Ley de preferencias arancelarias andinas y erradicación de la droga

According to Mishkin and Eakins (2013), the sub-prime global financial crisis started when new types of loans or financial products known as financial innovation (securitisation) were mismanaged due to improvements in technology and data mining techniques. This led to the birth of a new class of risky residential mortgage in the United States. These developments in computer

technology facilitated a process known as securitisation in which small loans are built into standard debt securities. Sub-prime mortgages are loans that are given to borrowers who are regarded to be a high credit risk and may have difficulty with their repayment schedule. These individuals often have poor quality collateral and usually lack a strong credit history. As a result of securitisation and financial liberalisation, many sub-prime borrowers were able to access mortgage loans and buy houses. Between 1997 and 2006, the Standard and Poor (S&P) home price index reported that American house prices had risen by 124% (see Figure 2.15).

Figure 2.15 shows diminishing returns of the US home price index reaching a peak in 2006, which eventually burst resulting in many sub-prime borrowers becoming delinquent in their repayment obligations since their assets were now lower than their mortgages.

Figure 2.15: The US Home Price Index

Source: S&P Home Price Indices Economic Indicators, 2012

The sub-prime mortgage crises started when a new set of financial products or loans was introduced called “asset-backed security” (ABS), specifically “mortgage-backed security” (MBS), where mortgage portfolios were packaged as securities and sold to investors. This form of securitisation was sold in tranches through “special purpose vehicles” (SPVs) to various investors. This new product allowed the banks to give out loans and augment their lending faster than their deposits but the banks fail to keep tab with the defaulters.

Figure 2.16 shows simplified ABS collateralised debt obligation (CDO) which is a process through which the lender combines other financial assets and later repackages different tiers of financial

instruments to other investors. The diagram shows a mechanism through which credit risk and shocks are transferred to other investors based on the rating of each asset from the senior tranche to the equity tranche. The main culprits behind the sub-prime crisis were the financial institutions for their lapses in transferring credit risk from balance sheet to capital market investors. Most of the financial institutions were not only holding predatory loans or non-conforming loans but were highly volatile and risky in the long run (Hull, 2012: 183).

Prior to the crisis, only creditworthy borrowers (known as prime borrowers) were given residential mortgages. However, improvements in technology and data mining techniques precipitated the advent of the residential mortgage bubble and shadow banking system comprising the hedge funds, money market funds, Over the Counter (OTC) transactions and derivatives market which operated outside the scope of the minimum capital requirements and prudential regulation (Mishkin, 2010: 204; Elson, 2010: 18).

Figure 2.16: ABS collateralised debt obligation (1bp=0.01%) Source: Adapted from Hull (2012: 183)

Worth mentioning from Figure 2.16 is a class of highly advanced financial products known as collateralised debt obligations (CDOs). These CDOs were paying out income streams from a collection of underlying assets and were designed to have certain risk characteristics that attracted investors of particular preferences.

A financial crisis takes place when an increase in asymmetric information triggered by a disruption in the financial system causes severe adverse selection and moral hazard problems that eventually cause financial markets to fail to execute their intermediary function efficiently (Mishkin and Eakins,

Special Purpose Vehicles (SPV) Senior Tranche: LIBOR + 60bp (AAA) Mezzanine tranche: LIBOR+ 250bp (BBB) Equity tranche: LIBOR +2, 000bp (Not rated)

2013). Therefore if the banking system, which plays the most important role within the financial system, fails to facilitate the efficient flow of funds from savers to borrowers, then productive investment opportunities which are the output of banks are lost in the process. For instance, during the crisis, the banking sector of most countries, particularly advanced economies, incurred additional costs of dealing with increasing NPLs and declining bank outputs.

Another major cause of the 2007 financial crisis was the principal–agent problem in the mortgage market. For example, the mortgage brokers who initiated loans did not make the required effort to ascertain whether the borrower was capable of paying off the loan. This lead to problems of adverse selection and moral hazard in the financial system. Hence, brokers have little incentive to monitor the ability of borrowers to fulfil and repay back their financial obligations. In some cases, it was reported that mortgage brokers went through desperate measures of encouraging sub-prime borrowers to take on loans by falsifying information for them in order to qualify for loans (Mishkin and Eakins, 2013).

Credit rating organisations also contributed to the eruption of the crisis. The credit rating organisations for CDOs) were characterised by inconsistencies and irregularities. For instance, the credit rating agencies were also gaining substantial income from rating debt securities of institutions that had an interest in seeing a positive rating. Hence the credit rating process became biased and this stimulated the crisis.