By early-2007, it became clear as housing prices began to decline, losses on sub-primate mortgages that originated in 2003-2006 were rising more rapidly than the assumptions used and risk-model predictions. The deterioration in borrowing quality and other shortcomings mentioned above gave little comfort to investors. The losses were hard to estimate, especially in an environment of house-price busts, and given that the sub-prime mortgage-backed security (MBS) had been re-packaged into complex collateralized debt obligation (CDOs) and CDO-conduits were financed by commercial paper and various notes.
The bursting of the housing bubbles in the United States, as reflected in a surge in defaults and foreclosures since mid-2006 in the US, resulted in a plunge in the prices of MBSs — assets whose value ultimately comes from mortgage payments. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt (US financial firms lost over $1 trillion by Dec. 2008). This problem is especially severe because households, corporations, and government took on so much debt during the bubble years (that debt cumulated to over 400% of US GDP and about 450% of UK GDP).
Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs. (US and European banks have been raising capital of about $400 billion from oil-producing countries and China but there is still a large gap as banks continue to write-down bad loans).
Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.” The US financial system is being crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Should the government put these financial firms in receivership/conservatorship or nationalize, or bring in foreign banks and private investors or have a public-private partnership to take over the US banks and insurance firms?
There were many other culprits. A long period of abundant liquidity, rising asset prices and low interest rates, in the context of international financial integration and innovation, led to the build-up of global macroeconomic imbalances as well as a global “search-for-yield” and general under-pricing of risk by investors. Complex, non-transparent instruments were mispriced and misunderstood. Regulators in some cases facilitated, and in other cases failed to respond to, the build-up in imbalances.
The uncertainty surrounding the losses to financial firms led to a flight to quality as reflected by widening spreads between LIBOR and Treasury bill yields as well as among other financial instruments. At about the same time as the financial crisis was engulfing the US, the excess asset demand that produced it did not collapse. The financial instruments were deemed not as sound by capital primarily from emerging markets and oil producers who were in search of investment opportunities. By early 2007, sovereign wealth funds managed over $3 trillion dollars, in addition to foreign exchange reserves in these countries of [$7 trillion dollars].
The oil price, which doubled between February 2007 and July 2008, is one such bubble that coincides as an endogenous response of a world economy that tries to increase the global supply of financial assets (see Figure below). It is not the increased demand for oil from fast growing China and India but the search for higher yields that is driving the commodity and financial bubbles. Managing booms and busts is still the main economic policy challenge for developed and developing countries.