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17 November 2009
Investors constantly seeking higher yields from their investments were another element contributing to the Global Financial Crisis, Deakin University’s Chair of Economics Professor Charles Corrado will tell The Finance on the Move Symposium this Friday, November 20.*
Professor Corrado’s address will be the first of several on the day which will feature The Honourable Lindsay Tanner, Member of Parliament and Federal Minister for Finance and Deregulation, and Stephen Brown, the David S. Loeb Professor of Finance at New York University and University of Melbourne as keynote speakers.
“The United States has been at the epicentre of the recent global financial crisis,” Professor Corrado explained.
“There is already an abundance of analysis available, much of which details the creation of “toxic debt”, in particular, securities created to repackage pools of mortgages in ways often not properly understood by those who invested in them.
“These discussions elaborate on the supply of these often risky securities. What is largely absent from these discussions is the demand for these securities.
“Why did so many investors invest in securities that were often ill-understood and ultimately caused a major financial crisis?”
Professor Corrado said that one must look beyond the boom and bust cycles of the stock market and look instead at the declining interest rates on default-risk free securities over the last 20 years. Interest rates offered on default-risk free securities in the United States have steadily trended downward from about 10% in 1990 to around 5% in 2009.
“As a result, investors demanding absolute investment security saw their investment income cut in half,” Professor Corrado said.
“To counter this decline investors began reaching for yield, in other words, investing in alternative securities that promised to pay a higher interest rate but involved a level of higher risk. For many this meant switching from the prime mortgage market which is essentially risk free to the sub-prime mortgage market which isn’t.”
Professor Corrado said a vicious circle then began.
“Demand for higher yields was met by increasing the supply of sub-prime mortgages, which in turn resulted in higher real estate values through easier financing," he said.
“Increasing real estate prices made sub-prime mortgages appear risk free and so the cycle continued until real estate values stalled and fears of massive mortgage defaults set in.
“The housing bubble had burst creating swathes of destruction across the US financial sector which was heavily invested in sub-prime mortgages.”
Professor Corrado said that if investors had any doubt about the safety of an investment, that doubt was justified. “If you don’t understand an investment product, don’t invest in it. Remember that investments promising a higher interest rate do just that, they promise a higher interest rate – a promise not always kept.”
*The Finance on the Move Symposium, is being held to recognise the career contributions of the most prolific financial markets researchers in Australian and New Zealand universities listed by name in "Most prolific authors in the finance literature: 1959-2008" (Heck and Cooley, 2009) and "Ranking of finance programs in the Asia-Pacific region: An update" (Chan, Chen and Lung, 2005).
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