Sherman Oh E S
Principles of banking & finance (PBF)
Mr Marvin Ang
26th January 2013
According to www.investopedia.com, the world “subprime” defines to “A classification of borrowers with a tarnished or limited credit history” and that is what led to the titanic crisis of 2008-2009. This essay will explore the events, which eventually led to many mortgage delinquencies and foreclosure of these sub prime borrower’s homes, causing the insurance company AIG and many other banks to foreclose thus forcing bail out money from the American government to prevent the next great depression.
In the past, traditional mortgage loans that could be acquired from the banks could only be loaned under the grounds of the borrower’s financial status and credit rating. If one did not have good credit rating, the bank would not be able to give him a mortgage loan due to fear of defaults from the customer. Sub prime lending however was different as the borrowers usually had bad credit rating and poor financial status. As such, sub primes loans were higher in risk but also in profit as lenders charged higher default interest rates accordingly.
To understand what caused the sub prime crisis, we have to look back to the year 2001 after the dot com bubble bust where Alan Greenspan who was Chairman of the Federal Reserve lowered interest rates to 1% in hopes of causing a housing boom and steering the economy away from another recession. These low rates injected a lot of excess money in the economy and caused a housing boom. In addition to that, the Gramm-Leach-Bliley Act that was already in place by the Clinton administration in 1999 had already created many new bigger banks such as Citigroup, Bank of America and J. P. Morgan Chase, huge banks that owned many brunches, bought and sold stock and lead corporate mergers. With such a sudden surge of increase of money, banks were now trying to come up with new ways lend out more money to push additional revenue. Their answer to it was sub prime loans. Before all this, it was practically impossible to borrow money from the bank if you were a sub prime borrower with bad credit rating but with this new lowered interest rate it was now easy to get such a loan as the bank would simply charge the loan at a higher default rate. That being said, many sub prime loans where issued to individuals who were unable to pay the mortgage or could not pay their mortgage in the future, but who could blame them? With good times in the economy, investors expected better returns. As long as the money expansion continued, investors believed that prices of their equity will increase and betting against it would be a losing proposition. The banks then started to target this group of sub prime lenders and developed a market for sub prime loans. This made banks and traders very rich. An estimated $3.2 trillion in loans were made to homeowners from 2002 to 2007. Now a question will come to mind on why would any bank want to lend out sub prime loans? The risk is high and the odds of the lender being able to return the money is low. The banks seemed to follow a greater plan that was going into play and that plan was none other then the creation of the new derivative known as collateral debt obligation (CDOs).
CDOs were a new form of derivative where banks could sell off their mortgages in bundles to investors in forms of bonds. These CDOs were under the heading of asset-backed bonds meaning that financial assets backed them. Do not be fooled when the words assets and bonds. Those are just miss-leading words to assure people they were doing the right thing. How these CDOs worked would be that the sub prime loans would be mixed in with prime loans (loans which had good credit ratings) and sold off to investors in a single investment for other banks and organizations to buy. These CDOs had a false sense of security as no one...