Question

Before the 2008 Financial Crisis, asset-backed commercial papers (ABCP) backed by subprime mortgages were a common source of liquidity for financial institutions. Describe the market forces and policy factors contributing to this development. (word count limit: 300)

Answer 1

The market forces before the 2008 financial crisis supported asset-backed commercial papers (ABCP) backed by subprime mortgages as a common source of liquidity for financial institutions. There were capital requirements for banks which they had to adhere to and to circumvent these requirements banks and financial institutions made use of Structured Investment Vehicles (SIVs). These were off-balance sheet SPV (special purpose vehicles) that was set up by banks and financial institutions to hold assets like MBS (mortgage backed securities), CDOs (collateralized debt obligations) etc. These assets were funded by SIVs through issue of ABCP. Banks and financial institutions were able to obtain cheaper finance through this means and this bolstered and augmented the market forces that were driving ABCP backed by subprime mortgages as a common source of liquidity. During the period before the 2008 financial crisis there was a prolonged rise in house prices and asset prices. This increased the level of leverage being used by financial institutions and drove the growth in aggregate liquidity. So during the period of rising prices banks and financial institutions gained by using the mark to market method in which the assets held by them were assigned a value which was based on the asset’s current (and high) market valuation.

The policy factors of Federal Reserve (Fed) also supported this. Fed’s policy of keeping the interest rate low after the 2001 recession led to financial institutions struggling to earn adequate return. This propelled the financial institutions to over leverage so as to be able to gain from the rising prices. The then Fed Chairman Mr. Alan Greenspan had warned about the bubble but still the interest rates were not increased. Low interest rates further battered the already low savings level in USA and this further fueled the level of borrowings at large.

(299 words)