Financial Crisis 2007-2009 Summary

Topics: Subprime mortgage crisis, Debt, Collateralized debt obligation Pages: 2 (568 words) Published: November 27, 2011
The financial crisis of 2007-2009 is an economic fiasco of global magnitude. It affects everyone. To understand how it happened one needs to go back a few steps. Years ago, after the dot-com bust and 9/11, borrowing money was cheap. Federal Reserve Bank chairman Allen Greenspan lowered interest rates to 1% to keep the economy strong. Treasury Bills were considered the safest investment, but due to low return, investors stayed away. Banks however were able to borrow enormous amounts of money on credit. They invested it and Wall St became extraordinarily rich. This is when investors became curious and expressed their interest in these procedures. Consequently, Wall St had the idea to connect investors with home owners. It works as follows. First, mortgage lenders lend money to families in order for them to become home owners. They buy a house. Secondly, the lender sells the mortgage to an investment banker. Then, the banker borrows millions of dollars and buys thousands more mortgages. This means, every month he gets payments from all the home owners concerned. After that, he collects the mortgages in a so-called “CDO”, a collateralized debt obligation. This CDO is split into three different risk classes, from safe to mediocre to risky. Additionally, he insures the safest part for a fee, called “credit default swap”. In so doing, credit rating agencies give the investment a “AAA” rating. What follows, is that the individual tranches of the CDO are sold. The banker sells the safest to investors and the mediocre tranch to other bankers. The risky one goes to hedge funds and other risk-takers. In the end, the investment banker earns millions. However, the investors want more. So, the investment banker contacts the mortgage lender. But, everyone who qualifies for a mortgage already has one. Hence, the following idea emerges. The mortgage lender is covered if a home owner defaults on his payment. That is, the lender then receives the house. Therefore, he can afford to...
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