Readings on the Financial Crisis
By Arnold Kling
The whole purpose of securitization is to lay risks off the economic balance-sheet of financial institutions. But the way securitization was achieved, especially during 2003-2Q 2007, was more for arbitraging regulation than for sharing risks with markets. The reason why banks face capital requirements is that they have incentives to take on excessive risks given their high leverage. Capital requirement ensures that first, banks find it costly to take on risks, and second, when they get hit by a shock, there is enough of a buffer zone to protect them.
But that’s not what happened. Banks set up a shadow banking sector of SIV’s and conduits funded by asset-backed commercial paper that was guaranteed — often fully — by banks through liquidity and credit enhancements. Designing things this way allowed banks to transform on-balance sheet loans and assets into off-balance sheet contingent liabilities, and thereby exploit loopholes in regulators “Basel” capital requirements.
Regular readers of this blog know that I very much endorse this analysis.
Also, the Government Accountability Office (GAO) has a report on leverage and the financial crisis.