financial crisis 2008 and UK actions
Banking crisis
To have a better understanding of 2008-2009 financial crisis we need to know where does it start and why it become global issue. The main reason for this financial meltdown of the economy was the Collateral debt obligation and rating agencies who rate them.
CDO is acronym for Collateralized debt obligation. Longstaff and Arvind (2008) describe CDO as: “financial claim to the cash flows generated by a portfolio of debt securities or, equivalently, a basket of credit default swaps (CD contracts)”. To find out the main reason for this crisis, it is important to know how these CDOs work.
Figure shows how the CDOs works from Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.128, figure 8.1 Banks combine loan such as Mortgage Backed Security (MBS) and Mortgages, with different risk combinations from AAA to BB. Financial engineers gathered these CDOs in a pool to make incentives for potential investors to purchase them with lower risk. McLean, Bethany and Nocera (2010) mentioned that CDOs contain variety of loans in early 2000. But with boom in hosing mortgages, a big tranches of CDOs become sub-prime mortgages with risk level of A or BBB. But rating agencies still rate CDOs as high rating investments (Barnett-Hart 2009 sited by Lewis 2010). This financial innovation allow investors all around world to invest in US housing industry, therefore when housing bubble collapse due to sup-prime mortgages, investors face an catastrophes loss.
The question here is why it became so easy for banks to start CDOs? Usually investors with huge amount of money buy treasury bills of US which are the safest investment with AAA ranking, but after dotcom bubble, US Federal Reserve chairman, Alan Greenspan, lowered interest rate of treasury bills to 1% to stimulate economy of US and keep it strong. On the other side of this decision, borrowing money for banks became very easy with very low
To have a better understanding of 2008-2009 financial crisis we need to know where does it start and why it become global issue. The main reason for this financial meltdown of the economy was the Collateral debt obligation and rating agencies who rate them.
CDO is acronym for Collateralized debt obligation. Longstaff and Arvind (2008) describe CDO as: “financial claim to the cash flows generated by a portfolio of debt securities or, equivalently, a basket of credit default swaps (CD contracts)”. To find out the main reason for this crisis, it is important to know how these CDOs work.
Figure shows how the CDOs works from Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, p.128, figure 8.1 Banks combine loan such as Mortgage Backed Security (MBS) and Mortgages, with different risk combinations from AAA to BB. Financial engineers gathered these CDOs in a pool to make incentives for potential investors to purchase them with lower risk. McLean, Bethany and Nocera (2010) mentioned that CDOs contain variety of loans in early 2000. But with boom in hosing mortgages, a big tranches of CDOs become sub-prime mortgages with risk level of A or BBB. But rating agencies still rate CDOs as high rating investments (Barnett-Hart 2009 sited by Lewis 2010). This financial innovation allow investors all around world to invest in US housing industry, therefore when housing bubble collapse due to sup-prime mortgages, investors face an catastrophes loss.
The question here is why it became so easy for banks to start CDOs? Usually investors with huge amount of money buy treasury bills of US which are the safest investment with AAA ranking, but after dotcom bubble, US Federal Reserve chairman, Alan Greenspan, lowered interest rate of treasury bills to 1% to stimulate economy of US and keep it strong. On the other side of this decision, borrowing money for banks became very easy with very low
References: Longstaff, F. A. & Rajan, A. (2008), An Empirical Analysis of the Pricing of Collateralized Debt obligations, The journal of finance, 63(2), 529-563 Crisis Inquiry report (2011), Final report pf the national commission on the causes of the financial and economic crisis in the united states. Submitted by Pursuant to Public Law 111-21 McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010, p.120 Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, aka The Financial Crisis Inquiry Report, p.127 Anna Katherine Barnett-Hart The Story of the CDO Market Meltdown: An Empirical Analysis-March 2009-Cited by Michael Lewis in The Big Short (2010) , Barnes and Noble Lewis, M.(2010), The Big Short , Barnes and Noble