A bank may have an ownership share in and/or provide credit lines to both the lender and several other types of special purpose vehicles. If problems arise in one of more of the intermediaries, the responsibility easily falls on the bank. US and European banks have also invested in securities issued by special purpose vehicles. An important part of the process is the packaging of mortgages by special purpose vehicles. The senior tranches have a high rating. The subprime mortgage market has thus gained access to funding from insurance companies and other financial institutions that would not otherwise have invested in this market, and credit risk associated with these mortgages has been spread to international financial markets. 2  BIS Review 115/2007  Rising defaults on subprime mortgages resulted in a sharp rise in the yield spread between securities backed by this type of loan and US government bonds. The turmoil quickly spread to other financial market segments. Uncertainty arose in banks that were directly or indirectly exposed to losses on loans to subprime borrowers. Banks’ oversight of their own potential losses was poor. It was also unclear to what extent special purpose vehicles would draw on credit lines. A number of takeover companies, known as private equity companies, had difficulty obtaining financing in bond markets for their leveraged buy-outs. As a result, banks that had guaranteed temporary funding for these companies were left holding these loans for longer than originally planned.
Given what we have experienced in the last two years, it is my hope that the international community will see the wisdom of not waiting for the next crisis to learn how we can make the international financial system a more robust and safe one for all of us.” 3. Ladies and Gentlemen, I made the above remarks over 10 years ago, in June 1999. It was ten months after the Asian Financial Crisis hit Hong Kong, which was then followed by the turbulence of the global financial system as a result of the abrupt collapse of the LTCM. It was rather unfortunate that the fear I expressed in 1999 has come true ten years later. The international community has failed to learn the lessons from the Asian Financial Crisis and the LTCM debacle and to make the financial system more robust and safer. As a result, we have been punished, and punished very, very severely. The latest Financial Tsunami, dubbed as “Once in a Century”, has demonstrated that somehow all the key safety valves and gatekeepers have failed functioning properly to prevent excessive leverage and risktaking within the financial system, leading to very heavy fiscal and social costs in the subsequent bail-outs. 4. Now the international community, led by G20, is trying very hard to draw lessons from this latest financial crisis. I sense that there is a very strong resolve to do something this time round.