The world’s top securities regulators gathered in the birthplace of luxury icons such as Chanel, Cristal and Louis Vuitton in late May, but it was the fortunes of impoverished U.S. homeowners that captivated their attention.

The U.S. subprime mortgage crisis and its knock-on effects on the world’s financial markets dominated the agenda at the International Organization of Securities Commissions’ annual conference in Paris this year.

What emerged from the meeting is a sense that, at its root, the cause of the market disruption is really a rather ordinary cyclical occurrence. But the increasingly sophisticated financial system loudly amplified and quickly spread that routine event, revealing fundamental systemic weaknesses. As a result, it will probably be some time before the financial services industry fully recovers from this episode. And problems in other segments of the market may yet emerge.

The process of ferreting out the causes of the credit crunch has been going on for months, and a number of culprits have been identified: deceptive borrowers, shady mortgage brokers, reckless bankers, feckless credit-rating agencies and foolish investors. Central bankers and regulators, who have struggled to ward off the worst effects of the crisis, have been assigning much of that blame. But at the IOSCO conference, they came in for their share of criticism.

MARKETS BLINDSIDED?

The sanguine view of the credit crunch is that markets were simply blindsided by an unpredictable, once-in-a-lifetime event. That explanation places most of the blame on borrowers, as a large number of them took out mortgages they couldn’t afford based on income they didn’t have. And because lenders were deceived into granting these so-called “liar loans” or “ninja” (no income, no job, no assets) loans, they could hardly be expected to anticipate the high default rates that ignited the crisis.

But another view argues that the rising defaults were entirely predictable. Markets went wrong because they essentially overlooked these risks, as sketchy loans were packaged up and sold off the lenders’ books to investors who didn’t carefully weigh what they were buying.

Indeed, as Malcolm Knight, a former senior deputy governor with the Bank of Canada and now general manager and CEO of the Bank for International Settlements in Basel, Switzerland, told the IOSCO conference: “Essentially, the financial turmoil that began in the summer of 2007 stemmed from the fact that participants in the securitization chain ignored the possibility of a general decline in U.S. house prices leading to unexpected mortgage delinquencies.”

Knight stressed that these risks were ignored, not unpredictable; many economists had been warning that the U.S. housing market was overvalued. Then, as house prices decline, the value of borrowers’ collateral diminishes; if the value falls far enough that the house is worth less than the outstanding mortgage, homeowners may well decide to bail on their mortgages.

Not surprising, this condition first arose in the subprime segment of the U.S. housing market, but, according to a report from the Paris-based Organization for Economic Co-operation and Development: “Defaults on subprime mortgages are not the cause of the crisis; they are one of its symptoms.”

The fact that so many market players disregarded these warnings meant they were unprepared to deal with the consequences of these defaults when they did materialize, causing liquidity to evaporate and setting off the cascade of problems that followed.

Weaker housing markets can only blossom into a full-blown global financial crisis if many players are doing their part to devalue risk. In this case, the culprits include: the banks that packaged and sold these loans, thereby masking to some extent the lurking credit risks; credit-rating agencies that contributed to the obscurity of these risks; and investors who bought the resulting securities without really understanding what the securities were.

Investors’ apparent negligence can be traced to the same factor that created the income-trust boom in Canada: low interest rates, which pushed investors to seek assets that could deliver higher yields and to bypass traditional savings vehicles.

Responsibility for that condition falls on the shoulders of the world’s central banks, Joachim Fels, managing director and co-head of global economics with Morgan Stanley & Co. Inc. in London, told the conference. Fels cites three main factors for the credit crisis: complexity, complacency and liquidity. The growth in securitizations and other innovations has made the global financial system increasingly complex, he says. Firms and regulators were complacent about the risks they were taking. And excess liquidity — created by expansive monetary policy, excess savings and a huge demand for yield — helped inflate a credit bubble.

@page_break@By keeping rates low and the market awash in money, central banks inflate potential asset bubbles and the bubble usually pops, Fels says, in whatever asset class gets most overvalued in the process (equities in 2000, housing in 2007). Indeed, he says, central bankers have been called “serial bubble blowers.”

The risk of a bubble is particularly acute in credit markets, Michel Aglietta, professor at the University of Paris X Nanterre, told the conference. Although markets are typically thought of as an interaction of supply and demand, that isn’t always the case in credit markets, in which supply can create its own demand.

In this case, the very low rates pushed investors in their search for alternative investments. The OECD report suggests investors’ quest for yield over the past few years led to the increase in “carry trades,” boosted the appeal of alternative investment vehicles such as hedge funds and drove investors into structured products such as mortgage-backed securities and collateralized debt obligations.

In Canada, income trusts found an eager audience in yield-starved investors. The demand proved so strong that numerous companies converted to the structure to take advantage of the demand — whether they were suited to it or not. Ultimately, it took a highly contentious government intervention to curtail that trend.

The same basic forces prevailed in the U.S. mortgage market. The hunger for yield products was so strong that structured-product manufacturers began packaging whatever they could find. Historically, subprime assets wouldn’t have made the cut, but this prohibition eventually gave way to the instinct to use whatever would sell.

For example, Knight recalls the BIS studying the “manufactured housing” market — essentially, trailer-park homes — in 2005. The bank was “astonished” to find mortgages on these homes included in structured products carrying a wide range of credit ratings.

ORIGINATE TO DISTRIBUTE

“These trailers are a little bit like a house because you live in them. But they’re really more like a car because they deteriorate physically. They rust, crack and little animals crawl in from beneath,” he says. “So, at the point at which your mortgage goes above the value of your mobile, you tend to hand in your keys.”

With such assets, defaults can hardly be a surprise. But with investors demanding yield products, banks were only too willing to lend against these assets, then securitize the loans — feeding the growth of the so-called “originate to distribute” model.

Yet, the rise in securitization is not itself a cause of the credit crunch, argues Adrian Blundell-Wignall, deputy director for financial and enterprise affairs with the OECD. Mortgage securitization has been around for 20 years. From 1984 to 2004, the value of residential mortgage-backed securities sold into off-balance-sheet entities by banks grew steadily to US$820 billion, he reports. But the practice took off in mid-2004. By the end of 2007, value had swelled to US$2.1 trillion.

What caused this sudden explosion is the real puzzle of the credit crunch, he suggests, pointing out that the suspects so far — securitization, structured-product innovation and rating agencies — were all around long before the big buildup in residential mortgage-backed securities without a major problem developing.

Instead, Blundell-Wignall points to another suspect: banking regulators. The new capital adequacy regime for large global banks (known as Basel II) was first published in June 2004. This regime was designed to introduce more risk-sensitive capital charges, which encouraged banks to focus on areas that would eat up proportionally less capital, such as supposedly safe mortgages, and to bundle those exposures off their balance sheets. In doing so, he suggests, the big banks were effectively creating their own private Fannie Maes and Freddie Macs (the massive U.S. mortgage corporations that were, at that time, coming under regulatory constraint).

It wasn’t readily apparent that many of these vehicles were fatally flawed. Although securitization alone isn’t to blame for the crisis, the OECD report notes: “The apparent disconnect between the true credit quality of the underlying assets and the promised performance of the structured instruments backed by them proved eventually to be a major flaw.”

This, in turn, touched off the liquidity crisis and credit crunch, as market players realized the implications of this inherent flaw: that risk was mispriced. Asset values were questioned, trust between financial institutions broke down and fear overtook greed as the dominant emotion.

Indeed, while it may be tempting to view the credit crunch as a series of unfortunate events, in fact dubious monetary policy, unintended consequences of regulations and market myopia are probably the true culprits of the crisis. IE