Friday, November 26, 2010

The short and true story of the financial crisis

This crisis originated in what are supposedly very safe assets, houses and mortgages, in what is supposedly the strongest and financially safest country, the USA, and in what are supposedly the absolute safest instruments, the triple-A rated. When we then hear even Nobel Prize winners talking about excessive-risk taking, it should be clear to all of us that something very serious has happened to risk. It happened in Basel.

The Basel Committee on Banking Supervision, in their irrational fear of bank defaults, while forcing the banks to have 8 percent of equity when lending to “risky” small companies or entrepreneurs, completely ignored the fact that bank crisis originate only where ex-ante risks are perceived as low, and allowed the banks to hold only 1.6 percent in capital when investing in triple-A rated securities, like those backed with lousily awarded mortgages to the subprime sector, or when lending to sovereigns rated A+ to A like Greece, and which implied allowing the banks to leverage 62.5 to 1, 

Of course, needing less capital when doing business with the “less risky”, made the profitability of bank business with the “less risky” shoot up to the skies, and so the banks forgot all the small businesses and entrepreneurs, and gorged up anything that had a good rating on it… until they choked on the triple-As and the Greeces of the world.