Thursday, September 18, 2008

The Financial Crisis

Most of the current financial crisis revolves around banks having to write off bad loans in the housing market. So, I wonder if the current financial crisis was a direct result of the Foreclosure Prevention Act of 2008. This new law altered the way that banks could recoup the cost of their investment and might have inadvertently made bad loans much worse than they already were.

Update: More on the crisis

What we need more than anything is some clarity about what the polices are--both now and going forward.

Although the author is making his point about a different aspect of the crisis, this is kind of the point I was trying to make. The Foreclosure Prevention Act of 2008 altered the clarity that financial institutions rely on to make wise investment decisions.

Update II: Accounting rules to blame

Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack.

The value of the underlying assets -- homes and mortgages -- declined, sometimes 10%, sometimes 20%, rarely more. That is a hit to the system, but on its own should never have led to the implosion of Wall Street. What has leveled Wall Street is that the value of the derivatives has declined to zero in some cases, at least according to what these companies are reporting.

The models might have failed because they failed to take in account the intervention of government into the market with the Foreclosure Prevention Act of 2008.