Hi 74.5
Let's say a Bank A foolishly decides to give mortgages to 100,000 people who are on the minimum wage (the CEO of the bank reads the Daily Express, and mistakenly believes that house prices are soaring, so thinks it's a low-risk decision!).
Bank A can either keep the risk (and the reward) in-house, or sell CDOs and CDSs to Bank B and Finance House C.
Assuming all three financial institutions fall into the 'too big to fail' category, is the potential damage to the economy not the same either way?
Jeff
Why are poker players so feted?
Before CDOs came into being,a lender retained a mortgage.If the borrower failed to keep up with the repayments,the lender suffered financially unless the house had equity.In this case,the lender could repossess the house and sell it to recover their losses.If the house was in negative equity, the lender lost financially.Lenders were therefore cautious and only gave mortgages to those that they thought were credit worthy.When CDOs came into being,lenders had no need to be cautious any more because they could lend to any and everyone because the mortgages that they sold would be sold on to financial organisations. Therefore,if a borrower went into default,it didn't matter to the mortgage provider because they,having sold the mortgage on,would not suffer financially.As a result,lenders acted irresponsibly because they lent to borrowers who couldn't afford the repayments.These became known as sub-prime mortgages.Ferru123 wrote:Hi 74.5
Let's say a Bank A foolishly decides to give mortgages to 100,000 people who are on the minimum wage (the CEO of the bank reads the Daily Express, and mistakenly believes that house prices are soaring, so thinks it's a low-risk decision!).
Bank A can either keep the risk (and the reward) in-house, or sell CDOs and CDSs to Bank B and Finance House C.
Assuming all three financial institutions fall into the 'too big to fail' category, is the potential damage to the economy not the same either way?Jeff
Once a financial organisation (eg. Lehman's and Bear Stearns) had purchased mortgages, the plan was to group them into CDOs in such a way that each CDO contained a large proportion of prime and a small proportion of sub-prime mortgages.In this way,if the sub-prime mortgages went sour, much of the value of the CDO was retained.So much for plans.There were just too many sub-prime and too few prime mortgages to allow the plan to be executed.The result was that when the sub-prime fiasco hit,CDOs plummeted because most contained too many sub-prime mortgages for their value to be retained.
What made matters worse was that many of the CDSs that were created to insure the CDOs in the event of their failure had been traded and were held by organisations /individuals that didn't understand how toxic the CDOs were and/or didn't have the funds to cover the CDO losses.The reason why the toxicity of the CDOs wasn't recognised was because they had been (erroneously) rated by Fitch, Moody's or Standard & Poor's as 'AAA'. They had rated the CDOs so highly because a)they weren't able to determine their true rating because of their (deliberate?) complexity and b)they were being paid by the CDO creators to rate them 'AAA' (conflict of interest?).
The real issue here is that if the initial mortgage lender retains the mortgage,it is in their own interests to lend responsibly.Once CDOs came into being,they could sell their mortgages to a third-party and no longer needed to act as a responsible lender.
Even if house prices had continued to soar,the brown stuff would eventually have hit the fan because too many mortgages were sold to too many people that couldn't afford the repayments.The only reason that they could afford the repayments initially was because the requirement for a deposit was waived and the first year's repayments were deeply discounted.In the second year,the repayments rose dramatically.Because they couldn't afford the increase,their homes were repossessed and placed back on the market.This large influx of homes hitting the market depressed prices and the rest is,as they say,history.
Basically,CDOs allowed lenders to de-couple themselves from borrowers and when this happens you get irresponsible lending.
Who's to blame?Is it the greedy bankers for lending irresponsibly,greedy people for borrowing irresponsibly,the regulators for not imposing the necessary financial controls,the credit rating agencies for rating CDOs and CDSs as 'AAA' rather than 'Junk' status,the companies that created the CDOs and CDSs or all of them?One thing is for sure.It wasn't the fault of traders (financial or otherwise).
74.5