How does a financial crisis start? Most often the origins are in a period of economic stability. Stable economic periods allow more innovative financing and more borrowing. And banks are like any other firms?for them too, innovation can lead to better margins or higher share prices. So stable economic periods lead to speculation that in the future, higher economic growth can be achieved or profits increased through financial innovation. In this period, financial firms do what Minsky calls hedge financing.
In the current crisis, growth expectations were not fuelled by just the domestic growths in the US and UK. Globalisation made investment banks rapidly increase their presence in the poster boys of future growth: in fact, investment banks used BRIC economies to hedge against a slowdown in the Anglo-Saxon economies. This ?decoupling? theory relied on the idea that growth pockets remain diversified and sort of de-linked. No one bet on the possibility that the Anglo-Saxon economies will unravel suddenly and that instead of ?de-coupling?, there will be scarily quick coupling.
Wall Street?s approach, as its optimism became self-fulfilling, is called ?speculative financing? by Minsky, who defines this as a stage where firms can service interest dues but the servicing of principle amounts requires more borrowing. Borrowing leads to more borrowing. This self-perpetuation enjoys some initial success, which ignites the ?innovation? appetite.
In the current context, collateralised debt obligations (CDOs)?a bunch of debt instruments parcelled together to form a freestanding financial instrument ?saw home loans being sliced and diced in exotic ways, and there were investors thinking that higher returns on these were ?infallible?. Investment banks started selling protection to hedge funds, and to each other. Credit default swaps (CDSs)?this insures against a debtor being unable to pay his debt?were sold as protections against ?reference assets?. But how about the coupling of defaults in reference assets with protection sellers? This happened because protection sellers sold far more than they could service. The third and the last phase of a crisis is called Ponzi finance, wherein, forget principle amounts, even interest dues can’t be serviced without further borrowing.
The word Ponzi has it origin in US schemes of the 1920s, which promised abnormally high returns but saw all the money going up in air. Exactly when the Ponzi phase starts in a crisis is difficult to identify, but that it will do so is a certainty.
In the current context, the initial success of CDSs and CDOs led to ever more exotics varieties of CDOs/CDS. ?Teaser? home loans were tipped with ?entry level? lower interest rates, which not only attracted subprime customers to buy homes (increasing home prices), but also encouraged the middle class and the speculators to buy homes that they could not afford in the long run. The margin of error for homebuyers became very thin.
Once the US economy started slowing down, interest rates climbed up and home prices went south. Naturally, even CDSs on asset-backed securities, where mortgage or other assets could be the underliers, start giving negative returns if the underlying assets? growth slows down.
Financial innovation via credit derivatives started faltering. ?Assured? payments on CDOs became uncertain. Financial markets realised that a stable scenario was giving way to a tottering one. This was brought home in late 2007. But, at that time, it was difficult to guess the magnitude of the crisis.
It is still difficult to predict the scale, since this is contingent upon the difference between the ?real value? of the underlying asset class and its current value. No one knows the ?real value??educated guesswork will calculate it on the basis of home prices when they begin to stabilise. No one can say now when home prices will stabilise.
?The author works as an associate vice-president with Risk Analytics & Instruments department, Deutsche Bank. These are his personal views