Monday, January 31, 2011

What caused the financial crisis?

Doug Holtz-Eakin of the Crisis Commission identifies ten things:
  1. Starting in the late 1990s, there was a broad credit bubble in the U.S. and Europe;
  2. and a sustained housing bubble in the U.S.
  3. Excess liquidity, combined with rising house prices and an ineffectively regulated primary mortgage market, led to an increase in nontraditional mortgages that were in some cases deceptive, in many cases confusing, and often beyond borrowers' ability to pay.
  4. Failures in credit-rating and securitization transformed bad mortgages into toxic financial assets.
  5. Managers of many large and midsize financial institutions amassed enormous concentrations of highly correlated housing risk;
  6. and they amplified this risk by holding too little capital relative to the risks and funded these exposures with short-term debt.  
  7. These risks within highly leveraged, short-funded financial firms with concentrated exposure to a collapsing asset class led to a cascade of firm failures. The losses spread in two ways. Some firms had large counterparty credit risk exposures, and the sudden and disorderly failure of one firm risked triggering losses elsewhere. We call this the risk of contagion.
  8. In other cases, the problem was a common shock.
  9. A rapid succession of 10 firm failures, mergers and restructurings in September 2008 caused a financial shock and panic
  10. Confidence and trust in the financial system evaporated, as the health of almost every large and midsize financial institution in the U.S. and Europe was questioned. The financial shock and panic caused a severe contraction in the real economy

1 comment:

  1. If past is prelude, then the past housing bubble should be a lesson to auto loan companies. According to the FT article, the current auto loan defaults this year are projected to be 1.7 million this year. This is surprising as auto loan defaults peaked between 1.8 million to 1.9 million respectively between the years of 2008 to 2009, which was during the housing market crash. Now that subprime auto loans are being packed as bonds, investors are more interested in the high returns that the bond products offer. The bigger issues are the same issues that contributed to the housing bubble, lack of regulation. More and more non-bank institutions are creating loans that have longer repayment periods than usual which makes borrows able to buy vehicles that they could not normally afford. This is compounded by the fact that these non-bank institutions are not regulated like banks, so essentially there is a lack of regulation as they use securitization markets or private equity firms. Competition is good but in this case, companies want to get as many of their vehicles out to consumers in the subprime sector to keep their profits up. I guess greed pushes aside the lessons learned during the housing market crisis when some firms went out of business and ruin many people’s lives. Essentially greed is driving contempt.