11. Another striking feature of the global macroeconomic
environment, according to Professor Buiter, was the declining
level of real interest rates, and specifically the marked decline
since the bursting of the so-called 'technology bubble' at the
end of 2000. Professor
Buiter explained that the proximate determinant of the trend decline
in real interest rates was "an ex-ante savings glut, caused
by the rapid growth of new emerging markets like China, which
have extraordinarily high propensities to save" as well as
more recently "the global redistribution of wealth and income
towards a limited number of producers of primary energy sources
(especially oil and natural gas) and raw materials".
12. The Governor of the Bank of England concurred
with Professor Buiter's explanation for the declining and low
level of real interest rates, stating in his 9 October 2007 speech
in Belfast that prevailing low real interest rates were primarily
caused by high rates of saving in other parts of the world:
The primary explanation is the high rates of saving
in other parts of the world. Japan has been a net saver for more
than a quarter of a century. Following the Asian crisis in the
mid-1990s, many of Japan's neighbours also raised their national
saving rates. That group includes the country which is now the
world's biggest saverChina. And more recently, after the
tripling of oil prices, they have all been joined by the oil-producing
nations from Saudi Arabia to Norway.
The Governor went on to explain that savings from
these countries flooded into world capital markets with the consequence
that borrowers were able to attract long-term loans at remarkably
low interest rates. These low interest rates encouraged borrowing
and spending (and reduced saving) in much of the developed world,
resulting in large and expanding trade deficits. The Governor
noted that, in order to keep overall demand growing and inflation
stable, in the face of these trade deficits, central banks in
the developed world responded by keeping official short-term interest
the price was unusually low interest ratesboth
short and long-termwhich were considerably below the levels
to which most investors had become accustomed in their working
lives. Dissatisfaction with these rates gave birth to the 'search
for yield'. This desire for higher yields could not be met by
traditional investment opportunities. So it led to a demand for
innovative, and inevitably riskier, financial instruments and
for greater leverage. And the financial sector responded to the
challenge by providing ever more sophisticated ways of increasing
yields by taking more risk.
14. The generally benign macroeconomic environment
combined with low real interest rates and the subsequent 'search
for yield' has provided the backdrop to a number of important
developments in financial markets over the last decade and a half.
Two of the most important developments have been the rise of new
actors in financial markets and the growth of new and more complex
financial instruments and markets, both of which we discuss below.
15. The 'search
for yield' has spawned the growth of complex new financial instruments
as well as new types of institutional investors. This 'search
for yield' encouraged many investors to invest in high-yielding
complex products that it turns out they did not always fully understand
and is at the heart of the problems which have affected financial
markets from mid-2007 onwards. We discuss the consequences for
financial stability of this 'search for yield' in greater detail
later in this Report.
18. The number of hedge funds has grown significantly
over the last decade with an estimated 9,800 hedge funds operating
globally by the end of 2006. These funds have attracted strong
inflows of capital over the last decade, with assets managed by
hedge funds totalling US $1.4 trillion at the end of 2006. The
growth of hedge funds over this period has been attributed by
the Reserve Bank of Australia to the prevailing low interest rate
environment which the Reserve Bank says "may also have encouraged
a shift in investments towards hedge funds as, in the past, hedge
funds have achieved higher average returns than traditionally
managed investments, albeit in exchange for greater risk".
19. The active investment approach of hedge funds
means that they account for a high proportion of market activity.
For instance, hedge fund trading activity was estimated to account
for around 40%-50% of daily turnover on the New York Stock Exchange
and London Stock Exchange in 2005.
Hedge funds are also significant investors in structured credit
markets. Hedge funds operate under conditions of reduced disclosure
and oversight compared to many other institutional investors and,
whilst often managed on-shore, are usually based off-shore, although
hedge fund managers in the United Kingdom are subject to regulation
by the FSA in respect of their governance and market conduct.
20. The increased
prominence of hedge funds makes it important to analyse the role
they play in financial markets. We intend to examine the role
of hedge funds as part of our ongoing work on financial stability
23. At the larger end of the private equity market,
private equity represents an alternative to the listed company
model of ownership. Our July 2007 Report discussed the nature
of the private equity industry and the differences between the
private equity and the Public Limited Company model. We concluded
that there were benefits and potential problems associated with
both private equity and Public Limited Company ownership and that
different forms of ownership might be appropriate at different
times for a particular company.
24. Our Report also discussed possible risks to financial
stability posed by recent developments in private equity. We noted
however extensive the due diligence conducted, higher
levels of leverage are likely to create additional risk, and
this becomes more significant the more important highly-leveraged
firms become in the economy. We also note that the recent increase
in the number of highly-leveraged private equity-owned firms has
occurred during a period of economic growth and stability, which
is not guaranteed to continue. We therefore urge the Bank of England
to examine the potential impact of an economic downturn, both
on highly-leveraged firms and on the wider economy. We also urge
the FSA to investigate the operation of due diligence in highly-leveraged
25. Since we published our Report on private equity
in July 2007, Sir David Walker has published his report on guidelines
for disclosure and transparency in private equity. 
The environment for private equity deals has also deteriorated
as a result of developments in the credit markets and the more
uncertain macroeconomic outlook.
26. We are continuing
our work on private equity, examining the proposals in Sir David
Walker's report as well looking at the impact on private equity
of the changing economic environment. We will also continue to
explore the implications for financial stability of the growth
of private equity in recent years as part of our ongoing work
on financial stability and transparency.
29. Sovereign wealth funds have played an important
role in the aftermath of the financial market turbulence of 2007.
Beginning in late 2007 a number of Sovereign wealth funds have
invested in financial institutions, primarily the large Wall Street
investment banks, which suffered large losses on sub-prime mortgages.
These investments in financial services firms, which are described
in greater detail in chapter five, have increased the presence
of Sovereign wealth funds in the financial services sector of
developed economies. This may present a new set of challenges
to policymakers, including implications for financial stability.
In addition, there is an ongoing debate about whether Sovereign
wealth funds have appropriate structures of governance and transparency
in place as well as concerns over possible political intervention
and the impact of potential large-scale market moves.
30. We recognise
the important role that Sovereign wealth funds have played in
helping to stabilise the financial system through their investments
in financial services firms in 2007. However, the increasing prominence
of such funds as institutional investors does raise valid public
policy questions about governance, transparency and reciprocity.
We intend to examine the role of Sovereign wealth funds as part
of our ongoing work on financial stability and transparency.
Offshore financial centres have often been linked
with the notion of a 'tax haven'. While the low tax environment
present in many OFCs is important in explaining their popularity,
an IMF background paper outlined other reasons why offshore financial
centres might be used by individual financial institutions:
OFCs can be used for legitimate reasons, taking advantage
of: (1) lower explicit taxation and consequentially increased
after tax profit; (2) simpler prudential regulatory frameworks
that reduce implicit taxation; (3) minimum formalities for incorporation;
(4) the existence of adequate legal frameworks that safeguard
the integrity of principal-agent relations; (5) the proximity
to major economies, or to countries attracting capital inflows;
(6) the reputation of specific OFCs, and the specialist services
provided; (7) freedom from exchange controls; and (8) a means
for safeguarding assets from the impact of litigation etc.
They can also be used for dubious purposes, such
as tax evasion and money-laundering, by taking advantage of a
higher potential for less transparent operating environments,
including a higher level of anonymity, to escape the notice of
the law enforcement agencies in the "home" country of
the beneficial owner of the funds.
32. One increasing use of offshore financial centres
is as the host of a 'special purpose vehicle'. For instance, Granite,
the Special Purpose Vehicle of Northern Rock, was located in the
offshore financial centre of Jersey. The IMF explains the advantages
of using an OFC as part of a special purpose vehicle:
One of the most rapidly growing uses of OFCs is the
use of special purpose vehicles (SPV) to engage in financial activities
in a more favourable tax environment. An onshore corporation establishes
an International Business Corporation in an offshore centre to
engage in a specific activity. The issuance of asset-backed securities
is the most frequently cited activity of SPVs. The onshore corporation
may assign a set of assets to the offshore SPV (e.g., a portfolio
of mortgages, loans credit card receivables). The SPV then offers
a variety of securities to investors based on the underlying assets.
The SPV, and hence the onshore parent, benefit from the favourable
tax treatment in the OFC. Financial institutions also make use
of SPVs to take advantage of less restrictive regulations on their
activities. Banks, in particular, use them to raise Tier I capital
in the lower tax environments of OFCs. SPVs are also set up by
non-bank financial institutions to take advantage of more liberal
netting rules than faced in home countries, reducing their capital
33. These potential uses of offshore financial centres
mean that they remain relevant in any discussion of financial
stability. There is an element of competition between major financial
centres and offshore financial centres around taxation and regulation.
As well as this, the links between offshore financial centres,
the institutions and entities registered in OFCs, and the financial
institutions regulated by UK authorities means that there is the
potential for a further opacity to be added to the financial system,
as the lines of sight to where economic risk actually lies may
be obscured by the link with an offshore financial centre.
34. We will
undertake further work on offshore financial centres in the context
of our ongoing scrutiny of financial stability and transparency
to seek to ascertain what risk, if any, such entities pose to
financial stability in the United Kingdom.
36. Many asset-backed securities have subsequently
been turned into structured finance products, which involve the
pooling of assets and the subsequent sale to investors of different
classes of securities, each with differing risk-return profiles,
on the cash flows backed by these pools.
Mr Gerald E Corrigan, Managing Director at Goldman Sachs, told
us that the driving force behind the growth of markets in structured
finance products was the 'search for yield' phenomenon:
in a very real way the fundamental driving force
that goes a considerable distance in explaining the explosion
of structured credit productsI agree with that characterisationwas
the long period during which there were abundant amounts of liquidity
on a worldwide basis and very low nominal and real interest rates.
To a significant degree it has been the reach for yield on the
part of institutional investors in particular that goes a considerable
distance in explaining this very rapid growth of structured credit
37. One structured finance product which has grown
strongly is collateralised debt obligations (CDOs), which can
be defined as securities backed by a portfolio of fixed-income
assets that are issued in tranches of varying seniority with different
tranches having differing repayment and interest earning streams.
The process of creating CDOs works through the purchase of underlying
asset-backed securities by other financial institutions, such
as managers of collateralised debt obligations (CDOs), which,
as the Bank of England describe, "create new and often complex
instruments with high embedded leverage, which they sell on".
This process adds a further layer of complexity because underlying
securities, including asset-backed securities such as residential
mortgage-backed securities, investment-grade bonds and leveraged
loans, have subsequently been repackaged into new structured finance
products such as CDOs.
38. Given the complexity of such instruments, we
asked representatives from the investment banks to explain what
a CDO and a CDO-squared were. Lord Aldington, Chairman of Deutsche
Bank, London Branch, explained to us that he had not "come
before this Committee as an expert on CDOs". Lord Aldington,
when questioned further as to whether Deutsche Bank was involved
in collateralised debt obligations replied that "my organisation
is involved in a very broad range of products and I would not
claim to be an expert on all of them". Jeremy Palmer told
us that "a CDO-squared is a derivative structure designed
to give investors exposure to a CDO" whilst Mr Corrigan replied
A CDO carves out of a plain vanilla mortgage-backed
security certain credit tranches of that security and reformulates
them in what is called a structured credit product into a particular
class of credit standards affecting those particular mortgages,
not the full pool of mortgages.
inquiry has highlighted the complexity of many new financial instruments,
such as Collateralised Debt Obligations. Nevertheless we are surprised
that the Chairman of the UK branch of a leading investment bank
could not explain to us what a CDO is, a financial product in
which he told us that his organisation deals. The fact that senior
board members may not have sufficient understanding of products
that their organisations are originating and distributing is a
major cause for concern. If the creators and originators of complex
financial instruments have only a limited understanding of these
products then it raises serious questions about how investors
in these products can possibly understand such complex products
and the risks involved in such investment decisions. We discuss
this issue in greater detail later in our Report.
40. The Bank of England in its October 2007 Financial
Stability Report argued that the 'search for yield' was behind
rising investor demand for US sub-prime residential mortgage-backed
securities as well as leveraged corporate loans and had stimulated
a wave of innovation, creating often opaque and complex financial
instruments with high embedded leverage. The Bank also attributed
the rapid rise in issuance of collateralised debt obligations
(CDOs) to this 'search for yield' on the part of investors.
41. According to the Bank of England, the size of
the global market in asset-backed securities was estimated at
$10.7 trillion at the end of 2006.
The market was dominated by securities backed by residential mortgage-backed
securities, which were worth $6.5 trillion, with the US market
worth $5.8 trillion and the European market $0.7 trillion. The
$5.8 trillion US market in residential mortgage-backed securities
includes £0.7 trillion of non-agency sub-prime mortgages,
which are mortgages held by sub-prime borrowers (who do not meet
prime market standards because they are perceived as a relatively
bad credit risk to the lender). Such sub-prime mortgages represented
around 6.5% of the market for securitised assets. A total of $3.5
trillion was accounted for by non-mortgage asset-backed securities
which included securitised home equity loans, auto loans, consumer
loans, credit card debt, student loans and other sorts of non-mortgage
42. Despite this strong growth in recent years, the
total size of the market of asset-backed securities and sub-prime
residential mortgage-backed securities is small when compared
with other securities markets, such as those for corporate equities
and corporate debt. According to the Bank of England, the biggest
securities markets are for corporate equities, which had an estimated
global value of $50.6 trillion at the end of 2006, whilst corporate
debt markets had an estimated value of $17.1 trillion at the end
44. Professor Buiter told us that the move away from
the 'originate and hold' banking business model first developed
in the United States in the 1970s as Fannie Mae (Federal National
Mortgage Association), Ginnie Mae (Government National Mortgage
Association) and Freddie Mac (Federal Home Loan Mortgage Corporation)
began the process of securitisation of residential mortgages,
operating increasingly under an 'originate and distribute' model.
The International Monetary Fund noted in December 2007 that this
market structure, with government-sponsored enterprises at its
centre, was a 'tremendous success' and attracted competition from
other major financial institutions, with the major Wall Street
firms launching an aggressive move into the issuance of mortgage-backed
45. Professor Buiter explained how securitisation
has evolved, and become more complex over time, by contrasting
'simple' securitisationwhich involved the pooling of reasonably
homogenous assets with a given (and generally lower) risk profilewith
second-tier and higher-tier securitisations:
However, second-tier and higher-tier-securitisation
then took place, with tranches of securitised mortgages being
pooled with securitised credit card receivables, car loan receivables
etc. and tranched securities being issued against this new, heterogeneous
pool of securitised assets. Myriad credit enhancements were added.
46. Recent years have seen an increasing number of
banks in the USA moving away from the 'originate and hold' model
and placing an increasing emphasis on an 'originate and distribute'
model. As a result, whereas in 2003, government sponsored enterprises
were the source of 76% of the mortgage-backed and asset-backed
issuances in the USA with 'private label' issues accounting for
the remaining 24%, by 2006 private sector banks were the source
for almost 60% of mortgage-backed issuances in the USA.
47. Under the 'originate and distribute' model, loans
that banks make are then sold to an off-balance sheet special
purpose vehicle (SPV). In theory at least, the insolvency of any
such SPV should have no impact on the bank which originated the
loans: the risk is said to have been distributed. Mr Corrigan
told us that the use of special purpose vehicles was common amongst
financial institutions in that "most financial institutions
have at least some form of off-balance sheet activities, typically
in the form of special purpose vehicle." 
The special purpose vehicle is simply a corporation registered
in what is usually an offshore financial centre.
The special purpose vehicle parcels together these loans into
securities backed by the cash flows from those loans (asset-backed
securities) with these securities sold to investors such as pension
funds, insurance companies, mutual funds, hedge funds and other
banks. This process is known as 'disintermediation'. Securitisation
allows the banking originator to earn fee income from their underwriting
activities without leaving themselves exposed to credit market
or liquidity risk because they sell the loans they make.
48. Securities have also been sold to off balance
sheet investment vehicles, many of which have been established
or sponsored by the banks themselves. These investment vehicles
include conduits and structured investment vehicles. The essential
difference between a conduit and a structured investment vehicle
is that conduits are established and owned by banks whilst structured
investment vehicles are not owned directly by banks, although
banks have close relations with them as sponsors. Professor Buiter
expanded on the difference between the two, explaining that conduits
were structured investment vehicles "closely tied to a particular
bank" while structured investment vehicles were special purpose
vehicles investing in long-term, often illiquid complex securitised
49. Professor Buiter told us that structured investment
vehicles "fund themselves in the short-term wholesale markets,
including the asset-backed commercial paper markets".
Asset-backed commercial paper is commercial paper collateralised
by loans, leases, receivables, or asset-backed securities. Conduits
are also largely funded through asset-backed commercial paper.
The proceeds from these short-term instruments, such as asset-backed
commercial paper, are then used by investment vehicles to fund
the purchase of assets of longer duration, such as asset-backed
securities and collateralised debt obligations. This maturity
mismatch, where the assets held by conduits and structured investment
vehicles have a long maturity whereas asset-backed commercial
paper is of short maturity, can leave these vehicles vulnerable
to disruption in investor demand for asset-backed commercial paper.
To mitigate this 'rollover' risk, conduits and structured investment
vehicles typically hold committed liquidity lines provided by
50. One of the key drivers behind the establishment
of conduits and structured investment vehicles was regulatory
arbitrage, as was explained to us by Professor Buiter:
Most of the off-balance sheet vehicles I am
familiar with are motivated by regulatory arbitrage, that is,
by the desire to avoid the regulatory requirements imposed on
banks and other deposit-taking institutions. These include minimal
capital requirements, liquidity requirements, other constraints
on permissible liabilities and assets, reporting requirements
and governance requirements. Others are created for tax efficiency
(i.e. tax avoidance) reasons.
51. Professor Buiter explained the attraction of
the 'originate and distribute' model to private banks as they
took advantage of securitisation techniques, using them to:
liquefy their illiquid loans. The resulting 'originate
and distribute' model had major attractions for the banks and
also permitted a potential improvement in the efficiency of the
economy-wide mechanisms for intermediation and risk sharing. It
made marketable the non-marketable; it made liquid the illiquid.
There was greater scope for trading risk, for diversification
and for hedging risk 
52. The Governor of the Bank of England cited some
of the advantages of the 'originate and distribute model' for
banks, telling us that it "has been a very healthy development
and had enabled a number of smaller financial institutions
to obtain funding from others by borrowing against the securitised
form of mortgages.
Mr Sants added that securitisation programmes which created long-term
secure funding are a very good source of funds.
The 'originate and distribute' model has also helped drive strong
profit growth in the banking sector. The Bank of England stated
in its October 2007 Financial Stability Report that profit growth
in recent years in the banking sector had been driven by the 'originate
and distribute' business model, with UK banks' and Large Complex
Financial Institutions' enjoying returns on equity often well
in excess of 20%.
54. Credit ratings are, broadly speaking, used by
investors as indications of the likelihood of receiving their
money back in accordance with the terms on which they invested.
Moody's told us that their credit ratings are forward-looking
opinions that address just one characteristic of fixed income
securities, the likelihood that debt will be repaid in accordance
with the terms of the security. Credit ratings reflect an assessment
of both the probability that a debt instrument will default and
the amount of loss the debt-holder will incur in the event of
56. Moody's had a slightly different scoring system
and explained that their "ratings are expressed according
to a simple system of letters and numbers, on a scale that has
21 categories ranging from Aaa to C". They told us that their
"lowest expected credit loss is at the Aaa level, with a
higher expected loss rate at the Aa level, an even higher expected
loss rate at the A level, and so on down through the rating scale".
in the specific context of securitisation, arrangers
who create these transactions have a goal to achieve a higher
rating, typically a triple-A rating, so they will structure a
transaction in a way that achieves the highest rating possible.
59. Credit enhancement is achieved through tranching,
which refers to the issuance of several classes of securities
against a pool of assets, each with distinct risk-return characteristics.
The creation of distinct classes of risk allows investors to purchase
tranches that match their appetite for risk, allowing, for example,
more risk-averse investors to purchase AAA tranches or 'senior'
tranches which offer lower yields, but greater protection against
60. In a common three-tranche, the least risky, or
'senior', tranche has the first claim on payments from the pooled
mortgages. The 'senior' tranche has the highest credit rating,
often triple-A investment grade, but receives a lower rate of
interest than the other tranches. After the senior claims are
paid, the middle or mezzanine tranche receives its payments. Mezzanine
represents greater risk and usually receives below-investment
grade credit ratings and a higher rate of return. The lowest,
or equity, tranche receives payments only if the senior and mezzanine
tranches are paid in full. The equity/first-loss tranche absorbs
initial losses. Equity tranches are therefore the most risky tranche
and consequently often unrated, but as a consequence offer the
highest rate of return. This process, whereby losses are applied
to more 'junior' tranches before they are applied to more 'senior'
tranches, is known as subordination and is one, albeit important,
form of credit enhancement. Ian Bell, Managing Director and Head
of European Structured Finance at Standard & Poor's explained
to us "that in order to have a triple A you have to have
a credit cushion [whereby more 'junior' tranches take initial
losses] so the pool of mortgages can absorb a certain amount of
losses before there are any losses at the triple A level".
Mr Bell went on to tell us that the credit cushions in the case
of sub-prime were very substantial so as to protect more senior
or triple A tranches against losses.
61. Other commonly used credit enhancements designed
to protect 'senior' tranche holders against losses include:
Monoline insurance: Third-party
insurance or other financial guarantees may be provided to protect
investors from losses.
Excess servicing: A pre-set amount of interest
is explicitly set aside from the servicing of the collateral each
month to be used to make up any shortfalls in cash flows for senior
Residual tranching: Additional cash flows above
and beyond excess servicing are set aside to cover losses as needed.
62. The 'search for yield' phenomenon and strong
investor interest has led to the rapid growth (or explosion) of
structured finance instruments with triple A or 'investment grade'
ratings. Representatives of the credit ratings agencies told us
that there were perhaps 30 or 40 triple A rated sovereign credits,
whilst globally only a 'handful' of banks and corporates enjoyed
a triple A rating. The agencies acknowledged that, by way of contrast,
there were thousands of structured finance products with a triple
63. The relatively
recent innovation of tranching, whereby a pool of assets is converted
into low-risk, medium-risk and higher-risk securities, has led
to a mushrooming of triple-A securities available for investment.
Rating these securities has been an increasing source of income
for the credit rating agencies. Tranching has proven successful
at tailoring investment opportunities to meet the risk-appetites
of investors, particularly those bound by strict investment mandates,
specifying AAA investments. This market innovation has, however,
led to greater complexity.
65. Chart 1 below, from the 2007 IMF's Global Financial
Stability Report, show, that a wide range of financial institutions,
including insurance companies, asset managers, banks and hedge
funds, have purchased asset-backed security CDOs, with hedge funds
the largest category of investor in such products. It also shows
how different types of investors purchased different tranches
of asset-backed security CDOs, with hedge funds and banks the
largest purchasers of equity tranches and hedge funds also large
purchasers of mezzanine tranches. Chart one also shows that the
US institutions were the largest buyers of asset-backed security
CDOs, but that European, Asian and Australian investors were also
purchasers of these products.
Chart 1: Buyers of Collateralised Debt Obligations backed by Asset Backed Securities
Source: IMF, Global Financial Stability Report,
October 2007, p 15
67. Sub-prime mortgages are loans made to borrowers
who are perceived to have high credit risk, often because they
lack a strong credit history or have other characteristics that
are associated with high probabilities of default.
Sub-prime status is calculated on the basis of credit scores.
The leading credit scoring agency is the Fair Isaac Corporation
(FICO). Its credit scores are on a scale of 300 to 850.
A score of 620 or below usually denotes sub-prime status.
Mr Bernanke outlined how the growth of securitisation
gave a further boost to sub-prime mortgage lending in the USA,
explaining that "the ongoing growth and development of the
secondary mortgage market has reinforced the effect of these innovations"
whereas once most lenders held mortgages on their
books until the loans were repaid, regulatory changes and other
developments have permitted lenders to more easily sell mortgages
to financial intermediaries, who in turn pool mortgages and sell
the cash flows as structured securities. These securities typically
offer various risk profiles and durations to meet the investment
strategies of a wide range of investors. The growth of the secondary
market has thus given mortgage lenders greater access to the capital
markets, lowered transaction costs, and spread risk more broadly,
thereby increasing the supply of mortgage credit to all types
69. Automated underwriting and securitisation were
therefore key developments in reducing the cost of sub-prime mortgage
lending and facilitated a relaxation of credit rationing for borrowers
previously considered too risky by traditional lenders.
Mr Corrigan explained to us that sub-prime lending took off in
the USA around 2003 and 2004 and that, whilst "there were
elements of it before that" it emerged as a major business
during this time frame.
Mr Palmer told us that "the huge growth of sub-prime lending
in the USA is a relatively recent phenomenon" and that "the
huge growth came about in 2005 and 2006".
Mr Palmer explained to us that this growth in the sub-prime market
took place in the context of the 'search for yield' phenomenon
discussed earlier in the chapter.
70. The development of the sub-prime market was welcomed
and even heralded by some as the "democratisation of capital",
and, as Mr Bernanke said in his May 2007 speech, made "home
ownership possible for households that in the past might not have
qualified for a mortgage and has thereby contributed to
the rise in the home ownership rate since the 1990s". In
1995, 65 percent of households owned their homes but this had
increased to almost 70% by 2006. This increase in home ownership,
according to Mr Bernanke, "has been broadly based, but minority
households and households in lower-income census tracts have recorded
some of the largest gains in percentage term".
Mr Sants expressed similar sentiments when he appeared before
us, telling us that there was a genuine social purpose in the
sub-prime market, which is to deliver affordable housing,
whilst Mr Corrigan argued that "the development of the sub-prime
mortgage market was a noble idea, because what it sought to do
was provide access to home ownership on the basis of individuals
and families who by historic standards never had any realistic
hope of being able to own their own homes".
72. Sir Callum McCarthy, Chairman of the FSA, stressed
the risk argument to us, stating that the "originate and
distribute" model "distributes risk much more widely,
and that in itself is attractive because it stops risk being concentrated
in highly geared banks.
In June 2007, Nigel Jenkinson, Executive Director, Financial stability
at the Bank of England, summed up the advantages resulting from
the evolution of financial markets and the growth of securitisation,
described in this chapter, as follows:
Financial innovation has delivered considerable benefits.
New products have improved the ability to hedge and share risks
and to tailor financial products more precisely to user demand.
That has enabled financial intermediaries and users of financial
services to manage financial risks more effectively, and has lowered
the costs of financial intermediation. And innovation and capital
market integration have facilitated the wider dispersal of risks,
which may have increased the resilience of the financial system
to weather small to medium-sized shocks. 
Mr Jenkinson in the same speech went on to discuss
some of the disadvantages and vulnerabilities of these changes:
Dependence on capital markets and on sustained market
liquidity has increased, as banks and other intermediaries place
greater reliance on their ability to 'originate and distribute'
loans and other financial products, and to manage their risk positions
dynamically as economic and financial conditions alter
And the greater integration of capital markets means that if a
major problem does arise it is more likely to spread quickly across
borders. So the flip side to increased resilience of the
financial system to small and medium-sized shocks may be a greater
vulnerability to less frequent but potentially larger financial