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Debt Crisis - Essay Example

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United States Debt Crisis Introduction The debt crisis began when the Federal Reserve slashed interest rates to 1% after 9/11 and the Dot com bubble burst, to boost the US economy. 1% was a very low return on investment. However, this meant that banks could borrow at very low rates…
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Debt Crisis
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Download file to see previous pages The debt/equity ratio increased from 15:1 to 30:1 after the US Securities and Exchange Commission allowed shadow banks to borrow as much as their own risk management departments considered prudent. So while commercial banks formed only 40% of total lending, shadow banks accounted for almost 60%. Banks borrowed a ton of money, made great deals and grew tremendously rich. They then paid back the borrowed money. Investors saw this and wanted a part in it. This gave banks the idea to connect investors to home owners through mortgages. Because real estate had been doing so well, investment banks were interested in buying the mortgage. The lender agreed to sell it to them for a fee. The investment banks then borrowed heavily, bought more mortgages and collected them in a box. The bank then cut the box into 3 slices: Safe, Okay, and Risky. It packed the slices back up and called it a Collateralized Debt Obligation (CDO). A CDO works like three layers. As the money comes in from homeowners paying off their mortgages the top tray fills first then the rest goes into the middle and the remainder goes into the last tray. If owners are unable to pay their mortgages, fewer payments are received and the last tray remains empty. For taking more risk, the lowest tray receives a higher rate of return as compared to the first tray which receives the lowest rate as it is the safest. Banks insured these slices for a minor charge called a Credit Default Swap (CDS). Credit rating agencies rated the top as a safe AAA investment and the middle as BBB. Because of the ratings, the investment banker could sell the slices to investors with different risk preferences. They made millions through this, and then repaid the loans. Since investors were making a lot more than 1%, they wanted more CDOs, investment banks wanted more mortgages and the demand for mortgages rose. They then approached the subprime market because if the homeowners defaulted on their mortgage, the lender would get the house which would increase in value. They started giving mortgages without requiring down payments, proof of income and any documents at all. These mortgages were Adjustable Rate Mortgages. The mortgage payments were attractively low during the initial period but they increased exponentially after the teaser period. As a result, from 2004 to 2006, the subprime mortgages accounted for approximately 1/5th of the overall mortgage market. Eventually the subprime borrowers started defaulting after the teaser period. The bank that was now the owner of the house went into foreclosure and put the house up for sale. Eventually, more houses went up for sale. Now there were so many houses for sale, increasing supply, causing house prices to fall, rather than rise. This created a problem for homeowners who continued to make their mortgage payments. The value of their houses began to decline as the number of houses for sale in the market increased. People refused to pay their mortgages. Default rates increased exponentially and prices nosedived. Consequently the value of CDOs which were backed by these mortgages also fell. Investment banks tried to sell the CDOs but there were no buyers. Through CDOs the problem spread to other financial markets. The problem was further compounded by CDS because sellers of CDS bought CDS from others to protect themselves. The Secondary market for subprime CDO trading halted because of lack of buyers in the market. Private financial institution refused to lend any cash ...Download file to see next pagesRead More
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