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Subprime Crisis:2008

 Subprime Crisis: 2008




"Stock market bubbles don't grow out of thin air. They have a solid basis in reality as distorted by misconception."   
-George Soros.



Dot-Com bubble-

                              Around 1995, In USA Tech companies started performing very well, they starting expanding their businesses across the globe. So stock prices of tech companies rises tremendously then after competition increases in tech field, prices of  tech companies started falling in year 2000 and touch low at year 2002. Simultaneously with this development Interest rates on bank deposits decreases sharply, in year 2001 it was around 1% only. As investors already took out investment from stock market and Interest rates also low so they started looking for new option for investment. 

Fundamental Developments- 


                            At the same time US government headed by Mr. Bush started encouraging to people for buying homes and designed policies accordingly. So from here fundamental  developments for housing bubble started. Duning this time as demand for new houses start increasing as simple logic of 'Demand & Supply', if demand rises with same rate of supply or slightly increase in supply then price of product started increasing. As banks having low interest rates on deposits so rates on lendings are also low. As result of cheap housing loans peoples started buying homes so real estate sector  started making huge profits and here investors get option for investment. 

Entry of Investment Banks- 


                               As real estate sector gaining profit, IB's are also planning to get benefits from this boom. Retail banks started lending home loans and start making profits through interest rates. While lending home loans, banks checking proper credit history of loan takers and only lend loans  to customer having prime credit history. IB's started buying loans from retail bank. Means if loan takers failed to repay loans they will pay behalf of customers.  IB's took this risk because these loans are mortgauge based loans. They thought they will manage risk by selling mortgauged properties. Retail banks also having no issue on this because banks transferring  risk of default loans to IB's.

So after purchasing loans from banks IB's makes bunch of loans and making new product from this, which known as CDO's(Collateralized Debt Obligation) or MBS(Mortgage backed securities), a complex derivative instrument which having underlying mortgaged homes. 
After IB's made new product , as derivative CDO's/MBS they managed to get 'AAA' ratings from rating agencies like Moody's. At that time rating agencies makes billion dollars profit  from giving rating to CDO's. These new securities having 'AAA' ratings became very attractive to investors. IB's starts providing more and more securities to investors and making billions of dollars and result of these risk was transferred to investors. 

Where system went wrong- 


                          Till this all was went well but from here journey towards disaster has been started. As CDO's & MBS was became more popular among the investors so demand increases. IB's started demanding more more housing loans from retail banks. So banks who providing housing loans as per procedures but from now they are started providing loans without evaluating customers credit history or lends to those having credit history was subprime. 

AIG (American International group) a American company started providing insurance on CDO's & MBS. And this is journey towards last mile of disaster. AIG thought all CDO's & MBS have 'AAA' rating and they are have underlying have mortgage, so chances of failure of them are very low or negligible. So CDO investors started buying insurance from AIG for safe guarding their investment in CDO's.

Trigger of crisis-


                        Many loans lends at ARL rate(Adjustable rate loans) means at initial years interest rates are lower but as period  increases rates are increasing. And many peoples who took loans they don't aware about it. So those having credit history not good or subprime credit history they started defaulting due to increased EMI amount. They unable to repay loans and crisis triggered and snow ball effect started. Banks started selling their homes to recover loan amount. As Banks started selling homes, prices are dropped drastically due to supply of homes in market increased.  So as current prices of homes  loan amount is far greater so peoples having primes credit history also started defaulting loans. 
As underlying which is homes in this case facing sharp price drop and resulted failure of CDO's  & MBS. So investors who brought insurance from AIG on CDO's  they started claiming insurance amount. As these insurance having no pre-condition of actual holding of CDO's so claimed amount was huge, resulted AIG failed to provide insured amount to investors CDO's and AIG made huge losses. Finally US Fed reserve bailout the AIG.

As failure of CDO's no new buyers for CDO's then IB's having lots of inventory of CDO's started making losses. In this crisis major IB's like Lehman Brothers, Merrill Lynch was worst affected and became bankrupt. IB's and Banks made losses of more than $450 Bn.

Main reason behind this bubble/crisis was there is no regulator on CDO's & MBS. Rights of regulation was vested in office of Fed Reserve but that times head of Fed Reserve was refused to regulate CDO's.

Impact of crisis-


                          This crisis leads to credit crunch in economy means very low availability of loans/credit in market.
So businesses getting trouble to get loans for business and many of then started closing. As businesses shuts down unemployment raised. Worlds is now global and also that time as US is major economy in world, global trades affected from this. As globalized world economies are interconnected so many countries become bankrupt. 

Link of PPT presentation-   👉👉  PPT's of Subprime Crisis




Mayur Jagtap

Investment Consultant.



For regular and daily small update 



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