The recent turmoil in global financial markets - and the liquidity and credit crunch that followed - raises two questions: How did defaulting sub-prime mortgages in the American states of California, Nevada, Arizona, and Florida lead to a worldwide crisis? And why did systemic risk increase rather than decrease in recent years?

Blame should go to the phenomenon of "securitisation." In the past, banks kept loans and mortgages on their books, retaining the credit risk. For example, during the housing bust in the US in the late 1980's, many banks that were mortgage-lenders (the Savings & Loans Associations) went belly up, leading to a banking crisis, a credit crunch, and a recession in 1990-1991.

This systemic risk - a financial shock leading to severe economic contagion - was supposed to be reduced by securitisation. Financial globalisation meant that banks no longer held assets like mortgages on their books, but packaged them in asset-backed securities that were sold to investors in capital markets worldwide, thereby distributing risk more widely.

What went wrong? The problem was not just sub-prime mortgages. The same reckless lending practices - no down-payments, no verification of borrowers' incomes and assets, interest-rate-only mortgages, negative amortisation, teaser rates - occurred in more than 50 per cent of all US mortgages between 2005 and 2007. Because securitisation meant that banks were not carrying the risk and earned fees for transactions, they no longer cared about the quality of their lending.

Indeed, a chain of financial intermediaries now earn fees without bearing the credit risk. As a result, mortgage brokers maximise their income by generating larger volumes of mortgages, as do the banks that package these loans into mortgage-backed securities (MBS's). Investment banks then earn fees for re-packaging these securities in tranches of collateralised debt obligations, or CDO's (and sometimes into CDO's of CDO's).

Moreover, credit rating agencies had serious conflicts of interest, because they received fees from the managers of these instruments. Regulators sat on their hands, as the US regulatory philosophy was free-market fundamentalism. Finally, the investors who bought MBS's and CDO's were greedy and believed the misleading ratings. Nor could they do otherwise, as it was nearly impossible to price these complex, exotic, and illiquid instruments.

Similar reckless lending practices prevailed in the leveraged buyout market, where private equity firms take over public companies and finance the deals with high debt ratios; the leveraged loan market, where banks provide financing to private equity firms; and the asset-backed commercial paper market, where banks use off-balance sheet schemes to borrow very short term.

Small wonder that when the sub-prime market blew up, these markets also froze. Because the size of the losses was unknown - sub-prime losses alone are estimated at between $50 billion and $200 billion, depending on the magnitude of the fall in home prices, which is also unknown - and no one knew who was holding what, no one trusted counterparties, leading to a severe liquidity crunch.

But the liquidity crunch was not the only problem; there was also a solvency problem. Indeed, in the US today, hundreds of thousands - possibly two million - households are bankrupt and thus will default on their mortgages. Around 60 sub-prime lenders have already gone bankrupt.

Many homebuilders are near bankrupt, as are some hedge funds and other highly leveraged institutions. Even in the US corporate sector, defaults will rise, owing to sharply higher corporate bond spreads. Easier monetary policy may boost liquidity, but it will not resolve the solvency crisis.

There are two reasons for this:

• Massive uncertainty about the size of the losses. In part, the size will depend on how much home prices fall - 10per cent? 20 per cent? Moreover, it is hard to price losses on exotic instruments that are illiquid - that is not having a market price.

• Thanks to securitisation, private equity, hedge funds, and over-the-counter trading, financial markets have become less transparent. This opacity means that no one knows who is holding what, which saps confidence. When the re-pricing of risk finally occurred in September, investors panicked causing a liquidity run and a credit strike.

So what is to be done? It will be hard to reverse financial liberalisation, but its negative side effects - including greater systemic risk - require a series of reforms.

First, more information and transparency about complex assets and who is holding them are needed. Second, complex instruments should be traded on exchanges rather than on over-the-counter markets, and they should be standardized so that liquid secondary markets for them can arise.

Third, we need better supervision and regulation of the financial system, including regulation of opaque or highly leveraged financial institutions such as hedge funds and even sovereign wealth funds. Fourth, the role of rating agencies needs to be rethought, with more regulation and competition introduced. Finally, liquidity risk should be properly assessed in risk management models, and both banks and other financial institutions should better price and manage such risk; most financial crises are triggered by maturity mismatches.

These crucial issues should be put on the agenda of the G7 finance ministers to prevent a serious backlash against financial globalisation and reduce the risk that financial turmoil will lead to severe economic damage.

The author is professor of economics at the Stern School of Business, New York University, and chairman of RGE Monitor (www.rgemonitor.com).

© Project Syndicate, 2007.

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