Full extent of financial crisis still not known, Purdue expert says

October 9, 2008

(PhysOrg.com) -- The depth of the current financial crisis is unknown partly because most financial institutions don't disclose they are in trouble until after the fact, a Purdue University expert says.

"The question we don't know is how deep the recession will be and low long it will last," says Sugato Chakravarty, a professor and head of the Department of Consumer Sciences and Retailing.

"The problems keep coming out in drips and drabs. Banks that have cash are leery of lending. The next couple of years could be very turbulent. The markets will be up and down. The next president, whoever he is, will have to deal with all of this."

Chakravarty says much of the current situation has been caused by credit default swaps.

"Credit default swaps are an insurance device much favored by banks and other financial institutions to cover potential losses on their loans in the event of a default, much like you and I would buy homeowner's insurance to protect ourselves from damage to our homes," he says. "These credit default swap contracts can be sold and resold several times in the secondary markets, and no one knows if the eventual buyer 10 degrees removed has the financial wherewithal to cover the losses if the underlying security defaults. There is hardly any oversight in these markets."

Chakravarty says the swaps usually apply to municipal bonds, corporate debt and mortgage securities but have expanded into structured finance containing pools of mortgages, especially pools of high-risk subprime mortages. The credit swap market is not regulated.

He says the problem came when there was a downturn in the housing market and thousands of subprime mortgages defaulted.

"Billions of dollars of credit default swap holders exercised their option to trigger the insurance, except there was no one on the other side to honor those insurance contracts," Chakravarty says. "There is no regulation and little you can do to enforce payment."

But Chakravarty said there is reason for optimism.

"The market always rebounds eventually, and the U.S. has deep financial resources."

Provided by Purdue University

Explore further: Study links credit default swaps, mortgage delinquencies

Related Stories

Online finance should be the next concern, not spying bins

April 8, 2014

As the hype around the internet of things grows, we are being presented with dystopian images of a future in which our fridges spy on us and our toothbrushes tattle to our dentists and insurers. But our concern about these ...

Sharing the risks, costs of biomass crops

September 4, 2013

Farmers who grow corn and soybeans can take advantage of government price support programs and crop insurance, but similar programs are not available for those who grow biomass crops such as Miscanthus. A University of Illinois ...

Rethinking investment risk

August 26, 2013

Financial innovation is supposed to reduce risk—in theory, at least. Yes, new financial instruments based on the housing market helped cause the financial crisis of 2008. But in the abstract, those same instruments have ...

Discover finds partners in evolving mobile payments

September 22, 2012

In a memorable episode of "Seinfeld," George suffers from back problems because of a ridiculously overstuffed wallet. His wallet later explodes. The episode mocked one of the inconveniences of the modern world, the explosion ...

Recommended for you

French teen finds 560,000 year-old tooth (Update)

July 28, 2015

A 16-year-old French volunteer archaeologist has found an adult tooth dating back around 560,000 years in southwestern France, in what researchers hailed as a "major discovery" Tuesday.

Oldest known Koran text fragments discovered

July 23, 2015

Two pages of text written on parchment that are believed to be sections of the Koran (Chapters 18 and 20) have been discovered by a PhD student in a British university library and are believed to be the oldest ever found. ...

0 comments

Please sign in to add a comment. Registration is free, and takes less than a minute. Read more

Click here to reset your password.
Sign in to get notified via email when new comments are made.