The Dallas Fed on Financial Risk TakingThe Federal Reserve Bank of Dallas has published an excellent article explaining how the current stress in US credit markets developed. "From Complacency to Crisis: Financial Risk Taking in the Early 21st Century" describes the way in which growing complacency about risk eventually led to subprime mortgage defaults that forced investors to recalibrate their risk assessments, a process that is still undeway.
The opening paragraphs of the article summarize the story that authors Danielle DiMartino (an economics writer), John V. Duca (VP and senior policy advisor at the Dallas Fed), and Harvey Rosenblum (executive VP and director of research at the Dallas Fed) lay out in remainder of their piece:
During the first half of this decade, the belief that new financial products would adequately shield investors from risk encouraged financial flows to less creditworthy households and businesses. By late 2006, U.S. financial markets were flashing warning signals of a potential financial crisis.At the end of their article, the authors list lessons learned from the credit crisis, including the fundamental need for a return to more sustainable risk taking.
In a sign that investors had become too complacent, risk premiums had all but vanished in junk bond and emerging-market interest rate spreads. Then, conditions changed abruptly. In the important and usually stable market for asset-backed commercial paper, premiums on three-month paper over Treasury bills jumped from 0.17 percentage point in February 2007 to 2.15 points in August. Meanwhile, rising subprime mortgage defaults led investors to abandon their sanguine beliefs about the risk of many mortgage and nonmortgage products.
The backdrop for these events was a period of macroeconomic stability that fed complacency about risk. This relatively benign economic environment, when combined with the new, structured financial products, increased financial flows to nonprime mortgage and business borrowers. The result was an overeager acceptance of risk taking that began correcting itself only after mounting subprime mortgage defaults reverberated through the broader financial markets.