A new CEPR book brings together a collection of articles from VoxEU.org to analyse the ongoing turmoil in global financial markets: why it happened, how it developed and what can be done.

PREFACE
This book is a selection of VoxEU.org columns that deal with the subprime crisis. VoxEU.org is a portal for research-based policy analysis and commentary written by leading economists. It was launched in June 2007 with the aim of enriching the economic policy debate by making it easier for serious researchers to contribute and to make their contributions more accessible to the public.

The subprime crisis, which boiled over in August 2007, was the perfect showcase for Vox’s unique approach. Mainstream media’s explanations of it as a liquidity crisis did not seem to fit the facts. How could a few deadbeat homeowners in the United States bring down a German Landesbank, force a restructuring on a major French bank, and compel the Fed and the European Central Bank (ECB) to undertake emergency injections of cash? The story was surely deeper than a standard-issue credit problem.

Starting on 13 August 2007, Vox posted a slew of columns by economists who really knew what they were talking about and were willing to explain the crisis in terms that any trained economist could understand. Mainstream media’s limits (800 words written for the average newspaper reader) just did not work for an event of this complexity. Vox provided commentators with the space to explain the situation using standard economic terminology.

It raised the level of the public debate and this attracted researchers who had also been at the cutting edge of policy-making, such as: Willem Buiter (professor at LSE and former member of the Bank of England’s rate-setting Monetary Policy Committee), Steve Cecchetti (professor at Brandeis University and former Executive Vice President and Director of Research at the New York Fed), Charles Wyplosz (professor at the Graduate Institute, Geneva and adviser to central banks), Marco Onado (professor at Bocconi and former Commissioner of the Italian public authority responsible for regulating the Italian securities market, CONSOB), Tito Boeri (professor at Bocconi and editor of LaVoce) and Luigi Spaventa (professor in Rome and former Chairman of CONSOB).

On behalf of CEPR and the Vox editorial board, I would like to thank Carmen Reinhart for agreeing to edit this compilation of columns. Together with her colleague at the University of Maryland’s School of Public Policy, Andrew Felton, the result is what follows, a primer on what is probably the worst financial crisis of our generation.

Richard Baldwin, VoxEU.org, Editor-in-Chief and CEPR Policy Director
June 2008

Visit The First Global Financial Crisis of the 21st Century Download Page

You can download full publication in PDF format.

A VoxEU.org Publication
Edited by Andrew Felton and Carmen Reinhart

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Glossary

ABX.HE Index: an index produced by Markit that tracks prices on credit-default swaps on tranches of selected asset-backed securities composed of residential mortgages.

Alternative-A (or Alt-A): a category of mortgage borrower, generally with FICO (see below) scores that qualify them for prime rates but that are not eligible for prime for other reasons, such as lack of income documentation.

Asset-backed security (ABS): a security collateralized by financial assets, such as mortgages.

Asset-backed commercial paper (ABCP): see Commercial paper.

Auction-rate security: a municipal bond whose interest rate is set at specified intervals, often two weeks, at auction. In early 2008 a large number of auctions failed due to lack of bidders, causing the municipalities to pay high penalty rates.

Basel II: a revision to the international rules governing bank capital allocation. Coordinated by the Bank for International Settlements. It was designed to lessen the amount of regulatory arbitrage that occurred under its predecessor, Basel I. European banks were supposed to implement Basel II rules by 2008, while US banks implementation may occur in 2009.

Commercial paper (CP): bonds with maturity of less than 270 days. CP can be issued by corporations, banks or trusts holding securities. The last is usually referred to as asset-backed commercial paper (ABCP). ABCP was one of the first casualties of the crisis, starting to decline rapidly in August 2007 as the SIVs unwound.

Collateralized debt obligation (CDO): a structured finance product composed of debt instruments such as corporate and consumer loans, mortgages and bonds. The cash flows from the underlying debt are paid out to the tranches of the CDO according to their seniority. CDO issuance averaged $500 billion in 2006 and 2007.

Conduit: a financial entity whose purpose is to buy financial assets from correspondents, repackage them and sell interests in the new securities to other entities.

Credit-default swap (CDS): a type of insurance against a firm defaulting on its debt. According to the Bank for International Settlements, the notional amount of CDS outstanding was $43 trillion as of June 2007.

Discount window: the mechanism through which the Federal Reserve lends directly to banks, thrifts and other chartered depository institutions. The PDCF essentially extended the discount window to primary dealers.

Fannie Mae/Freddie Mac: US government-sponsored enterprises (GSEs) that enhance the flow of credit to the mortgage market. The GSEs purchase mortgages from banks and thrifts and either keep the mortgages or package them into RMBS (see below) and sell them to the secondary market.

FICO score: a numerical rating of the credit history of individuals, developed by the Fair Isaac Corporation.

LIBOR: London interbank offered rate, the interest rate that banks charge each other to borrow money. Denominated in various currencies. US dollar LIBOR is usually tied closely to the federal funds rate but diverged beginning in August 2007 due to a combination of credit and liquidity risk.

Monoline insurer: An insurance company that specializes in insuring the performance of financial instruments, usually mortgage-related. Most offer private mortgage insurance, which is used to insure payments on mortgages with high loan-to-value ratios. Many also insure AAA-rated portions of CDOs.

Mortgage-backed security (MBS): a security that is composed of mortgages. Often separated into MBS backed by residential mortgages (RMBS) and commercial mortgages (CMBS). Fannie Mae and Freddie Mac dominated MBS issuance in the United States until 2004 when private-label MBS, often of subprime mortgages, became more prevalent. Payments of interest and principal on the underlying mortgages can be paid pro-rata (pass-through MBS) or in a ‘waterfall’ fashion, with ‘tranches’ getting paid in order of seniority.

Primary dealer credit facility (PDCF): A new policy introduced by the Federal Reserve that essentially opens the discount window to primary dealers. Normally only banks and other depository institutions have access to the discount window. The PDCF was introduced by the Federal Reserve the same weekend that Bear Stearns was acquired by JPMorgan Chase.

Residential mortgage-backed security (RMBS): see Mortgage-backed security.

Securitization: the practice of bundling securities into new securities. Used by financial institutions as a way of moving assets off their balance sheets in order to lend more. Mortgages are most commonly securitized but other debt instruments can also be included. In the United States, Fannie Mae and Freddie Mac actively promote mortgage securitization.

Structured investment vehicle (SIV): a fund that holds long-term securities (such as mortgages) and funds its investments with commercial paper.

Subprime: borrowers whose poor credit history does not qualify them for prime interest rates. In the United States, about 20% of mortgage originations totalling over $1 trillion in 2005 and 2006 were subprime, far above historical levels.

Term auction facility (TAF): an auction held by the Federal Reserve for a set quantity of money. The TAF was introduced in December 2007 in response to pressures for short-term lending in the money markets.

Term securities lending facility (TSLF): The TSLF is an arrangement by the Federal Reserve to lend to Treasuries and accept other AAA-rated financial instruments as collateral.

Tranche: a method of apportioning cashflows in a structured finance product, such as an asset-backed security. Senior tranches are paid principal and interest first, and junior tranches are paid with whatever cash is left. Senior tranches have more security and consequently earn lower interest rates than junior tranches. Several tranches may be rated AAA. The most senior of the AAA tranches is often called ‘super-senior’.

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