Corporate Finance 307

Topics: Subprime mortgage crisis, Mortgage, United States housing bubble Pages: 21 (7947 words) Published: September 4, 2013

Student Name / ID:Chay Yu Xi15907811
Jacqueline Teo Hui Yun15805054
Ting Heng Huat14973837

Tutor: Leo Kee Chye

Tutorial Day / Time: Monday / 2pm
Table of Contents

The Tech Bubble
Lowering of Interest Rates
Adjustable Rate Mortgage
Mortgage Backed Securities
Collateralized Debt Obligation
Credit Default Swap
Government Reaction and Policies
Future Policy
Reference List

Review of the causes of the 2008 Financial Crisis in US.

This paper seeks to summarize a stream of research that has delved into the major causes of the financial crisis in 2008. More precisely, we will be looking at a combination of causes such as the sub-prime mortgage crisis, the mortgage backed security, the collateralized debt obligation as well as how the incidental credit-default swap contributed to the incident. This paper will begin from analyzing the past, when it happened and how it built up and resulted in the financial crisis. The significance of this literature review seeks to give a simplified explanation of the financial crisis of 2008 and will be useful for the people unversed in economics or finance but wish to have a basic understanding of its causes and history.

The Tech Bubble
During the early 2000, numerous companies and individuals bought new operating systems that were Y2K-ready in fear that the “Y2K” problem would cause computer systems to malfunction. This had allowed technology companies to generate obscene amounts of revenue. At one point, the telecommunications giant, Nortel, owned one third of the stock markets in Canada (Wahl 2009). As a result, stock prices of these companies started to increase rapidly and this led to investors investing in all sorts of high tech companies, spawning the “Tech Bubble”.

The bubble eventually burst, and as stock prices began to decline, so did the value of these tech companies and many were forced to declare bankruptcy. The American Stock Exchange Index, Nasdaq, dropped from 5048.62 to 3649 (Trading Charts 2013). Along with the disruption and uncertainty after the 9/11 bombing of the World Trade Centre, the US economy took a serious hit and was plunged into recession.

Lowering of Interest Rates
In an effort to improve the situation, the Federal Reserve attempted to reduce the American interest rate drastically. Interest rates were lowered 13 times from 2001 to 2003, from 6.5% to 1.0%, causing the interest rates to be at their lowest level since 1958 (Jones, Swonk and Frank 2003).

Table 1: Federal Reserve Interest Rates from 03/01/2001 to 25/06/2003

Indeed, the primary effect of a low interest rate is that it stimulates economic activity. With lowered interest rates, the cost of borrowing becomes much lower as borrowers do need not pay as much interest as before thus are willing to borrow more money. Mortgages, car loans and other credit products can now be obtained relatively cheaper than in the past. This results in an increase of individual household expenditures on consumer products such as houses or cars.

Furthermore, the lowered rates would allow large corporations to incur less operation cost and spend more on business expenditures which in turn, allowing them to achieve a better profit margin on their balance sheets. . In addition, that an increase spending in capital goods can also indirectly lift the long-term performance of the economy (Kliesen 2010).

Another benefit of the low interest rates is that it helps to recapitalize the industry’s banking system, allowing the net interest margin (NIM). The net interest margin is a performance measure of how rewarding a firm’s investment decisions when compared to its debt situations. A positive interest margin would indicate that the firm has made an optimal decision, as interest...
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