Paul D. Mizen, professor of monetary economics and director of the Centre for Finance and Credit Markets at the University of Nottingham, and a visiting scholar at the St. Louis Fed, looked at the market reactions and policy responses to the credit crunch for the September/October issue of Review, the Reserve Bank's bi-monthly journal of economic and business issues. The publication is also available online at the St. Louis Fed's web site: http://research.stlouisfed.org/publications/review.

Mizen noted that from 1993 to 2006, a number of macroeconomic conditions sowed the seeds of the "credit crunch."

"Low interest rates encouraged greater borrowing, low savings ratios and higher debt to income levels for consumers in industrialized countries," said Mizen. "With low volatility, steady growth and increasing house prices, lenders did not perceive great risks. Revolving debt in the form of credit card borrowing increased significantly and, as prices in housing markets across the globe increased faster than income, lenders offered mortgages at ever higher multiples (in relation to income), raising the level of secured debt to income. Credit and housing bubbles reinforced each other."

The innovation in mortgage-backed securitization to lower quality subprime mortgage categories created assets with greater risks than the issuers or the end-investors appreciated. "Sellers of subprime mortgage securities mispriced risks by using models that assumed house prices would continue to rise while interest rates would remain low," he said. "This was a false assumption, but many other practices reinforced the error as buyers and sellers of subprime mortgage securities and collateralized debt obligations failed to assess risk characteristics properly. There was a failure in the incentives mechanism to assess risks carefully because the risk would be held by others."

Mizen said when risks were realized in mid-2007, there was a crisis of confidence in the financial markets as banks stopped funding short term paper, MBS and CDO issuance slumped, and banks reduced the lending at more than one month to maturity as they assessed the implications of the newly perceived risks.

"While many analysts have stated, rightly, that the root of the problem lay with the subprime market," said, Mizen, "any number of other high-yield asset classes could have provided the trigger -- for example, hedge funds, private equity, or emerging market equity.