Integrated Financial Systems: Boon or Bane

The subprime mortgage meltdown has raised many questions in the markets. Most of them have been unpleasant and most of them have been about things which we earlier thought were good and which are now viewed in a negative light. One such issue is the issue of integrated financial markets.

The subprime mortgage crisis is supposed to be a very local crisis in scope. It is a crisis of the real estate industry in the United States i.e. one industry in one nation. However, it turns out that this crisis metamorphosed into a catastrophe.

All markets all over the world were affected by the impact of this crisis and the result was a global recession. This brings to the fore the extreme connectedness of the markets in the world today. In this article, we will have a closer look at the connections between these markets and how they affected the subprime mortgage meltdown.

Mortgage Markets and Bond Markets

As we have already discussed in previous articles, the very nature of mortgage products was changed. Banks were no longer the ones supplying the money to the homeowners to buy the mortgage. Instead, it was the people in the bond market who were doing so. The banks were just a pass through vehicle to facilitate the meeting of these two counterparties.

With the advent of the quasi government agencies, big chunks of mortgages started to be securitized and be sold in the bond market. These agencies had the backing of the government and were therefore able to make stellar profits out of these transactions. This attracted Wall Street and its brand of subprime and Alt A mortgage backed securities to the bond market too. Towards the end of the crisis, pretty much every mortgage loan made in the United States found its way into the bond markets. The volumes of these bonds were so high that they formed the majority of bonds being traded in the market.

Hence, it would be safe to say that mass securitization linked the fate of bind markets and mortgage markets together. A change in any of these markets was certain to affect the functioning of the other one.

Bond Markets and Stock Markets

Just like the mortgage markets, the stock future of the stock markets was also inexorably linked with the bond markets. Most of the companies selling these mortgage backed securities and collateralized debt obligations were listed on the stock exchange. This includes all Wall Street Investment Banks as well as quasi government agencies like Freddie Mac, Fannie Mae and Ginnie Mae.

Real estate was the dominant investment theme in those days. Hence investors looking for an indirect exposure to the sector were also heavily invested in these stocks. This coupled with the fact that mark to marked accounting allowed all these firms to post sky high profits was also responsible for bringing about a stock market boom which was driven by the mortgage and bond markets.

Hence, another level of financial integration was inadvertently reached. The bond markets and the stock markets were linked together in a manner that both would move in tandem and more often than not this movement was caused by the mortgage market!

Bond Markets and Derivative Markets

Another very important linkage is the one between the bond market and the derivatives market. As we are aware that most of the financial instruments being sold over the counter in the mortgage markets also had derivative counterparts.

For instance collateralized debt obligations and credit default swaps were the famous derivatives products being sold. The volume of trade in the mortgage market had exploded and so had the volume of trade in the linked derivatives market.

The number of securities and contracts outstanding was simply astounding. In fact they were enough to bring erstwhile financial behemoths to their knees. And a large number of these contracts were either directly based on the mortgage markets or were based on the bonds and stocks that were mimicking the mortgage markets.

Hence, along with the stock and bond markets, the derivative markets were also linked to the mortgage market creating a scenario wherein every major market in the United States would move in correlation.

Local Markets and Foreign Markets

To add to the above fact, the securities based on subprime mortgage loans were not based in the US only. Rather investors all the world had developed an appetite for them. It is for this reason that pension and municipality funds from far off places like Europe were rapidly making its way into the subprime securities.

Some municipalities like the Municipality of Dusseldorf were heavily invested in these mortgages. Therefore, there was a situation where in a slight movement in the mortgage markets could send shockwaves all over the United States and even overseas!

This was not the case, a couple of decades earlier. The markets were fairly independent of one another. However, the new age financial innovation led to an inadvertent consequence of sewing these markets together!

This was one of the ingredients in the final bust of 2008. What should ideally have been a local crisis became an international crisis threatening the financial system! This brings us to the question as to whether linking together of the financial markets is a good thing? Sure, it can provide convenience in the short run. However, it also leads to the correlation of all the markets. Therefore everything goes through the boom bust cycle simultaneously causing the massive shockwaves.

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