stages already seemed severe, but the most challenging third stage, the inferno period, saw the full outbreak of the subprime crisis in September and October 2008. The most iconic event was the collapse of Lehman Brothers, turning the financial market into a raging inferno, forcing the U.S. government to take drastic rescue measures.

In the authors' view, counting from August 2007, this financial crisis lasted a year before Lehman Brothers went bankrupt; however, in the public's eyes, this crisis began with the collapse of Lehman Brothers. This is a discrepancy between professional and non-professional understanding, also indicating the systemic importance of Lehman Brothers.

In the global investment banking community, Lehman Brothers had always been a shining presence. Founded in 1850, this investment bank operated globally for 158 years, enduring multiple crises on Wall Street. By 2008, its asset scale exceeded $600 billion, 1.5 times that of Bear Stearns. In the eyes of Americans, Lehman Brothers was almost an unassailable financial institution.

Yet, during the 2008 crisis, Lehman Brothers, due to its deep involvement in mortgage derivative trading and risky use of excessive leverage, accumulated debts exceeding $610 billion and suffered severe losses, with its stock price plummeting.

Following the previous method of rescuing Bear Stearns, Bernanke and others attempted to find a buyer for Lehman Brothers. However, this time, negotiations did not progress smoothly.

On September 15, 2008, Lehman Brothers officially filed for bankruptcy, marking the largest corporate bankruptcy filing in U.S. history, with devastating negative impacts.

The shockwaves first hit the financial industry. Giants like Goldman Sachs, Morgan Stanley, and Citigroup, as well as insurance giants like AIG, found themselves in financing and trading difficulties. Investors rushed to redeem their funds, leading to a series of bank runs, and the Wall Street stock market plummeted by over 50%.

Ultimately, this shockwave spread worldwide: any foreign financial institutions or industrial companies related to the U.S. financial market faced severe impacts. Even the People's Bank of China and China Investment Corporation, which held large amounts of dollar assets at the time, had to take emergency measures to avoid greater losses.

It can be said that the collapse of Lehman Brothers was the peak event of the 2008 financial crisis, turning the financial market into a raging inferno. Faced with a severe crisis, the U.S. government was forced to take drastic rescue measures, and Bernanke, Geithner, and Paulson stepped onto the front lines of firefighting.

0x4: Summary#

1. The 2008 financial crisis can be divided into three stages, from the appearance of the first flame to the spread of the fire, culminating in a raging inferno, spanning from August 2007 to October 2008.
2. The first stage lasted from August 2007 to March 2008, during which the risks triggered by subprime loans erupted, but the U.S. government did not intervene in a timely manner.
3. The second stage lasted from March 2008 to September 2008, during which financial panic began to intensify, with the collapse of Bear Stearns and the crisis of Fannie Mae and Freddie Mac, prompting government intervention.
4. The third stage occurred in September and October 2008, marked by the collapse of Lehman Brothers, turning the financial market into a raging inferno, forcing the U.S. government to take drastic rescue measures.

3. What Complex Games Did the Rescue of the Crisis Involve?#

0x1: Troubled Asset Relief Program#

As early as the late 19th century, when facing financial crises, the general rescue model in Europe and America was for central banks to increase lending and inject liquidity into the market to avoid a complete collapse.

However, in addressing the 2008 financial crisis, the firefighting trio did not simply apply this principle. This crisis was different from previous ones; it was a result of massive speculation in subprime loans and related derivatives, creating enormous amounts of troubled assets. As the crisis continued to unfold, many large institutions faced the inability to operate healthily, even facing bankruptcy. Therefore, whether to allow them to collapse became a key discussion at the time.

The biggest criticism from the public was that these large financial institutions had serious problems with risk control and should be held accountable. However, this criticism overlooked the fact that the collapse of large institutions would trigger a chain reaction.

Moreover, the biggest issue at the time was the public's psychological panic and loss of confidence. Investors avoided all securitized products related to mortgages and the companies holding such products.

After summarizing the rescue of Bear Stearns and the case of Lehman Brothers, the firefighting trio realized that to rescue more troubled financial institutions, they needed greater authorization and to take more significant measures.

Thus, in the spring and summer of 2008, Paulson, representing the U.S. Treasury, proposed the Troubled Asset Relief Program (TARP), frequently communicating between the White House and the U.S. Congress; at the same time, he and Bernanke and Geithner dealt with the two largest bank failures, Washington Mutual and IndyMac Bank.

Ultimately, the Federal Reserve, U.S. Treasury, and Congress gradually reached a consensus to implement the Troubled Asset Relief Program to rescue the crisis in various ways.

In the fall of 2008, the U.S. Congress approved a bailout plan totaling $700 billion. For the firefighting trio, how to use this money to reduce systemic financial risks became a significant challenge.

• First, they injected capital directly into systemically important financial institutions facing difficulties. This differed from the Federal Reserve's approach of releasing liquidity to the entire market; through capital injection, the government could directly intervene or take over troubled financial institutions.
  Then, the Federal Reserve coordinated with major global central banks to take collective action, agreeing to lower interest rates by 0.5 percentage points. Although the effects of the coordinated rate cuts did not show immediately, the commitment of global central banks to loosen monetary policy alleviated liquidity fears in the market.

• Next, the firefighting trio urged the financial institutions receiving government capital injections to optimize management and improve efficiency. For example, any institution with severe troubled asset issues had to strictly limit the CEO's compensation.
  Finally, the U.S. Treasury injected capital in the form of preferred shares, agreeing on a dividend rate of around 5% to 9%. This indicated that the government’s capital injection was intended to relieve the company's capital pressure, not to intervene in the daily management of financial institutions long-term. As long as these institutions improved their operations, private capital could replace government capital at any time.

• Through these constraints, the Troubled Asset Relief Program was advanced. However, they soon discovered that the $700 billion budget was insufficient, and they needed an additional $680 billion for rescue.

This further triggered public skepticism, with people worried that the government's spending was a bottomless pit. More voices began to call for allowing high-risk financial institutions to go bankrupt.

After careful scrutiny, especially examining the systemic importance of various financial institutions, Paulson invited the CEOs of nine important financial institutions to the U.S. Treasury for a meeting, hoping these institutions would accept around 3% of Treasury capital injection.

This was crucial for the full implementation of the rescue plan; without government capital injection, there would be no government guarantee. The nine systemically important financial institutions had no choice but to accept Treasury capital injection and join the Troubled Asset Relief Program.

As soon as the news was announced, on October 13, 2008, the Dow Jones Industrial Average on Wall Street surged by 936 points, marking the largest single-day increase at that time; on October 28, the Dow rose again by 889 points, an increase of 10.88%, halting the previous stock market crash.

Seizing this opportunity, the firefighting trio continued to advance rescue actions, injecting capital into nearly 700 small banks, which helped stabilize the entire banking system and reduce market panic. In this battle between the government and public opinion, the government's rescue plan began to show initial effectiveness.

However, the effects of the rescue plan still needed time to manifest. In the fourth quarter of 2008, U.S. economic growth remained weak, with nearly 2 million people laid off nationwide, and personal and corporate debts were rampant. The difficulties faced by the public further exacerbated the problems on Wall Street, as two super-large financial institutions began to face survival difficulties.

In the fall of 2008, AIG announced massive losses, and the only way to resolve this issue was to implement the Troubled Asset Relief Program. Subsequently, the U.S. government decided to inject $40 billion into AIG to enhance its credit rating and market confidence.
Another troubled financial giant was Citigroup, whose asset scale could reach $2 trillion. Should it also be rescued?

After repeated discussions, the U.S. Treasury and the Federal Reserve used $20 billion to purchase Citigroup's preferred shares, with a dividend rate as high as 8%, which increased Citigroup's capital. They then isolated Citigroup's worst-quality assets, totaling over $300 billion, from its normal assets, ultimately providing government guarantees for 90% of Citigroup's losses to prevent a complete system collapse. Through these measures, external concerns about Citigroup were significantly reduced.

0x3: Summary#

1. In the fall of 2008, the U.S. Congress approved a $700 billion financial rescue plan. How to effectively use this money to address issues in the financial system and balance the relationship between the public and the government became a significant challenge for the firefighting trio.

2. In the early 2009 government transition, the U.S. made three efforts to continue rescuing the crisis: first, to rescue troubled large industrial companies; second, to conduct "stress tests" on financial institutions; and third, to implement quantitative easing monetary policy. This effectively curbed market panic.

3. Complex systemic financial risks cannot be self-resolved by the market alone; it is essential to follow legal procedures and coordinate key resources from political, economic, and social systems to address these issues.

4. What financial risk lessons were reflected upon after extinguishing the fire?

0x1: Structural Reflection#

From the perspective of understanding and judging financial crises, we must always maintain a high level of vigilance.

This makes predicting financial risks extremely difficult. Sometimes it aligns with rational logic, but more often it is influenced by unexpected factors, especially human emotions. Since financial crises are hard to predict, prevention and response are not easy, and we must not be complacent.

Have you noticed that compared to other mature market economies, such as Germany, Japan, France, and the UK, financial crises often start on Wall Street after the 19th century? This is related to the rise of U.S. economic strength and is closely tied to the prevalence of speculative culture on Wall Street.

Speculation thrives in under-regulated financial markets and inevitably evolves into catastrophic disasters in such flawed markets.

Therefore, for Wall Street, the U.S., and even the global financial market, re-evaluating and advocating for sustainable business values, transitioning from a culture of speculation to a culture of investment, and shifting from short-termism to long-termism are crucial for reducing financial crises.

To achieve this positive transformation, financial institutions, regulatory bodies, opinion leaders, and various media must reposition themselves and communicate cautiously. At the same time, there should be continuous in-depth research on historical financial crises to extract lessons.

Thus, rethinking the 2008 financial crisis from the perspectives of cognitive judgment, decision-making action, and cultural public opinion reveals many lessons worth reflecting upon. It reminds us once again that financial risks are no small matter, and we must pay more attention.

0x2: Regulating the Subprime Mortgage System#

Well, what we just discussed mainly focuses on the overall structural reflection of the financial industry. Now, returning to the micro level, the trigger for the 2008 financial crisis was the irresponsible large-scale lending by subprime mortgage institutions, coupled with extensive leveraged trading, resulting in uncontrollable consequences.

From this perspective, subprime mortgages related to real estate are essentially high-risk products that violate financial common sense and should be subject to stricter regulation. The forces that stimulated the large-scale issuance of such real estate loans are also worth being wary of.

Why do mortgage loans worldwide require a certain percentage of down payment, ranging from 10% to 50%? It is because real estate prices are subject to cyclical fluctuations; lending institutions must consider not only the prosperity brought by rising prices but also the losses incurred from falling prices.

Thus, the key role of down payments is to prevent losses to lending institutions caused by declining property values. Therefore, the less optimistic the outlook for future property prices, the higher the down payment ratio; even if the outlook is relatively optimistic, the down payment ratio for long-term financial products like mortgages cannot be too low.

However, before the 2008 financial crisis, subprime lending institutions maintained an overly optimistic expectation that property prices would continue to rise during the real estate boom from 2001 to 2007, leading them to continuously lower down payment ratios and interest rates, even to zero down payment. This was indeed very risky.

Another force driving the rapid growth of subprime mortgages was the unrealistic encouragement from the U.S. government since the 1990s for more low- to middle-income individuals to buy homes through subprime mortgages.

The result was that these individuals did not possess the economic strength to purchase homes; once there was any disturbance or unemployment, they could not repay their mortgages, leading to bankruptcy or even homelessness.

For a long time, the homeownership rate among U.S. residents hovered around 50% to 60%, which is relatively reasonable and comparable to developed countries like Germany and Japan. In these developed countries, residents who cannot afford homes can resolve their housing issues through affordable housing options.

However, starting from the 1990s, several U.S. administrations, from George H.W. Bush to Clinton and George W. Bush, made increasing the homeownership rate a significant policy goal. Gradually, the homeownership rate among Americans rose. After 2001, subprime mortgages grew rapidly, and by 2005, the homeownership rate in the U.S. reached nearly 70%, a historical high.

This figure was politically impressive but exceeded the actual purchasing power of lower- and middle-class residents. A large number of subprime loans were irresponsibly issued, with low down payments and interest rates. Ultimately, this temporary prosperity was unsustainable, leading to a return to reality during the crisis.

Although having a mortgage means that real estate has financial attributes, if the pursuit of homeownership is excessive, a tragedy similar to the U.S. subprime mortgage crisis may repeat itself, which is a risk we must remain vigilant about.

0x3: Strict Regulation of Financial Derivatives
Previously, we mentioned that financial institutions immediately repackaged mortgages after issuing loans, designing them as financial derivatives for trading in the market. This shifted the risks of these loans through financial derivatives.

Therefore, after the 2008 financial crisis, both you and regulatory agencies must maintain a high level of vigilance regarding those complex, high-risk financial products.

We previously discussed that lending companies like Fannie Mae and Freddie Mac were aware of the higher risks associated with subprime mortgages, yet they still issued large amounts of loans precisely because these high-risk subprime loans could be packaged and converted into tradable derivative securities.

As long as the real estate market continued to prosper, the short-term trading prices of these derivatives would rise, and speculators would dare to engage, seeking short-term profits. Such speculative trading, which clearly disregards long-term considerations, typically involves leveraging several or dozens of times, amplifying short-term returns significantly. Thus, these derivatives were highly sought after by Wall Street investors and speculators from 2003 to 2006.

However, when these securities became overheated and risks increased, even more complex financial derivatives were designed based on these securities. The trouble became even greater. Ordinary investors could hardly understand them, but institutional investors, especially hedge funds, were eager to leverage and surf the speculative waves in these high-risk financial derivatives, rapidly accumulating risks.

Reflecting on the 2008 financial crisis a decade later, the three authors clearly realized that regulatory agencies had not fulfilled their responsibilities in overseeing financial derivatives.

During the wave of financial freedom, both the Federal Reserve and the U.S. Securities and Exchange Commission excessively indulged these financial innovations that detached from the real economy.

This crisis also reaffirmed that when troubles become significant enough, regulatory agencies and government departments can only step in and spend large sums to clean up the mess, facing severe criticism from taxpayers. Given this, can we effectively strengthen regulatory thinking and defensive systems?

0x4: Summary#

1. Reflecting on the 2008 financial crisis, we must always maintain a high level of vigilance regarding financial crises; government intervention should be timely and sufficient; and we must abandon speculative culture from a cultural public opinion perspective.

2. Reviewing the triggers of the 2008 financial crisis leads to two deep reflections: one is to regulate the real estate mortgage system, and the other is to strictly regulate financial derivatives.

3. For those complex financial products that are severely detached from the real economy and for excessive financial innovations, both you and regulatory agencies must maintain a high level of vigilance.

4. How to Defend Against Systemic Financial Risks in the Future
   As the three authors stated, no one knows exactly what the next financial crisis will look like. In my view, this speaks to the inevitability of financial risks and the unpredictability of financial crises.

Having endured the test of the 2008 financial crisis, both the U.S. government and the market have recognized that there are many regulatory gaps in the financial sector that need to be filled. For example, there is insufficient restriction on high-leverage financing speculation, insufficient sensitivity to excessive financial innovation, inadequate regulation of the transfer of financial risks to "shadow banks," and insufficient coverage of the Federal Reserve's emergency safety net, among others.

Therefore, establishing a more robust systemic risk defense system has become an important goal for the U.S. government and the Federal Reserve after 2008. So, after years of effort, how has this defense system been constructed? What emergency response mechanisms or resources are still lacking? Let's take a look.

0x1: Establishing a Systemic Risk Defense System#

According to the authors' explanations in the book, the U.S.-led systemic risk defense system focuses on strict risk limitations from three aspects, aiming to reduce systemic financial risks in the entire economy.

First, let's look at corporate financing.#

After the crisis, Bernanke and Geithner believed that the most important measure was to require companies to reduce leverage. Therefore, companies must hold more liquid assets. For example, lending companies must hold more cash and other liquid assets to reduce reliance on short-term financing to avoid new bank runs.

At the same time, strict limits should be placed on the debt ratios of large companies. There must be stricter constraints on the risk-bearing and financing scale of companies; those with systemic importance must be especially guarded against triggering financial risks due to excessive debt.

Next, let's look at derivative trading.#

On one hand, traditional commercial banks, securities brokers, and non-bank financial institutions must significantly reduce their leverage.
On the other hand, specific financial derivative transactions must be publicly traded on exchanges and cannot be negotiated privately, which reduces the risks associated with information opacity in the past.
At the same time, newly passed relevant legislation has increased the margin requirements for leveraged trading to curb excessive speculation. In 2008, Wall Street's daily securities lending reached $2.5 trillion, but by 2015, this figure had dropped to $1 trillion.

Through these restrictive regulations, some high-risk financing tools that had troubled institutions like Bear Stearns and Citigroup during the 2008 financial crisis have been eliminated and have not reappeared since. In other words, high-risk financial derivatives can indeed be regulated.

Finally, let's look at the banking system.#

The core of the reform is to prevent the collapse of systemically important banks. To this end, the U.S. has promoted relevant regulatory legislation from both international and domestic perspectives.

Internationally, the U.S. promoted and achieved the Basel III Accord, the core provision of which requires banks' minimum capital to be raised to three times the original level, and for large banks, to four times the original level, along with clear requirements for core capital adequacy ratios, comprehensively enhancing banks' risk resistance capabilities.

The U.S. has resolutely implemented this, and China has also actively followed suit. Preventing systemic risks in large banks is a regulatory consensus that cannot be ambiguous.

Domestically, it is required that the largest banks hold more capital than smaller banks, reducing operational leverage and increasing buffer capacity. For example, it is explicitly required that a bank's total debt cannot exceed 10% of the financial system, which effectively limits the size of banks.

Based on this legislation, the U.S. has also established a new agency: the Consumer Financial Protection Bureau. It has merged the consumer protection departments of various regulatory agencies into a larger new department. If you want to redeem investment or savings funds or file shareholder lawsuits, this protection bureau can back you up.

Through these reforms, the regulatory system for defending against systemic risks in the U.S. has been strengthened, reducing the likelihood of crises, and large financial institutions now hold more high-quality capital.

0x2: Strengthening the Disposition Authority of the Federal Reserve and Treasury#

However, in the view of the three authors, while implementing these rules and regulations can enhance the government's and regulatory agencies' ability to anticipate systemic financial risks, it cannot prevent all financial crises.

To prevent financial crises from escalating, the monetary policy tools of the central bank and the fiscal measures of the Treasury must be strengthened. This is also why, during the 2008 financial crisis, Paulson had to first lobby Congress to approve a $700 billion rescue plan.

The three authors propose that when a severe financial crisis occurs, since we cannot rely on the market to restore normalcy automatically, the Federal Reserve and the Treasury must have stronger and more flexible disposition authority in monetary and fiscal policies.

For the Federal Reserve, it must enhance its emergency lending authority, which should not require temporary approval from Congress but should be authorized from the outset, allowing for flexible use.

However, the three authors believe that the Federal Reserve's authority as a lender of last resort is still subject to many constraints. For example, when lending to target companies, in addition to collateral, more information disclosure is required. While this increases the transparency of the Federal Reserve's lending, it may also trigger market panic due to excessive negative information disclosure.

At the same time, Congress has explicitly prohibited the Treasury from using the foreign exchange stabilization fund for guarantees and has restricted the administrative departments and the Federal Reserve from jointly assuming credit risks.

Therefore, overall, the U.S. has established stronger safeguards against panic after the 2008 crisis, but the Federal Reserve and the Treasury's emergency powers in responding to financial panic remain relatively weak.

Why do we say this? Because these frontline crisis managers cannot inject funds, guarantee debts, or purchase assets without obtaining authorization from Congress.

Thus, if it were not for the fact that the Federal Reserve had sufficient room to cut interest rates before the 2008 crisis and could also adopt quantitative easing to loosen monetary policy, the handling of the 2008 crisis would not have been so smooth.

Therefore, they insist on the recommendation that while the crisis is calming down, reforms should continue to fill the regulatory and authorization gaps in defending against systemic financial risks, actively preparing for future financial crises.

0x3: Integrating the Financial Sector Regulatory System#

Beyond specific defense systems and regulatory authorizations, the final reflection and recommendation from the three authors point to the financial sector regulatory system, which has operated in the U.S. for a long time based on different business and institutional subjects. So how should it be optimized and improved?

This involves the repeated evolution of the U.S. financial regulatory system over the past 100 years. Before the Great Depression in 1929, traditional commercial banks and investment banks were combined. However, this led to the riskier investment banks dragging down the stable commercial banks when they encountered problems.

Therefore, according to the U.S. Banking Act of 1933, commercial banks and investment banks must be separated and regulated by different agencies, following different rules. However, the 2008 crisis demonstrated that financial sector separation can create regulatory vacuums.

Efforts to reduce the issues among various financial regulatory agencies make it necessary to further improve the financial regulatory system. For example, the protection of financial consumers' rights has been legally merged and restructured. However, how to better integrate more financial sector regulations is clearly a massive undertaking.

At the same time, the complex political and economic ecology in the U.S. also hinders reforms of the financial regulatory system and emergency authorizations. Therefore, the three authors call for: considering the importance of the U.S. financial system and the dollar, can the emergency disposition authority of the Federal Reserve and the Treasury be expanded? This question remains to be discussed.

0x4: Summary#

1. The U.S.-led systemic risk defense system focuses on strict risk limitations from three aspects: corporate financing, derivative trading, and the banking system.
2. To prevent financial crises from escalating, the Federal Reserve and the U.S. Treasury must obtain greater authority in monetary and fiscal policies.
3. To avoid issues arising from the separation of financial sector regulations, it is necessary to work hard to reduce overlaps in responsibilities and territorial disputes among various financial regulatory agencies.