The financial crisis began in early 2006 when the subprime mortgage market in the U.S. began to display an increasing rate of mortgage defaults. These defaults lead, in late 2006, to a decline in US housing prices after nearly a decade of exceptionally high growth. Many Americans watched as their primary source of wealth become increasingly devalued. By late 2007, the prime mortgage markets were showing higher than normal default rates as well.
Collateralized Mortgage Obligations (CMOs), a type of collateralized debt obligations (CDOs), allowed these problems to spread from the mortgage market to other sectors of the economy, having especially widespread effects on financial markets as a whole. CMOs were mortgage-backed securities issued by investment banks and other financial institutions, which since they were not part of the commercial banking system, were allowed to operate unregulated by the federal government. As the value of mortgages fell due to increasing default rates, the value of these securities fell likewise.
The problem was compounded by another financial product, the Credit Default Swap (CDS). CDSs were nominally insurance contracts on CMOs, but they became a tangled web which dragged the financial system down as sellers of CDSs bought matching CDSs to protect themselves against default risk until nearly all the players in the investment banking market were linked together by these liabilities.
These CMOs and CDSs became the infamous “toxic assets”. The defaults in the mortgage markets caused a collapse in the value of the corresponding CMOs, which created a cascade of additional problems as the multitude of CDSs were executed, dragging down the balance sheets of the major players in investment banking. It was this that lead to the freezing of private credit markets. The collapse in value of CMOs lead to a significant problem: since no one was trading CMOs, it was no longer clear what they were worth. The financial system is...
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