While the current turmoil in international financial markets has multiple roots, it can perhaps be traced to the global glut of savings relative to investment and the easy-money policy of the US Fed after the dotcom bust of 2001-03. The monetary tightening from June 2004 onwards was very measured, with the US Fed too narrowly focused on stable consumer prices even as there was unprecedented exuberance in asset prices. Asset bubbles and falling yields fuelled a shift to risky high yielding assets such as subprime housing loans and structured products like collateralised debt obligations (CDOs), leveraged buyouts (LBOs) and other derivatives. A good measure of this ?disintermediation? is the sharp fall in the share of banks in household borrowing, which fell from 95% in 1973 to just 56% in 2007.
Years ago, when banks made loans and held them until maturity, credit analysis was their essential skill. But as loans turned into tradeable securities, credit analysis standards fell. Investors began to rely on credit ratings. Because rating agencies were also associated in designing complex structured financial instruments, bundling cash flows of varying risk, including subprime housing loans that proliferated since 2003, there was a possible conflict of interest in objectively assessing risks.
The proximate cause of the financial turmoil was rising interest rates and falling house prices. Subprime borrowers found it impossible to refinance backloaded ?teaser? adjustable rate mortgages, such as 2/28 and ?interest only? loans, through softer home equity (the difference between the NPV of the mortgage and house valuation) second mortgages. Since many mortgages are now worth more than the underlying asset, increasing defaults and foreclosures may be expected. These systemic shocks could trigger defaults in prime segments as well. Resets of mortgages this year are estimated to occur at rates about four percentage points higher than the current rate on 30-year home loans.
Defaults to date have been relatively modest and subprimes comprise a very small segment of the housing mortgage market. The real problem lay in the fact that investment in structured products was mostly leveraged. While losses from fully funded investments could have been contained (being limited to some investors), contagion spread because investors found that they could not refinance their cheap short-term commercial paper invested in high yielding long-dated securities. They were forced to sell off assets at knockdown prices.
The value of even high-quality mortgages fell because the market could not pinpoint where repayment risk resided in view of information asymmetries arising out of the global dispersal and complexity of structured products with subprime exposures. The liquidity crisis was transmitted to banks managing these ?conduits? and underwriting the commercial paper. Forced to take off balance sheet exposures on their books, they became reluctant to extend credit as they now faced capital adequacy problems. Although Europe does not have a subprime problem, financial integration transmitted the contagion instantaneously to Europe since, unlike product markets, adjustments in financial markets are immediate.
The new model of financing, in which debt is repackaged and risk dispersed through a web of leveraged derivative contracts, has much merit. It has deepened financial markets and enabled those with modest incomes, including minorities, to buy homes. But it plainly has had an unhappy consequence: when a problem emerged (in this case, in subprime mortgages), it was harder to work out whom it was safe to do business with. Banks became wary of even lending to each other, leading to a flight-to-quality that raised credit cost across the board. Symptomatic of this is the widening spread between US Treasuries and Libor, which reached a 20-year high.
While central banks have stepped in to slash benchmark rates and inject liquidity into the banking system, the underlying crisis in the real estate market remains unresolved, making a taxpayer funded bail-out likely.
?The writer is a civil servant. These are his personal views