financial crisis
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Many people like to compare the current financial crisis and the Great Depression in 1930s. However, what we are facing is a much different version from many aspects. In this severe crisis, what is definitely of great value is our deeper understanding on our past wrong conceptions. BsA4/Bf
A brief review on the current crisis can be traced to the Greenspan’s age. After the fast development in the 1990s, financial institutions began to pursue higher profits by bearing higher risks. The risky desire located itself on the strategy to encourage people with imperfect credit history to purchase houses by taking mortgages with higher interests. As years of practice, with the help of the securitization, financial institutions discovered that it seemed quite safe to securitize those mortgages into Mortgages Backed Securities (MBS). Through this practice, financial institutions could get sufficient funds from MBS to support their loans towards the mortgage takers while using the cash flow from the interests of the mortgages to pay back the return for the MBS. However, the obvious mismatch between the asset and liability didn’t raise enough attention. The mortgages are long-term investment for financial institutions, while the MBS are usually short-term. If default rate of the mortgages becomes very high, financial institutions won’t be able to pay back the returns and principals of the MBS investors. Nonetheless, the seemingly prosperous world economy didn’t allow the elite to give the potential risk a second thought. This was even blessed by the deregulation of the financial sector under the reign of Alan Greenspan. ~=yU%5 s@
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The up-and-down cycle finally turned to its dark side. When the house owners discovered that they were not able to clear the mortgages they had taken and more and more defaults occurred, the nightmare started. The drying up of the cash flow made the payment for the MBS difficult. What’s more, the financial institutions discovered that they had made another mistake, issuing credit default swaps. The credit default swaps are designed to insure the case when the third party’s (mortgage takers) default. For those MBS investors, buying credit default swaps may be a good idea in case that the mortgage takers defaulted. For financial institutions, they might take the long position of the swaps as a kind of insurance as well. Nonetheless, betting on the positive economic development and pursuing a higher profit, they took the short position; i.e. they are going to pay the investors if those mortgage takers default. Now stories became complex. The sudden turn of the housing market led doubled losses. Financial institutions had to pay the investors not only for the MBS but also for the swaps out of limited income streams. That was the end of the pride of those elite. They began to face the real trouble. m+M^we*R
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When the trouble spread from the housing market to the financial market, it could not be controlled easily any more. The financial markets nowadays are so interdependent that any fault in the chain may cause the dysfunction of the whole. Obviously the securitization was overused in the financial industry worldwide and the problem starting from the housing issue of the US became a global concern. Stock markets became so trembling that the confidence in the market was lost. This was the time for the test of hypothesis of “perfect arbitrage”. The perfect arbitrage is believed to be the base of modern financial markets, a hypothesis different pricing methods of financial instruments established. One example can show the profound influence of this hypothesis; Robert Merton, the 1997 Nobel Prize laureate, was awarded for his paper on “option pricing” which is deeply based on the perfect arbitrage assumption. According to the perfect arbitrage assumption, whenever the asset price seriously deviated from the true price, the arbitrageurs will fully take advantage of the opportunities to gain the arbitrage profit and correct the mispricing resulting from their arbitrage behavior. If it was true under no conditions, we would not see the Asian Financial Crisis in 1998 and would not see the messy financial markets today. In The Limits of Arbitrage, Andrei Shleifer pointed out the weakness of the perfect arbitrage assumption. The long-term capital management was the case to prove this point. When the market is full of panic atmosphere, arbitrage may not happen leaving the free fall of the asset price. That is what we are talking now; when everyone loses confidence in the market, who dares to put money into the market again?
