Risk-taking must be reined in to restore markets

What caused the great financial crisis of 2008-2009, how are we adjusting to its aftermath and what have we learned in the process?

The extraordinary housing bubble that preceded the crisis was particularly damaging. It was accompanied by huge increases in debt and leverage both by individuals and financial institutions. The bubble was associated with a fundamental change in the way the US banking system operated.

During the 20th century, banks made mortgage loans to individual homeowners and then kept these loans as assets on their balance sheets until they were repaid. This system was known as the originate-and-hold model.

That system changed, however, during the 2000s to an originate-and-distribute model. Banks continued to originate mortgage loans (as well as other kinds of loans) but held them only briefly until they could be sold to an investment banking institution, which packaged the mortgages into mortgage-backed securities.

The mortgage-backed securities themselves were sliced into tranches. The first (or senior) tranche had first claim on principal and interest payments, and the lower tranches had only residual claims. Through this system, by a kind of alchemy, investment banks produced very highly rated securities on the senior tranches, even though the underlying mortgages might be of relatively low quality or sub-prime.

Lending deteriorates

The system led to a deterioration in lending standards. If the originating institution held the mortgage for only a few days, the lending officers were far less careful to ensure the credit worthiness of the borrower.

The federal government contributed to the problem as well. Government-sponsored enterprises such as the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation also securitised home loans and encouraged originators to make credit available to borrowers who could not afford to make substantial down payments and who had less than perfect credit. Since the bonds of the GSEs had government backing, they could continue to sell increasing amounts of mortgage-backed debt at relatively low interest rates. The result was to make vast additional sums of money available for the purchase of housing, which led to an enormous increase in the amount of debt carried by consumers.

Moreover, a substantial share of their debt was short-term rather than long-term, increasing the risk that they would be unable to roll over their indebtedness during a crisis.

To make matters even more complicated, second order derivatives were sold on the mortgage-backed bonds. Credit default swaps were sold as insurance policies that would pay off if the underlying bond defaulted.

The lowered lending standards and the vast increase in the amount of funds available for mortgages led to an enormous bubble in house prices. According to the Case-Shiller home price index, the inflation-adjusted price of a typical single family home was approximately the same in 1999 as it was in 1899. Between 2000 and 2006, however, inflation-adjusted home prices doubled.

When the bubble burst, house prices began to plummet. By the mid-2009, they had declined by more than one-third from their peak. Many homeowners found that their houses were worth less than the amount of the money owed on their mortgage and simply returned their keys to the lenders and stopped servicing their loans. As defaults increased, the value of the vast amounts of mortgage-backed securities declined precipitously. Since these securities were held by highly leveraged institutions, a major panic ensued.

The de-leveraging process has just begun. Consumers still carry an extraordinary amount of debt and have just begun to repair their balance sheets by restraining spending. Financial institutions are still overleveraged and are not lending freely, especially to small businesses.

New standards needed

We have learned that our regulatory system must be more effective. Systemically important institutions can't be allowed to assume so much leverage that they impose instability on the entire financial system. Improved regulation of capital standards also needs to be buttressed by imposing liquidity standards as well. Most credit default swaps should be fully collateralised and traded on organised exchanges. These kinds of changes are currently under consideration.

What we need is an effective resolution mechanism whereby financial institutions with complicated sets of liabilities can be recapitalised quickly without government subsidies. Losses must be assumed by bondholders and methods found to unwind a variety of swap contracts. Only then will we be able to rely on market incentives to rein in excessive risk-taking.

- The writer is a professor of economics at Princeton University. The opinions expressed are his own


Keep up with the latest business news from the region with the Emirates Business 24|7 daily newsletter. To subscribe to the newsletter, please click here.


Print Email