Abstract: The global financial crisis clearly started with problems in the U.S. subprime sector and spread across the world from there. But was the direct exposure of foreigners to the U.S. financial system a key driver of the crisis, or did other factors account for its rapid contagion across the world? To answer this question, we assessed whether countries that held large amounts of U.S. mortgage-backed securities (MBS) and were highly dependent on dollar funding experienced a greater degree of financial distress during the crisis. We found little evidence of such “direct contagion” from the United States to abroad. Although CDS spreads generally rose higher and bank stocks generally fell lower in countries with more exposure to U.S. MBS and greater dollar funding needs, these correlations were not robust, and they fail to explain the lion’s share of the deterioration in asset prices that took place during the crisis. Accordingly, channels of “indirect contagion” may have played a more important role in the global spread of the crisis: a generalized run on global financial institutions, given the opacity of their balance sheets; excessive dependence on short-term funding; vicious cycles of mark-to-market losses driving fire sales of MBS; the realization that financial firms around the world were pursuing similar (flawed) business models; and global swings in risk aversion. The U.S. subprime crisis, rather than being a fundamental driver of the global crisis, may have been merely a trigger for a global bank run and for disillusionment with a risky business model that already had spread around the world.

“In fact, it is ironic that, although the global financial crisis appeared to originate in the U.S. sub-prime sector, losses on U.S. ABS accounted for only a small part of the total losses taken by foreigners on their holdings of U.S. assets. As indicated in Table 4, foreigners experienced some $1.3 trillion in losses on their portfolio holdings in the United States, but only $160 billion of those losses were linked to ABS. By far the greatest losses were on their holdings of U.S. common stock.”

Comment: This paper indicates that the U.S. subprime sector was only a trigger to a global financial crisis. Globally opaque balance sheets were filled with assets and liabilities which were not marked to market and missing many off-balance sheet items. These missing assets and liabilities were later brought onto statements only to be written down to the detriment of the financial institution’s capital position. FASB has begun to address such issues by issuing FAS 157, market to market, and updating FAS 140, which eliminates Qualified Special Purpose Entities. QSPE’s help keep certain liabilities off a firm’s balance sheet.

During the 1930’s a concerted effort was made to bring clarity to a firm’s financial statements. The results of these efforts included the Securities Act of 1933, 1934 and 1940. Financial statement reform took the better part of a decade after the U.S. stock market crash of 1929, but led to greater clarity for investors. Today it is encouraging to see FASB work towards this same goal.