Munich Personal RePEc Archive

Conversion Theory: the key to understanding economic developments before and after the 2008 financial crisis

De Koning, Kees (2018): Conversion Theory: the key to understanding economic developments before and after the 2008 financial crisis.

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Abstract

Conversion is a term often used for exchanging one currency into another. This can be done on basis of daily exchange rates: the spot rates, but also on basis of future needs: the forward rates. There is a second type of conversion, which in economic terms may be much more relevant than the currency spot and forward rates: it is the capacity of governments, central banks and the financial sector to turn long term obligations into daily tradable ones and vice versa.

In the U.S., prior to the financial crisis in 2007-2008, banks started to accelerate the underwriting of subprime mortgages. By 2007, subprime mortgages comprised 14%; equivalent to $1.46 trillion. Of these mortgages, the securitized element was about 75% or about $ 1.1 trillion. This element accounted for about 15% of all outstanding U.S. mortgage-backed securities ($7.3 trillion).

As a trick of financial alchemy, securitization turned long term obligations by the borrowers into daily tradable investments by the holders of such debt: conversion. In mixing prime borrower debt with subprime debt to form single securities, the risk assessment for investors was made extremely difficult. Many relied on U.S. credit rating agencies for such assessment; the latter often indicated AA or AA+ ratings. The investors were proven wrong and bad risks repelled good risk taking. Short-term doubts drove away the prospect of securing long-term commitments. Liquidity evaporated.

In the U.S. the legal system took charge of the outstanding loan recoveries. Over the years 2007-2014, 21.228 million households were confronted with foreclosure filings out of the 51.234 million households who had a mortgage: 41.4% of all mortgage holders!

This legal system approach is at odds with what may have been a recommendable economic solution. The legal approach created a snowball effect; a negative feedback loop of more doubtful debtors leading to more forced home sales; dropping house prices and subsequently more doubtful debtors.

History shows that the U.S. government debt increased by $4.5 trillion between 2007-2009, while real GDP still shrank. The actions of the Fed by creating money through Quantitative Easing, to the extent of $3.5 trillion, made borrowing cheaper for future borrowers but did little to improve the life of existing ones.

This paper will set out the dangers of conversion and will propose an alternative economic approach to address the conversion-driven changes in the financial position of individual home mortgage borrowers.

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