Abstract
We are currently experiencing a liquidity shock to the financial system, initiated by problems in the subprime mortgage market, which spread to securitization products more generally—that is, mortgage-backed securities, asset-backed securities, and asset-backed commercial paper (MBS, ABS, and ABCP). Banks are being asked to increase the amount of risk that they absorb (by moving off-balance sheet assets onto the balance sheet), but the related losses that the banks have suffered are limiting somewhat the capacity of banks to absorb those risky assets. The result is a reduction in aggregate risk capacity in the financial system as losses force those who are used to absorbing risk to have to sell off or close out their positions.
During the Russian crisis in 1998 emerging market hedge funds facing reduced leverage capacity had to dump their other securities, for example Brazilian bonds, producing large reductions in Brazilian and other sovereign bond prices. Similarly, during the recent turmoil banks have withdrawn funding from equity hedge funds investing in quantitative trading of equity, and cancelled or reduced some lines of credit. The limited risk absorbing capacity of intermediaries causes shocks that originate in one sector to spread more broadly. The financing of many risky activities unrelated to the core mortgage market shock has been reduced relative to their pre-shock levels. There are, at least temporarily, lots of ?innocent bystanders? that are affected due to the aggregate scarcity of equity capital in financial intermediaries relative to the risk that needs reallocating.
Is this the beginning of a financial or economic "crisis"? Said differently, is it (as many journalists and bloggers have labeled it) a "Minsky moment"—that is, the beginning of a recession induced by the realization that asset prices and leverage are too high, and that we are about to suffer a broad-based decline in credit availability?