Page 30 - Accelerating out of the Great Recession

THE DAMAGED ECONOMY

failed, so the logic went, the absence of concentrated risk would
prevent systemic problems. This belief, more than any other
factor, explains why—instead of being wary of a market bub-
ble—people were under the impression that this time things
were, and would continue to be, different. What seems so sur-
prising is that this bubble came hot on the heels of—only seven
years after—the bursting of the dot-com bubble.
Unfortunately, not only was homeowner credit suspect, the
market too had misread the risk. In the ensuing panic and
resulting liquidity crisis, the safety net of risk analytics and rat-
ings was revealed to be an illusion. When investors realized that
the risk was largely concentrated in bank balance sheets, their
confidence in the financial system eroded rapidly.

■ HOW GLOBAL MARKETS ABSORBED ■
SO MUCH RISKY BORROWING

A critical and related question now begs to be asked: Why did
global capital markets grow as fast as they did, and how were
they able to absorb so much borrowing that appeared to be—in
retrospect anyway—so risky?
The answer lies as much in the banks’ economics and
investor demand for apparently low-risk fixed-income securities
that offered good returns as it does in the insatiable appetite of
consumers for debt to fuel their spending.
That the banks had become principals, as opposed to merely
agents, played an important role in this bubble dynamic. This is so
because they (particularly investment banks) were using the prof-
its from their leveraged investments in these risky assets to mask
the deteriorating profitability in their core traditional businesses.

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