Term Paper on "Evolution and Spillover of the Subprime Crisis"

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"This decade's great credit bubble really got underway the morning of

Jan.2. That's when Asian markets began selling off as investors worried

that the fallout from the relatively obscure sub-prime sector had spread

into the broader economy" (Sanford, 2008, p. 53). The effects of the Asian

market sell-off quickly spread in dramatic fashion to stock indexes from

"Tokyo to Toronto, where Canada's national exchange plunged 605 points"

(Sanford, p. 53). The severity of that correction is in direct correlation

to the severity of the excess brought about by the speculative nature of

the investments, and in this case, according to the market's reactions, the

speculative nature was very speculative indeed.

Minsky focused his research on understanding financial crisis and how

it takes place. "Minsky claimed that in prosperous times, when corporate

cash flow rises beyond what is needed to pay off debt, a speculative

euphoria develops, and soon thereafter debts exceed what borrowers can pay

off from their incoming revenues, which in turn produces a financial

crisis" (Tan, 2008). According to Minsky, the financial crisis is the

result of banks and lenders tightening credit availability even for

companies that can afford the loans and subsequently the economy contracts.

Minsky's core model is known as Financial Instability Hypothesis" (FIH),

which simply declares stability is inherently destabilizing. In a

nutshell, Minsky believed that there were three stages that business and

industry goes through in order to reach a financial crisis. Those three

stages include the hedge, speculative and Ponzi phases.

The hedge phase is the most conservative and takes place with business

and banking ventures of a very conservative nature. It points to the

buyer's cash flow being sufficient to paying interest and principal for any

amounts borrowed to purchase an asset. The loans are fully hedged in

nature.

The second phase is when those loans become more speculative. The

bankers and the business owners project increasing profits to cover

increasingly speculative loans that are for assets that are appreciating in

value.

The third phase is the harbinger of financial crisis. It is during

this phase that the business owners see assets that are steadily and

rapidly increasing in value, the owners speculate that their profits and

margins will continue to expand, and bankers follow along those

speculations by offering higher and higher loans to value.

The financial crisis can be precipitated when a business owner (or

home owner as the case might be) defaults on the loan. Interestingly

enough, the bankers are usually caught with their collective pants down,

not having anticipated that their speculative actions will have any dire

consequences.

Observing the current financial crisis as defined by Minsky displays

an excellent example of how this crisis followed those patterns he set

forth. What Paul Krugman would have us believe in the case of financial

crisis just might ring true in this particular case. He has long espoused

the fact that it is the new technology being created primarily in the

United States that creates opportunities for such events to take place.

One recent report espoused the opinion that "We are faced with a major

financial crisis inflamed by the subprime mortgage meltdown, which will

have a negative impact on companies, particularly those with weak

financials that depend extensively on borrowing to meet their expansion and

operating needs" (Gomez, 2008, p. 28).

Wall Street would probably agree with him on this case, at least if

they were honest with themselves they would. Wall Street has always been

on the forefront of creating investment opportunities and vehicles that

create additional profits, not necessarily for the investors, but most

definitely for themselves. Some of those investments are the core of the

current debacle and may ultimately have a rippling effect on many

individuals, communities, countries and governments.

"Thanks to the Great Mortgage Panic of 2008, your home value is

tumbling, credit is harder to get and the job market may turn a lot

tougher" (Regnier, 2008, p. 138). Krugman would espouse all this is due to

the home-grown technology used to extrapolate new investment vehicles.

These vehicles include such items as collateralized debt obligations

(CDO's), collateralized mortgage obligations (CMO's) and real estate

mortgage investment conduits (REMIC's). These investment vehicles were

initially created during the 1980's and marketed to investors throughout

the world as fixed income opportunities that were relatively safe in

nature. Investors snapped many of them up because they offered regular and

consistent distributions of income coupled with the fact that they were

'collateralized' by mortgages that were being paid on a monthly basis.

Many of the investors believed that the mortgages were made on

properties that were constantly rising in value, so not only did they

receive a regular dividend, but their investment holdings were rising in

value as well.

This was all fine and dandy until (of course) the mortgages that were

being made were made to an increasingly more risky borrower. Not only was

there a higher risk assumed by the investor due to the creditworthiness of

the borrower, but the underlying property was oftentimes overpriced or

inflated in value. This was a prescription for disaster according to

Krugman, and according to Minsky it was the third phase of three stages

leading to a financial crisis.

During a financial crisis, bank liquidity is affected due to the

tightening of standards that always follows investor's realizations that

properties and real estate used as collateral on loans is not worth as much

as what they thought. Developers are unable to finance or refinance

construction costs and have to curtail construction. Foreclosures rise,

and even good creditworthy individuals find it difficult to qualify for a

mortgage. Homes depreciate in value and people lose confidence in the

financial industry and the economy. Many of these problems could have, and

probably should have, been foreseen by those very experts who created such

investment vehicles to begin with. However, during a Minsky 'ponzi' phase

many of those same investors become euphoric over their ever increasing

profits, and fail to recognize any of the impending events that can spell

disaster.

One recent article states, "from 2004 to 2006 subprime originations

rose from $300 billion to $600 billion. By 2006, these loans made up 21.8

percent of the market and the bulk of the $1 trillion in subprime mortgages

in today's collateralized debt obligations" (Risk, 2008, p. 26).

These types of investments are typically difficult to price due to the

underlying collateral, and due to that difficulty can often be priced much

higher than the true worth of the investment. The same article continued by

stating, "it's become clear that the market vastly mispriced the value of

these risky assets and could have used a healthy dose of paranoia, though

even many conservative investors did not include such a radical liquidity

scenario in their models" (Risk, p. 27). It is easy, of course, to see why

the firms that were garnering such profits from the investments would find

it easy to overlook the warning signs. Now those same firms are scrambling

to stay afloat in some cases, and are completely going under in others. It

is not just the little firms that are having trouble either, but some of

the biggest firms on Wall Street are writing off billions of dollars, as

are many insurance companies. One recent report showed that "the subprime

mortgage crisis will be a significant insurance issue, with significant

coverage issues. Insurers should now prepare to handle these claims"

(Rutkin, 2008, p. 102). Such reactions have effects around the world and

in a variety of manners. Companies are not the only entities that will… READ MORE