University of Southern California

Is Financial Regulation Structurally Biased to Favor Deregulation?

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Note by Carolyn Sissoko
From Volume 86, Number 2 (January, 2013)

In the early months of the financial crisis that started in August 2007, Citigroup suddenly had to take onto its balance sheet $25 billion of assets–which, due to subprime mortgage exposure, were worth on the market only a third the amount that Citigroup was required to pay for them. The reason for the appearance of these troubled assets on the bank’s balance sheet was a liquidity guarantee provided by Citibank from the time it originally sold the assets to protect short-term lenders from the possibility that their debt could not be refinanced at maturity. The Financial Crisis Inquiry Commission would conclude that such guarantees helped “bring the huge financial conglomerate to the brink of failure.”

The assets in question were collateralized debt obligations (“CDOs”), which package together a large number of loans and other debt products and use the income from those loans to pay returns to the investors in the CDOs. It is clear, however, that not all of the “loans” underlying Citibank’s CDOs were actual loans. Some of them were financial contracts called derivatives that promised payments based on the performance of a specific set of actual loans. That is, some of the underlying assets were not loans, but simply represented the promise of one financial institution to make payments to another.

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