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Financial instruments responsible for Global Financial Crisis

Financial instruments responsible for Global Financial Crisis

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Published by abhishek gupte
following is a report on the financial crisis of 2008 , how Credit Default Swaps , Mortgage Backed Securities ,Collateral Debt Obligations and Leveraging were responsible for the crisis . This article is written in very simple words with the help of examples so that even a layman can understand why this crisis happened and how it could have been avoided .
following is a report on the financial crisis of 2008 , how Credit Default Swaps , Mortgage Backed Securities ,Collateral Debt Obligations and Leveraging were responsible for the crisis . This article is written in very simple words with the help of examples so that even a layman can understand why this crisis happened and how it could have been avoided .

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Published by: abhishek gupte on Mar 23, 2009
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01/30/2013

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The
global financial crisis of 2008
is a major ongoingfinancial crisis, the worst of its kind since theGreatDepression.In the following report I have explained how a series of events inthe US resulted in the ongoing financial crisis. The financialinstruments (mortgage backed securities, collateral debt obligations,credit default swaps) that resulted in the stock market crash in the USand subsequently in the rest of the world were outside the regulatorypurview of the Fed. Each and every thing that happened in the USmarket is linked and could have been avoided.Following the dot-com boom bubble burst and the stock marketcrash in 2000, the US economy went to recession in 2001. The tragicevent of September 11, 2001 further boosted the market decline. As aresult of this downturn in US economy the Federal Reserve reduced thefederal fund rate in order to stimulate demand. Credit was madeavailable to the people on a large scale at that time however they didnot realize at that time the consequences of such a monetaryexpansion. The lower interest rates increased demand for housing andbig ticket items. People were able to take loans from banks at very lowrates of interests.Because of this monetary measure in 2001 the demand for thecommodities increased right from 2001 to 2006 but the supply did notincrease proportionately, because of this the excess demand wasimmediately passed on to the prices and there was an increase in thegeneral level of prices (or increase in inflation). In order to counterinflation the FED raised short term interest rates. During the period of 2001 when loans were available at low rates, the banks gave loans topeople who were deemed subprime or under banked. subprimelending” is a term that has been popularized by the media during thecredit crunch of 2007 and involves financial institutions providing creditto borrowers deemed "subprime. Subprime borrowers have aheightened perceived risk of default, such as those who have a historyof loan delinquency or default, those with a recorded bankruptcy, orthose with limited debt experience. In the US borrowers are deemedas subprime when their FICO score (creditworthiness) is below 660.These subprime borrowers started defaulting on their loans on a verylarge scaleAs a result, the banks started to foreclose (law to take possession of property bought with borrowed money because repayment has notbeen made) on the mortgage-defaulted homes. Most foreclosed homes
 
were worth less than their loans’ balance when their prices fell. Forthat reason the banks had to short sell them. That means the bankssold the houses for less than their loans’ principals and took thelosses. 
An example of a foreclosure in US which rose 55 % in 2008HOW DID MORTGAGE BACKED SECURITIES BRING DOWN THEUS ECONOMY?
In 2008, the United States teetered on the brink of financial disaster.Unemploymentlooked to reach its highest levels in two decades.Homeowners defaulted on their loans in record numbers. Enormousinvestment banks that had been in business for more than a centuryand had endured TheGreatDepression faced collapse. The economy,in other words, went belly up. Every last part of this looming economicdisaster was due to a unique financial instrument called the mortgage-backed security. 
Now what is a mortgage backed security?
 Let me tell this to you by giving an example.Countrywide Financial Corporation, (CFC) the Brown family and Bankof America (BOA) are the 3 parties in this example.The brown family purchases a house with a loan of $200,000.Countrywide Financial Corporation loans out the money to brownfamily through the Bank of America, here Countrywide FinancialCorporation receives commission on the business that they gave to the
 
Bank of America. Countrywide Financial Corporation in itself does notfund the loan through its deposits, instead it securitize's the loan, andsells it to Wall St investors, hedge funds and commercial banks. Theinvestors used to get dividends on mortgage backed securities in theform of monthly installments which the borrowers of loans used to giveto the banks.A pooling of mortgage only related loans is called as
MortgageBacked Security
akin a bond
.Collalterized Debt Obligation
(CDO)– this can be defined as apooling of not only mortgage related loans but also credit card loan of family X , subprime loan of family Y and so on.
Here is a small example
A CDO is bought by a bank in Norway; the bank does not know itsassets. I.e. it does not know the underlying asset of the CDO.It knows the CDO is rated AAA by Moody's. Alls well until the "asset"backing the securitized product hits a wall. I.e. there may be default ininterest payment by the borrower. So the bank in Norway has to writedown the value of such assets which reduces their capital ratio and inturn affects their ability to give loans.
One question that you might get is by packaging and sellingthese MBS’ and CDO’ how does CFC and BOA get affected?
- One thing to note is that the deposit money that is lended out tothe borrower is not of Countrywide Financial Corporation but it is of BOA. So Countrywide Financial Corporation only sells the loan to us. Itacts like an intermediary. It sells the loan to us at a rate of interestwhich is higher than rate of interest at which BOA sells. The differencein rates of interest is CFC’s profit .CFC also gets a good commissionout of the securitized product (MBS) that it sells on Wall Street. All wasperfectly fine until defaults started happening and because of defaultsthe portfolio of securitized products of Countrywide FinancialCorporation reduced in value and it had to further bear the losses of the defaults that were taking place in home loans. All this had acascading effect and Countrywide Financial Corporation and Bank of America suffered huge losses.Home loans in 2008 were so divided and spread across thefinancial spectrum, it was entirely possible a given homeowner couldunwittingly own shares in his or her own mortgage. A person whobought a new home in January 1996 for $155,000 could reasonably

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