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The Dark Matter of Financial Globalization

The recent turmoil in global financial markets – and the liquidity and credit crunch that followed – raises two questions: how did defaulting sub-prime mortgages in the American states of California, Nevada, Arizona, and Florida lead to a worldwide crisis? And why did systemic risk increase rather than decrease in recent years?

Blame should go to the phenomenon of “securitization.” In the past, banks kept loans and mortgages on their books, retaining the credit risk. For example, during the housing bust in the United States in the late 1980’s, many banks that were mortgage lenders (the Savings ampamp; Loans Associations) went belly up, leading to a banking crisis, a credit crunch, and a recession in 1990-1991.

This systemic risk – a financial shock leading to severe economic contagion – was supposed to be reduced by securitization. Financial globalization meant that banks no longer held assets like mortgages on their books, but packaged them in asset-backed securities that were sold to investors in capital markets worldwide, thereby distributing risk more widely.

What went wrong?