What caused the financial crisis

The US $ 700 bailout package proposed by the US government is one of the most extensive government interventions in the financial markets since the great depression. The bailout plan is similar to the 1933 Home Owners' Loan Corporation of the post-depression era. Way back in 1933 it helped in stopping foreclosures and refinance defaulting mortgages , and increasing liquidity . That a similar proposal is being considered indicates the extent of damage caused to the banking and financial services systems all over the world.

Excessive leverage

But how did the banks and investment banks create this crisis? Let's cut through the financial jargon and understand in simple words how this problem was created in the first place. The root cause for the current crisis seems to be the excessive use of leverage.

To take an example, a company with a net worth of US$ 25 billion borrowed 26 times its net worth and creates leveraged funds of US$ 650 billion to invest or lend them. When a small portion of the company's investments turns bad, as is the norm for the industry, the company's capital is under threat. To put things in perspective a 3.8 percent misjudgment in their books was enough to wipe out their shareholders' capital of $ US 25 billion.

Bad lending policies

In 2005-07 the property markets were on a high growth path. The property prices kept increasing. A sense of complacency had set in the real estate markets . It was assumed that the residential property prices would keep increasing forever. Mortgage lenders relaxed lending standards. Billions of dollars of sub-prime loans were to given borrowers with the sketchiest credit histories on recommendations of mortgage brokers who were more interested in their commission.

Loans were structured very innovatively. Some gave borrowers the ability to skip repayments and some had interest rates that rose over the life of the loan. Lenders were not worried about repayments as defaults if any, on loans, could be recouped from the property itself.

Contrary to this assumption, the property bubble burst leading to sharp depreciation in property prices. As loans were given to people who could not repay it in the best of time, mortgage repayments defaults kept increasing, triggering off a chain of events that led to the bankruptcies of the hallowed institutions of Wall Street.

Financial engineering

Now you may ask how investment banks of the Wall Street who generally deal in investments in stocks, bonds and commodities have anything to do with mortgage loans. To understand this we move into the realms of financial engineering. Wall Street investment banks purchased the mortgages from the banks. This freed up banks' funds to lend more and gave the investment banks an underlying asset to create their financial magic.

Using these assets as collateral, they created derivative instruments and sold them to various institutional investors like hedge funds, pension funds, mutual funds and banks in all parts of the globe, including Europe and Asia. The instruments were to be redeemed as and when mortgage payments were received from borrowers.

The mortgages were categorised according to their quality. The good ones were pooled together under one derivative instrument. After being highly rated by credit rating agencies and insured from insurance companies these instruments were sold to institutional investors.

Reproduced from The Economic Times, Oct 5, 2008

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