Tuesday, March 10, 2009

What caused the recent US Financial Crisis

“What exactly happened” is a scope I don’t have answers for. But I do have a certain understanding I have gathered from the internet.

It started with the FED deciding to tighten the monetary policy. This resulted in low real interest rates. Returns from financial securities are tied to interest rates set by the FED such that the basic return [on their money] anybody can make is from a short-term government bond, which impacts the return customers are going to get when they put their money in the bank, which impacts the money people want if they decide to raise the stakes and put their money in some place riskier with the promise of higher returns such as buying from the stock market.

In fact there are a number of different types of securities available such as the various kinds of stocks and bonds. All these securities make an inverted pyramid that make up all the financial instruments available for people to trade in.

So back to our story… when the FED reduced the interest rates all the financial securities were affected such that all of them were now providing low returns.

At this time people were becoming interested in buying houses in the US.

With an increasing trend in real estate purchases “mortgages” came in high demand.

Financial engineers developed a number of securities [that were part of the financial pyramid] that were based on these mortgages [with mortgages being the fundamental instrument at the bottom of the pyramid on which all these securities were based]. Since fundamentally people were buying houses, mortgages and all mortgage-based-instruments were a strong investment option for customers.

At a certain point in time a lot of real estate had been purchased in the US and there were signs that new customers would not come forward to buy real estate.

If I understand correctly Freddie Mac and Fannie May the two companies who owned most of the mortgages sold in the US were asked by the US Senate for a plan. At this point the two companies decided to enter the sub-prime market [prime is a credit rating threshold for a debtor below which he is denied a loan and above which he qualifies to get a loan. A sub-prime applicant is one who falls below this credit threshold] taking the percentage share of the sub-prime debtors in the mortgage market from below 5 % to about 20%.

When the sub-prime market came to its exhaustion point like the main market before it there were signs of trouble.

Investors decided to sell their share of mortgage-based-securities but nobody was willing to buy. The banks that had a major investment in these mortgage-based-securities were asked to mark-to-market these investments [mark to market means to mark the value of the security on their books at the market price] by [I think] the State Bank.

When this happened, the reserves of banks took a huge fall over-night and as a result they could not meet their reserve requirements [reserve requirement is the amount of money that banks are told to ALWAYS have with them as per government requirement]. This impacted the financial industry badly. All other investors who had invested in mortgage based securities also had their investments brought down to near zero.

This is how I read, things unfolded themselves!

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