THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 238

206 PA R T I I I Financial Institutions The agency problems went even deeper Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off The credit rating agencies that were evaluating these securities also were subject to conflicts of interest: they were earning fees from rating them and from advising clients on how to structure the securities to get the highest ratings The integrity of these ratings was thus more likely to be compromised Information Problems Surface Although financial engineering has the potential to create products and services that better match investors risk appetites, it also has a dark side Structured products like CDOs, CDO2s, and CDO3s can get so complicated that it can be hard to value the cash flows of the underlying assets for a security or to determine who actually owns these assets Indeed, in a speech in October 2007, Ben Bernanke, the Chairman of the Federal Reserve, joked that he would like to know what those damn things are worth In other words, the increased complexity of structured products can actually destroy information, thereby making asymmetric information worse in the financial system and increasing the severity of adverse selection and moral hazard problems Housing-Price Bubble Bursts As housing prices rose and profitability for mortgage originators and lenders was high, the underwriting standards for subprime mortgages fell to lower and lower standards Riskier borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% LTV mortgage, so that they had to put almost no money down on their houses When asset prices rise too far out of line with fundamentals, however, they must come down, and eventually the housing-price bubble burst With housing prices falling after their peak in 2006, the rot in the U.S financial system began to be revealed The decline in housing prices led to many subprime borrowers finding that their mortgages were underwater, that is, the value of the house fell below the amount of the mortgage When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender Defaults on mortgages shot up sharply, eventually leading to over million mortgages in foreclosure Crisis Spreads Globally Although the problem originated in the United States, the wake-up call came from Canada and Europe, a sign of how extensive the globalization of financial markets had become After Fitch and Standard & Poor s announced ratings downgrades on mortgage-backed securities and CDOs totalling more than $10 billion, the assetbased commercial paper market seized up and a French investment house, BNP Paribas, suspended redemption of shares held in some of its money market funds on August 7, 2008 Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to hoard cash and were unwilling to lend to each other As can be seen in Figure 9-2, the U.S Treasury bill-to-Eurodollar rate (TED) spread, a good measure of liquidity in the interbank market, shot up from an average of 40 basis points (0.40 percentage points) during the first half of 2007 to a peak of 240 by August 20, 2007 The drying up of credit led to the first major bank failure in the United Kingdom in over