Well-functioning financial markets are crucial to maximizing sustainable economic growth because they channel funds to the people with the most productive investment opportunities. However, financial markets can do their job well only when they solve information problems that would otherwise impede the efficient allocation of credit to worthy borrowers. The history of financial development can be characterized as a process in which innovation tends to lead to improvements in the quality of information, and this, in turn, enables new financial products and markets to develop. Indeed, in the past decade or so, technological innovations and financial market liberalization improved the flow of information and capital to broader groups of people. For example, the microfinance revolution in developing countries has made capital available to many poor, small entrepreneurs. In the United States, financial innovation has recently manifested itself partly in the development of the market for subprime mortgages. While that market had serious weaknesses that eventually imposed large costs on many borrowers and their communities, it also brought considerable benefits to many others who were able to take advantage of responsible products never before available. As a result, they found themselves far better off financially than they probably would have been otherwise. As this recent experience suggests, financial liberalization and innovation bring many benefits but can also create information and incentive problems that lead to mistakes. When mistakes of this nature become evident, financial markets can seize up, with potentially significant adverse consequences for the economy.
Advances in information technology and financial innovations in recent decades encouraged new lending products and faster securitization of debt. This lowered transaction costs and contributed to a "democratization of credit"--that is, the extension of credit to a wider spectrum of possible borrowers than in the past. In the United States, a potential customer with an Internet connection could quickly fill out an online form, and a mortgage broker could rapidly price a loan with the help of credit-scoring technology. The resulting mortgages were bundled together to produce mortgage-backed securities, which could then be sold off to investors. Advances in financial engineering took the securitization process even further by carving mortgage-backed securities into more-complicated structured products, such as collateralized debt obligations (CDOs), or even CDOs of CDOs, with an eye to tailoring the credit risks of various types of assets to risk profiles desired by different kinds of investors. All seemed well as long as the economy--particularly, the housing market--was booming, and credit became more and more available. But when the housing market turned down, substantial problems were exposed.
The subprime crisis exposed problems with the securitization of mortgages. In particular, it became painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products. Some appraisers, brokers, and investment banks were motivated by transaction fees and had little stake in the ultimate performance of the loans they helped to arrange. Many securitized products were complex, and the ownership structure of the underlying assets was opaque. Investors relied heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies failed to fulfill their raison d'etre. The result has been rising defaults, particularly in the subprime mortgage markets, with losses to both investors and financial institutions.
The ultimate losses from the recent residential mortgage-market meltdown have been estimated by Wall Street analysts at about $500 billion--less than 3 percent of the outstanding $22 trillion in U.S. equities.[2] Why did a relatively small amount of losses on subprime mortgage loans lead to such broad-based financial disruption? After all, a 3 percent decline in stock market prices sometimes happens on a daily basis with hardly a ripple in the U.S. economy.
In part, the outsized impact of mortgage losses on broader financial markets probably stems from the fact that they exposed a more extensive set of problems in financial intermediation that were not limited to the original subprime loans. The liquidity shock that hit us in August has been described by one of my colleagues as a global margin call on virtually all leveraged positions.[3] The liquidity shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range of securities, especially structured credit products. Along the way, the inadequacies of the business models of many large financial institutions were exposed, and these models are now in the process of significant re-examination and rehabilitation.
As has happened in the past, the long-run benefits of financial innovations were easier to anticipate than the problems. The originate-to-distribute model of securitization, unfortunately, created some severe incentive problems--or agency problems--in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan). Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. These agency problems resulted in lower underwriting standards, giving borrowers with weaker financial positions access to larger loans than they should have had. Investors in mortgage-backed securities apparently ignored the importance of these agency problems and did not adequately understand the risk characteristics of the securities they were holding. The practices in place to align the incentives of the originators, securitizers, and resecuritizers with the underlying risks proved to be woefully inadequate.
In retrospect, it is clear that investors were too reliant on credit ratings: Because many of the securities were rated very highly by the credit rating agencies, investors did not understand the underlying risk and had a false sense of safety. Many structured finance products experienced multiple-tier downgrades, a development that is unheard of for more traditional securities such as corporate bonds. This episode was a jarring wake-up call to investors regarding the risk properties of all structured finance products. The credit ratings agencies' failure to correctly assess these underlying risks further undermined investor confidence and worsened market worries about when the next shoe might drop.
When these problems came to light, investors--including leveraged financial institutions--took large losses as the values of mortgage-related assets were marked down in anticipation of higher defaults on the underlying collateral. The market for newly issued subprime and alt-A mortgage-backed securities virtually closed, and the availability of jumbo mortgages dried up. Banks were caught with assets they couldn't securitize, which put further pressure on their capital positions.