Opinion

Make No Mistake, Size Matters with Systemic Risk

By Roy C. Smith
In 2007, according to the McKinsey Global Institute, global financial assets had a combined market value of $202 trillion, a surprisingly large amount and equal to three and a half times’ global gross domestic product.

The following year, precipitated by a sharp and steady drop in liquidity supporting the $6 trillion securitised mortgage market, and accelerated by unpredictable government actions, a staggering $28 trillion plunge in the value of global equities occurred.

Prices of mortgage-backed securities dropped steadily as investors reacted to events that started in mid-2007. A May 2008 study by the Bank of England of $900bn of collateralised mortgage obligations estimated that the correct intrinsic value of the pool, using conservative assumptions, was 81% of par value but their market price was only 58%. By late September the price had dropped considerably further.

The market overreacted massively. The actual “default and near-default” rate of investment-grade structured mortgage debt, according to Standard and Poor’s, was less than 6.5% in 2008. The market movement, however, forced large-scale mark-to-market write-offs, resulting in unsupportable capital deficits among banks. Though highly leveraged, the banks were fully in compliance with Basel I rules applicable at the time.

Read full article as published in Financial News

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Roy C. Smith is the Kenneth G. Langone Professor of Entrepreneurship and Finance and Professor of Management Practice.