Today, the world economy is in recession and the financial sector is experiencing a severe credit crisis. The origins of the credit crisis can be traced back to the subprime mortgage market in the U.S., where subprime refers to mortgagees who are unable to qualify for prime mortgage rates due to myriad reasons. These include past payment delinquencies, personal bankruptcies, low credit scores, large existing liabilities, or high loan to value ratios. As such, they represent a high-risk class of loan-borrowers with respect to defaulting on prospective payments.
In the last five years or more, a boom in subprime lending was fueled by, and it in turn propelled, a bull-run in the market for mortgage-backed securities. A Mortgage-backed security (MBS) is simply a merged pool of multiple mortgages that has a recurring stream of annuity payments associated with it over a horizon of 15 to 30 years. The annuity stream originates from the monthly mortgage payments that are purportedly expected from the corresponding loan borrowers. The lending boom sparked a spike in demand for homes, which in turn artificially inflated home prices and made investments in MBS assets very attractive for the banking sector. Banks consequently invested heavily in MBS assets, many of which had significant exposure to underlying subprime borrowers. They sought to neutralize the default risk to the associated annuity streams by investing in a form of insurance known as Credit Default Swaps (CDS). However, this turned out to be a superficial and temporary transfer of the underlying default risk. This is because of the high counterparty risk that was later realized in the overextended CDS market when subprime borrowers started to default en masse, and home foreclosures started to rise. Defaulting-led foreclosures in turn led to depressing home prices, particularly in subprime zip codes. These dynamics implied a significant downward pressure on the value of MBS assets as well as real physical home assets that ended up on the books of the banking sector through write-downs. A faster depreciation of assets relative to liabilities in turn put a downward pressure on the capital held by various banks.
As a consequence of pressure on capital, banks were concerned about the magnitude of future write-downs and counterparty risk. They have been trying to keep as much cash as possible as a cushion against potential losses. They have been wary of lending to one another and, consequently, have been charging each other much higher interest rates than normal in the inter bank loan markets (Crouhy et. al. (2008)). This has led to a downslide in the availability of commercial credit and business loans that form the life blood of the economy. As a result, a recessionary downturn has materialized on the economy that has led to lower consumption and higher unemployment. This has led to even higher downward pressure on affordability at the level of individual families, thereby increasing the rate of defaults and leading to more foreclosures and further downward asset valuation in the banking sector. The chain-reaction dynamics that we have described above is in effect a vicious, self-fulfilling negative spiral, also referred to a ‘deflationary spiral’ that is triggered by ‘systemic risk’ in the financial literature. We are now at a point where the government is embarking on a bold economic stimulus package to revive the economy.
There has been a lot of recent research work aimed at analyzing the financial crisis. Allen and Gale (2006) investigate transferring system risk from banking sector to insurance sector, as witnessed with the proliferation of the CDS market. They conclude that depending on the dynamics of the market, it could be beneficial or adverse. Murphy (2008) concludes that there were serious problems in valuation of CDS instruments, which exploded upon cataclysmic rises in residential mortgage defaults and led to significant worry about counter-party risk, thereby fueling the ‘contagion’. Whalen (2008) discusses causes of the subprime crisis in greater detail. Especially, three factors are pointed out, 1) multiple agencies (including government) enhanced the availability of “affordable housing” via the use of “creative financing techniques”, 2) federal regulators encouraged practice of over-the-counter derivatives like CDS, and 3) the security exchange commission (SEC) embraced “fair value accounting”. Demyanyk and Van Hemert (2008) provide evidence that the rise and fall of the subprime mortgage market follows a classic lending boom-bust scenario, in which unsustainable growth leads to the collapse of the market.
Our take-away message from the above scholarly articles is that modeling and understanding the dynamics between multiple aggregate entities, namely the banking sector, the housing market, and the prevailing economic environment is critical for developing intuition about the evolution of the financial system. It is also important with respect to developing intuition about the lagged timing and magnitude of the effects of various corrective actions such as economic stimulus packages. The chain-reaction dynamics that we have attempted to elucidate above leads us to believe that a Systems Dynamics model is an appropriate modeling approach. We follow the methodology proposed by Forrester (1960). He proposed to use systems-thinking to capture causal relationships in any target system and described a mental model in the form of stock-flow diagram. A stock is accumulative quantity that increases by inflow and decrease by outflow. Its flow rates are formulated as a consequence of driving forces in the system – physical reasons that lead to flows. The methodology has been successfully used to model various applications, like supply chain, disease propagation, decision rules in project management etc. summarized in Sterman (2000).
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