reduce the cost of borrowing. At the same time, securitization provided investors with new
products to invest in at a competitive yield.
This relatively small amount of debt was leveraged with much larger amounts of debt. In practice, each transaction could generate
a margin of profit from which the managers of the institutions and their shareholders, brokers, dealers, rating agencies,
designers of asset packages, sales staff and lawyers could all take their cut. The degree of leverage involved also amplified
the debt, sometimes to astronomical proportions. In effect, institutions borrowed money in order to buy debt, which was the
security for the borrowing, and the money they borrowed was in turn borrowed, sometimes through several institutions. In addition,
debt default could be insured against, but the insurers depended in turn on borrowed capital. Derivatives markets alsomade it possible to hedge (or speculate) against the risk of default. The credit default swap market, for example, which grew
on the back of the growth of these debt instruments, achieved a notional value of over $60 trillion. This, in turn, represented
about one tenth of the overall size of derivatives markets, which Warren Buffet warned us was the H-bomb to follow the sub-prime
A-bomb.
How has the downturn in the US housing market, and increase in mortgage default, had such a profound impact on financial markets,
triggering panic among the sophisticated financiers who thought they had diluted the toxicity of sub-prime loans to harmless
levels? At first sight, the sums of money involved in sub-prime losses simply do not justify the collapse of confidence that
has occurred. Let us assume, for the sake of illustration, that roughly one third of the total US sub-prime debt eventually
has to be written off by the financial institutions that hold it: that is, around $400 billion. Perhaps this overstates the
problem, since the earlier sub-prime loans, before 2005, seem to have held up well. The sum is less than the losses in the
1980s savings and loans crisis, even in nominal terms. It represents only 3 per cent of total mortgage debt. In fact, when
the IMF made its estimate of total US financial sector losses in its Global Financial Stability Report, it estimated that,
of total losses of $1.4 trillion ($1400 billion), only around $150 billion could be traced to mortgages, and only a fraction
of that to sub-prime mortgages. So much for the idea that US sub-prime lending caused the crisis. It was merely the fuse that
lit the bomb. The explosive was non-traditional lending outside the banking system, centring on securitization. Through securitization,
loans once held on the books of banks were repackaged and sold. The scale and complexity of this repackaging increased many
times in the rapidly growing pool of debt-based products created by investment banks.
The genius of securitization is also its central weakness. Debt is so widely and skilfully diffused that it becomes impossible
to trace it. No one really owns the loans. So institutions havestruggled to identify how much their own financial assets, backed by sub-prime mortgages, are actually worth, and how much
should be written down. A yet more serious problem is what are called ‘amplifiers’, multiplying losses (and gains) and adding
to uncertainty. Amplification of losses has come from several sources, the most important being excessive leverage. Banks,
and particularly investment banks, increased borrowing relative to equity (share capital) in order to achieve higher returns
for shareholders’ equity when the value of assets was rising. In a world where investors were seeking higher returns on their
assets, one recourse, which occurred here on a grand scale, was to assume more and more debt in order to buy assets, thus
pushing up their value further, but increasing risk in the process.
The investment banks were at the heart of this process of
products to invest in at a competitive yield.
This relatively small amount of debt was leveraged with much larger amounts of debt. In practice, each transaction could generate
a margin of profit from which the managers of the institutions and their shareholders, brokers, dealers, rating agencies,
designers of asset packages, sales staff and lawyers could all take their cut. The degree of leverage involved also amplified
the debt, sometimes to astronomical proportions. In effect, institutions borrowed money in order to buy debt, which was the
security for the borrowing, and the money they borrowed was in turn borrowed, sometimes through several institutions. In addition,
debt default could be insured against, but the insurers depended in turn on borrowed capital. Derivatives markets alsomade it possible to hedge (or speculate) against the risk of default. The credit default swap market, for example, which grew
on the back of the growth of these debt instruments, achieved a notional value of over $60 trillion. This, in turn, represented
about one tenth of the overall size of derivatives markets, which Warren Buffet warned us was the H-bomb to follow the sub-prime
A-bomb.
How has the downturn in the US housing market, and increase in mortgage default, had such a profound impact on financial markets,
triggering panic among the sophisticated financiers who thought they had diluted the toxicity of sub-prime loans to harmless
levels? At first sight, the sums of money involved in sub-prime losses simply do not justify the collapse of confidence that
has occurred. Let us assume, for the sake of illustration, that roughly one third of the total US sub-prime debt eventually
has to be written off by the financial institutions that hold it: that is, around $400 billion. Perhaps this overstates the
problem, since the earlier sub-prime loans, before 2005, seem to have held up well. The sum is less than the losses in the
1980s savings and loans crisis, even in nominal terms. It represents only 3 per cent of total mortgage debt. In fact, when
the IMF made its estimate of total US financial sector losses in its Global Financial Stability Report, it estimated that,
of total losses of $1.4 trillion ($1400 billion), only around $150 billion could be traced to mortgages, and only a fraction
of that to sub-prime mortgages. So much for the idea that US sub-prime lending caused the crisis. It was merely the fuse that
lit the bomb. The explosive was non-traditional lending outside the banking system, centring on securitization. Through securitization,
loans once held on the books of banks were repackaged and sold. The scale and complexity of this repackaging increased many
times in the rapidly growing pool of debt-based products created by investment banks.
The genius of securitization is also its central weakness. Debt is so widely and skilfully diffused that it becomes impossible
to trace it. No one really owns the loans. So institutions havestruggled to identify how much their own financial assets, backed by sub-prime mortgages, are actually worth, and how much
should be written down. A yet more serious problem is what are called ‘amplifiers’, multiplying losses (and gains) and adding
to uncertainty. Amplification of losses has come from several sources, the most important being excessive leverage. Banks,
and particularly investment banks, increased borrowing relative to equity (share capital) in order to achieve higher returns
for shareholders’ equity when the value of assets was rising. In a world where investors were seeking higher returns on their
assets, one recourse, which occurred here on a grand scale, was to assume more and more debt in order to buy assets, thus
pushing up their value further, but increasing risk in the process.
The investment banks were at the heart of this process of
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