Discussed in this essay will be key factors that played in the development of the financial crisis of 2007, an overview of the causes and instruments used to the build up and possible preventions, followed by the influences from the government, if any that had an underlining effect toward the outcome. The Involvement Of New Bank Innovations Bank capital has a massive influence on the banking system effecting loan defaults, profits and lending, although the amount of outstanding lending has not decreased appropriately in early 2007, not being due to new lending but the previous loan commitments, lines of credit and securitisation. . New innovations have allowed banks reliant on funding market sources, with the rise in the covered bond market and the increase in securitisation made banks dependant on capital markets and less dependant on expanding their loan base allowing banks to easily switch deposits to other forms of financing, acquiring funds from affiliates for example.
2 Growth in securitisation activity created a lack of incentive for banks to grant credit and comply with monetary policy changes, an unregulated approach to the screening of borrowers, checks would assume securities passed through the market allowing borrowers in the past declined credit being able to qualify and later on would lead to greater default rates on loans.
Thinking that by selling the pool of mortgages banks are also passing on the risk, they exposed themselfs , their underwriting issuances, when the market collapsed banks suffered great losses with their related products, by the start of 2008 CDO related write downs and credit losses had reached $181 billion the massive decline lead to more cautious investors, greater liquidity demand and declining stock, this resulted in massive losses to the bank and securities firms, an example would be the collapse of Bear Stearns and Lehman Brothers using these examples shows how complex the system was and lead to the decline of CDO value this had a direct relation to the US housing market which began early 2007. Derivatives And Insurance The market for subprime mortgages and their securities grew and increased the market for default insurance, taking the form of credit default swaps a derivative security such as the insurance industry this involves gambling, and is estimated $16 trillion greater then the gross domestic product.
Government sponsored companies like Fannie Mae refused to lend to buyers wanting to purchase homes in poor areas, agreeing to these terms they would have to show proof, distributing quotas of mortgages to ethnic minorities wishing to buy, when lenders were unable to meet these quotas Fannie Mae and Freddie Mac persuaded lenders to buy subprime mortgages. A poor investment which was made worse by the fact that charges to subprime borrower were at a higher interest rate increasing the risk of default, for lenders it didn’t matter the worth of the investment just as long as they could sell to the secondary mortgage market. Fannie Mae and Freddie Mac packaged mortgages to sell the securities solely based on mortgage payments from the mortgages accumulated, creating securities based on the initial first/last claims of mortgage payments.
These companies showed a small profit margin using securitisation but were soon to lose after paying over the odds on subprime mortgages and not enough on the default insurance they provided. 4. The resell of a mortgage to a secondary market is commonly known as a mortgage backed security which is often bought by a hedge fund, which then takes out parts of the MBS from the 2nd or 3rd years of the interest only loans, this creates a greater risk but provides a high interest payment, using CDOs with other MBS to then resell to other hedge funds this is known as tranche, profitable until housing prices decline or interest rates restart, making mortgages default.
Mortgages provide substantial value for derivatives, if the substantial value is classed as corporate debt, credit card debt or auto loans the derivative known as CDO, a payment that is due within a year, for instance insurance it can then be known as a CDS, a complicated market to value, unregulated by the SEC means that a lack of rules and oversights were unable to encourage trust and when bankruptcy occurs results in fear amongst the hedge funds and the banking system. Credit Rating Agencies Credit rating agencies share a fair amount of blame for the financial crisis, very little regulations regarding rating methods and lack corporate governance. The past 2 years changes in the rating system of structured redit has grown evermore unstable and has created a lack of confidence toward the future stability of credit ratings. CRAs lowered credit risk by applying AAA ratings to tranches like that of CDOs, giving the same ratings to government and corporate bonds creating lower returns, poor rating assessments underestimated credit default risks of subprime mortgages, providing unreliable data relating to the subprime market and underestimated relations in the defaults that would occur in a downturn, and with more securitisation meant greater portions of credit assets were held by investors assured by credit ratings, increasing the effects of forced selling by corporations using standard investment rules based on ratings.
5. Hedge Funds. The hedge fund industry has grown over the past 2 years, fueled by the demand of higher returns from stock market declines and mounting pension fund liabilities, these inflows have had a positive effect on hedge fund returns and risks in recent years, this has been evident in the changes in reduced performance, increased illiquidity, hedge funds were designed by wealthy investors to work anonymously. At times of financial uncertainty rates on low credit illiquid investments, demand for high credit liquid investments, accompanied by the increase in credit spreads lead to greater margin calls and the relaxing of illiquid positions which generate further losses concluding the hedge fund collapse, these funds relied heavily on leverage and used to buy mortgages, as soon as loans were to default, 9investors left and were faced with abrupt liquidation.
Credit spread is the strongest to affect hedge funds and during the crisis they were left with contact to emerging markets and convertible bond arbitrage. Hedge funds have been effected by the instability of the current financial market, bans on short selling, downturn on asset values in markets, the decline to take risks through banks and investors, The banking system is also affected through hedge fund risk from proprietary trading activities, credit arrangements, structured products and prime brokerage services. 6. The government played a part in the crisis in a number of ways, Interest rates were kept below guidelines globally prior to 2007 the unregulated structure of how mortgages were packaged and low risk assessment lead to the ise of house prices and the involvement towards the persuasion to buy MBS with Fannie Mae and similar companies which lead to their bankruptcy. 7 Due to the unpredictable downturn of the situation in late 2007 with complex financial products, a lack of equilibrium in credit ratings, bans and the premature sell out of investors in hedge funds, has created a domino effect in the financial market and resulted in the governments failure to identify the real issues in the collapse, polices associated with liquidity were put forward to only create matters worse, and finally realising the failure of the subprime mortgage market the Troubled Asset Relief Program was brought forward to no effect.
The unregulated banking system created instability and was inevitable for the bailouts of banks and failing companies. The government had very little influence toward the preventions of the crisis and that in turn made them heavily responsible for each factor described above, the lack of regulation and constraints to which resulted in massive cash bailouts with no conditions, this worked as an incentive for the banks to continue as they were, this is evident in the continuation of bonuses despite substantial losses with banks the governments generosity with bailouts allowed companies like Goldman Sachs to put $2. 6 billion aside for bonuses from a $13 billion bailout.
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