Financial Institutions Mismanaged Their Risk Profiles
Financial institutions were making a lot of money a few years back when credit was cheap and the housing market was booming. Their risk profiles grew as they sought ever higher profit margins.
Their basic strategy was to originate loans and then repackage them into asset backed securities to sell to investors. The cash received from the securities would then be used to originate more loans as the cycle continued.
Fed Chairman Ben Bernanke discussed the risk management of financial institutions and the underlying causes of the credit crunch at a conference on bank structure and competition earlier this week.
The revenues of the originators of subprime mortgages were often tied to loan volume rather than to the quality of the underlying credits, which induced some originators to focus on the quantity rather than the quality of the loans being passed up the chain. However, the problems with subprime mortgage underwriting were disguised for a time by the continued appreciation in home values.
As long as house prices kept rising, subprime borrowers saw their home equity increase and were often able to refinance into more-sustainable mortgages. But when house prices began to stagnate and then fall, many subprime borrowers found themselves trapped in mortgages they could not afford. Because subprime loans were frequently securitized and incorporated into complex structured products, the resulting losses spread throughout the financial system.
Financial institutions were selling these high risks loans as securities to unsuspecting investors, yet they were also taking huge losses. That’s because they exposed themselves to their own risky loans through the explosion of the derivatives market and credit default swaps in particular.
The highly leveraged system of credit, valued in the trillions was only backed by a fraction of that in real capital. The entire financial system essentially became a house of cards that eventually collapsed under it’s own weight, once the rising housing prices which supported it became a distant memory.
