The Risk Cycle

AEI recently published an interesting report on the economy. It’s a bit long, but here’s a sample:

The temptation during the last half of 2007 was to view the problems tied to falling house prices as contained and manageable. At first, it was just a subprime crisis, but by the end of 2007, it had become clear that the subprime crisis was expanding into a real-estate sector crisis that, in turn, had been magnified by the securitization of claims on real estate whose value was falling. Every financial statement by a bank or investment bank that failed to specify underlying assumptions about the path of real-estate prices was and is subject to constant revision. Fourth-quarter reports by U.S. commercial and investment banks all reflect the sharply elevated losses attributed to worsening conditions in the real-estate market that, in turn, reduced the value of derivative securities on the balance sheets of U.S. financial institutions.
The negative interaction between the real economy and the financial sector has been exaggerated in this cycle. House prices stopped rising in 2006 because they had exceeded affordability levels for most potential buyers. As house prices leveled off, the initial wave of problems emerged in the subprime sector late in 2006 and early in 2007. The hope of containment of the subprime problem evaporated in the summer of 2007 as leveraged investment funds like the Bear Stearns Asset-Backed Securities Fund collapsed. Unfortunately, in terms of providing a timely response to the rapidly deteriorating financial conditions tied to falling real-estate prices, the real economy grew strongly in the third quarter with substantial help–since reversed–from inventory accumulation and strong net exports. The real economy slowed during the fourth quarter, and the economy probably entered recession at year’s end. Substantial damage to the balance sheets of U.S. banks and investment houses had occurred that added to the negative pressure on the real economy.

Posted by on February 1st, 2008 at 9:05 am


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