Overextended borrowers were soon unable or disinclined to pay their instalments. Retail payment defaults first affected mortgage lenders, who had passed on the risks to third party investors via derivatives. As payment streams dried up, the value of underlying assets went into freefall, and financial markets underwent a seizure.
This was the anatomy of the worst financial crisis since World War II. On August 2, 2007, IKB Deutsche Bank AG was the first to break the bad news, followed by BNP Paribas on August 9, the second domino to fall. Within weeks, defaults and foreclosures threatened to spiral out of control. Post-crisis, a number of other aspects have gained currency. The crisis occurred, they say, as market players were often unregulated and undercapitalized mortgage originators who operated with very little capital and used short-term financing to fund subprime mortgages that they did not expect to hold for very long. Once the US housing market started crashing in 2007, whoever left holding the can was in trouble. As asset-backed securities were downgraded, issuers of such paper found it extremely difficult to roll over maturing asset backed paper into new longer term paper. When these could not be sold to finance whizkids to package into readily marketable securities, uncertainty took hold. As soon as the markets solvency troubles emerged, players became illiquid, and trading ceased. So diffused had risks become that market participants were unable to identify their nature and location, so everything underwent reappraisal. Naturally, lending rates shot up.
In this scenario, it did not take very long for confused and scared investors to grow panicky and try to flee. This was styled as the great credit crunch of December 2007. Interbank markets became very disorderly as default risks increased, and central banks had to exercise their role as lenders of last resort.
Several issues are now left to be agonised over. In retrospect, the use of innovative credit instruments led to dispersion of risks, but also placed too many layers between the points of possible default and where this risk was borne. Special investment vehicles and hedge funds had scarcely any idea of their locus of vulnerabilities in the real world of houses and repayments. An apt analogy is the Horcruxes from the Harry Potter series. These are disaggregated pieces of the soul of Lord Voldemort. Like mortgage risks, they are dispersed for safekeeping in unknown places. Like in what was arguably the most popular book of 2007, all the Horcruxes must be expunged, before the dark lord Voldemortgage has a chance to wreak further havoc.
The author is chief general manager, Bankers Training College, Mumbai. Email: firstname.lastname@example.org These are her personal views