What caused the current financial sector meltdown?

All the papers nowadays are full of the subprime credit crisis. What caused the present crisis?

One of the responsible factors has been global interest rates that have fallen and are exceptionally low by historical standards – they are about 200 basis points below their long run average. Stephen Jen of Morgan Stanley Research calculates that the market capitalization weighted real interest rates (10-year rate) for the US, Eurozone, UK, Canada, Switzerland, Sweden, Norway, Japan, Australia, and New Zealand was 3.2% from 1991-2000 and this average is down to 2.25% from 2002-2006. With very low interest rates people began to “search for yield” or for higher return and were prepared to take on more risk to achieve that objective.

Second, there was an unjustifiable confidence about the continued rise in US housing prices that went up about 90 percent between 1996 and 2005. People began to feel that at such times if they did not buy a new house they were missing out on a market upswing that would be foolish to not participate in when most others were doing so. Mortgage lenders did not bother about making loans in the face of rising house prices as they figured that if repayments were not made they could put the house on the market and since it was a rising market there was no risk of losing money by reselling the house.

Third, mortgage lending sought high yields by lending towards less creditworthy borrowers – subprime borrowers who do not have a strong credit history or who have characteristics associated with a higher than usual probability of default on their credit repayments. Between 2003 and 2006 the share of subprime mortgages more than tripled.

Fourth, the introduction of capital markets in the financing of mortgages led to incentive problems. It used to be the case that if you got a mortgage you got it from a bank that checked your eligibility to borrow and held the loan till you paid it off and so took on all the credit risk. In the last decade this changed as your mortgage is sold by the bank to a third party that packages it with other mortgages and sells it onwards to others who purchase these assets – a process called securitization. In the process of securitization the bank had an incentive to sell more loans and the risks associated with those as its returns were tied to the volume of loans processed and not the quality of those loans. Incomplete income documentation and weak borrower credit histories began to become part of the mortgages given that was not the case earlier.

Fifth, credit rating agencies that rated the securitized products had incentives to give them higher ratings which indicate more safe products than was the case. Credit rating agencies were heavily into consulting as well and so one part of the firm would provide consulting as to how to design securitized products that could get a high credit rating and then another part of the firm would give a credit rating that the consulting part had suggested they would get if they were designed that way. Rating firms like Moody’s made much money in the recent past in this way.

Sixth financial regulation was weak as the Federal Reserve that regulates banks did not monitor how much of bank portfolios were going into housing related loans.

This all may seem like what should have happened in developing economies and not in mature markets. However, the view about financial markets in the mature economies in the last decade was that financial players know best about the nature of financial products and the risk associated with such products as they trade in them more continuously than do bureaucrats and regulators who would just impede the development of such markets due to their ignorance. We are about to see a new phase of regulation in financial markets that will emerge from the ashes of the credit crisis.