(which had more of a risk-taking culture).<sup>47</sup> As a result of the adoption of the Gramm-BlileyLeach Act, large banks could be a commercial bank, an insurance company, an asset manager, a hedge fund and a private equity fund at the same time. Consequently, banks with access to deposit insurance and Central Bank support pursued high-risk activities, thus endangering the soundness of the financial system as a whole.

74. Also, in 2004, the U.S. Securities and Exchange Commission relaxed the net capital rule which enabled investment banks to substantially increase the level of debt they could assume, fueling the growth in mortgage-backed securities supporting subprime mortgages. Mortgagebacked securities became increasingly popular in the 1980s; but it was not until the 1990s that they really took off. These securities include Collateralized Mortgage Obligations, Collateralized Debt Obligations (CDO‘s) and Collateralized Loan Obligations (CLO‘s), as well as CDO‘s of CDO‘s of CDO‘s (CDO3) which assembled a bunch of credit default swaps to mimic an underlying CDO.<sup>48</sup> These new instruments assembled a multiplicity of tranches, each of which represented a certain level of risk tolerance. They and the risk they implied became difficult to value; as a result, the financial system became prone to a high level of risk. The lack of transparency associated with financial innovation through securitization allowed even quasipublic institutions like Fannie Mae and Freddie Mac and prospective borrowers to avoid careful scrutiny. In this context, it became increasingly common for borrowers to misrepresent their income and to fail to provide written confirmation about their salary (the so-called NINJA loans).

75. Unlike stocks, bonds and options, there was no clearinghouse for trades in most of the new derivative instruments. Moreover, the Commodity Futures Modernization Act of 2000 ensured that derivatives remained unregulated. In such conditions, derivatives trading expanded quickly, increasing from a total outstanding nominal value of $106 trillion in 2001 (1039 percent of U.S. GDP, and 331 percent of world GDP), to a value of $531 trillion in 2008 (3688 percent of U.S. GDP and 868 percent of world GDP).<sup>49</sup> However, the legal and technological infrastructure of the industry was inadequate to handle such an explosion of the volume of derivatives, which worsened the impact of the lack of regulation of derivatives.<sup>50</sup> 76. The development of mortgage-backed securities was largely driven by the shadow banking system (Figure 45), which experienced dramatic growth in the run-up to the crisis. The growth of the shadow banking system was partly the result of the perceived decline in the profit-

> 47 Roubini and Mihm (2010): p.74.

> 48 CDO’s essentially bundled high-risk subprime mortgages and then sliced them into tranches (equity, mezzanine and senior). Purchasers of the equity tranche had the highest return and highest risk, while purchasers of mezzanine and senior tranches had correspondingly less return and less risk.  If any homeowner in the underlying pool defaulted, the holders of equity tranches would see the highest loss. 49 Bank of International Settlements, Semiannual OTC derivatives statistics at end-June 2011.

> 50 Goodman, Peter S.: “Taking hard new look at a Greenspan legacy,” New York Times, October 8,  2008.

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