“Part 3 focuses on how policy decisions altered economic agent behaviours, and distorted market signals in market- based economies, across the globe”
Issues pertaining to the banking crises are the net effects of microeconomic distortions, too commonly resulting from government subsidisation of risk (Calomiris 2011) (1). What arose from 1988 to 2006 was a banking system which had reason to expand the scope of participation into risky activities. Activities, where;
- Banks originate assets
- Manage assets In SPE’s
- Provide underwriting of securities which were collateralised with the initial assets they had originated
- Service and collect fees from the originated assets
The consequent mortgage backed securities (MBS) and the collateralised debt obligations (CDO) required a favourable credit rating in order for institutional investors to purchase such securities. Credit rating agencies (CRA) rated the MBS and CDO products in a convoluted fashion, which, at heart, was flawed. The rating process involved using the historical default risk on mortgages, prior to the use of MBS and CDO products, as well as, mortgages that were a part of the old originate and hold banking model.
Chart 5 – CDO Issuance in Billions (2004-2008)
Chart 5 (Barnett-Hart 2009) (2); displays the CDO issuance boom, peaking at over $180Bil in Q1 2007, to eventually imploding by 92 percent in only 12 months. Explanations of such behaviour by banks, the shadow banking system, financial institutions and government sponsored enterprises, were under the political mantra of improving affordable housing which had tremendously negative microeconomic ramifications. (Calomiris 2011, p. 81) (1) Strictly indicates the government sponsorship of mortgage risk, as the key factor in such behaviours seen in Chart 5.
Credit evaluation was an essential function under the originate and hold banking model, whereby, banks where directly responsible for the assets held in their loan books, and so therefore, would not lend to borrowers who failed their credit risk evaluation. However, under the new originate and distribute model, banks were handing out NINJA loans (No Income, No Jobs, No Assets) to borrowers. The surge in subprime lending, flowed from the demand for origination by banks, regardless of the poor quality credit attributes of borrowers. Subprime carried heightened risk, relative to the mortgage securities prior the banking system shift in the late 1980’s. Put in plain English, there was never an easier time to obtain a home loan in the US, and, never a worse type of debt floating around in financial markets. The credit ratings by ratings agencies were severely skewed for various reasons, some of which being:
- The combination of government sponsored risk
- Government policy push for ‘affordable housing’
- Extremely loose monetary policy
- The banking model shift from; originate and hold, to an originate and distribute model
Critically, however, before the complex structured finance products such as the MBS and CDO’s could enter the market for institutional investors, the rating agencies had to assess and approve these products as triple-A. Moral hazard was intrinsic to the three main rating agencies, as they were remunerated for rating the product. If one chose not to, clients could, and did, go for a seven and a half minute walk to a competitor who would obtain their business.
Chart 6 – House Price Appreciation in 6 Countries (2002-2008)
Chart 6 (FCIC 2011) (3); visualises the rapid increase in house prices in six countries including the US and Australia. It is quintessential to understand that the rapid movement observed in equities, realty and instruments such as CDO’s and MBS’s (having their origins in realty), model the aggregate behaviour of all economic agents within the US and indeed across the globe. What is invariably obvious given the aforementioned policies and charts, is that they became the proverbial carrot dangled before the faces of economic agents, to get involved and buy in, of which, many found irresistible.
In such an expansionary environment, investment decisions were concentrated toward high growth areas, further distorting the evaluation of risk, over-borrowing and over-investment in these high growth markets (Kregel 2008, p. 6) (4). Calomiris, like Taylor, agree that loose monetary policy, in combination with global instabilities acted as the tipping point for the subprime crisis.
Securitisation, however, was not just a recent phenomenon. A high degree of securitisation occurred during the roaring 1920’s, for the funding of residential and commercial construction. The commercial backed securities market was affected prior to the stock market crash of 1929, precisely the reason for the continued surge in the US stock market, up till it’s peak in August 1929 seen in Chart 1.
(1) Calomiris, C. 2011, ‘Origins of the Subprime Crisis’, Columbia Business School and National Bureau of Economic Research, pp. 73-91.
(2) Barnett-Hart, A. 2009, ‘The Story of the CDO Market Meltdown: An Empirical Analysis’, Harvard College Cambridge, p. 6.
(3) Financial Crisis Inquiry Commission 2011, ‘Financial Crisis Inquiry Report’, The Financial Crisis Inquiry Commission, Pursuant to Public Law 111-21, p. 415.
(4) Kregel, J. 2008, ‘Using Minsky’s Cushions of Safety to Analyze the Crisis in the U.S. Subprime Mortgage Market’, International Journal of Political Economy, vol. 37, no. 1, Spring 2008, pp. 3–23.