The second, less noted, is the network effect that arises from the fact that more and more firms use financial instruments that are meant to export ri

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The potential for profits is vast so far as there are massive numbers of such modest households and the aim is large numbers for bundling and then selling off, rather than long-term investment.

These particular types of mortgage-backed securities have quite the potential for delivering profits to wholesale finance, for devastating the savings of modest-income households, and for leading to macro-crises. The potential for profits is vast so far as there are massive numbers of such modest households and the aim is large numbers for bundling and then selling off, rather than long-term investment. The potential for devastating household losses is also vast, as we have seen with the sharp jump in 2005-06 in home foreclosures among low-and-modest-income households under these new types of mortgages; foreclosures are expected to reach their highest point in 2010-11. Finally, the potential for macro-level crises is unexpectedly strong, though partial, as indicated by the so-called “sub-prime mortgage crisis” that exploded in 2007. Given the globality and interconnection of financial markets, when something goes wrong with the new mortgage-backed securities in one country, the spill-over effects can be massive and go well beyond the originating country.

In my analysis of the subprime crisis, two dynamics of financial markets have come together. Both arise out of the interlinking of markets. One is usually described as a spillover effect; in this case, it is a spillover from US markets to the rest of the world. The second, less noted, is the network effect that arises from the fact that more and more firms use financial instruments that are meant to export risk: in electronically linked markets this becomes a network effect that hits all firms back. I address each in turn.

US market has been far more aggressive in developing high-risk instruments than other countries showing extremely high incidence of mortgages in their GDP, and hence it is in the US that the subprime mortgage crisis begins. The viral infection of sub-prime mortgages originated in the United States but spread to other countries given the globalisation of financial markets.


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Source : IIPM Editorial, 2008
An Initiative of IIPM, Malay Chaudhuri and Arindam Chaudhuri (Renowned Management Guru and Economist).


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