David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 18 Money and banking
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bundles and sold them on to new buyers in London, Frankfurt and Mumbai. The market was convinced that
this trick was a bit like insurance - although one poor sub-prime household might go bust, they would not
all go bust together. Holding a large bundle made them safer, just as an insurance company pools the risk of
individual burglary by having large numbers of clients. This was the alchemy of risk reduction. A recipe for
profits and bonuses.
Two things went wrong. First, buyers of securitized mortgages had miscalculated. It was quite likely that
circumstances could arise in which all sub-prime borrowers would get into trouble at the same time - a fall
in house prices, a fall in confidence, a rise in risk perception - especially if they could barely afford the loan
in the first place. So smart bankers in London, New York and other financial capitals had mispriced the risk:
the securitized bundles were riskier than had been thought.
Second, the perfect storm did indeed arise. As US house prices fell sharply, the chain of events was triggered.
Banks found their assets worth much less than they had thought. Worse, the boards of the banks had not even
realized the extent to which their bonus-hungry employees had exposed them to such large risks. The lefthand
figure below shows annual changes in US house prices, which peaked around 2006. The right-hand side
shows the level of UK house prices, which peaked around the end of 2007.
House price change, US, annual (%)
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