Even though the current global financial crisis follows the boom/bust dynamics of other episodes, it is atypical in its magnitude, systemic character and especially in the pervasiveness with which, regardless of their risk, assets became ‘prime’ in the boom and ‘sub prime’ in the bust.
The stage for the current crisis was set up by the generalized adoption of off balance sheet funding practices through out the financial system of the developed world. The off balance sheet funding procedure consists in the creation of a financial asset structure that is remote from the possible bankrupt or insolvency status of the originator. In this way, off balance sheet funding seemingly separated the risk of the portfolio of the originating financial institution from that of its own.
Moreover, off balance sheet funding provided additional protection to the investor through credit enhancing techniques permitting to blur the distinction between securities issued against low risk loans, from those issued against high risk loans. This in turn, allowed risk perceptions to move in tandem in the boom and bust phases. As a result, in the boom phase, as the price of assets tended to increase sharply, all securities would be viewed as prime. Contrarily in the bust phase all securities would tend to bear the ‘sub prime’ label. This particular and unique feature of the crisis is reflected in the difficulty of reforming the financial system by separating the ‘toxic’ from the ‘non-toxic’ assets in the balance sheets of financial institutions.
Off balance sheet funding and its effects on the prices and on risk perceptions and ratings of securities became widespread by pro-cyclical leverage management. Pro-cyclical management entailed reducing debt in the bust phase which eventually led to a cumulative asset deflation and the generalized categorization of assets and securities as ‘sub prime.’
The consequent loss in the value of assets and contraction in financial institutions balance sheets reduced their lending capacity and set the stage for a credit crunch.
The above working logic of these financial mechanisms and more precisely the combination of off balance sheet practices with pro-cyclical leverage management can explain, in part, a most fundamental question regarding the current episode, namely how can such a disruption in such a relatively small market as the subprime market cause such a world debacle only comparable in magnitude, virulence, and systemic character to the Great Depression?
This paper addresses this question focusing on off-leverage funding practices and pro-cyclical management. It is divided into five sections. Following this introduction, the second section argues that while the subprime crisis episode follows the pattern of past crisis it is atypical in the disproportion between the small size of the market which generated the crisis (i.e., the subprime market) and its worldwide effects. The third section explains the specificities of the current crisis on the basis of off leverage funding and pro-cyclical management. The fourth and fifth sections focus on each of these financial practices respectively. The sixth sections centers on the ensuing credit crunch and the final reflections are found in the conclusion.
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