This presentation explains the events and causes that led to Global Financial Crisis in 2007-08, mainly focused on Collateralized Debt Obligations, Sub-Prime Mortgages, Credit Default Swaps and Housing Bubble.
3. INTEREST RATE
➢ Federal Reserve lowered the Federal funds rate 11
times - from 6.5% in May 2000 to 1.75% in
December 2001, creating a flood of liquidity in the
economy.
➢ In June 2003, the Fed lowered interest rates to 1%,
the lowest rate in 45 years.
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➢ For the investors, Treasury Bonds yield was very low,
and they were eagerly looking for the alternate safe
investments – CDO’s & CDS’.
➢ This caused banks to go crazy with Leverage.
Leverage is borrowing money to amplify the
outcome of a deal.
4. Collateralized Debt Obligations
➢ A collateralized debt obligation (CDO) is a
complex structured finance product that is
backed by a pool of loans and other assets
and sold to institutional investors.
➢ A CDO is a particular type of derivative
because, its value is derived from another
underlying asset. These assets become the
collateral if the loan defaults.
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5. Sub-Prime
Mortgages
➢ A subprime mortgage is a type of loan granted
to individuals with poor credit scores who
wouldn't qualify for conventional mortgages.
➢ The term subprime itself refers to the borrowers
and their financial situation rather than the loan
itself. Subprime borrowers are more likely to
default than those who have higher credit
scores.
➢ More home loans, more home buyers, more
appreciation in home prices.
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➢ The rating agencies began to give false AAA ratings
for the CDO’s issued by the banks and large financial
institutions. which led to the belief that Mortgage
CDO’s are the safest.
6. Credit Default Swaps
➢ Credit Default Swaps are like an insurance which is
taken against a risk for a fixed amount of premium.
➢ Credit Default Swaps were turned into other securities,
that essentially allowed traders to bet huge amount of
money on whether the values of mortgage securities
would go up or down.
➢ All these financial instruments led to the web of
assets, liabilities and risks. So when things started to
go bad, they went bad for entire financial System.
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7. Raghuram Rajan
➢ Rajan predicted financial crisis saying, “The financial market had developed
to become more complicated and less safe.” He said financial instruments
such as derivatives like credit default swaps were risky.
➢ Credit default swaps, a relatively new and potentially volatile financial
instrument, were surging; in 2001, they made up just 5 percent of private-
sector bank credit; by 2004, they made up more than 30%.
➢ Incentives were horribly skewed in the financial sector, with workers reaping
rich rewards for making money, but being only lightly penalized for losses.
That encouraged financial firms to invest in complex products with
potentially big payoffs, which could on occasion fail spectacularly.
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8. ❖ A perverse incentive is when a policy ends up having a
negative effect, opposite of what is intended.
❖ An incentive is a bullet, a key: an often tiny object with
astonishing power to change a situation.
Perverse Incentives
- Steven Levitt, Freakonomics
9. The United States housing bubble was a real estate bubble
affecting over half of the U.S. states. Housing prices peaked in
early 2006, started to decline in 2006 and 2007.
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Housing Bubble
What is Housing Bubble?
A housing bubble, or real estate bubble, is a run-up in
housing prices fuelled by demand, speculation, and
exuberant spending to the point of collapse. Housing
bubbles usually start with an increase in demand, in the
face of limited supply, which takes a relatively extended
period to replenish and increase.
Speculators pour money into the market, further driving up demand. At some point, demand decreases or
stagnates at the same time supply increases, resulting in a sharp drop in prices—and the bubble bursts.
11. The Beginning of the End
➢ The trouble
started when the
interest rates
started rising, and
home ownership
reached a
saturation point,
the Federal
funds rate had
reached 5.25%
which remained
unchanged until
August 2007.
PHASE 1
➢ No one was interested
in buying or eating
more candy. Then,
during the last quarter
of 2005, home prices
started to fall.
➢ Many subprime
borrowers now could
not withstand the
higher interest rate,
started defaulting on
their loans.
PHASE 2
➢ Every month, one
subprime lender or
another was filing for
bankruptcy. During
February and March
2007, more than 25
subprime lenders filed
for bankruptcy, which
was enough to start
the tide.
PHASE 3
➢ Financial firms and
hedge funds owned
more than $1trillion in
securities backed by
these now failing
subprime mortgages,
enough to start a
global financial
tsunami if more
subprime borrowers
started defaulting.
PHASE 4
➢ The financial
market could not
solve the
subprime crisis on
its own and the
problems spread
beyond the United
State's borders.
PHASE 5
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12. 12
TARP
Troubled Assets
Relief Program
The Troubled Asset Relief Program (TARP) was an initiative created and
run by the U.S. Treasury to stabilize the country’s financial system,
restore economic growth, and mitigate foreclosures in the wake of the
2008 financial crisis. TARP sought to achieve these targets by
purchasing troubled companies’ assets and stock.
HENRY PAULSON
U.S TREASURY SECRETARY
GEORGE W. BUSH
THE PRESIDENT OF USA
ALAN GREENSPAN
CHAIRMAN OF FEDERAL RESERVE
13. 13
The Legacy of
TARP
➢ In December 2013, the Treasury wrapped up TARP and the
government concluded that its investments had earned more
than $11 billion for taxpayers. To be more specific, TARP
recovered funds totalling $441.7 billion from $426.4 billion
invested.
➢ The government also claimed that TARP prevented the
American auto industry from failing and saved more than 1
million jobs, helped stabilize banks, and restored credit
availability for individuals and businesses.
14. "The fault lies not in the stars, but in us.”
-SHAKESPEARE
It happened in a system made up of humans, with human failing.
Some didn't understand what was happening.
Some wilfully ignored the problems.
And some were simply unethical,
motivated by the massive amounts of money involved.
TO
CONCLUDE…