The Global Financial Crisis
The global financial crisis which started in early 2007 has proven to be perhaps the great financial catastrophe in history. Although it traces its roots back to the starting of the millennia, the subsequent meltdown was most gruesome over the past 3 years. What began as a crisis of the sub-prime mortgage market in the United States quickly transcended national borders and developed into a upheaval of epic proportions. What ensued was a systematic debacle of stock exchanges, investment banking, derivatives etc. all financial markets ranging from equity, currency, real estate, futures etc.
In order to fully understand the devastation caused by ...view middle of the document...
This was augmented by the rise in prices of the housing sector due to demand pressures. Thus banks were successfully convincing customers to engage in credit facilities as the market prices seemed to show substantial hikes in value.
Consumers were so busy buying houses that they missed the interest charge they would have to bear over the years. The structure of such contracts was that the first 2 years would be a fixed, flat rate, after which the rate mechanism would be ARM. Thus banks succeeded in creating a large pool of assets associated with high risk profiles. As Malhar Nabar from Wellesley College points out in his article US Policy Response to the Financial Crisis, “The lending boom and the increase in house prices that it supported resulted from a combination of factors – a build‐up of liquidity in financial markets and a subsequent “search for yield” in a low interest rate environment, the erosion of lending standards, and the deterioration in the metrics used by credit‐rating agencies to rate the financial securities involved.
Asset Securitization of Sub-Prime Loans
The banks that were lending in the sub-prime market were also busy in another set of transactions, one of which was passing on the risk of these assets to other institutional investors. The process of securitization involves the restructuring of a pool of assets including loans, real estate into viable investments. In this case, mortgage-backed securities and collateralized debt-obligations were the instruments utilized. Investment Banks and various financial corporations’ purchased these instruments with the understanding they were safe investments. These included investors from the US, the EU and some parts of Asia. Extremely complex derivatives were employed to mask the risk profiles of the assets, such as credit default swaps. Off-balance sheet items were increasing, known as SPVs’ or Special Purpose Vehicles where bad loans and defaulting assets were parked as a separate entity so that the parent company seemed to be doing prosperously.
When the interest rates in the US were raised in 2007, the consumers using the ARM mechanism started to default on payments. As the delinquency ratio increased for the market, the banks that had given the loans started charging more risk premium. This in turn increased the defaults. At the same time, the housing bubble came crashing down and prices of real estate fell drastically. Customers who planned to use the house they had loaned to repay the debt in case of defaults now realized that their houses had lost a significant proportion of its value. With the asset now worthless and the debt obligation constantly rising, the housing bubble became a nightmare for the consumers.
On the other hand, the institutional investors who had purchased the CDOs’ and MBSs’ now realized that they’re money had eroded overnight. Due to this revaluation of the asset value, Bear Stearns, a Financial Powerhouse, lost approximately $5 billion...