Since last year, the massive crisis generated by subprime defaults and related, collateralized financial assets has crowded out any other major media story. The huge write-offs made by US major financial institutions have led some opinion-makers to view the present crisis as unprecedented in modern finance.
In truth, financial crises are recurrent phenomena, although economists have traditionally underestimated its importance, persuaded as they are that the self-regulating market is the rightful mechanism to deal with even the most problematic crises. Moreover, financial crises seem to present a certain periodicity since the mid-80s. The stock-exchange crash of 1987, the Savings & Loans bailout in 1990, the Tequila crisis of 1994, the run on Indonesian and Thai currencies in 1997, the dot-com crash of 2000, the Enron bankruptcy of 2002: all these events give us plenty of evidence to ascertain the typical characteristics of financial crises and the typical trigger sequence that brings them into being. While the roots of a crisis can be varied, the events leading to a financial crash are rather homogenous and can be divided in three phases.
The first phase is characterized by excessive optimism in financial markets (of the kind that Alan Greenspan termed "irrational exuberance"), with investors having abundant liquidity and usually lowering their adversity threshold to risk.
The second phase is triggered by an undiscounted for and thus unexpected event. The first signs of difficulties in US real estate markets and early defaults on subprime mortgages are good examples of such an event. The unanticipated event rapidly changes investor behavior, making investors suddenly more cautious and augmenting their propensity for liquidity, as well as their search for higher credit quality and financial safety, in the so-called "flight to quality".
If the unexpected event is not rapidly countered, the third phase of full-fledged financial crisis ensues. Either voluntarily or because of institutional constraints, many investors start to deleverage and liquidate their positions, as a self-fulfilling spiral of rising sales and dropping prices sets in motion. In such a phase, the following sequence can occur: a liquidity crisis (whoever has it hoards it or lends it only at very high interest rate premiums), then a credit crunch, and, in the most severe cases, a domino effect wreaking havoc in money markets.
The subprime crisis fits well into this three-stage sequence. The market for collateralized assets issued by securitization vehicles has developed until the first link of the risk chain has held fast (i.e. until households fulfilled their mortgage obligations). The initial deflation in real estate prices immediately increased the loan-to-value rations of US banks (phase 1, unexpected event), which increased the perception that many loans could soon turn into insolvencies (phase 2, higher market cautiousness). This in turn undermined the possibility of refinancing securitization operations with additional operations; liquidity has become scarce, and asset prices have ended up crashing (phase 3, as panic follows crisis).
by Stefano Gatti,
Professor of Financial Markets and Intermediaries, Bocconi University