Monday, November 5, 2012
Getting to Normal
November 5, 2012
A financial crisis erupts when a large volume of assets in the financial system suddenly appears to be risky and investors want to get rid of their holdings. These assets become “toxic” – not simply risky, but carrying a risk that cannot be quantified. Toxic assets are not traded according to a normal risk-return calculus. Given that their risk cannot be calculated, their owners just want to sell them – sometimes at any price.
In 2007-2008, this was the case for a class of securities based on residential mortgages in the United States (RMBS, or residential mortgage-backed securities). During the boom phase, these securities were sold as risk-free, on the assumption that US house prices could not decline, as this had never happened before in peacetime.
But this assumption was shattered when a broad-based decline in real-estate prices began in 2007 and loss rates on mortgages suddenly increased. As a result, RMBS were found to be much riskier than anticipated. Initially, there was little basis for re-pricing them rationally, because the event (a peacetime decline in US house prices) was unprecedented. Moreover, banks and other financial institutions, which held large volumes of RMBS, were ill-equipped to measure the risk, and in some cases would have been bankrupted had they been forced to sell their holdings at the fire-sale prices prevailing at the height of the crisis.
The euro crisis followed a similar pattern. Until recently, public debt was considered the ultimate safe asset. Indeed, its risk-free status was embedded in the European Union regulatory framework, which allows banks to hold large volumes of any eurozone country’s public debt without having to put aside any capital to cover potential losses.