Table of Contents

Managing Risk in the Financial System

Managing Risk in the Financial System

Edited by John Raymond LaBrosse, Rodrigo Olivares-Caminal and Dalvinder Singh

Managing Risk in the Financial System makes important and timely contributions to our knowledge and understanding of banking law, financial institution restructuring and related considerations, through the production of an innovative, international and interdisciplinary set of contributions which link together the law and policy issues surrounding systemic risk and crisis management.

Chapter 1: Investor Behaviour in the Period Before the 2007–08 Financial Crisis

Richard J. Rosen

Subjects: economics and finance, financial economics and regulation, money and banking, law - academic, finance and banking law

Extract

1 Richard J. Rosen 1.1. INTRODUCTION The period leading up to the financial crisis that began in 2007 was marked by a rapidly expanding array of securities, especially what are known as structured securities. Structured securities, which include bonds issued as part of the securitization process, often are very complex in structure and it is difficult to understand the underlying elements. They can be very difficult to evaluate, even by the financially sophisticated investors that they are marketed to. This chapter explores why investors may have flocked to these securities in the pre-crisis period. In the wake of the financial crisis, the US passed the Emergency Economic Stabilization Act of 2008. That act gave the Treasury Secretary the authority, through the Troubled Asset Relief Program, to purchase troubled assets from banks. The troubled assets that many legislators had in mind were largely structured products such as mortgage-backed securities (MBS) backed by subprime mortgages or collateralized debt obligations (CDO) backed by subprime MBS. Possibly because of the difficulty of pricing these structured securities, the Treasury turned away from asset purchases as the primary means of combating the crisis. The complexity that made valuation difficult during the crisis also was present in the precrisis period, yet structured securities markets had been booming, with new products and increased volume in the early part of this century. In many countries, including the US, only financially sophisticated investors can purchase structured securities. The thought behind restricting the purchasers of these securities is to ensure that...

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