The 2007 financial crisis and how it was caused

You must watch ‘The Inside Job’ to understand how the 2007-8 financial crisis came about. To give you a short preview of what went on – in the past, the lender would loan money to the home-owner. Since mortgages took decades to pay off, they were very careful in lending to anyone. Over a period of time, the introduction of ‘securitization’ where the lender in turn could sell the mortgage to another person/institution to get rid of his risk. Bigger banks would assume the risk because over the period of loan they obviously make a profit. Now the banks and financial institutions would consolidate many such loans and various types of loans (school loans, mortgages, credit card debt, etc) and offer what are called as derivatives or CDOs. These are the so called financial instruments that they could in turn sell it to someone who could assume the risk. In order for that someone (investor) to buy the CDOs, these needed to be rated. The ratings agencies were influenced by the institutions and these got grade AAA which is the highest rating on a debt that pension funds (one of the investors) could buy as AAA rating was the minimum rating needed for them to invest by regulation. The investors in turn will need to pay the investment banks a premium to buy these obligations. Thus these investors now have a steady stream of revenue in the form of monthly mortgage/debt payments. The institutions now had an incentive – the more they sold CDOs, the more their profit. Thus they would push for more loans to be given out and the strict conditions began to become lax. These are the sub-prime mortgages, where higher interest was charged for giving out a loan, in effect resulting in riskier securities. Now comes AIG into the picture. AIG starts to sell policies where they will assume the risk of default by the debtor in exchange for a premium. The term for this instrument is called Credit Swaps. But Credit Swaps being a derivative is not financial regulated by the government. Thus AIG could sell as much Credit Swaps as they wanted without having to have the required funds on their balance sheet to cover the risk. Thus they went on selling. Their sales people were paid commission based on how much credit swaps they sold. This in turn increased the leverage ratio of the institution, meaning they could borrow a lot more than they had funds to cover, just because there was no regulation. In the meantime, because of the demand, the home prices went sky rocketing. When there were some defaults, there were many investors who were affected as many could buy the same CDOs. These many would have borrowed in order to assume their risk and now many are defaulting. Big banks all around the world were holders of sub-prime risk and banks in Iceland and other countries now faced huge losses. AIG who insured these banks couldn’t pay either because they didn’t have sufficient funds in the first place. Thus the banks (Lehman, Bear Sterns, Banks in Iceland, etc) and AIG were now defaulting. More and more foreclosures (and add fraud in lending) led to steeper losses and these firms ran out of cash one day in late 2007 and the collapse was imminent. All the people who so far overlooked of the lack of regularization in the government and other agencies now tout that a collapse would hurt the economy and the government is forced to step in paying tax payers dollars to shore up the firms. Thus the debt of US increased double-fold because of the crisis. A fascinating look into the Financial Crisis – MUST watch.

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