Paper 1

Terms such as credit default swaps, collateralized debt obligations, trouble asset relief program, sub-prime mortgages and adjustable rate mortgages were foreign to majority of Americans prior to the financial crisis. Most Americans also accepted several notions as truths, one of them being that your home was an appreciating asset. What we’ve come to realize amidst this global catastrophe is that we are all connected, for better and for worst, Thomas Friedman claimed the “world was flat” due to globalization, this financial crisis proves his thesis.

The root cause of the crisis truly stems from the subprime loan market. A subprime loan is a loan given to borrowers that are considered risky. In the years leading up to the subprime crisis, interest rates had been cut to 1% in order to avoid the country going into recession after the “dot com bubble” burst in 2000. This allowed businesses to borrow money easily which allowed them to spend more generously which is great because it grows the US economy. So much money was now available that financial institutions started offering loans to buyers with poor credit scores. Because these borrowers were considered less likely to be able to pay the loans back, these subprime borrowers were charged higher interest rates. Banks then began to offer diverse types of subprime loans such as interest only mortgages, and adjustable rate mortgages (ARMs) after initial success with subprime lending. ARMs would usually offer an initial low “teaser” rate for a certain period of time and then reset to a higher rate, resulting in a dramatically higher monthly mortgage payment than the initial payment the borrower was making.

Traditionally, if one were to get a mortgage from a bank, the bank would lend the money and then hold the loan, earning money from the fees they charge and the interest paid to the bank on that loan. The bank was limited on how many loans it could lend by the amount of money it had on deposit. The bank held all the risk for those loans as all the loans were on its books. In order to spread the risk and allow banks to make more loans, investment bankers developed a process for securitizing mortgages by selling the risks to other financial institutions and investors in another market. So lending institutions were now able to bundle these loans together and sell them to other financial institutions and investors. The bundles that the loans are put into are referred to as Collateralized Debt Obligations, CDOs. This frees up capital for the bank and reduces their risk, so they can lend more mortgages and earn more fees. The types of financial firms that invested in these CDOs varied from banks, to hedge funds, to pension funds, to insurance companies all over the world including Great Britain, continental Europe, the Emirates, and Asia. In order to insure against the risk in purchasing such CDOs, the buyer may enter into a Credit Default Swap in which the buyer purchases something similar to insurance in order to protect against the risk of buying such CDOs. Corporations such as AIG sold credit default swaps. Yet AIG was unable to meet their CDS guarantees to their clients resulting in the United States government “bailing out” such firms in order to rescue the US economy with fears of a looming depression if the businesses were allowed to fail also resulting in a global financial catastrophe.

The “bailout” term stems from the Emergency Economic Stabilization Act of 2008, in which the Secretary of the Treasury, Henry Paulson, was authorized to spend up to $700 billion to purchase distressed assets from companies involved in the US financial system, especially in mortgage-backed securities, and make capital injections into banks. This brings us to today, fear and uncertainty of the future, and unemployment looming around 10%.