Financial Shock (Book Resume)

This book by Mark Zandi, a leading economist with Moddy’s gives an insightful account of the various factors that combined to fuel the sub prime crisis. How did it start? What went wrong?
How did the crisis get so bad? Several factors contributed to the biggest financial meltdown we have seen in decades. A ballooning US trade deficit put too many dollars in the hands of the trade surplus countries. These dollars, needing an outlet for investment, went into mortgage securities. Securitisation ensured that the risks inherent in mortgage lending were so widely dispersed that the different market participants thought that someone else would preserve the integrity of the process. Regulators believed that the flaws in the financial system would correct themselves. They assumed that market forces on their own, would impose the necessary discipline. Newly designed global capital standards and credit rating agencies would substitute for the discipline of regulators. To top it all, there was hubris. People started to believe that the ordinary rules of economics and finance no longer applied. The boom would go on forever!
The build up
At the heart of the sub prime crisis lay financial innovation. Low interest rates, surging global investor demand and the Internet fuelled innovation. As liquidity increased, global investors started looking for higher yields. But thanks to investor demand, prices of bonds increased and yields fell. Eventually, a sub prime mortgage security fetched little more yield than a US treasury bond. To boost returns, investors started to use leverage. As funds poured into mortgage rated securities, home loan lenders started to aggressively sell their products to home buyers.
Meanwhile, the Internet transformed the mortgage industry by cutting transaction costs and increasing competition.
As the housing boom came to an end in spring 2005, lenders looked for various ways to keep the boom going. Adjustable rate mortgage loans that minimized initial monthly payments and smaller down payments were two of the ways to make loans attractive to borrowers. This served to keep the boom going. But rising home prices and further interest rate tightening by the Fed undermined home affordability even more. Lenders began to offer loans without the need for any documentation. These loans came to be known as stated income loans or more popularly liars’ loans.
There were other innovations too. Many banks had set up structured investment vehicles (SIVs) to invest in sub prime mortgage securities. This way the banks could get around capital requirements. When interest rates were low and credit was easy to get, SIVs could easily issue short term commercial paper to fund longer term instruments. But when money market funds and other investors began to withdraw, the SIVs collapsed.
Another innovation was the credit default swap, that served as an insurance against bond default. Insurance companies which had been guaranteeing municipal bonds had expanded the business and started to sell credit default swaps. When rating agencies started issuing warnings to bond insurers, worries about the financial strength of the insurers mounted. Soon the municipal market went into turmoil. Even municipalities with traditionally high credit rating, had to pay very high interest rates normally applicable to high risk borrowers.
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