Chapter 1. The emergence of the crisis
References [
CPB |
General |
Scientific ]
Summary
Authors
Michiel Bijlsma & Gijsbert Zwart
Contact:
Michiel Bijlsma
In this chapter
Mortgages
Delinquency Rates
Fast growth securitised subprime and Alt-A mortgages
Delinquency Rates on U.S. Residential Mortgage Loans
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References
CPB
General
Scientific
Summary
This chapter investigates the origin of the financial crisis. Investors in a firm want to make sure that the firm's management uses their money prudently. This usually requires someone to monitor management's activities. But monitoring suffers from a free-rider problem: each investor prefers the other investors to carry out this monitoring task. Banks are the market's solution to free-riding in monitoring by functioning as delegated monitors to investors. On behalf of their depositors, banks make sure that firms behave properly. Banks only have an incentive to do so if they have their own capital at stake as well. Capital regulation makes sure they do.
Financial innovation, in particular the ability to offload loan risks from their own balance sheets to market investors, offered banks a convenient way to absorb the savings glut that originated from global imbalances and loose monetary policy. But this innovation, the so-called originate-and-distribute model, had two adverse consequences. First, it reduced the stake that banks retained in the loans they originated. This undermined banks' incentive to adequately monitor borrowers. Second, the innovation allowed banks to take on more risk outside the scope of regulation.
Banks’ business was increasingly to originate loans, repackage them into securities with a well defined credit risk, which could then be sold to investors with sufficient appetite for such risks. As a result, cheap credit and banks willingness to originate increasing amounts of mortgages fuelled the housing boom in the U.S. When the housing market in the U.S. started to deteriorate, investors discovered that credit rating agencies had severely underestimated the risks involved in these securitised subprime mortgages. Again due to free-riding, a deal’s originator, instead of the investors who bought the deal, paid the rating agencies for their services.
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