2007-2008 financial crises
TRANSCRIPT
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The 2007-2008 DebtCrises
The Worst Economic Crisis that Spread
like epidemic.Ahmed Faizan
Ahmed Faian ! St"dent #d$ %&&&7
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The 2007-2008 Debt Crises
Table of ContentsCore 'eport
#ntrod"ction................................................................................................................(
)art #$ *o+ We ,ot *ere.............................................................................................
)art ##$ The "bble.................................................................................................... %2
The ori/ins o the ho"sin/ b"bble......................................................................... %(
The second phase o the ho"sin/ b"bble..............................................................%(
The access o ho"sin/ b"bble............................................................................... %&
The Financial Contrib"tor o the "bble................................................................%1
)art ###$ The Crisis......................................................................................................2%
Declines e/in....................................................................................................... 2%
The andslide e/ins- Time ine...........................................................................22
The Wa3 For+ard................................................................................................... 2&
E4ect on )akistan..................................................................................................21
S"pplementar3 'eadin/$
S3nopsis
)art #$ *o+ We ,ot *ere
)art ##$ The "bble
)art ###$ The Crisis
#mportant Terminolo/ies Disc"ssed
"bble Econom3$
S"b-prime mort/a/es$
Foreclos"re$
Collateralied Debt 5bli/ation 6CD5$
*o+ #t WorksE9ample$
*ed/e "nds$
:ort/a/e-acked Sec"rities$
Ad;"stable-'ate :ort/a/e ! A':$
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The 2007-2008 Debt Crises
Credit Dea"lt S+ap 6CDS$
==========================================.
Introduction The nancial crisis of 2007–2008> also kno+n as the lobal
Financial Crisis and 2008 nancial crisis> is considered b3
man3 economists to be the +orst ?nancial crisis since the ,reat
Depression o the %@(0s. #t res"lted in the threat o total collapse
o lar/e ?nancial instit"tions> the bailo"t o banks b3 national
/oernments> and do+nt"rns in stock markets aro"nd the +orld.
#n man3 areas> the ho"sin/ market also s"4ered> res"ltin/ ineictions> oreclos"res and prolon/ed "nemplo3ment. The crisis
pla3ed a si/ni?cant role in the ail"re o ke3 b"sinesses> declines
in cons"mer +ealth estimated in trillions o BS dollars> and a
do+nt"rn in economic actiit3 leadin/ to the 2008!20%2 /lobal
recession and contrib"tin/ to the E"ropean soerei/n-debt crisis.
The b"rstin/ o the B.S. ho"sin/ b"bble> +hich peaked in 2001>
ca"sed the al"es o sec"rities tied to B.S. real estate pricin/ to
pl"mmet> dama/in/ ?nancial instit"tions /loball3. The ?nancialcrisis +as tri//ered b3 a comple9 interpla3 o policies that
enco"ra/ed home o+nership> proidin/ easier access to loans or
s"bprime borro+ers> oeral"ation o b"ndled s"b-prime
mort/a/es based on the theor3 that ho"sin/ prices +o"ld
contin"e to escalate> "estionable tradin/ practices on behal o
both b"3ers and sellers> compensation str"ct"res that prioritie
short-term deal o+ oer lon/-term al"e creation> and a lack o
ade"ate capital holdin/s rom banks and ins"rance companies toback the ?nancial commitments the3 +ere makin/.
The !nited "tates housin# bubble is an economic b"bblea4ectin/ man3 parts o the Bnited States ho"sin/ market in oerhal o American states. *o"sin/ prices peaked in earl3 2001>started to decline in 2001 and 2007> and reached ne+ lo+s in
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20%2. 5n December (0> 2008 the Case-Shiller home price inde9reported its lar/est price drop in its histor3. The credit crisisres"ltin/ rom the b"rstin/ o the ho"sin/ b"bble is accordin/to /eneral consens"s the primar3 ca"se o the 2007!200@
recessions in the Bnited States.
#ncreased oreclos"re rates in 2001!2007 amon/ B.S.homeo+ners led to a crisis in A"/"st 2008 or the s"bprime> Alt-A>collateralied debt obli/ation 6CD5> mort/a/e> credit> hed/e"nd> and orei/n bank markets. #n 5ctober 2007> the B.S.Secretar3 o the Treas"r3 called the b"rstin/ ho"sin/ b"bble themost si/ni?cant risk to o"r econom3.
The collapse o the B.S. *o"sin/ "bble had a direct impact not
onl3 on home al"ations> b"t the nationGs mort/a/e markets>home b"ilders> real estate> home s"ppl3 retail o"tlets> Wall Street
hed/e "nds held b3 lar/e instit"tional inestors> and orei/n
banks> increasin/ the risk o a nation+ide recession.
The immediate ca"se or tri//er o the crisis +as the b"rstin/ o the Bnited States ho"sin/ b"bble +hich peaked in appro9imatel3200!2001. Alread3-risin/ dea"lt rates on s"bprime andad;"stable-rate mort/a/es 6A': be/an to increase "ickl3thereater. As banks be/an to /ie o"t more loans to potentialhome o+ners> ho"sin/ prices be/an to rise.
Eas3 aailabilit3 o credit in the BS> "eled b3 lar/e ino+s o orei/n "nds ater the '"ssian debt crisis and Asian ?nancialcrisis o the %@@7!%@@8 period> led to a ho"sin/ constr"ctionboom and acilitated debt-?nanced cons"mer spendin/. a9lendin/ standards and risin/ real estate prices also contrib"ted tothe 'eal estate b"bble. oans o ario"s t3pes 6e./.> mort/a/e>
credit card> and a"to +ere eas3 to obtain and cons"mersass"med an "nprecedented debt load.
As part o the ho"sin/ and credit booms> the n"mber o ?nanciala/reements called mort/a/e-backed sec"rities 6:S andcollateralied debt obli/ations 6CD5> +hich deried their al"erom mort/a/e pa3ments and ho"sin/ prices> /reatl3 increased.S"ch ?nancial innoation enabled instit"tions and inestors
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The 2007-2008 Debt Crises
aro"nd the +orld to inest in the B.S. ho"sin/ market. As ho"sin/prices declined> ma;or /lobal ?nancial instit"tions that hadborro+ed and inested heail3 in s"bprime :S reportedsi/ni?cant losses. Fallin/ prices also res"lted in homes +orth less
than the mort/a/e loan> proidin/ a ?nancial incentie to enteroreclos"re. The on/oin/ oreclos"re epidemic that be/an in late2001 in the B.S. contin"es to drain +ealth rom cons"mers anderodes the ?nancial stren/th o bankin/ instit"tions. Dea"lts andlosses on other loan t3pes also increased si/ni?cantl3 as the crisise9panded rom the ho"sin/ market to other parts o the econom3.
Total losses are estimated in the trillions o B.S. dollars /loball3.
$art I% &o' (e ot
&ere The /lobal ?nancial crises o 2008 cost tens o millions o people
their sain/s> their ;obs and their homes.
#n September 2008> the bankr"ptc3 o the B.S. inestment ank
)ehman *rothers and the collapse o the +orldHs lar/est
ins"rance compan3 AI tri//ered a /lobal ?nancial crisesI the
res"lt +as a /lobal recession +hich cost the +orld tens o trillions
o dollars and rendered (0million people "nemplo3ed.
Ater the ,reat Depression> the Bnited States had &0 3ears o
Economic ,ro+th +itho"t a sin/le ?nancial crisesI the ?nancialsector +as ti/htl3 re/"lated. #n the %@80Hs the ?nancial ind"str3
e9ploded the inestment banks +ent p"blic 6prior to that the3
+ere priate o+ned entities /iin/ them h"/e amo"nts o stock
holder mone3. The 'ea/an Administration> s"pported b3
economist and ?nancial lobb3ist started a (0-3ear period o
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?nancial dere/"lation. #n %@82> the 'ea/an administration
dere/"lated sain/s and loan companies allo+in/ them to make
risk3 inestments +ith their depositorHs mone3I b3 the end o the
decade h"ndreds o sain/s and loan companies had ailed and
the crises that ollo+ed cost ta9 pa3ers %2&billion o dollars and
cost man3 people their lie sain/s.
B.S. ,oernment polic3 rom the %@80s on+ard had emphasied
dere/"lation to s"pport b"siness> +hich res"lted in less oersi/ht
o actiities and less e9posJ o inormation abo"t ne+ actiities
"ndertaken b3 banks and other /ro+in/ ?nancial instit"tions.
Th"s> polic3makers did not instantl3 kno+ the increasin/l3 ke3
role pla3ed b3 ?nancial instit"tions s"ch as inestment banks andhed/e "nds> also kno+n as the shado+ bankin/ s3stem. Some
e9perts beliee these instit"tions had become as important as
commercial 6depositor3 banks in proidin/ credit to the B.S.
econom3> b"t the3 +ere not s"b;ect to the same re/"lations.
3 the late %@@0Hs the ?nancial sector had consolidated into e+
/i/antic ?rms> each o them so lar/e that their ail"re co"ld
threaten the entire s3stem. #n %@@8> Citicorp and Traelers
mer/ed to orm Citi/ro"p> the lar/est ?nancial serices compan3in the +orld. The mer/er iolated the ,lass-Stea/all Act> a la+
passed ater the ,reat Depression +hich preented banks +ith
cons"mer deposits rom en/a/in/ in risk3 inestment bankin/
actiities- in other +ords it +as ille/al to ac"ire Traellers. #n
%@@@> the B.S Con/ress passed the ,ramm-each-lile3-Act it
oert"rned ,lass- Ste/all and cleared the +a3 or "t"re mer/ers.
The ne9t Crises came at the end o the %@@0Hs> the inestment
banks "eled a massie b"bble in #nternet Stocks> +hich +as
ollo+ed b3 a crash in 200% that ca"sed trillion dollars in
inestment losses.
e/innin/ in the %@@0Hs dere/"lation and adances in technolo/3
lead to an e9plosion o comple9 ?nancial prod"cts called
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deriates. Economist and bankers claimed the3 made markets
saer> b"t instead the3 made markets "nstable. Bsin/ deriaties>
bankers co"ld /amble on irt"all3 an3thin/I the3 co"ld bet on the
rise or all o oil prices> the bankr"ptc3 o a compan3 etc-b3 the
late %@@0Hs deriates +ere a 0 trillion dollar "nre/"lated market.
#n December 2000> the B.S con/ress passed the Commodit+
Future ,odernization ActI it banned the re/"lation o
deriaties and the "se o deriaties e9ploded dramaticall3 ater
2000. The B.S ?nancial sector had b3 then become astl3
pro?table> concentrated and more po+er"l than eer beore.
Dominatin/ this ind"str3 +ere inestment banks ,oldman
Sachs> :or/an Stanle3> ehman rothers> :errill 3nch and earsStearnsI t+o Financial con/lomerates Citi,ro"p and K) :or/anI
three sec"rities- ins"rance companies A#,> :#A> A:AC and
three ratin/ a/encies :ood3Hs> Standard L )oorHs and Fitch.
inkin/ all o them to/ether +as the "ecuritization Food Chain$
This Sec"ritiation Food Chain +as a ne+ s3stem +hich connected
trillions o dollars in mort/a/es and other loans +ith inestors all
oer the +orld.
#n the old s3stem beore sec"ritiation> +hen the homeo+ner paid
their mort/a/e eer3 month the mone3 +ent to their local lender
and since mort/a/es took decades to repa3 lenders +ere care"l.
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The 2007-2008 Debt Crises
#n the ne+ s3stem> lenders sold the mort/a/es to inestment
banks
The inestment banks combined tho"sands o mort/a/es and
other loans- incl"din/ car loans> st"dent loans and credit carddebt to create comple9 deriaties> called Collateralized Debt
bli#ations .CD/s.
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The inestment banks then sold the CD5Hs to inestors.
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The 2007-2008 Debt Crises
Mo+ +hen homeo+ners paid their mort/a/es> the mone3 +ent to
inestors all oer the +orld.
The inestment banks paid ratin/ a/encies to eal"ate the CD5s>
and man3 o them +ere /ien AAA ratin/ +hich is the hi/hestpossible inestment /rade.
This made CD5Hs pop"lar +ith retirement "nds> +hich co"ld onl3
p"rchase hi/h leel sec"rities.
This s3stem in essence +as a tickin/ time bomb as lenders didnHt
care an3more +hether a borro+er co"ld repa3 the loan> so the3
started makin/ riskier loans. The inestment banks didnHt care
either the more CD5Hs the3 sold the hi/her their pro?ts. The
ratin/ a/encies +hich +ere paid b3 the inestment banks had no
liabilit3 i their ratin/s o CD5s +ere proed +ron/.
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The 2007-2008 Debt Crises
et+een the 3ears 2000 and 200(> the n"mber o mort/a/e loans
made each 3ear had nearl3 "adr"pled.
While in the earl3 2000s there +as a h"/e increase in the riskiest
loans> called s"bprime loans.
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"t +hen tho"sands o s"bprime loans +ere combined to orm
CD5s> man3 o them still receied AAA ratin/s.
The inestment banks preerred s"bprime loans beca"se the3carried hi/her interest rates> this in t"rn lead to a massie
increase in )redator3 lendin/. orro+ers +ere needlessl3 placed
in e9pensie s"bprime loans> and man3 loans +ere /ien to
people +ho co"ld not repa3 them.
"uddenl+ hundreds of billions of dollars a +ear 'ere
1o'in# throu#h the securitization chain and since an+one
could #et a mort#a#e home 3urchases and housin# 3rices
s4+roc4eted the result 'as ine5itabl+ the bi##est nancial
bubble in histor+6
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The 2007-2008 Debt Crises
$art II% The *ubble
The origins of the housing bubble
The ho"sin/ b"bble in the Bnited States /re+ "p alon/side the
stock b"bble in the mid-@0s. The lo/ic o the /ro+th o the b"bble
is er3 simple. )eople +ho had increased their +ealth
s"bstantiall3 +ith the e9traordinar3 r"n-"p o stock prices +ere
spendin/ based on this increased +ealth.
The stock +ealth ind"ced cons"mption boom also led people to
b"3 bi//er andor better homes> since the3 so"/ht to spend some
o their ne+ stock +ealth on ho"sin/. This increase in demand
had the e4ect o tri//erin/ a ho"sin/ b"bble beca"se in the short-
r"n the s"ppl3 o ho"sin/ is relatiel3 ?9ed. Thereore an increase
in demand leads ?rst to an increase in price. #ncreased prices /otincorporated into e9pectations. The e9pectation that prices +o"ld
contin"e to rise led homeb"3ers to pa3 ar more than the act"al
price o real state.
The act that rents had risen b3 less than %0 percent in real terms
sho"ld hae proided more eidence to s"pport the ie+ that the
co"ntr3 +as e9periencin/ a ho"sin/ b"bble. # there +ere
"ndamental actors driin/ the r"n-"p in ho"se sale prices the3sho"ld be hain/ a comparable e4ect on rents. *o+eer> the
increase in rents +as ar more modest and +as trailin/ o4 alread3
b3 2002.
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The second phase of the housing bubble
The r"n-"p in prices in both the o+nership and rental markets +as
hain/ a si/ni?cant s"ppl3-side e4ect> as ho"sin/ starts rose
s"bstantiall3 rom the mid-@0s thro"/h the late @0s. 3 2002>
ho"sin/ starts +ere almost 2 percent aboe the aera/e rate
oer the three 3ears immediatel3 precedin/ the start o the
b"bble. The loss o aith in the stock market ca"sed millions o
people to t"rn to inestments in ho"sin/ as a sae alternatie. F"rther> the econom3 +as er3 slo+ in recoerin/ rom the 200%
recession. The +eakness o the recoer3 led the Federal 'esere
oard to contin"e to c"t interest rates> eent"all3 p"shin/ theederal "nds rates near to %.0 percent in 200(. :ort/a/e interest
rates ollo+ed the ederal "nds rate do+n.
These e9traordinaril3 lo+ interest rates accelerated "rther ho"se
prices. *o"sin/ rates starts eent"all3 peakin/ at 2>070>000 in
200> more than 0 percent aboe the rate in the pre-b"bble
3ears. The r"n-"p in ho"se prices also had the predictable e4ect
on sain/s and cons"mption. Cons"mption boomed beca"se thesain/s rate allin/ to less than %.0 percent 6200-07.
The ol"ntar3 oreclos"res take place +hen people realie that
the3 o+e more than the al"e o their home> and decide that
pa3in/ o4 their mort/a/e is in e4ect a bad deal. #n cases +here a
home is al"ed ar lo+er than the amo"nt o the o"tstandin/
mort/a/e> homeo+ners ma3 be too able to e4ectiel3 pocket
h"ndreds o tho"sands o dollars b3 simpl3 +alkin/ a+a3 romtheir mort/a/e. There is no +a3 that an econom3 can see a loss
o +ealth o this ma/nit"de +itho"t e9periencin/ er3 serio"s
?nancial stress.
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The 2007-2008 Debt Crises
The access of housing bubble
As the ho"se prices /re+ "rther o"t o line +ith "ndamentals>
the ?nancial ind"str3 adopted more sophisticated ?nancial
innoations to s"pport its /ro+th. A ke3 part o the stor3 +as the
/ro+th o non-standard mort/a/es. The ast ma;orit3 o
mort/a/es had al+a3s been ?9ed rate mort/a/es. *o+eer>
ad;"stable rate mort/a/es became a /ro+in/ share o mort/a/es
iss"ed d"rin/ the boom> peakin/ at close to ( percent in 200&-
01. Mot onl3 did these mort/a/es not proide the sec"rit3 o ?9ed
rate mort/a/es> the3 +ere oten iss"ed +ith belo+ market Nteaser
ratesO that +o"ld reset to hi/her leels ater t+o 3ears> een i
interest rates did not rise.
The s"bprime market e9ploded d"rin/ this period> risin/ rom less
than @ percent o the market in 2002 to 2 percent o the market
b3 200. #n addition> to this e9plosion in s"bprime loans there +as
also a boom in the intermediate NAlt-AO mort/a/e cate/or3. These
+ere loans /ien to homeb"3ers +ho either had a mi9ed credit
record 6better than s"bprime> b"t not "ite prime or +ho
proided incomplete doc"mentation o income and assets.
The Alt-A loans +ere in man3 cases o more "estionable "alit3
than the s"bprime loans. :an3 6perhaps most o these loans
+ere or the p"rchase o inestment properties. The Alt-Aloans
+ere een more likel3 to hae er3 hi/h loan to al"e ratios> +ith
man3 b"3ers borro+in/ the "ll al"e o the p"rchase price> or in
some cases een a e+ percenta/e points more than the
p"rchase price.
The s"bprime and Alt-A cate/ories to/ether comprised more than
&0 percent o the loans iss"ed at the peak o the b"bble. The
e9plosion o loans in these hi/her risk cate/ories sho"ld hae
been s"Pcient to si/nal re/"lators> as +ell as inestors> that
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The 2007-2008 Debt Crises
there +as a serio"s problem in the ho"sin/ market. K"st to take
the case o the s"bprime marketI it is abs"rd to think that the
n"mber o credit +orth3 people in the s"bprime cate/or3 had
more than do"bled rom 2002 to 200&> een as the labor market
remained +eak and +a/es la//ed behind ination. The increase
in s"bprime lendin/ oer these 3ears> b3 itsel> +as an
"nmistakable +arnin/ si/n o the problems in ho"sin/ market.
Bnort"natel3> instead o takin/ this +arnin/> political leaders and
most e9perts o ho"sin/ celebrated the record rates o home
o+nership.
#ncreased oreclos"re rates in 2001!2007 amon/ B.S.
homeo+ners led to a crisis in A"/"st 2008 or the s"bprime> Alt-A>collateralied debt obli/ation 6CD5> mort/a/e> credit> hed/e
"nd> and orei/n bank markets.
The s"bprime lendin/ alone increased rom (0 billion a 3ear in
"ndin/ to oer 100 billion a 3ear> in %0 3ears +ith Co"ntr3+ide
Financial> the lar/est s"bprime lender> iss"ed @7 billion dollarsH
+orth o loans 6#t made oer %% billion dollars in pro?ts as a
res"lt.
n (all "treet this housin# and credit bubble 'as
leadin# to hundreds of billions of dollars of 3rots6 The
real issue ho'e5er 'as it 'asnt real 3rots it 'asnt real
income it 'as 9ust mone+ that 'as bein# created b+ the
s+stem and if there 'ere to be a default it 'ould all be
'i3ed out6
The Financial Contributor of the Bubble
There +as another tickin/ time bomb in the ?nancial s3stembesides the ho"sin/ sector.
A#,> the +orldGs lar/est ins"rance compan3> +as sellin/ h"/e"antities o deriaties> called credit dea"lt s+aps. For inestors
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+ho o+ned CD5s> credit dea"lt s+aps +orked like an ins"rancepolic3. An inestor +ho p"rchased a credit dea"lt s+ap paid A#, a"arterl3 premi"m.
# the CD5 +ent bad> A#, promised to pa3 the inestor or theirlosses.
"t "nlike re/"lar ins"rance> spec"lators co"ld also b"3 creditdea"lt s+aps rom A#, in order to bet a/ainst CD5s the3 didnGto+n.
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Since credit dea"lt s+aps +ere "nre/"lated> A#, didnGt hae top"t aside an3 mone3 to coer potential losses. "t i the CD5s
later +ent bad> A#, +o"ld be r"n massiel3 hea3 losses as it+o"ld hae to pa3 both spec"lators and inestors.
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A#,Gs Financial )rod"cts Diision in ondon iss"ed 00 billiondollars +orth o credit dea"lt s+aps d"rin/ the b"bble> man3 o them or CD5s backed b3 s"bprime mort/a/es
As per the ,oldman Sachs iss"e o sec"rities on s"bprime loanssho+ed borro+ers had borro+ed> on aera/e> @@.( percent o theprice o the ho"se +hich essentiall3 meant the3 hae no mone3 inthe ho"seI i an3thin/ +ere to /o +ron/> the borro+ers +ere likel3to +alk a+a3 rom the mort/a/e and the loan +o"ld end "p bein/dea"lted. #n essence ,oldman Sachs sold at least (.% billiondollarsG +orth o these to9ic CD5s in the ?rst hal o 2001I +hilet+o thirds o this loan +ere rated AAA> +hich meant the3 +ererated as sae as /oernment sec"rities +hich +as obio"sl3misleadin/.
3 late 2001> ,oldman had taken thin/s a step "rther. #t didnGt
;"st sell to9ic CD5sI it started actiel3 bettin/ a/ainst them b3p"rchasin/ credit dea"lt s+aps rom A#,.
,oldman co"ld bet a/ainst CD5s it didnGt o+n> and /et paid +henthe CD5s ailed.
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The 2007-2008 Debt Crises
,oldman Sachs bo"/ht at least 22 billion dollars o credit dea"lts+aps rom A#,. #t +as so m"ch that ,oldman realied that A#,itsel mi/ht /o bankr"pt A#,Gs potential collapse.
#n 2007> ,oldman +ent een "rther. The3 started sellin/ CD5sspeci?call3 desi/ned so that the more mone3 their c"stomerslost> the more mone3 ,oldman Sachs made.
:or/an Stanle3 +as also sellin/ mort/a/e sec"rities that it +asbettin/ a/ainst> and itGs no+ bein/ s"ed b3 the /oernmentemplo3eeHs retirement "nd o the Qir/in #slands or ra"d. The
la+s"it alle/es that :or/an Stanle3 kne+ that the CD5s +ere ;"nk. Altho"/h the3 +ere rated AAA> :or/an Stanle3 +as bettin/the3 +o"ld ail. A 3ear later> :or/an Stanle3 had made h"ndredso millions o dollars> +hile the inestors had lost almost all o their mone3.
The *ed/e F"nds Tricadia L :a/netar made billions bettin/a/ainst CD5s the3 had desi/ned +ith :errill 3nch> K.). :or/anand ehman rothers. The CD5s +ere to CBST5:E'S AS SAFE#MQEST:EMTS b3 ratin/ a/encies :ood3Gs and Standard and
)oorGs +ho rated these er3 same CD5Hs as AAA +hich essentiall3meant the3 +ere as sae as /oernment sec"rities.
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The 2007-2008 Debt Crises
$art III% The CrisisDeclines Beginthere +ere earl3 si/ns o distress$ b3 200&> B.S. homeo+nership
had peaked at 70RI no one +as interested in b"3in/ or eatin/
more cand3. Then> d"rin/ the last "arter o 200> home prices
started to all> +hich led to a &0R decline in the B.S. *ome
Constr"ction #nde9 d"rin/ 2001. Mot onl3 +ere ne+ homes bein/
a4ected> b"t man3 s"bprime borro+ers no+ co"ld not +ithstand
the hi/her interest rates and the3 started dea"ltin/ on their
loans.
This ca"sed 2007 to start +ith bad ne+s rom m"ltiple so"rces.
Eer3 month> one s"bprime lender or another +as ?lin/ or
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The 2007-2008 Debt Crises
bankr"ptc3. D"rin/ Febr"ar3 and :arch 2007> more than 2
s"bprime lenders ?led or bankr"ptc3> +hich +as eno"/h to start
the tide. #n April> +ell-kno+n Me+ Cent"r3 Financial also ?led or
bankr"ptc3.
Investments and the Public
)roblems in the s"bprime market be/an hittin/ the ne+s> raisin/
more peopleGs c"riosit3.
Accordin/ to 2007 ne+s reports> ?nancial ?rms and hed/e "nds
o+ned more than % trillion in sec"rities backed b3 these no+-
ailin/ s"bprime mort/a/es - eno"/h to start a /lobal ?nancialts"nami i more s"bprime borro+ers started dea"ltin/.
3 K"ne> ear Stearns stopped redemptions in t+o o its hed/e
"nds and :errill 3nch seied 800 million in assets rom t+o
ear Stearns hed/e "nds. "t een this lar/e moe +as onl3 a
small a4air in comparison to +hat +as to happen in the months
ahead.
The Landslide Begins- Time LineChronolo#ical order%
February 2!- The Federal *ome oan :ort/a/e Corporation
6Freddie :ac anno"nces that it +ill no lon/er b"3 the most risk3s"bprime mort/a/es and mort/a/e-related sec"rities.
"pril 2! -Me+ Cent"r3 Financial Corporation> a leadin/
s"bprime mort/a/e lender> ?les or Chapter %% bankr"ptc3
protection.
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The 2007-2008 Debt Crises
#une 2! - Standard and )oorHs and :ood3Hs #nestor Serices
do+n/rade oer %00 bonds backed b3 second-lien s"bprime
mort/a/es. Standard and )oorHs places 1%2 sec"rities backed b3
s"bprime residential mort/a/es on a credit +atch. Co"ntr3+ide
Financial Corporation +arns o NdiPc"lt conditions. ear Stearns
li"idates t+o hed/e "nds that inested in ario"s t3pes o
mort/a/e-backed sec"rities.
"ugust 2!- American *ome :ort/a/e #nestment Corporation
?les or Chapter %% bankr"ptc3 protection. M) )aribas> FranceHs
lar/est bank> halts redemptions on three inestment "nds.
$eptember 2!- The Chancellor o the E9che"er a"thories
the ank o En/land to proide li"idit3 s"pport or Morthern
'ock> the Bnited in/domHs ?th-lar/est mort/a/e lender.
#anuary 2%- ank o America anno"nces that it +ill p"rchase
Co"ntr3+ide Financial in an all-stock transaction +orth
appro9imatel3 & billion.
February 2%- Morthern 'ock is taken into state o+nership b3
the Treas"r3 o the Bnited in/dom.
&arch 2% - The Federal 'esere ank o Me+ Uork anno"nces
that it +ill proide term ?nancin/ to acilitate K):or/an Chase L
Co.Hs ac"isition o The ear Stearns Companies #nc. A limited
liabilit3 compan3 6:aiden ane is ormed to control (0 billion o
ear Stearns assets that are pled/ed as sec"rit3 or 2@ billion interm ?nancin/ rom the Me+ Uork Fed at its primar3 credit rate.
K):or/an Chase +ill ass"me the ?rst % billion o an3 losses on
the portolio.
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The 2007-2008 Debt Crises
$eptember 2% - ank o America anno"nces its intent to
p"rchase :errill 3nch L Co. or 0 billion. ehman rothers
*oldin/s #ncorporated ?les or Chapter %% bankr"ptc3 protection.
5n September %1> 2008> A#, s"4ered a li"idit3 crisis ollo+in/
the do+n/rade o its credit ratin/. #nd"str3 practice permits ?rms
+ith the hi/hest credit ratin/s to enter s+aps +itho"t depositin/
collateral +ith their tradin/ co"nter-parties. When its credit ratin/
+as do+n/raded> the compan3 +as re"ired to post additional
collateral +ith its tradin/ co"nter-parties> and this led to an A#,
li"idit3 crisis. A#,Gs ondon "nit sold credit protection in the orm
o credit dea"lt s+aps 6CDSs on collateralied debt obli/ations
6CD5s that had b3 that time declined in al"e.V21 The BnitedStates Federal 'esere ank anno"nced the creation o a sec"red
credit acilit3 o "p to BS8 billion> to preent the compan3Gs
collapse b3 enablin/ A#, to meet its obli/ations to delier
additional collateral to its credit dea"lt s+ap tradin/ partners.
A#,Gs share prices had allen oer @R to ;"st %.2 b3 September
%1> 2008> rom a 2-+eek hi/h o 70.%(.Vcitation needed The
compan3 reported oer %(.2 billion in losses in the ?rst si9months o the 3ear. The A#, Financial )rod"cts diision headed b3
Koseph Cassano> in ondon> had entered into credit dea"lt s+aps
to ins"re &&% billion +orth o sec"rities ori/inall3 rated AAA. 5
those sec"rities> 7.8 billion +ere str"ct"red debt sec"rities
backed b3 s"bprime loans.V(& CMM named Cassano as one o the
Ten :ost Wanted$ C"lprits o the 2008 ?nancial collapse in the
Bnited States.
Till %& December 20%2 the crisis en/"led &@( banks in the BS
alone> incl"din/ the likes o ehman rothers *oldin/s> American
#nternational ,ro"p and ear Stearns. 6BS Federal Deposit
#ns"rance Corporation.
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The 2007-2008 Debt Crises
The 'ay For(ard
#n Kohn :a3nard e3nes e3nesG ie+> +hen main pillars o the
econom3 are ailin/ - cons"mer spendin/> inestment and net
e9ports - the onl3 pillar that is let to s"pport the econom3 is the/oernment.
e3nes s"pported /oernment interention d"rin/ times o
economic t"rmoil. Amon/ the theories he presented in ,eneral
Theor3 +as that economies are chronicall3 "nstable and that "ll
emplo3ment is onl3 possible +ith a boost rom /oernment polic3
and p"blic inestment. e3nes belieed that it +as "p to the
/oernment to brid/e the /ap bet+een the econom3Gs potential
and its act"al o"tp"t d"rin/ a ?nancial crisis> een i that meant
takin/ on debt.
*ence ollo+in/ the e3nes economic model> to keep the
econom3 rom alterin/ an3 "rther the /oernments needed to
take action and thatHs precisel3 +hat happened ne9t.
The B.S. Federal 'esere and central banks aro"nd the +orld took
steps to e9pand mone3 s"pplies to aoid the risk o a deationar3
spiral> in +hich lo+er +a/es and hi/her "nemplo3ment lead to a
sel-reinorcin/ decline in /lobal cons"mption.
#n addition> /oernments had enacted lar/e ?scal stim"l"s
packa/es> b3 borro+in/ and spendin/ to o4set the red"ction in
priate sector demand ca"sed b3 the crisis. The B.S. e9ec"ted
t+o stim"l"s packa/es> totalin/ nearl3 % trillion d"rin/ 2008 and
200@. The B.S. Federal 'esereGs ne+ and e9panded li"idit3
acilities +ere intended to enable the central bank to "l?ll itstraditional lender-o-last-resort role d"rin/ the crisis +hile
miti/atin/ sti/ma> broadenin/ the set o instit"tions +ith access
to li"idit3> and increasin/ the e9ibilit3 +ith +hich instit"tions
co"ld tap s"ch li"idit3.
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The 2007-2008 Debt Crises
This credit reee bro"/ht the /lobal ?nancial s3stem to the brink
o collapse. The response o the Federal 'esere> the E"ropean
Central ank> and other central banks +as immediate and
dramatic. D"rin/ the last "arter o 2008> these central banks
p"rchased BS2. trillion o /oernment debt and tro"bled
priate assets rom banks. This +as the lar/est li"idit3 in;ection
into the credit market> and the lar/est monetar3 polic3 action> in
+orld histor3. The /oernments o E"ropean nations and the BSA
also raised the capital o their national bankin/ s3stems b3
%. trillion> b3 p"rchasin/ ne+l3 iss"ed preerred stock in their
ma;or banks.
)*ect on economic situation in Pa+istan)akistanHs deterioratin/ macroeconomic conditions ater the
,lobal Financial Crisis had res"lted in sharp do+nall in ,D)
/ro+th rate. 'eal ,D) /ro+th rate declined si/ni?cantl3 in 2008
as it reached to %.1 R and in 200@ it rose sli/htl3 to (.& R.
Bnort"natel3> )akistan +as alread3 s"4erin/ rom
macroeconomic instabilit3 beore the Financial Crisis d"e to hike
in oil prices and depletin/ orei/n e9chan/e reseres. Financial
Crisis +idened trade /ap. #ncrease in b"d/et and c"rrent acco"ntde?cits and soarin/ ination bro"/ht "rther problems or
)akistanHs econom3.
Bnder #:F a/reement )akistan has to adopt ti/ht ?scal and
monetar3 policies. #:F pro/ram is directed to+ards restorin/
macroeconomic stabilit3 in )akistan. State ank o )akistan has
increased disco"nt rates to c"rb ination b"t it has also hampered
economic /ro+th. )riate inestment is restricted d"e to increase
in disco"nt rates. )"blic ?nances remain in a precario"s state.)akistan has no ?scal space and there is less room or co"nter
c3clical ?scal polic3. #n co"nter c3clical ?scal polic3> ta9es are c"t
and spendin/ is increased d"rin/ do+nt"rns to promote economic
recoer3 and /ro+th. Discretionar3 ?scal polic3 cannot be
adopted in )akistan as p"blic debt is hi/h and /oernment is
"nable to ?nance the res"ltin/ ?scal de?cit. Ta9 easion is alread321 < ) a / e
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The 2007-2008 Debt Crises
on peak in )akistan and as a res"lt )akistanHs ta9 to ,D) ratio is
er3 lo+.
#t can easil3 be concl"ded that ,D) is one o the meas"res o
macroeconomic stabilit3 and re/ression res"lts hae made it clear
that C"rrent Acco"nt alance> Trade De?cit and een #nation had
an impact on ,D). :"ltiple 'e/ression Anal3sis has depicted that
M"ll *3pothesis sho"ld be accepted. ,lobal Financial Crisis had a
seere impact on macroeconomic stabilit3 o )akistan. M"ll
*3pothesis that hi/h ?scal de?cit decreased ,D) /ro+th has not
been ;"sti?ed b3 the re/ression anal3sis. M"ll *3pothesis that
+idenin/ o trade de?cit has ca"sed decline in ,D) needs to be
accepted as sho+n b3 the re/ression res"lts.
#t has been established b3 research that ,D) carries importancein assessin/ macroeconomic stabilit3. 'e/ression res"lts hae
sho+n that potential impendent ariables hae an impact on ,D).
Current $cenario
Si9 3ears ater the ?rst tremors in 2007> the +orld looks rather
di4erent. #nterest rates are m"ch lo+er. 'isk pricin/ is m"ch moresharpl3 di4erentiated. The threat o deation is no+ real or
seeral co"ntries> and ination is er3 lo+ or others. #n most
adanced co"ntries since the crisis> real per capita ,D) /ro+th
has been insipid at best. Altho"/h +eak banks appear to be m"ch
less o a problem in A"stralasia> impaired bank balance sheets in
the Morthern *emisphere are castin/ a lon/ economic shado+.
The ne+ enironment creates some str"ct"ral and strate/ic
challen/es or the /lobal ?nancial ind"str3. :"ch-red"ced?nancial en/ineerin/ and +eaker ?nancial instit"tions are likel3 to
see some retrenchment o certain bankin/ actiities. Also> +ith
er3 lo+ 3ields> ?nancial instit"tions s"b;ect to obli/ations or
stron/ e9pectations to pa3 ?9ed ret"rns 6s"ch as pension "nds
ace press"re to increase holdin/s o risk3 assets> so the3 can
s"pport these ret"rns. A rene+ed search or 3ield or these
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The 2007-2008 Debt Crises
reasons raises the risk o e9cessie inestment or b"bbles in s"ch
lo+er "alit3 assets.
,lobal spendin/ and inestment appear er3 ca"tio"s> and seem
likel3 to remain so or some time> /ien the oerhan/ o debt rom
beore the crisis. #n adanced economies> deleera/in/ in the
priate sector appears to hae started> b"t +ill take a lon/ time !
perhaps a /eneration. Qer3 ca"tio"s ho"seholds are a lar/e part
o the stor3 o a slo+ and ra/ile recoer3. The3 hae been hit
hard b3 s"stained labor market +eakness> and in the BS and
some other adanced economies this has been compo"nded b3
loss o ho"sin/ +ealth and balance sheet +eakness.
#n E"rope> the preailin/ perception is that the EB has no+reached a ork in the road. There is a clear "nderstandin/ that the
real econom3 needs "rther str"ct"ral chan/e. )"blic ?nances
need to be p"t "nder control in co"ntries that are breachin/ the
p"blic debt threshold o 10 per cent o ,D). etter /oernance is
still needed in the bankin/> ?scal and economic areas. The EB is
c"rrentl3 makin/ pro/ress in all these areas and is oc"sin/ on
implementation. Conse"entl3> the debt crisis can also be seen as
a health3 catal3st or improin/ economic /oernance in E"rope. Thro"/ho"t its post-World War ## histor3> crisis has been the
en/ine o pro/ress in E"ropean inte/ration.
The stron/er hopes are d"e primaril3 to the more rapid o"tp"t
and emplo3ment /ro+th in the BS econom3 that hae come in
better than e9pected in late 20%%. #t no+ appears possible that
,D) in the Bnited States mi/ht /ro+ at a rate close to ( per cent
in 20%2> compared to %.7 per cent in 20%%. :oreoer> or seeralmonths> ;ob creation has e9ceeded ne+ entries into the labo"r
orce> red"cin/ "nemplo3ment to +ell belo+ @ per cent or the
?rst time since the emplo3ment pl"n/e in 200@. While this is
modest pro/ress compared to the challen/e ahead it +o"ld
take almost a decade to red"ce "nemplo3ment to pre-crisis leels
at the pace o recent months it has tri//ered a si/ni?cant stock28 < ) a / e
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The 2007-2008 Debt Crises
market s"r/e> reinorcin/ a positie d3namic in the BS econom3.
,ro+th in the emer/in/ and deelopin/ co"ntries has slo+ed> b"t
still contin"es at a rob"st pace> +ith their internal /ro+th
d3namics pla3in/ an increased role compared to their e9ports to
the adanced +orld.
"u33lementar+ :eadin#
:e3ort At a lance This report +o"ld tr3 to e9plain the ?nancial crises in a three part
scenario as ollo+s$
Part I, o( 'e .ot ere The American ?nancial ind"str3 +as re/"lated rom %@&0 to %@80>
ollo+ed b3 a lon/ period o dere/"lation. At the end o the %@80s>
a sain/s and loan crisis cost ta9pa3ers abo"t %2& billion. #n the
late %@@0s> the ?nancial sector had consolidated into a e+ /iant
?rms. #n :arch 2000> the #nternet Stock "bble b"rst beca"se
inestment banks promoted #nternet companies that the3 kne+
+o"ld ail> res"ltin/ in trillion in inestor losses. #n the %@@0s>
deriaties became pop"lar in the ind"str3 and added instabilit3.E4orts to re/"late deriaties +ere th+arted b3 the Commodit3
F"t"res :oderniation Act o 2000> backed b3 seeral ke3
oPcials. #n the 2000s> the ind"str3 +as dominated b3 ?e
inestment banks 6,oldman Sachs> :or/an Stanle3> ehman
rothers> :errill 3nch> and ear Stearns> t+o ?nancial
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The 2007-2008 Debt Crises
con/lomerates 6Citi/ro"p> K):or/an Chase> three sec"ritied
ins"rance companies 6A#,> :#A> A:AC and the three ratin/
a/encies 6:ood3Hs> Standard L )oors> Fitch. #nestment banks
b"ndled mort/a/es +ith other loans and debts into collateralied
debt obli/ations 6CD5s> +hich the3 sold to inestors. 'atin/
a/encies /ae man3 CD5s AAA ratin/s. S"bprime loans led to
predator3 lendin/. :an3 home o+ners +ere /ien loans the3
co"ld neer repa3.
Part II, The BubbleD"rin/ the ho"sin/ boom> the ratio o mone3 borro+ed b3 an
inestment bank ers"s the bankGs o+n assets reached
"nprecedented leels. The credit dea"lt s+ap 6CDS> +as akin toan ins"rance polic3. Spec"lators co"ld b"3 CDSs to bet a/ainst
CD5s the3 did not o+n. M"mero"s CD5s +ere backed b3
s"bprime mort/a/es. ,oldman-Sachs sold more than ( billion
+orth o CD5s in the ?rst hal o 2001. ,oldman also bet a/ainst
the lo+-al"e CD5s> tellin/ inestors the3 +ere hi/h-"alit3. The
three bi//est ratin/s a/encies contrib"ted to the problem. AAA-
rated instr"ments rocketed rom a mere hand"l in 2000 to oer
&>000 in 2001.
Part III, The Crisis The market or CD5s collapsed and inestment banks +ere let
+ith h"ndreds o billions o dollars in loans> CD5s and real estate
the3 co"ld not "nload. The ,reat 'ecession be/an in Moember
2007> and in :arch 2008> ear Stearns ran o"t o cash. #n
September> the ederal /oernment took oer Fannie :ae and
Freddie :ac> +hich had been on the brink o collapse. T+o da3slater> ehman rothers collapsed. These entities all had AA or
AAA ratin/s +ithin da3s o bein/ bailed o"t. :errill 3nch> on the
ed/e o collapse> +as ac"ired b3 ank o America. *enr3 )a"lson
6B.S. Treas"r3 Secretar3 and Timoth3 ,eithner 6)resident o the Federal
'esere ank o Me+ Uork decided that ehman m"st /o into
bankr"ptc3> +hich res"lted in a collapse o the commercial paper(0 < ) a / e
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The 2007-2008 Debt Crises
market. 5n September %7> the insolent A#, +as taken oer b3
the /oernment. The ne9t da3> )a"lson and Fed chairman en
ernanke asked Con/ress or 700 billion to bail o"t the banks.
The /lobal ?nancial s3stem became paral3ed. 5n 5ctober (>
2008> )resident "sh si/ned the Tro"bled Asset 'elie )ro/ram>
b"t /lobal stock markets contin"ed to all. a3o4s and
oreclos"res contin"ed +ith "nemplo3ment risin/ to %0R in the
B.S. and the E"ropean Bnion. 3 December 2008> ,: and
Chr3sler also aced bankr"ptc3. Foreclos"res in the B.S. reached
"nprecedented leels.
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The 2007-2008 Debt Crises
Im3ortant
Terminolo#iesDiscussedBubble )conomy,A s"r/e in the market ca"sed b3 spec"lation re/ardin/ a
commodit3 +hich res"lts in an e9plosion o actiit3 in that market
se/ment ca"sin/ astl3 oerinated prices. The prices are nots"stainable and the b"bble is "s"all3 ollo+ed b3 a crash in prices
in the a4ected sector.
$ub-prime mortgages,A t3pe o mort/a/e that is normall3 made o"t to borro+ers +ith
lo+er credit ratin/s. As a res"lt o the borro+erGs lo+ered credit
ratin/> a conentional mort/a/e is not o4ered beca"se the lender
ie+s the borro+er as hain/ a lar/er-than-aera/e risk o
dea"ltin/ on the loan. endin/ instit"tions oten char/e interest
on s"bprime mort/a/es at a rate that is hi/her than a
conentional mort/a/e in order to compensate them or carr3in/
more risk.
Foreclosure, The process o takin/ possession o a mort/a/ed propert3 as a
res"lt o someoneGs ail"re to keep "p mort/a/e pa3ments.
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The 2007-2008 Debt Crises
Collaterali/ed Debt 0bligation 1CD0,
A collateralized debt obli#ation .CD is a sec"rit3 thatrepacka/es indiid"al ?9ed-income assets into a prod"ct that can
be chopped into pieces and then sold on the secondar3 market. The3 are called collateralied beca"se the assets bein/ packa/ed-- mort/a/es> corporate debt> a"to loans or credit card debt- -sere as collateral or inestors.
*o+ #t WorksE9ample$
CDOs are described as str"ct"red asset-backed sec"ritiesbeca"se the3 pa3 cash o+s to inestors in a prescribedse"ence> based on ho+ m"ch cash o+ is collected rom the
packa/e o assets o+ned.
The CD5 is split into di4erent risk classes kno+n as tranches.#nterest and principal pa3ments are made in order o seniorit3 sothat senior tranches hae the least risk. K"nior tranches> +hichhae hi/her dea"lt risk> "s"all3 hae hi/her co"pon pa3ments.
Collateralized debt obligations allo+ banks and corporations tosell o4 debt and ree "p capital to re-inest or loan. The do+nside
o CD5s is that the loan ori/inators hae little incentie to collect+hen loans in the packa/e come d"e since these loans are no+o+ned b3 other inestors. This ma3 make ori/inators lessdisciplined in adherin/ to strict lendin/ standards.
Another do+nside o CD5s is the comple9it3 o these prod"cts."3ers ma3 not kno+ e9actl3 +hat the3 are b"3in/ or +hetherthe packa/e is reall3 +orth the price. The opa"eness andcomple9it3 o CD5s can res"lt in a market panic i inestors losecon?dence and CD5s become more diPc"lt to re-sell. This +asthe scenario d"rin/ the S"b-)rime Crisis o 2007 +hen man3banks +ere orced to take siable +rite-do+ns on their CD5holdin/s.
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The 2007-2008 Debt Crises
edge funds,
&ed#e funds are priate> actiel3 mana/ed inestment "nds. The3 inest in a dierse ran/e o markets> inestment
instr"ments> and strate/ies and are s"b;ect to the re/"lator3restrictions o their co"ntr3.
&ortgage-Bac+ed $ecurities,A t3pe o asset-backed sec"rit3 that is sec"red b3 a mort/a/e or
collection o mort/a/es. These sec"rities m"st also be /ro"ped in
one o the top t+o ratin/s as determined b3 a accredited creditratin/ a/enc3> and "s"all3 pa3 periodic pa3ments that are similar
to co"pon pa3ments. F"rthermore> the mort/a/e m"st hae
ori/inated rom a re/"lated and a"thoried ?nancial instit"tion.
Also kno+n as a mort/a/e-related sec"rit3 or a mort/a/e pass
thro"/h.
When 3o" inest in a mort/a/e-backed sec"rit3 3o" are
essentiall3 lendin/ mone3 to a home b"3er or b"siness. An :S isa +a3 or a smaller re/ional bank to lend mort/a/es to its
c"stomers +itho"t hain/ to +orr3 abo"t +hether the c"stomers
hae the assets to coer the loan. #nstead> the bank acts as a
middleman bet+een the home b"3er and the inestment markets.
This t3pe o sec"rit3 is also commonl3 "sed to redirect the
interest and principal pa3ments rom the pool o mort/a/es to
shareholders. These pa3ments can be "rther broken do+n intodi4erent classes o sec"rities> dependin/ on the riskiness o
di4erent mort/a/es as the3 are classi?ed "nder the :S.
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The 2007-2008 Debt Crises
"d3ustable-4ate &ortgage 5 "4&,A t3pe o mort/a/e in +hich the interest rate paid on the
o"tstandin/ balance aries accordin/ to a speci?c benchmark.
The initial interest rate is normall3 ?9ed or a period o time ater
+hich it is reset periodicall3> oten eer3 month. The interest rate
paid b3 the borro+er +ill be based on a benchmark pl"s an
additional spread> called an A': mar/in.
An ad;"stable rate mort/a/e is also kno+n as a ariable-rate
mort/a/e or a oatin/-rate mort/a/e.
Credit Default $(ap 1CD$,A s+ap desi/ned to transer the credit e9pos"re o ?9ed income
prod"cts bet+een parties. A credit dea"lt s+ap is also reerred to
as a credit deriatie contract> +here the p"rchaser o the s+ap
makes pa3ments "p "ntil the mat"rit3 date o a contract.)a3ments are made to the seller o the s+ap. #n ret"rn> the seller
a/rees to pa3 o4 a third part3 debt i this part3 dea"lts on the
loan. A CDS is considered ins"rance a/ainst non-pa3ment. A
b"3er o a CDS mi/ht be spec"latin/ on the possibilit3 that the
third part3 +ill indeed dea"lt.
The b"3er o a credit dea"lt s+ap receies credit protection>
+hereas the seller o the s+ap /"arantees the credit +orthiness
o the debt sec"rit3. #n doin/ so> the risk o dea"lt is transerredrom the holder o the ?9ed income sec"rit3 to the seller o the
s+ap. For e9ample> the b"3er o a credit dea"lt s+ap +ill be
entitled to the par al"e o the contract b3 the seller o the s+ap>
sho"ld the third part3 dea"lt on pa3ments. 3 p"rchasin/ a
s+ap> the b"3er is transerrin/ the risk that a debt sec"rit3
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The 2007-2008 Debt Crises