Short Review of the 07-09 Financial Crisis

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Short Review of the 07-09 Financial Crisis

The 2007-2009’s financial crisis started with the development of the subprime mortgage in the United States housing sector. The sub-prime mortgage followed an originate-to-distribute model whereby the mortgage originators did not have much incentive to make sure the loans were paid back. This led to the principal-agent problem whereby the agents (sellers of the mortgage) had incentives to (loan) sell off as many of these subprime mortgages as possible without determining whether the households the loans were being given to were bad credit risks. There was also not a lot of collateral on the loans; the only collateral was the house which borrowers could just walk away from if they could not meet the payments on the loans. These subprime mortgages were then securitized into assets called CDO’s, these securitized assets were certified as investment grade quality by the rating agencies and traded by investment banks. The CDO’s had become quite distributed and some banks such as the Lehman Brothers had kept a large inventory of them in their portfolios. Due to the increased ease with which the subprime mortgages could be bought by everyone and the relatively little risk for them, the demand for housing had increased dramatically and with the increased demand came increased prices. This high price was all artificial as the loans had no backing and in retrospect in referred to as a “housing bubble”. Once people started defaulting on their payments- which was to be expected given the fact that the mortgage agents had not bothered to check whether people had enough income to support the payments or not- and others realized that the houses were overpriced the bubble burst and house prices came down to their fundamental economic values. There was a realization in the market that these mortgages could not be paid back and there was deterioration in financial institutions’ balance sheets and reduction in their net worth’s,...
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