For example, it could be that the underlying complexity and risk characteristics of certain financial instruments were so opaque that even some of the most sophisticated financial institutions in the world and their supervisors were simply caught off guard. A much more plausible explanation lies in the fact that the preceding eight to ten years had witnessed multiple financial disturbances with multiple causes – all of which resolved themselves with limited damage and negligible contagion. These experiences undoubtedly gave rise to a false sense of security that the emerging problems of the summer of 2007 would also resolve themselves with little or no systemic damage.
Much has been written and said about the underlying causes of this systematic failure in financial discipline. For that reason, the Policy Group does not wish to repeat that litany in any detail, but it does see some value in briefly highlighting what it considers the most critical of these underlying causes of the credit market crisis:
First: for several years running, global financial markets had been awash with liquidity. This condition reflected in part the recycling of (1) excess savings from Asia in general and China in particular and (2) excess cash from energy producing countries. It may also have reflected the phenomenon of an extended earlier period of very low interest rates, especially in the United States. These factors are also related to global economic and financial macroeconomic imbalances that have long been recognized as potential sources of instability.
(If "these factors are...related to global economic and financial...imbalances...that have long been recognized as potential sources of instability," why weren't they taken into account by the firms who employed the individuals who wrote this report?)
There can be no doubt that ample financial market liquidity and relatively low interest rates were an important driving force behind the pervasive “reach for yield” phenomenon of recent years and that the “reach for yield” phenomenon was, in turn, an important factor in driving the surge in demand for and supply of highly complex structured credit products.
("There can be no doubt..." -- huh? Up until about a year ago, Wall Street, the Federal Reserve, administration officials and sundry other seemed to have no doubt that the stampede into "highly complex structured credit products" was anything but a good thing -- until it wasn't.)
Second: reflecting in part the forces discussed above and the intensity of competitive factors in the financial marketplace, it is clear that credit risk had been mispriced for some time. The evidence of this is clear in the terms and conditions of credit extensions in the subprime mortgage market, in the leveraged finance sector, and in the willingness of market participants to acquire highly leveraged structured credit products whose attractiveness relied on a continuation of benign credit conditions for an extended period of time. More generally, the extraordinary tightness of credit spreads across virtually all classes of credit products was widely seen as unsustainable. In these circumstances, it was recognized that, sooner or later, credit spreads and credit terms would inevitably adjust. However, it was all too easy for many, if not most, market participants to conclude that when the correction took place it would be gradual and orderly. Obviously, that conclusion was wrong.
(If "the extraordinary tightness of credit spreads...was widely seen as unsustainable," why did so many Wall Street firms end up with billions of dollars of mispriced securities on their balance sheets? Otherwise, history clearly shows that "corrections" have rarely been "gradual and orderly." Tell me again: Why are people who work for firms that don't understand how Wall Street works writing reports about how Wall Street needs to work?)
Third: for a variety of reasons – some structural, some technological and some behavioral – contemporary finance has become incredibly complex.
