Financial Crisis and the Effects on the Credit System from the Investor Perspective - Research Paper Example

With the repeal of the “Glass Steagall Act” the distinction between the commercial banks and investment banks was removed. Together with it, the dream of the US Presidents, for every nation to own a ‘dream home’ forced the banks to direct credit to the sub-prime borrowers. The sub-prime borrowers are the borrowers with a poor credit record. Previously these borrowers were shut out of mortgage lending. But with the introduction of the innovative “Adjustable Rate Mortgages (ARM)” this class of borrowers also became eligible for loans.

In this type of mortgage, the interest rates which were low initially and were re-set later. This type of credit increased the number of sub-prime borrowers which was further accelerated by financial innovations like “securitization”. In a securitization, the mortgages were pooled into packages and the securities with the packages as the ‘underlying’ were sold to the investors. The investment banks and the private commercial banks packaged the sub-prime mortgages into “Collateralized Debt Obligations (CDO)” and divided the cash flows into tranches based on the risk tolerance level of the various investor classes.

In addition to this protection insurance like “credit default swaps” were sold that would compensate in the event of a loan default. But the CDS sellers kept aside little capital to cushion their transactions. By this way, the institutional investors’ funds were transmitted to the booming housing market.These financial innovations flourished owing to the lax monetary policy of the Federal Reserve and regulatory failure. The low rate of interest and lack of regulation encouraged the financial institutions to increase the leverage to purchase the mortgage-backed securities.

In the off-balance sheet items of the banks, entities like Structured Investment Vehicles (SIVs) were created for purchasing mortgage-backed assets, as these items are not subjected to capital requirements.