The Perfect Storm

• Pages: 37-39

Page 37

Olivier Blanchard’s view of the underlying causes of the crisis

The IMF’s Chief Economist explained in a November 2008 lecture how a crisis that began in mortgage-backed securities turned into the worst recession since the 1930s.

FOR A TIME after the start of the financial crisis, its effects on real activity appeared limited, but this did not last. Lower housing prices, lower stock prices—triggered initially by the decreased stock market value of financial institutions—higher risk premiums, and credit rationing started taking their toll in the second half of 2007. In the fall of 2008, however, the effect suddenly became much more pronounced. Concern that the financial crisis was worsening, and might lead to another Great Depression, led to a sharp decrease in stock prices and to a dramatic fall in consumer and corporate confidence around the world.

This happened as a result of a buildup during the preceding good times of underlying conditions that helped shape the crisis, plus the triggering of amplification mechanisms that dramatically boosted its impact.

Blanchard identified two related, but distinct, mechanisms: first, the sale of assets to satisfy liquidity runs by investors and, second, the sale of assets to reestablish capital ratios. Together with the initial conditions, these mechanisms helped create the worst global recession since the 1930s.

Four initial conditions

The trigger for the crisis was the decline in housing prices in the United States. But the initial losses from the subprime crisis were not huge in comparison with a measure such as U.S. stock market capitalization and were greatly overshadowed by subsequent worldPage 38 stock market declines (see chart). However, over the years, the stage was being set for a much larger crisis. Blanchard cited four preconditions: the underestimation of risk contained in newly issued assets; the opacity of the derived securities on the balance sheets of financial institutions; the interconnection of financial institutions, both within and across countries; and the high degree of leverage of the financial system as a whole.

Assets were created, bought, and sold that appeared much less risky than they truly were. With the expectation of stable or rising housing prices, most subprime mortgages appeared relatively riskless: the value of a mortgage might be high relative to the price of a house, but that imbalance would slowly disappear over time as prices increased. In retrospect, the fallacy of this proposition was in its premise: if housing prices actually declined, many mortgages would exceed the value of the house, leading to defaults and foreclosures. Why did the people who took on these mortgages, and the institutions that held them, so underestimate the true risk? Many explanations have been...