An Overview of the Credit Crunch
The credit crisis of 2007 began in the United States sub-prime mortgage industry. The effects of the collapse of the sub-prime spread all over the United States economy and into the global market. It was not suspended within the residential real estate market.
About the Effects
The effects have been very difficult on the financial services companies, with several investment banks having a short but thorough history of applying mortgage-supported securities or MBSs to spread risk and gain more capital. The failure of the MBS market minimized the capital supply provided to institutional investors, thereby leading to a snow ball effect. It is important that you understand the effects and general definition of the term to hopefully develop means and methods of coping for the long term.
Some Examples
The auction rate securities market collapsed in 2008, when a major bank, together with a couple of other banks that auction the securities refused to function as bidder of last resort. The refusal negatively impacted various institutions like hospitals, cities and schools that issued the bonds.
The refusal was brought by the scope of the market’s failure and the banks’ need to reduce risk after the widespread write-offs of MBS. Other affected institutions include the companies that owned the schools and hospitals. Freezing the auction rate securities market is an example of the major impact of the credit crunch, with the catalyst being traced back to one source, which is mortgage investment. This cannot be easily contained.
The Effects Spread
A lot of big investment agencies and firms have had the stock prices drop due to the sub-prime bust and credit crunch. While companies under have dealt with the largest losses as of the first quarter in 2008, agencies all over the industry have been negatively affected by the financial crisis. Lehman Brothers Fin SA or LEH reported the first quarterly loss in history for the second quarter of 2008. The company lost more than $2.8 billion for that quarter. Just recently, the stock price of Lehman has dropped more than 62% YTD.
Other firms in Wall Street were also greatly affected, such as Citigroup who just reported a fourth quarter loss of more than $9 billion, including %18 billion in pre-tax write downs on sub-prime-linked assets. This is reportedly the biggest lost in Wall Street history. UBS AG also shut down one hedge fund after incurring losses amount to around $123 million. UBS reported a loss of $4.4 billion on fixed-income securities for the third quarter of 2007. At present, UBS is exposed to $16.8 billion in subprime mortgage-supported securities and $1.8 billion in collateralized debt requirements.
Mortgage Bust
Several of the sub-prime mortgages started in 2000, having adjustable interest rates, compared to fixed rates. In 2006, about 80% of all sub-prime loans started to feature teaser rates, offering as low as 1% only during the introductory period. When introductory time ended, borrowers suddenly discovered that they have monthly payments that were very high.
A study in 2007 showed that monthly payments for 60% of the entire adjustable-rate mortgages created since 2004 will increase by around 25% of more. With the payments rising, over 24% of sub-prime loans were in foreclosure or delinquent by 2008. Securities supported by the mortgages also started to fall in value. Banks and investors were hit hard as they package mortgages into securities.
Securities and Obligations
One of the primary features of the sub-prime rise was the extensive use of mortgage-supported securities, complex financial instruments and collateralized debt obligations by investment banks, to obtain more capital and spread the risk all over. On a typical case, sub-prime debt became too risky to be worth investing in. However, the rise of CDOs and MBS allowed banks to spread the losses from a single default over several other mortgages. The risk of significant losses for investors was then reduced.
On Security
The idea of security, together with the possibility of having bigger returns than on prime-backed securities, caused the sub-prime MBSs very popular among different investors, also including investment banks, asset management agencies and hedge funds. As sub-prime defaults increased and banks started to post big losses on securities related to sub-prime, investments have to be cut back on to build more capital.
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Author: Selva Sugunendran CEng,MIEE,MCMI,CHt,MIMDHA,MBBNLP,MABNLP. Selva is an Integrated Systems Business Consultant,Internet Marketer, Master NLP Practitioner and Master Hypnotherapist.
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