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one blemish

significant imbalances were building up at various levels in the global economy and the global financial system

exuberant real estate prices and an ebullient securitisation business which facilitated huge credit growth

developments were unsustainable and would only need a spark to cause turmoil in the financial markets and the world economy

US mortgage market provided that spark.

Rising delinquencies and foreclosures revealed the exuberance in the housing market, and brought the sub-prime business to a sudden halt. Securitisation markets froze, banks had to bring assets from special purpose vehicles back onto their balance sheets, and confidence in the financial markets started to crumble. The crisis rapidly spread through the financial sector and spilled over to other industrialised and emerging market economies.

Central banks became the first line of defence, responding to the emerging crisis by injecting liquidity into the financial system. When the liquidity crisis became a solvency crisis that threatened the stability of the financial system, governments initially resorted to traditional measures to rescue individual institutions: liquidity lines were granted to insolvent institutions which in many cases were then sold and merged with a partner presumed to be stronger.

inancial system stood on the brink of disaster in autumn 2008 after the collapse of Lehman Brothers on 15 September. Its failure sent a shock wave through the global financial system, largely due to its importance as a counterparty in the credit derivatives market.

Conditions in interbank markets and other short-term funding markets deteriorated sharply. Credit risk spreads rose to new highs, and equity prices fell sharply. And financial markets in emerging market economies came under pressure as a flight to safety reversed capital flows.

“The entire public was caught up in the belief that housing prices couldn’t fall dramatically. Very, very, very few people could appreciate the bubble — that’s the nature of bubbles. They become mass delusions.”

nearly 90 percent of their ratings linked to the housing market underwent mass downgrades that helped precipitate the crisis

Moody’s “tweaked” its rating model for products linked to the housing market, “when they should have gone at it with a meat ax.”

“Neither we nor most other market participants, observers or regulators fully anticipated the severity or speed of deterioration that occurred in the U.S. housing market or the rapidity of credit tightening that followed and exacerbated the situation,”

The graph below shows the evolution of Hedge Fund indices recently, for each strategy used (Equity Market Neutral, Convertible Arbitrage, Event Driven, Macro & Equity Hedge); it proves that Hedge Funds suffered the crisis (because of spreads widenings and liquidity contraction).

One common argument you may hear is that traders' desire to get big bonuses led them to take too many risks, which ended up in the crisis; this is completely false

Actually, a good trader is an efficient risk-manager, and not a speculator. Inside a trader's book, there are - sometime complex - financial instruments that carry some risks (rate risk, credit risk, forex risk....), and the trader's job consists in managing those risks to hedge his book.

This is a touchy part that deserves a clear explanation; when American banks started to lend money to individuals who didn't meet underwriting guidelines, they didn't keep these loans in their balance sheet, using a sophisticated financial technique called securitization: described simply, a bank create a pool of the mortgages embedded in its balance sheet and produce a financial security (called ABS, "asset-backed security")  which is in turn sold to investors, and freely negotiated on capital markets.

Once those mortgages were packaged in MBS (for "Mortgage-Backed Securities"), they were traded on capital markets, either directly or through tranches of CDO (for "collateralized-debt obligations"); those products were supposed to offer a very interesting risk-reward profile, so many investors and banks buy those products throughout the World, and consequently regional banks in Germany, Scandinavia turned out to have subprime mortgages in their balance sheets; they were exposed to the US Real Estate market.

The conclusion is that banks' balance sheets and assets are so much intertwined that flaws in securities built on American Mortgages impacted banks in the entire World; an interesting thing to underline is that bankers faced fierce criticism for creating sophisticated derivatives products, but no one ever thought of asking to treasurers in smaller banks and financial institutions why they bought those complicated products.

And as one can see, every financial crisis that occured during the past thirty years had nothing to do with structured products and/or derivatives; the subprime crisis of 2007-2008 had one simple reason: the end of the rise of the Real Estate Market in the US, that is shown on the graph below:

Since the mortgages lent to American borrowers were based on the value of their houses, and not on their own wealth, things started deteriorating when the Real Estate market stopped rising. Obviously, US bankers that recommanded those mortgages were not absolutely honest...

Some pointed at the Rating Agencies (Moody's, S&P, Fitch) for they role in the crisis; but not enough, to my mind... and even if more regulation is being discussed at the time, one could wander if strong decisions will be taken in the end.

A Rating Agency assesses the credit worthiness of a firm which issues bonds; this credit worthiness is symbolized by letters, from AAA (the company has very little chance of defaulting) to C or D (the company has defaulted or is close to default); surprisingly, and though many banks fiercly compete with each others to get customers, rating agencies almost form a monopoly: only three major rating agencies exist, two of them acting as leaders on the market (Fitch is a little less active).

The way they work carries some conflict of interest; the firm who want to have its debt ranked has to pay the agency, which in turn must be as objective as possible when assessing the firm...

The Rating Agencies not only rated debts issued by companies, but also the famous Asset Backed Securities, Mortgage Backed Securtities and CDOs discussed above; many of those products got a very good grade, mostly AAA, though it appeared that the risks embedded in those products were largely undervalued.

As a matter of fact, the issue with the subprime crisis was that no one was fully aware of where lied the risks, no that there was too much risk.... the difference is important.

CDS are one of the things that create uncertainty in the banking sector; a bank may look healthy, but it may be counting on CDS payouts from other banks that you can’t see, so you can’t be sure it’s healthy, so you won’t lend to it.

The cumulative effect of CDS is to spread risk, which sounds good, but to spread risk in unpredictable and invisible ways

One of the major reasons why the government refused to let AIG fail – one day after letting Lehman fail – was that AIG was a large net seller of CDS, and if it had defaulted on those swaps no one could predict what the implications would be for the rest of the financial sector.

2. Alan Greenspan (May 2005)"The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions. ... Derivatives have permitted the unbundling of financial risks." Finance is probably the one industry where innovation is mostly problematic. Banking should be easy: Lend money to people who can pay you back. Most attempts to complicate it beyond that are steps toward instability.

The subprime lending increased the homeownership rate in the United States significantly and about 5 million people went from tenants to homeowners. As a result, rents went down and house prices went up till they reached unsustainable heights relative to rents.

Thus, when the rise in housing prices stopped in 2006, inevitably many subprime borrowers had difficulty making their mortgage payments. The housing bubble and particularly the excesses of the subprime mortgage market became even more evident when many subprime mortgage lenders began declaring bankruptcy around March 2007.

Confidence in many financial institutions was shaken and the stock market witnessed systemic weakness across financial sectors. The share prices for large, small, and investment banks all significantly dropped and between July 2007 and March 2008, lost about a third of their value. What is more, banks stopped trusting other banks and interbank lending was disrupted.

Second, the increased demand from the GSEs and the competition with private-label issuers drove up the value of sub-prime and Alt-A mortgages, reducing the risk premium that had previously suppressed originations. As a result, many more marginally qualified or unqualified applicants for mortgages were accepted.

Since these mortgages aggregate more than $2 trillion, this accounts for the weakness in bank assets that is the principal underlying cause of the current financial crisis.

state-based residential finance laws give homeowners two free options that contributed substantially to the financial crisis. First, any homeowner may, without penalty, refinance a mortgage whenever interest rates fall or home prices rise to a point where there is significant equity in the home, enabling them to extract any equity that had accumulated between the original financing transaction and any subsequent refinancing.

The homeowner’s opportunity to walk away from a home that is no longer more valuable than the mortgage it carries exacerbates the effect of the cash-out refinancing.

From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in sub-prime and Alt-A loans.

interest on home equity loans is deductible no matter how the funds are used. As a result, homeowners are encouraged to take out home equity loans to pay off their credit card or auto loans or to make the purchases that would ordinarily be made with other forms of debt.

Bank regulatory policies should also shoulder some of the blame for the financial crisis.

Bank assets are assigned to different risk categories, and the amount of capital that a bank holds for each asset is pegged to the asset’s perceived riskiness.

These rules provided an incentive for banks to hold mortgages in preference to commercial loans or to convert their portfolios of whole mortgages into an MBS portfolio rated AAA, because doing so would substantially reduce their capital requirements.

U.S. housing policies are the root cause of the current financial crisis. Other players--greedy investment bankers; incompetent rating agencies; irresponsible housing speculators; shortsighted homeowners; and predatory mortgage brokers, lenders, and borrowers--all played a part, but they were only following the economic incentives that government policy laid out for them.

our first order of business should be to correct the destructive housing policies of the U.S. government.

In the United States, homeowners' net equity as a percentage of home value has plummeted from around 65% to 45% over the last two decades. with more than half that drop coming since 2000. In Canada, on the other hand, this ratio has remained stable at between 65% and 70% since the 1980s.

Less off-balance-sheet mortgages. The frenzy of mortgage securitization that gripped the United States in recent years (famously explained/satirized in this comic strip) never really took off here. According to Scotiabank "The majority of mortgages are held on balance sheet in Canada, with only 24% having been securitized." That's huge, because it is the radioactive quality of these securities — many of which contain a tangled welter of mortgages of varying quality — that has really sunk the U.S. credit market: Since no one knows how much these complex instruments are really worth, they still haven't established an equilibrium price level, thereby freezing the credit market for any entity that has a large number of them on their books. (What's more, even those 24% have mostly been securitized through the CMHC, a Crown corp. with government backing.)

Finally, there is the fact that Canada simply has a different — and more prudent — banking culture:

Canada banks continue to apply prudent underwriting standards. In other words, they have always checked, and continue to check, incomes, verify job status, asks for sales contracts, etc.,

On average, Canadian home prices are roughly 200% what they were in 1989. In the United States, the corresponding ratio peaked at 260% before crashing down to 220%.

This is the most shocking stat of all. In the United States, a full 4.5% of mortgages are in 90-day arrears (i.e. the local sheriff is ready to move in and tack a notice to the door). In Canada, the figure is one 20th that level — just 0.27%.

All in all, what do these figures show? A prudent, risk-averse, well-regulated Canadian real estate and mortgage community that — on both the seller, mortgagor and buyer sides — has avoided the pitfalls swallowing up the United states.

To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy.

prey in restless bankers - and even more restless borrowers who had no income, no job and no assets.

environment of easy credit and the upward spiral of home prices made investments in higher yielding subprime mortgages look like a new rush for gold.

Fed continued slashing interest rates, emboldened, perhaps, by continued low inflation despite lower interest rates

Fed lowered interest rates to 1%, the lowest rate in 45 years.

everything was selling at a huge discount and without any down payment.

the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now investments.

trouble started when the interest rates started rising and home ownership reached a saturation point

Federal funds rate had reached 5.25%

home prices started to fall

many subprime borrowers now could not withstand the higher interest rates and they started defaulting on their loans

financial firms and hedge funds owned more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more subprime borrowers started defaulting

could not solve the subprime crisis on its own and the problems spread beyond the United State's borders

interbank market froze completely

central banks and governments around the world had started coming together to prevent further financial catastrophe

Fed started slashing the discount rate as well as the funds rate

Federal funds rate and the discount rate were reduced to 1% and 1.75%

The market in credit-default swaps and other complex instruments known collectively as derivatives has become huge and lucrative in recent years, but is unregulated. Observers expect Congress and the regulators to make the field more transparent and to introduce new regulations.

Reserve requirements could be established. Commercial banks, for example, are generally required to keep on hand $1 of cash for every $10 they owe to account holders or they loan out. (Investment banks typically have no such requirements, and keep only $1 for every $30 or more they borrow to invest. They have made fortunes. But when investments go bad, they have few reserves to cover their losses.) Perlow, the attorney, expects Congress to debate amending the Commodity Futures Modernization Act of 2000, which kept derivatives unregulated