Page 31 - Accelerating out of the Great Recession

ACCELERATING OUT OF THE GREAT RECESSION

In the early part of the decade, with U.S. Treasury bonds
offering low returns for the foreseeable future, Wall Street met
investors’ demand for new instruments by packaging higher-
yielding mortgage debt into (apparently) AAA-rated securities.
But the incentives driving the mortgage originators and securi-
ties distributors created a moral hazard: their rewards were not
aligned with sound credit-underwriting principles or the distri-
bution of assets backed by sound collateral. Credit was granted
to noncreditworthy individuals, packaged into securities, and
pushed out into the market. And seemingly unlimited investor
demand inflated the bubble further.
The impact of this bubble on the profitability of the financial
sector was impressive: if discretionary bonuses are added back,
the financial sector’s share of total profits of the U.S. corporate
sector rose to close to 50 percent in 2007—up from levels of
between 20 and 30 percent in the late 1990s.
When the asset bubble burst, broker-dealers and many banks
found themselves with a significant exposure to assets that they
thought were sitting off the balance sheet in special-purpose vehi-
cles. Having leveraged up some 30 to 40 times on cheap debt in
order to make the numbers work on thin profit margins, they had
minimal equity cover for the significant (unrealized) losses caused
by marking the investments down to market value. Counterparty
alarm set in, and money markets froze as banks panicked about
creditworthiness and liquidity exposures. This led to a race to
deleverage, reduce exposures to the interbank markets, and safe-
guard balance sheets. While banks were the original victims, the
contagion spread to the corporate finance markets.
Of course, some observers saw the crisis coming. But how-
ever loudly they shouted, their voices were not heard because of
the coalition of interests that relied on believing in the contin-

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