AAA Stands For…?

Reviewing the best of CIR in 2010.

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story_images_for_saleLooking back we can see that an asset price bubble started in the US in January 1995 when the S&P500 stock index started rising at a rate well in excess of 10% per year (see Figure 1). This was the dot-com bubble. The rising stock market was joined by rapidly rising housing prices in 1997 when US housing prices started to grow at a rate of 10% per year or more. The stock market bubble was over by 2002 and housing prices started to decline in August 2006. The end of the asset price bubble precipitated the financial crisis that started in the summer of 2007.

The causes of the asset bubble are hotly debated. Possible candidates include US monetary policy (low interest rates), US housing policy (attempting to make home ownership available to all), and US regulatory policy (failing to adequately regulate financial institutions). Export driven economies such as Japan, Germany and China also played a role since a fundamental rule of economics is that in order to run a trade surplus you must provide financing for your customer, in this case the US. This low cost financing stimulated consumption in the US contributing to rising asset prices. In addition to the possible causes listed above much criticism has been aimed at the alphabet soup of securitizations (RMBS – residential mortgage backed security, ABS – asset backed security, CDO – collateralized debt obligation, ABS-CDO, CDO-squared, and so on) and the role of the rating agencies in assigning AAA ratings to many of the securitizations. Read the full paper here.

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