Debunking the securitisation myth: Understanding why the 2007 credit crunch happened

Abstract

If the core risk management mantra of financial institutions is ‘no surprises’ the unprecedented, broad-scale write-downs resulting from the 2007 credit crunch represent a systematic failure of institutional risk governance. The co-incidental backdrop to the crisis was: first, a hyperbolic US real estate market, and secondly, an abundance of international liquidity. Paradigmatic shifting technological innovation and financial engineering techniques provided the fission physics for the former to meet the latter in the form of a securitisation market. Securitisation is the banks' platform to on-sell loan risk to investors. In reality, the 2007 credit crunch was a consequence of bank risk originators retaining both explicit and implicit exposure to high octane risk. In the following discussion the author examines the various forms by which banks retained outsized exposures to the US sub-prime market which ultimately resulted in billions of dollars of surprises across financial institutions.