Getting to Normal

In both the US subprime crisis and Europe's sovereign-debt crisis, assets previously regarded as risk-free proved to be anything but safe. Recovery for Europe, however, is likely to be much slower than it has been for the US, owing to the absence of debt mutualization and continued uncertainty about default risk.

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.

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