And of course this measure of leverage has increased a great deal since US

And of course this measure of leverage has increased

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very little equity in their homes by the time the boom peaked. And of course, this measure of leverage has increased a great deal since US housing prices started to fall. US households weren’t alone in gearing themselves up like this. Although corporate sectors around the world were by and large relatively restrained in their behaviour, there were some pockets where borrowing and gearing expanded a great deal. Some examples include the asset- backed commercial paper market, which is often used to finance entities that invest in other securities, and the leveraged loan market, often used to finance buyouts of companies. And as Graph 7 shows, leveraged buyout activity boomed, especially in North America and Europe. As with the mortgage market, the excesses built up most where the financing structures were most 0 10 20 30 40 50 0 10 20 30 40 50 US Mortgage Debt Per cent of real estate assets Source: Board of Governors of the Federal Reserve System 2008 % 1996 1984 1972 1960 % Graph 6 Graph 5 0 10 20 30 40 50 60 65 70 75 80 85 Sub-prime Lending Standards Source: Demyanyk YS and O Van Hemert (2008), ‘Understanding the Subprime Mortgage Crisis’, Federal Reserve Bank of St. Louis Supervisory Policy Analysis Working Paper 2007-05, rev Aug 2008. 2007 % Per cent that are low-doc (LHS) Repayments to income ratio (LHS) 2006 2005 2004 2003 2002 2001 % Average loan-to-valuation ratio (RHS)
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2 8 R E S E R V E B A N K O F A U S T R A L I A opaque, and the underestimation of the risks was greatest. The Onset of the Crisis But you can’t borrow your way to a good time forever, and this recent example of a credit-fuelled boom was no exception. The first signs of trouble were in the US mortgage market. Lending standards had eased so far – and outright fraud had gotten to be such a problem – that arrears rates started to rise more than lenders and investors expected. Graph 8 shows that the rise started in around 2006 for both prime and sub-prime mortgages, but became more obvious through 2007. The extraordinary thing was that, unlike in every other housing bust, arrears rates increased significantly before the labour market started to weaken. The first consequence of this was the failure of a number of US mortgage lenders. Some of these were brought down by early defaults, where the borrower didn’t even make the first payment. If a loan is securitised and sold, the lender typically has to compensate the buyers of the securities if the loan defaults soon afterwards. But not all of these losses on mortgages could be pushed back on the original lender or broker, especially if these had already gone out of business. After years of underestimating risks on mortgage-related and other complex securities, banks and other investors started to realise just how risky these securities were. They also started to realise that they didn’t know how exposed their counterparties were to these losses. Following a series of loss announcements and suspensions of some bank-sponsored investment funds in mid 2007, market participants began to hoard liquidity. They were worried about their counterparties, but they were also worried about their own future liquidity needs.
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