Allecks Juel R. Luchana Group No.

6 TTh 7:30am-9:00am

The Crisis of Credit

Financial Crisis

Financial Crisis is a worldwide problem that affects everyone. As explained by the video The
Crisis of Credit by Jonathan Jarvis, the financial crisis that we are facing today is caused by a
sudden and drastic change in the normal cash movement such as when there is default on bank
loan. This started when the federal government lowered the interest rate up to 1% which
resulted to cheap credit wherein financial institutions went crazy with leverage. This
subsequently effected to critical events like bank shortage of cash available for lending and
borrowing.

Systematic Risks in the Financial Market

Sub-Prime Mortgages

Sub-Prime Mortgages are new mortgages from defaulted prime mortgages that are acquired by
the lenders. These mortgages are covered by defaulted owners so the lenders can start adding
risks like not requiring down payments, no proof of income, no documents at all. These sub-
prime mortgages are subsequently offered or issued to borrowers with low credit level.

Collateralized Debt Obligations

Collateralized Debt Obligations are cash flow generating assets such as mortgages, bonds, and
other types of debt, that are gathered by investment banks which are later on divided into
classes – safe, okay, risky – based on the level of credit risk assumed by the investor. To
compensate for higher risks, the bottom class receives a higher rate of return while the topmost
class receives a not so low rate of return.

Frozen Credit Markets

There is a frozen credit market when financial institutions such as banks cannot anymore
extend credit to individuals or businesses which would result to economic recession and other
drastic measures.
Credit Default Swaps

In collateralized debt obligation, the topmost class which is the safe class a not so low rate of
return, to make the top even safer banks will ensure it for a small fee called a credit default
swap. It is a contract that allows an investor to swap or offset his or her credit risk with that of
another investor (Investopedia, 2020)

Financial Instruments and Markets that are greatly affected

Everyone is affected but it greatly affected the home-owners, mortgage brokers, mortgage
lenders, investment banker, and investors. This is when home-owners contact the mortgage
brokers which connects the family to a mortgage lender who gives the home-owners a
mortgage, the brokers then makes a nice commission. Then the lender sells the mortgage to an
investment banker who wants to buy the mortgage for a very nice fee. The investment banker
then borrows millions of dollars and buys thousands more mortgages and collateralized all
these debt obligations. This means that every month, he gets the payments from all home-
owners of all the mortgages. The investment bankers then sell the CDO to different investors
depending on their risk capacity. In other words, all these financial instruments and markets are
interrelated which means, what can affect to one, can affect to all.

Too Little Regulations

Regulation of the financial markets was too little. There should have been a limit as to when
and where large financial market participants should invest their money. Financial sectors
should focus more on protecting consumers from economic harm, which is a topmost priority
of other firms. This is so that households do not become collateralized debt obligations because
of the decisions of financial players who are supposedly knowledgeable of the risks behind
financial investments. Consequently, financial sectors or firms must be required to take full
responsibility of the consequences of their actions prioritizing the protection of their consumers
from unintended consequences.

Preventive actions

Consumers as well as financial institutions and market participants should’ve limited their
investments not going beyond their maximum capability. In this case, they should have not
suffered great loses and prevented themselves from drowning in debts. Also, proper regulation
should’ve been observed so as to not deny consumers sufficient access to credit. Moreover,
consumer literacy should’ve been improved as well as restricting consumer leverage.
Consumers perhaps didn’t have sufficient knowledge about the risks of being leveraged and
they might’ve underestimated the financial burden of opting for sub-prime mortgages. If only
consumer literacy was improved, they could’ve made better and prudent financial decisions.

Learning Points

First, I learned how money moves in the financial system and the factors that can affect
possible changes of this movement. Second, I learned all about the financial market participants
who play a huge part on the circulation of money. And lastly, I learned that investing on an
asset without taking into considerations the unhealthy risks that it comes with, and not being
knowledgeable enough about how the financial system works can lead to a non-ideal economy.