Economic crises are similar to occurrence of cancer in the human body. Different cells emerged from the same zygote, it is called mosaicism. Cancer occurs when cells from the same genotype mutate. The Asia Financial Crisis (AFC) and the Subprime Crisis (SPC) exhibit ‘Mosaics’ type Propagating Mechanism. They shared similar characteristics but are unique on their own.

SPC started with the investment banks and securities firm buying the mortgages from lenders, rating them with the credit rating agencies, packaging and eventually selling them to investors as collateral debt obligations (CDOs), with the poorly rated and highly risky ones parked in their ‘warehouses’ that are known as ‘Special Investment Vehicles’. At the same time, they also sold related derivatives to the market on the CDOs. Here they took on the long term CDOs as assets and acted as counterparties to insure the value of the CDOs by keeping the short term premium as liabilities. This eventually parallel a maturity mismatch like that of commercial banks which resulted in the Great Depression in 1930s.

AFC started with ASEAN countries opening up their market to attract foreign capital that eventually flow to build up asset bubbles that burst when their economies were not competitively overtime to sustain the high interest rates to support their fixed exchange rates. 

For more details on the respective mechanism, please refer to the appendix A1  and appendix A2 as this paper attempts to focus on understanding the ‘genotype’ of both crises by finding looking for the originator and the source of contagion. After that, it attempts to understand the rise of both crises by understanding the effectiveness of regulation, the presence of moral hazard and the triggering mechanisms. Last but not least, the paper attempts to discover the phenotype by understanding the unique expression of the crises in terms of their spread pattern and spillover effects.

US: the originator for both crises. 

The US seems to be the originator for both crises. The consequence of the Plaza Accord of the 1985 where US pressured Japan to appreciate Yen against the dollar to relieve the trade deficit with Japan lead the massive inflow of capital from Japan to ASEAN countries. Along the timeline, the American Mutual funds also started pouring in capital into the same region.(World 1997) This is the new beginning of the miracle economic growth in the ASEAN region and also the start of the AFC. In 1999, under pressure from the Clinton administration, Fannie Mae, the nation’s largest home mortgage underwriter, relaxed credit requirements on the loans it would purchase from other banks and lenders, hoping that easing these restrictions would result in increased loan availability for minority and low-income buyers and that time was the birth of securitization. (Altman 2008) The unintended consequences of both these events started to unveil the beginning of the subprime crisis. The US kick-started the build up of both these events but the bank was the common source of contagion for the spread.

Bank: the common source of contagion 

However, the manner of spread for each crisis is unique. SPC began with the deteriorating quality of lending and rating of the mortgages while the AFC began with the intermediation of borrowing foreign currencies and lending local currencies to local enterprises who are not utilizing these loans effectively. (Tai 2004) empirically proved that bank is a major source of contagion during the AFC. The bank could not have become the medium of both economic pandemic if regulation promptly comes in to reduce risk and contain the spread.

Effectiveness of Regulation 

Both crises present a situation that the government intention to improve welfare stirred unintended disasters. The US policy goal for increase homeownership is getting everyone to get a home by allowing low interest rates and liberating the financial market. By having consistent low interest rates and lax regulation on the derivative markets, the US policies was promoting asset value rather than promoting affordability which could be the alternative definition for increase homeownership. Prior to the AFC in 1990, Thailand in particular liberated its exchange controls in the midst of attracting foreign capital inflow to boost economic growth.

Moreover, authorities did not impose effective regulation to anticipate their policy implementations. In the US, the existing consumer protection legislation is not effectively enforced to ensure loans are given to informed borrowers who are aware of their loan payment capability. (LP) data indicates that aggregate delinquency and foreclosure rates on subprime mortgages indicate that the default rates on the 2006 and 2007 vintages far exceed the rates observed on the earlier vintages. This probably implies that the lenders are getting more lax in issuing loans. (Demyanyk 2008) data indicate that the debt service to income ratio is increasing over time, the combined loan to value ratios is rising and the falling share of fixed rate mortgages. These ratios basically mean that the lax lending practice lead to increasing risk which move from the main street to the wall street and institutional investors. Eventually the risk escalated into realized losses that cause the financial market panic that affect enterprise, which eventually lowered investment and ignited staff redundancies. In addition, the lax regulation also occur upstream of the value chain in this industry. Credit standard is a key factor for creating the SPC bubble. The US system was growing on eroding credibility of the value that the investors are buying into. (Demyanyk 2008) result indicate that a significant and systematic decline in the implicit credit standards remain after controlling other factors. The complexity of the mortgage drives inadequate borrowers to take up these loans. The structure of the mortgage bankers’ incentive is skewed to cheaply supplying the loan. Adverse selection cost is not imposed on the loan underwriter.  Although the federal trade commission is there to enforce the consumer protection laws[1] , no one was actively policing the occurrence of fraud on the mortgage market and that also reinforced the distortion of the value of these mortgages to the investors. It was after the subprime crisis, that the US Treasury proposed creating the mortgage origination commission.

Prior to AFC, Commercial banks were later allowed to authorise foreign exchange transactions without the approval of the Bank of Thailand (Rao 1998). In addition, the SEA countries did not actively monitor and regulate the capital inflow & outflow when they allowed foreign players to be significant participants in the domestic banking operation. Prior to floating the exchange rate, the SEA countries set up high interest rates to keep & attract foreign investments. Given that the ASEAN government giving high interest rates & liberating the financial sector without properly regulating the allocation of foreign investment in the private sectors, such actions prompted short term investment horizon & eventually led to the creation of asset bubble in the financial asset market. Had the government guided the direction of these capitals into sectors such as education, technology and manufacturing, the country will be able to stay competitive by offering high value added goods as competition heats up for commodity goods among China and Vietnam.

One could argue that there will be no perfect regulation and water tight supervision to guard a dynamic and evolving financial market because there will always be the moral hazard.

Moral hazard 

Moral Hazard occurs prior to SPC when Investment Banks were paying the credit agencies to rate their products. The rating of these agencies affected the value of the potential revenue of their customers so indirectly affecting their revenue given that this industry is an oligopoly. Hence there is still greater doubt on whether the agencies are impartial and independent. On the other hand, if the credit agencies get investors to pay for their rating, there would be free riding issues. This is because the bank can buy and distribute on behalf of their clients and potentially limit the earning capacity of these profit-driven agencies. Credit rating agencies can seek payment from the government or central bank but there will be market efficiency issues. Therefore this presents a dilemma for the financial market to be efficient in term of pricing risk and return of these fixed income products.

Moral Hazard also occurs prior to AFC when bank managers were lending based on political or personal interest rather than proper evaluation of risk and return (Rao 1998). Unlike the previous moral hazard dilemma, adverse selection effect can be minimised with stronger surveillance policy and audits.

With moral hazard, adverse selection and uncertainty in place, a trigger is just needed to ignite market panic.

Triggering Mechanism: 

The triggering mechanisms of these crises differ in their impact and manifestation.

 Thailand Budget deficit during the AFC was significantly lower than the US during the SPC. Yet Thailand experience significant devaluation and foreign capital flight during the AFC and that was not seen in the US during the SPC. The situation is unique for US during the SP crisis because the bulk of US Treasury bonds and foreign investment belong to China who not only depend heavily on US consumer’s economy but also has yet to develop strong domestic consumption behaviour.

The moment, investor sustain a confidence crisis that their investment are not getting expected return upon considering that the Central Bank cannot sustain high interest rate for its fixed exchange rate given excessive real estate supply and defaulting loan. Eventually a currency crisis occurred and that led to capital flight plaguing the ASEAN economies on the 2nd July 1997 after the central banks float their currencies which depreciated heavily.

The SPC was triggered by the falling house prices, rapid defaulting loans and deleveraging mortgage back portfolio. An investment banker with good credit history saw the interest rate of his loan application jumped by 5% within 3 days.(Dash 2007)

Market panic and realization of faulty assumptions commonly trigger both crises. The wrong assumption that housing prices will always rise to give a return despite potential default losses, induced SPC. The faulty assumption that ASEAN economies will continuously be progressing to support short term investment, induced AFC.

Externalities & Effect:

SPC and AFC spillovers are not evenly spread across the epicentre of its respective affected region (Janssen 2008). However, SPC has a relatively greater impact on economies than AFC in terms of spread, magnitude and penetration power. This is because SPC infected the financial system at a time in which the global market is heavily integrated via affecting the derivative market and the credit market.

 (Bird 2007) empirical results prove that the source of epidemic in the FX market is not solely Thailand even though it was first to report significant devaluation. However (Dibooglu 2006) indicated through the study of volatility of stock market during the SPC that the spread pattern of the crisis started from Thailand to Malaysia and Korea at one state and from Philippines to Taiwan and Indonesia at another state. This implies that AFC transmit via a single channel and in a geographical manner from 2 epicentres.

AFC did not significantly affect the North American economy because of strong domestic demand and low inflation rate. The America even benefits from capital flight from the AFC (Loser 1998). However, SPC affected everyone including Asia.

In addition, SPC strike in an escalating manner that spread via multiple channels and throughout the global financial systems. SP led to the derivative crunch that led to Bear Stern merged with JP Morgan at fire sale price. The derivative crunch led to the subsequent downfall of Lehman Brothers. Given the huge significant role that Bear Stern and Lehman Brothers in the derivative and custody financial market, this led to systemic credit crunch that escalate funding cost and counterparty risk that eventually led to financial market failure that marked the beginning of the New World Great Economic Recession.


Country Absolute Difference
on economic losses
(US$1 billion)
Difference of GDP
(US$1 billion)
Time of event (discounted back to 1997) at assumed rate of 5% per annum  
 Thailand -68 -40%  
 Indonesia -171 -83%  
 Philippines -28 -37%  
 Malaysia -35 -39%  
 South Korea -147 -34%  
ASEAN Countries -449 -46%  
US -5095 -43%  
Sources: (Roger C.Altman 2009), (Cheetham 1998), (CIA 2009)  

AFC generated lower absolute economic losses than the SPC but AFC generated higher % losses than SPC. Referring to the above diagram, ASEAN countries suffered US$449 billion losses during the AFC while the US suffered US$5095 billion losses during the SPC in terms of absolute difference. On the other hand, ASEAN countries lost about 46% of their GDP during the AFC while the US lost about 43% of its GDP during the SPC.


 The US originated both crises and Bank was a common medium to breed SPC and AFC. However, Bank securitization deteriorated in SPC while Bank Intermediation supported excessive short term foreign investment in AFC. Government intention to improve welfare implemented with disaster for both crises. Moreover, authorities did not impose effective regulations to anticipate their policy implementations. Authorities were lax in regulating the value chain of securitization prior to SPC. Regulations on capital flow were relaxed but could have been guided properly prior to AFC.  Even then, perfect regulation and heavy supervision were impossible to guard dynamic and evolving financial markets because moral hazard will always be present. Moral Hazard exhibited in SPC when credit agencies were paid by their clients to rate products that will affect the credit firm’s profitability. Moral Hazard also occurs in AFC when bank lending was based not on investment objectives. Nonetheless, Moral Hazard can be minimised on bank lending practices but will remain in the credit rating industry. Market panic and realization of faulty assumptions commonly trigger both crises. Victims of SPC who invest in CDO realized their stupidity when falling house prices exceed the defaulting rate while victims of AFC should have learn that short term investment works when the economy stay competitive. SPC and AFC spillovers spread unevenly across its respective affected region. AFC transmit via a single channel and in a geographical manner from 2 epicentres. AFC did not significantly affect the North American economy but SPC affected everyone including Asia. SPC furiously strike across multiple channels and throughout the global financial systems.


(LP) Loan Performance Data. First American Core Logic

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Cheetham, R., 1998. “Asia Crisis. In: U.S.-ASEAN-Japan policy Dialogue.”, School of Advanced International Studies of Johns Hopkins University June 7–9, Washington, D.C.

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Demyanyk, Y.a.O.V.H., 2008. “Understanding the Subprime Mortgage Crisis.” In: Supervisory Policy Analysis Working Paper. Federal Reserve Bank of St Louis, St Louis

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Tai, C.-S., 2004. “Can Bank be a source of contagion during the 1997 Asian Crisis?” Banking and Finance 28, 399-421

World, B., 1997. “South Asian Nations face more market weakness,top banker says.” In: Business World

[1] The Truth in Lending Act, The Homeowner Equity Protection Act, the Real Estate Settlement and Procedures Act


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