With economists analyzing the Global Financial Crisis left, right and centre, it sometimes becomes difficult for people to understand what is actually going on. Economic and financial terms are being thrown about and those of us not very familiar with the subject feel lost.
So it’s classroom time once again, let’s try to see what’s going on.
1- Who started the crisis?
The crisis is closely related to the mortgage system in the
2- How do mortgages in the U.S work?
Qualified buyers work with a mortgage broker to get a loan from a mortgage lender, and in the process the broker makes a commission.
3- What is the relation between mortgages and Wall Street?
Investment banks became interested in buying mortgages from mortgage lenders, but they usually bought them using leverage i.e. using money that is part theirs and part borrowed in order to buy a lot of mortgages. These mortgages are bundled together into a bigger asset and turned into collateralized debt obligations (CDOs). CDOs are asset backed securities that have been sliced up into three different tranches which are sold off to different investors, enabling investment banks to make huge profits and re-pay their loans. Money coming in the form of homeowners paying their mortgages goes to cover the CDO tranches and pay their rate of return. However, each tranche carries a different level of risk according to its coverage priority. What happens is that as money comes in to cover these tranches, it first covers one tranche, once covered the money pours over to the second tranche and once that is covered it pours over to the third. Accordingly, the top tranche is the safest as it is the first to be covered, the second carries moderate risk, while the third is the riskiest as it is the first to be affected if mortgage payments dwindled due to defaults.
This is why the riskiest tranche has the highest rate of return –to make up for the risk level- while the safest has the lowest rate of return. Rating agencies also rated these tranches. The safest tranche was given a AAA rating and was also insured by banks for a small fee called a credit default swap, the moderately risky tranche was given a BBB rating, while the riskiest tranche was left unrated.
4- So what went wrong?
Investors really liked the high returns these CDOs were bringing in, so the demand for them increased, yet the availability of qualified mortgages (prime mortgages) did not match this demand, so brokers started finding people who wanted a mortgage but did not necessarily qualify for one, hence they became called sub-prime mortgages. This along with the dot com bust of 2000 which caused the American Federal Reserve to bring down interest rates considerably, contributed to the increase of people who could afford borrowing money to buy houses. Mortgages were also offered with very lenient terms in order to encourage more people to buy houses. However, this meant a greater risk for default. If the homeowners defaulted on their mortgages, property of the house went to the investment bank which then tried to sell it off.
This was initially fine as housing prices were constantly on the rise. Rising prices even encouraged homeowners to take out home equity loans (loans that used home equity [the actual value of the house minus any outstanding mortgage/debt value] as collateral). But as more sub-prime mortgages were added to investment banks’ portfolios –USD 3.2 trillion between 2002 and 2007-, this meant that investment banks faced more defaulting homeowners, which meant that they had to put up more and more houses for sale. This increased the supply of houses against demand, which accordingly brought housing prices down. With house prices decreasing, many prime mortgage owners disliked the fact that their houses’ values were falling yet they were still paying the same mortgage installments, so they too defaulted on their mortgages and walked away from their houses. This in turn meant that investment bankers now owned houses that were practically worthless, which also meant that the investors no longer wanted to buy CDOs from those bankers. This turned into a grave situation for investment banks, as they had taken out huge loans in order to buy more mortgages and were now unable to repay those loans. Lenders were also affected as they could no longer sell mortgages to investment banks, while many investors lost money as they owned worthless CDOs. Individuals with home equity loans were also unable to repay as the value of their houses no longer covered those loans. The financial system froze and everybody started going bankrupt.
The first week of September 2008 witnessed a critical turning point in the sub-prime mortgage crisis as global credit liquidity began drying up and investment banks and financial institutions faced the threat of insolvency.
On September 14, Lehman Brothers announced that it would file for bankruptcy and Merrill Lynch was sold to Bank of America. On September 16, American International Group (AIG), heavily involved in the credit default swaps markets, suffered a liquidity crisis. After AIG could not find lenders to solve its insolvency problem, the Federal Reserve bailed it out through a USD 85 billion credit facility in exchange for a 79.9% equity interest. On September 21, Goldman Sachs and Morgan Stanley turned from investment banks into bank holding companies, which made them subject to more regulation.
5- How does this crisis affect the rest of the world?
6- How will
At this stage, the true effects of the global financial crisis on
The Egyptian government will be trying to alleviate the effects of the crisis through a EGP 15 billion stimulus package which will be directed at infrastructural projects, increasing export subsidies, as well as a one-year exemption from sales tax and customs on capital goods.
Economists are still unable to foretell how this crisis will unfold and how long it will last, but what they do know is that it has not reached its peak yet. The only thing we can do is to hold on tight and prepare for the worst, for this ride will not be an easy one.