Money and Banking

Fall 2012

The Recent U.S. Financial Crisis

The recent U.S. financial crisis had many dimensionsbad lending decisions,
overinvestment in housing, new and complex financial instruments,
excessive use of debt, etc. There is plenty of blame to go around. The video
House of Cards tells the basic story, which emphasizes subprime mortgage
lending and mortgage securitization.
Bad decisions were made in the mortgage market by both lenders and
borrowers. Economists have debated whether lender behavior was rational
or not. Many lenders may have responded rationally to the incentives in
place, earning large fees and getting out before things collapsed. But a lot of
smart lenders and investors also lost a lot of money, and there is anecdotal
evidence they didnt understand the risks they were taking.
Mortgage securitization was widely viewed as reducing the risks in the
financial system by spreading the risks around to different institutions rather
than holding it all at the originating lenders. But in practice, it seemed at
times to concentrate the risk, and big financial houses active in securitization
either went bankrupt (Lehman) or were forced to merge with stronger firms
(Bear Stearns with JP Morgan Chase, Merrill Lynch with Bank of America).
Financial innovations often were too complex for many investors to
understand and were opaque (hard for even knowledgeable observers to tell
what assets backed up the securities and how sound those securities were).
One of the innovations was collateralized debt obligations (CDOs).
CDOs issued securities of differing risk levels or tranches (senior, junior,
mezzanine). Risk was assessed by ratings agencies based on computer
models, but many of the assumptions fed into these models turned out to be
wrong. As a result, holders of AAA tranches found themselves with big
unexpected losses.
Much of the crisis, however, can be traced to problems we have seen many
times before in other financial crisesexcessive use of leverage, credit
risk, liquidity risk. Many financial markets seized up and rate spreads on
risky debt widened because banks and other institutions were unwilling to
lend to each other through asset-backed commercial paper and repurchase
agreements. Investment banks like Lehman and Bear Stearns that relied
heavily on borrowed funds to conduct their business found they could no
longer borrow.

Money and Banking

Fall 2012

As banks hoarded their liquid assets, they also reduced lending to

businesses and households, helping cause a recession. Thus, real factors
like housing influenced the financial sector, and vice versa. In response to
the crisis, the Federal Reserve played a key role as lender of last resort,
extending massive amounts of credit to the financial system. Although the
recession has ended, debt problems and high unemployment have
lingered.Some Financial Terminology
Subprime: a reference to market participants who have poor, non-existent,
or insufficient credit history to qualify for conventional financing. A subprime
mortgage may be made to individuals who cannot verify their income.
Securitization: pooling a group of loans into a trust and then selling
securities issued against the trust, thus transforming nontraded loans into
traded securities.
Collateralized Debt Obligations (CDOs): a form of asset-backed security.
They are typically created by bundling together a portfolio of fixed-income
debt (such as bonds) and using those assets to back the issuance of notes.
Such notes usually carry varying levels of risk.
Tranche: a class of securities that are issued by a collateralized debt
obligation or asset-backed security that carries a certain level of risk.
Normally, CDOs issue several different tranches of securities including a
senior tranche (least risky), junior tranche (most risky), and mezzanine
tranche (in between).
Leverage: the degree to which a financial intermediary, or any company, is
financed by debt versus equityoften measured in banking by the leverage
ratio, which equals stockholders equity divided by total assets.
Credit risk: the risk associated with the possibility that borrowers may
default on their obligation.
Liquidity risk: the risk to a bank that unexpected deposit withdrawals or
unexpected loan demand will leave it short of funds.
Liquid asset: An asset that can be converted quickly into a medium of
exchange without suffering a loss.
Recession: A time span marked by a drop in the level of economic activity
and increased unemployment.

Money and Banking

Fall 2012

Lender of last resort: The Federal Reserve, which acts as the ultimate
source of funds to banks and other financial institutions by providing
reserves to prevent bank failures.
These definitions come either from the textbook or Gillian Tett, Fools Gold,
Free Press, 2009.