A Liquidity Crisis in Housing Is on the Way
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Create account Login Subscribe. Luigi Spaventa 06 September The subprime problem became a crisis when some of this risk landed back on banks. Still, it is not obvious why an even pronounced increase in delinquency rates on such loans, with the attendant losses on mortgage exposures, should have sparked a financial crisis that touched all classes of assets globally, even those relatively immune from credit risk.
True, the share of the less safe loans in the issuance of mortgage-backed securities had almost doubled in the past few years. But an estimate of the direct losses of the actual and expected defaults ranges between and billion dollars — relatively little, considering the valued of aggregate of financial assets and also in comparison with the 5 trillion dollars lost in the dot.
We know how the crisis has unfolded 1. After a sharp drop in the prices and market liquidity of all mortgage-backed securities, an equally sharp increase mortgage credit market crisis liquidity the price of risk and in spreads, and a drying-up of the issuance of all asset-backed securities, contagion extended to the short-term end of the financial market — first to a wide class of commercial paper and then to the money and interbank markets.
As uncertainty and mutual mistrust spread to counterparties even banking counterpartiesovernight interest rates jumped and, as they say, cash became king. The repeated injections of liquidity on the part of various monetary authorities have so far provided only limited solace to this state of affairs.
All this is clear, but the question is: Why should a surge of subprime defaults affect though not disruptively mortgage credit market crisis liquidity the moment the banking system and more worryingly general credit conditions?
The banks originate the loans and then distribute the underlying risk to a myriad of outside investors. Among the undisputable mortgage credit market crisis liquidity of this model more complete markets, a wider range of instruments available to investors, enhanced liquidity, improved allocation of resources is that the transfer of credit risk away from banking intermediaries would make the system more resilient to financial shocks.
The fragmentation of risk and its distribution to non-bank players providing liquidity in several markets would alleviate the systemic consequences and allow an easier absorption of such shocks. Mortgage credit market crisis liquidity, however, is not what has happened. Though the credit underlying all kinds of asset-backed securities and of credit derivatives should no longer be on the balance sheet of the originating banks, the collapse of one segment of mortgage credit market crisis liquidity securities has affected and is affecting the banking system.
The answer is that part of the credit risk flowed back to some banks, mortgage credit market crisis liquidity not on to their books. The banks provide such entities with financial guarantees that only appear below-the-line in their balance sheet, playing the role of last-resort liquidity providers if and when difficulties of refinancing arise.
The precise extent of such commitments mortgage credit market crisis liquidity the aggregate and for individual banks is unknown.
As the prices and market liquidity of the collateral collapsed, refinancing by rolling over the outstanding commercial paper has become almost impossible.
This is why the committed banks mortgage credit market crisis liquidity financial institutions have been required to provide emergency liquidity. Two small German financial institutions IKB and SachsenLB found themselves exposed to their vehicles to such an extent, that they had to be bailed out with emergency rescues. The mortgage credit market crisis liquidity of bigger banks, with more solid capital positions, has obviously not reached anything near a critical stage, but the suspicion of hidden difficulties infects the market.
The problem is compounded by the fact that when the credit risk transfer mechanism froze in August, some core banks which arranged bridge financing for important private equity operations found it impossible to pass on the risk as usual. They are now unable to securitize and transfer the credit that they granted on the eve of the crisis to the tune of over billion. The next question is: Were regulators aware of this roundtrip of credit risk from banks to market and back to banks?
Hardly, one is tempted to answer. This is that mortgage credit market crisis liquidity of the widespread recommendations that banks should obtain greater information on hedge-fund positions and improve counterparty risk measurement and management when dealing with them. I may be wrong, but I could find no mention of the potential problems arising from the existence of off-balance sheet vehicles sponsored and guaranteed by the banks.
Second, only in the past few weeks have supervisory bodies been hastily inquiring on the exposure of individual mortgage credit market crisis liquidity to such vehicles.
Supervisors have puzzled over the problem of where the credit risk ended up. Little did they know, apparently, that a chunk of it had returned where it came from.
This crisis, however it ends, is likely to prompt ill-conceived regulatory proposals. But, if there is one field where something ought to be done, even before damning the sins of rating agencies, it is to find a way to deal with the off-balance sheet operations of banks and achieve greater transparency of their effective exposure to risk.
Also see the Vox columns on the subprime crisis. Subprime crisis and credit risk transfer: Working hours, political views, and German reunification. Globalisation, government popularity, and the Great Skill Divide. Spring Meeting of Young Economists Economic Forecasting with Large Datasets. Homeownership of immigrants in France: Evidence from Real Estate.
Giglio, Maggiori, Stroebel, Weber. The Permanent Effects of Fiscal Consolidations. Demographics and the Secular Stagnation Hypothesis in Europe. Independent report on the Greek official debt. Step 1 — Agreeing a Crisis narrative. A world without the WTO: The economics of insurance and its borders with general finance. Banking has taken a wrong turn.