Tuesday, August 7, 2007

S&P crisis in early 1980s compared to current subprime crisis

http://www.ft.com/cms/s/24fcb15e-415a-11dc-8f37-0000779fd2ac.html http://ftalphaville.ft.com/blog/2007/08/03/6307/the-subprime-lessons-of-americas-sl-crisis/ --the rapid unraveling of US subprime market reminded us of the adage that history repeats its self: many of the sad excesses of today's subprime markets are but an echo of costly savings and loans crisis in early 1980s. --securitization seperate originator of mortgage loans from final outcome, relaxing their responsiblity to scrutinize the quality --Two further financial market innovations have played important roles. The first was the increased use of collateralised debt obligations, which allowed AAA ratings to be obtained for the larger part of subprime mortgage loan pools, thereby substantially expanding the participation in this market to pension funds and insurance companies. The second was the introduction of financial market instruments such as adjustable rate mortgage loans or negative amortisation loans. These instruments, which were introduced with the encouragement of the Federal Reserve, allowed very much less creditworthy borrowers to qualify for mortgage financing for the first time. --&L meltdown of the 1980s also had its origins in financial market innovation and poor regulation --the balance sheets of savings and loans - the US equivalent of building societies - came under severe pressure from higher interest rates. Congress then substantially loosened S&L lending standards and allowed them to diversify into riskier and very much more profitable commercial real estate lending. --At the same time, federally backed deposit insurance at these institutions was raised from $40,000 to $100,000. Not only did this trigger a rush of money into the S&Ls, it also further encouraged the S&Ls to increase risk taking. --Compounding the S&L crisis was the considerable loosening of regulatory standards. In particular, the S&Ls were given the option of choosing whether they were to be state or federally regulated. Predictably, this encouraged many states, which stood to earn large fees from registering S&Ls, to enter a race to the bottom by offering ever more lax supervisory regimes. --A cautionary lesson to be learnt from the S&L crisis is how official estimates of its scale were repeatedly ratcheted up and how in the end it was the taxpayer who got stuck with the bill. Initially, the cost was put at some $50bn. However, when the dust settled, it turned out that the federal bail-out of the S&Ls cost the taxpayer some $150bn.

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