Chapter 3: Some lessons from the Global, or Great, Financial Crisis
In an environment of historically low interest rates, low returns and plentiful liquidity, investors actively sought higher yields; often through capital gains from rising asset prices. Risk was widely mispriced due to lax internal controls at banks and other financial institutions. As a result, an increased number of innovative and complex instruments were designed to offer more attractive yields, often combined with increased leverage. Specifically, financial institutions securitized their loans into mortgage-backed securities, which were subsequently converted into collateralized obligations (CDOs and CLOs), generating a dramatic expansion of leverage within the financial system as a whole. Financial institutions engaged in very high capital leverage ratios in pursuit of historically high returns on their equity; leaving them highly vulnerable to even a small decline in underlying asset (property) values, or even their rate of increase. The institutional shareholders came to expect banks to pursue high returns on equity, leading to large dividend pay-outs, and governments, particularly in the UK, where the financial sector was nearly four times GDP, were happy to reap the consequently substantial tax revenues form profits, high salaries and large bonuses. Meanwhile, the real wages of the middle- to low-income earners in the US had been stagnant for a number of years and so there was a ‘growth imperative’ and a need for easy access to credit to boost the consumption levels of this important set of voters (Rajan, 2011).
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