* Chart shows that the estimated losses on U.S subprime loans and securities, estimated as of October 2007, was about $250 billion dollars. * The expected cumulative loos in world output associated with the crises to be forecast around $4,700 billion so about 20 times the initial subprime loss * And the decrease in the value of stock market capitalization from July 2007 to Novemeber 2008 was equal to $26,400 billion, so about 100 TIMES the initial subprime loss.
Hence the question is how could such a relatively limited and localized event (the subprime loan crisis in the US) have effects of such magnitude.
Four initial conditions which caused/shaped the crisis:
1. Exuberance/Housing market/ignorance to risk. * Condition on no house price decline, most subprime mortgages appeared relatively riskless. The value of the mortgage might be high relative to the price of the house. But it would slowly decline over time as prices increased. If and when housing prices actually declined, many mortgages would exceed the value of the house, leading to defaults and foreclosures. * Many reasons for this premise – large savings by Chinese households, low interests and expansionary monetary policy. * However fundamental reasons may be that history teaches us that benign economic environments often lead to credit booms. Recent and current strong returns leads to stronger optimism for future returns. * Sustained economic growth. House prices increased for every year since 1991 and even through the recession of 2001. * Understatement of risk also spread to CDSs, as issuers were happy to accept low premia, as they assumed the probability of having to pay out was nearly negligible.
2. Securitization * In mid-2008, more than 60 percent of all U.S mortgages were securitized. In the mortgage market, mortgages were pooled to form mortgage-based securities (MBS), and the income streams cut in tranches and sold to offer more or less risky flows to investors. * While is possible to determine the value of simple mortgage pools (the MBSs), it was harder to assess the value of the derived trenched securities (the CDOs) and even harder to assess the value of the derived securities resulting from tranches of derived securities (the CDO2s). * Hence worries about the original mortgages translated into large uncertainties about the values of all the derived securities * Furthermore the face securities were held by a large set of financial institutions implied large uncertainty affected a large number of balance sheets in the economy.
3. Global connectedness * In the same way securitization increased connectedness across financial institutions. Globalization increased connectedness of financial institutions across countries. * Had examples of regional German banks holding surprisingly large exposure to US subprime loans. * Steady increase in foreign claims by banks from the major five advanced economies increased from $6.3 trillion in 2000 to $22 trillion by June 2008.
4. Leverage * Financial institutions financed their portfolios with less and less capital, thus increasing the rate of return on that capital. * Possible through the numerous holes in regulation, for example banks were allowed to reduce required capital by moving assets off their balance sheets in so called ‘structured investment vehicles’ (SIVs). * In 2006 Citigroup had 2.1 trillion off balance sheet more than the 1.8 trillion on balance sheet. * In 2006 Monoline insurers (Insurance again default on municipal bonds) had capital equal to $34 billion to back insurance claims against more than $3 trillion of assets. * If for any reason, the value of the assets became lower and/or more uncertain, then the higher the leverage, the higher the probability that capital would be wiped out, the higher the probability that institutions would become