Page 29 - Accelerating out of the Great Recession

ACCELERATING OUT OF THE GREAT RECESSION

home-equity release products enabled many borrowers to treat
their homes as if they were ATMs (automated teller machines).
For those who wanted to look, the information about what
was really happening was readily available: the doubling of U.S.
house prices in real terms over just 10 years, the fact that con-
sumer debt doubled as a percentage of GDP between 1974 and
2007, and the collapse in U.S. savings rates from around 11 per-
cent in the late 1980s to below zero in 2005.
But lenders insisted on lending to people who could not
afford the homes they were buying or who were increasing their
debt as house prices rose—leading to rapid growth in the
innocuously named subprime market.

The Sophistication of Investors Was Also Low
The second assumption—that investors were sophisticated—
provided further false comfort. Because they had unprecedented
access to data and analytics, lenders and investors were assumed
to be exceptionally adept. Advanced financial technology meant
that risk could be finely tailored to their specific needs.
Bolstered by credit insurance and endorsed by rating agencies,
this risk was assumed to be negligible.
Consequently, the capital applied against the perceived neg-
ligible risk was minimized, and this allowed for a rapid expan-
sion of this asset class. This modus operandi ignored both the
poor quality of the underlying collateral and the enormous
increase in bank leverage needed to make money from a busi-
ness with increasingly thin margins.

Risk Was More Concentrated Than Was Widely Believed

The third assumption was that risk was widely distributed
among global investors. Even if credit worsened and analytics

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