By Dian L. Chu, Economic Forecasts & Opinions
In his State of the Union address, President Obama reiterated his ambitious agenda to improve the economy and enact sweeping financial reform aimed specifically at the Big Banks. The European Union is also pursuing similarly ambitious changes aimed at preventing another crisis in the future.
At the World Economic Forum in Davos, Switzerland, where more than forty heads of state met, the proposals for financial regulatory reform were part of the focus of deliberation.
There is undeniably an inexorable drive on both sides of the Atlantic to find new ways to tighten bank and capital market regulations in response to an international financial crisis triggered by the bursting of a U.S. property price bubble and the resulted global domino effects.
Foreigners to Blame?
The financial crisis of 2007 to 2010 has been called the worst since the Great Depression of the 1930s. Many causes have been proposed and recently, MIT economist Ricardo Caballero made a suggestion that caught the attention of TIME:
"There is no doubt that the pressure on the U.S. financial system [that led to the financial crisis] came from abroad ". Foreign investors created a demand for assets that was difficult for the U.S. financial sector to produce. All they wanted were safe assets, and [their ensuing purchases] made the U.S. unsafe."
Did foreign investment demand really "make the U.S. unsafe"? Let's go back and take a closer look.
Close Point of Origin Housing
Most economists and pundits seem to agree that the collapse of the U.S. real estate market in 2006 was the close point of origin of the crisis. The housing bubble bursting caused the values of securities tied to real estate pricing to plummet, thus damaging financial institutions globally.
Sophistication Beyond Comprehension
Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address the 21st century financial markets.
However, the entire financial system had become fragile as a result of one factor, among others, that is unique to this crisis - the transfer of risky assets from banks to the markets through creation of complex and opaque financial products.
In fact, these derivative products are so complex that they mystified even Alan Greenspan, the former chairman of the Federal Reserve.
Unknowing & Unwilling Participants
The banks' strategy of unloading risk off balance sheets backfired when investors, foreign or otherwise, finally became aware of the complexity and risk underlying these asset backed securities.