Getting to Normal
BRUSSELS – A financial crisis erupts when a large volume of assets in the financial system suddenly appears to be risky and investors want to get rid of their holdings. These assets become “toxic” – not simply risky, but carrying a risk that cannot be quantified. Toxic assets are not traded according to a normal risk-return calculus. Given that their risk cannot be calculated, their owners just want to sell them – sometimes at any price.
In 2007-2008, this was the case for a class of securities based on residential mortgages in the United States (RMBS, or residential mortgage-backed securities). During the boom phase, these securities were sold as risk-free, on the assumption that US house prices could not decline, as this had never happened before in peacetime.
But this assumption was shattered when a broad-based decline in real-estate prices began in 2007 and loss rates on mortgages suddenly increased. As a result, RMBS were found to be much riskier than anticipated. Initially, there was little basis for re-pricing them rationally, because the event (a peacetime decline in US house prices) was unprecedented. Moreover, banks and other financial institutions, which held large volumes of RMBS, were ill-equipped to measure the risk, and in some cases would have been bankrupted had they been forced to sell their holdings at the fire-sale prices prevailing at the height of the crisis.