Chapter 1


If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.
George Bernard Shaw (1856–1950)

Between 2004 and 2006, US interest rates rose from 1% to over 5%, triggering a slowdown in the US housing market. Many homeowners, who had been barely able to afford their payments when interest rates were low, began to default on their mortgages. Default rates on subprime loans (made to those with a poor or no credit history) hit record levels. US households had also become increasingly in debt, with the ratio of debt to disposable personal income rising. Many other countries (although not all) had ended up in a similar situation. Years of poor underwriting standards and cheap debt were about to catalyse a global financial crisis.

Many of the now toxic US subprime loans were held by US retail banks and mortgage providers such as Fannie Mae and Freddie Mac. However, the market had been allowed to spread due to the fact that the underlying mortgages had been packaged up into complex structures (using financial engineering techniques), such as mortgage-backed securities (MBSs), which had been given good credit ratings from the rating agencies. As a result, the underlying mortgages ended up being held by institutions that did not originate them, such as investment banks and institutional investors outside the US. Financial engineering had created a global exposure to US mortgages.

In mid-2007, a credit ...

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