P.V. VISWANATH
FOR A FIRST COURSE IN INVESTMENTS
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 Changes in the way mortgages were originated.
 Formerly banks originated mortgages and held them. Later,
after the development of Fannie Mae and futures in MBS,
secondary markets in mortgages developed and banks were
able to package their mortgages, sell them off and remove
them from their balance sheet. This allowed to concentrate on
mortgage origination.
 As long as conforming mortgages were securitized, they could
be priced more easily. Once private firms being securitizing
non-conforming mortgages, and mortgages began to carry all
sorts of option-like characteristics, the possibility of their
mispricing rose.
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 Problems in the functioning of the market
 Incentives for short-term gains then led to underpricing of
mortgage backed securities.
 CDS contracts did not perform as expected because systemic
risk was not taken into account.
 Starting from a period of low-interest rates, when rates rose
and over-leveraged banks needed to sell-off their mortgages,
the market collapsed.
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 Systemic Risk: a potential breakdown of the
financial system in which problems in one market
spill over and disrupt others.
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One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral as asset
prices drop
Lack of liquidity compounds the problem since asset owners
have to sell to raise cash immediately.
Potential contagion from institution to institution, and from
market to market
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 Add liquidity to reduce insolvency risk and break a
vicious circle of valuation risk/counterparty
risk/liquidity risk
 Increase transparency of structured products like
CDS contracts
 Change incentives to discourage excessive risktaking and to reduce agency problems at rating
agencies
 Prevent the growth of too-big-to-fail institutions
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 Certain financial institutions are so large and so
interconnected that their failure will be disastrous to
an economy (high systemic risk).
 These institutions become recipients of beneficial
financial and economic policies from governments or
central banks to keep them alive.
 Companies that fall into this category take positions
that are high-risk, as they are able to leverage these
risks based on the policy preference they receive.