Domino Effect: How Did the US Financial Crisis Become a Global Epidemic ?

By now, much has been written about the fall of three of the biggest global financial institutions in the US - Bear Stearns, Lehman Brothers and Merrill Lynch in addition to other recent casualties within the Banking sector. The fact that these were reputed institutions in existence for more than an average human lifetime suggested that they would withstand the test of time and weather all odds. Yet, in one fell swoop, these companies vanished without a trace ! Worse still, their disappearance caused a trail of casualties across the globe. Why did the crisis in the US become a global epidemic of such a large proportion ?

The concept of securitisation leading to the creation of a market of Mortgage backed securities (MBS) was initiated in the United States many decades ago with the intent to attract new market participants who were interested in buying a share of the Loan cash-flows that existed on the books of various banks across the country. Loans, although assets on the books of the banks as they ensured interest payments from borrowers, brought with them risks - most important among them being the risk of default. The creation of an MBS market gave the banks an opportunity to offload the default risk to investors who were interested in buying a percentage of the cashflow of their loan portfolio, thereby, clearing their books of any contingency capital (which is a percentage of risk rating of their portfolio).

This ecosystem was laid on the foundation of transferring default-risks from institutional lenders to various investor categories like retail, institutional, banking, fund houses, pension funds etc... This process of allowing retail banking portfolio to enter the capital markets as trade-able paper (security) caused the capital markets to be exposed to the retail banking system. This, in hindsight would be the biggest reason for loan defaults to cause a big dent in the capital market system of a trillion-dollar economy.

So, why should a loan default on a mortgaged home in Iowa cause a ripple in China ?