Questions

MARCH 20, 2017
THE 2007-08
FINANCIAL CRISIS
CAUSES, IMPACTS AND THE NEED FOR NEW REGULATIONS
SUBMITTED TO
DR. S.DASGUPTA
HIMANSHU SANGA
2K16GA010
SECTION - A
Describe the new financial instruments that triggered the crises? (7 marks)
Is it new financial instruments that triggered the crisis or something else or someone did? It is hard to
proclaim that the financial crisis happened due to the lust of earning profits from huge investments made
in real estate or investment bankers did some shady deals. So, to narrow down the possibilities and to get
the exact problem, which actually cause the financial crisis, I was following finding from the case THE
2007-2008 FINANCIAL CRISIS: CAUSES, IMPACTS AND THE NEED FOR NEW REGULATIONS as follows:
Investors wanted to invest, as they had a pile of money. Traditionally, they invest into treasury bill from
the US Federal reserve, but due to the DOT COM boom in September 11, Federal reserve chairman Alan
Greenspan, lowers interest rate to 1% as return on investment. So, investors said no to treasury bills, but
on the other side, this means that banks can borrow money from the federal reserve at every low interest
rate as it was 1% adding to which, reserves from japan, china, and other middle east countries. Which
made cheap credit and bank can borrow easily. This gave banks to play with leverage (leverage is
borrowing money to amplify the outcome of a deal)
How leverage works? In normal case without leverage, a person with Rs10000 will buy a box and sell it to
another person for Rs11000, which resulting in making Rs1000 as profit, but in case of using leverage, a
person with Rs10000 will borrow Rs990000, making it total Rs1000000 and then he buys 100 boxes and
sell it to another person for Rs1100000 and then he pays back that Rs990000 borrowed money with
Rs10000 as interest. He still left with Rs100000 after his initial investment takes out of Rs10000 from it,
he left with Rs90000 as profit. This concludes that in the normal case, a person makes Rs1000 as profits,
whereas in leverage cash, he could earn Rs90000 a profit.
The family wanted their own house, they had saved down payments and through brokers, they get
connected with mortgage lenders, who gave them a mortgage. Everyone was happy, until that investor
banker, who wanted to invest their money and make profits, they contact the mortgage lenders and those
investor bankers purchased those mortgages from lenders. Investment banker saw the opportunity to
earn profits, as they were getting money with interest every month from home owners. Investment
banker borrowed millions of dollars, as it was available at lower rate of interest and they bought more
and more mortgages. Then investment bankers made a box, by putting in all those mortgages in it and
dividing that box into 3 stages, safe, ok and risky. That box named CDO (Collateralized debt obligation).
To make the top stage safer, bank insured a small fee, called CDS (Credit default swap), a credit default
swap is a financial swap agreement that the seller of the CDS will compensate the buyer (usually the
creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. After
all these, credit agency rates (Frozen credit market) the stages by AAA (safe), BBB (okay) and Unrated
(risky).
Investment bankers sell that AAA rating (safe) mortgage to those investors, who wants safe investments,
BBB rating (okay) to other bankers and Unrated (risky) ones to hedge funds. Through this process,
investment bankers make a tremendous load of money with profits after repayment of borrowed money.
Investors who bought those CDO (safe one), they getting more than 1% as return on investment on
treasury bills from the Federal reserve. So, they wanted more of these types of CDOs
So, to create a need of mortgage among the families brokers started accepting those families application
with no down payments, no proof of income, no proper documentation, etc. they provided Cov light
loans with fewer conditions than traditionally. So instead of lending to responsible homeowners called
Prime mortgage, they lend to less responsible homeowners, these are subprime mortgage. This
eventually gave birth to financial crisis 2007-08. In 2001, housing price was rising by 8% and by 2004-05 it
went to 14%, which concluded that investment bankers can borrow at 1% and house appreciated by 14%.
Which eventually led to increase monthly defaulters against mortgage, directly effecting the investment
bankers.
As time flies, more and more payments were getting default and investment bankers end up with a lot of
houses, as owners were defaulted and mortgage got breached, therefor ultimately making investment
bankers a true owner. They end up with so many houses and no monthly payments, forcing it to sell
publicly, as they need to repay borrowed money but they couldnt find buyers for the house, as they
created more supply against demand of houses and devalued the house value. Banks couldnt sell assets
or buy assets and which led to losses spiral out of control and it turned $228 billion-dollar problem in $300
billion-dollar problem and eventually increased to $13 trillion-dollar problem. Which led to decrease in
housing price instead of increasing, as it supposed to. Investors, who already bought those CDOs, also
faced the same problem, as they were unable to sell and sound mortgage faced the same problem.
Everyone got affected.
This led to affect the investors, investment bankers, mortgage lenders, homeowners, brokers, banks,
which led to broke whole financial system. Everyone got Bankrupt.
What federal reserve does is they go out and buy bonds and when they buy bonds, they inject cash into
the banking system and typically banks take that money and lend it out, but after 2007-08 crisis, banks
have sit on excess reserve and so when you look at the economy today and see how it's grown, whats
fascinating about this growth is actually coming from Entrepreneurship.
Which actually indicates that the free market works and realize that many times government rules,
regulations and actions, especially with interest rate have a major impact. I personally feel that
understanding of the 2008 crisis, people have the conventional wisdom that banks lost control is actually
the wrong, I believe it is the government who lost control and by fixing that we actually started
recovering?
Do you think the BASEL accord will reduce risk? (3 marks)
Basel II is a regulatory accord that is based on three main pillars: minimal capital requirements, regulatory
supervision and market discipline. Minimal capital requirements play the most important role in Basel II
and obligate banks to maintain minimum capital ratios of regulatory capital over risk-weighted assets
because banking regulations significantly varied among countries before the introduction of Basel
accords, a unified framework of Basel I and, subsequently, Basel II helped countries alleviate anxiety over
regulatory competitiveness and drastically different national capital requirements for banks.
The basic concepts involved in calculating risk were being challenged as the Basel Accord modification
was allowed. Banks were given authority to categories as per the risk and degree to which these different
categories should have different reserve ratios. The problem with this model was an 8 % reserve ratio that
could be modified in accordance with the various risk categories. Also, 8% is not very adequate to cover
the risk. After studying the case, I think the Basel Accord will not reduce the risk but will increase the risk.

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MARCH 20, 2017

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