3 - Caught in the headlights

Summary

It all started on the other side of the Atlantic.

Given the design faults of its construction, a crisis in the eurozone was, with hindsight, just an accident waiting to happen. Many observers place that accident in Greece in early 2010, when the country progressively lost access to international financial markets and eventually had to rely on official support from its eurozone partners and the IMF. The problem, however, had already manifested itself in a different guise earlier in a number of eurozone countries, including in Europe’s “virtuous” North. What is more, the roots of the crisis can be found not in Europe, but on the other side of the Atlantic, in the financial and economic problems caused by the housing bubble and toxic debts of the subprime mortgage market in the US.

The US banking system was characterized by lower capital requirements under the Basel II banking regulatory framework, the deregulation of derivative transactions and “voluntary regulation” programmes reducing capital requirements for the largest banks. This lack of robust regulatory oversight resulted in extensive financial engineering and contributed to the creation of a housing bubble. Housing prices rose sharply as borrowers took advantage of low interest rates and easy lending conditions. Meanwhile, lenders masked the riskiness of their loan portfolios by issuing mortgage-backed securities and by “packaging” risky loans into synthetic financial assets such as collateralized debt obligations (CDOs), which were then rated highly by credit rating agencies. These higher levels of subprime lending, together with speculation on residential housing, drove prices higher and increased the indebtedness of households.

When in 2007 the bubble eventually burst and housing prices collapsed, borrowers with variable rate mortgages found themselves with negative equity, unable to refinance their loans and meet obligations. Mass foreclosures ensued, coupled with a sharp decline in the value of securities backed by housing loan portfolios held by financial institutions. Their financial distress was marked by the collapse and takeover of Bear Sterns in March 2008, the takeover of mortgage corporations Freddie Mac and Fannie May, the bailout of insurance giant AIG and eventually the crisis-defining moment of Lehman Brothers filing for bankruptcy in September 2008.