In the case of the current financial crisis this resulted in pooling together of various Jumbo, Alt-A, and Subprime loans.
This is where the real mess happened. Somehow, mixing up a combination of these
risky loans resulted in investments with AAA ratings. With
low interest rates, these investments provided an exceptional level of return
for the perceived level of risk. As a result of this these products were in
high demand and could be traded without requiring a credit assessment.
Many investors hedged against the risk of default by purchasing a credit-default swap. Derivatives,
described by Warren Buffet as "financial
weapons of mass destruction" in
early 2003 were had also exploded during this period. According to
the International Swaps and Derivatives Association, in 2008 the estimated
value of CDS’s in the market was $62 trillion.
So the Banks had removed these securities off their balance sheets
and had insured themselves in case of them defaulting. However in 2007,
when house prices began to fall and delinquencies increased there was also a
fall in demand for subprime backed securities. The credit rating agencies
suddenly realized that their investment
grade ratings were incorrect and
had provided a false sense of security to investors. This resulted in the
credit rating agencies downgrading these securities which in turn caused
investors to start selling them. Many securities fell below investment grade so
demand for these products fell rapidly.
This led for the demand of insurers to meet their commitments to
their CDS’s and guarantees. Many did not even know who was currently holding
them and whether the holders can actually pay in the event of a negative credit
event. It soon became quite clear that many
insurers were unable to meet their commitments. These CDS’s were not
regulated, not traded on an exchange, subject to re sale and subject to
counterparty risk. For example when Lehman Brothers went bankrupt, any CDS
protection it offered was nullified.
In my opinion, this was the primary
cause of the subprime
mortgage crisis in America coupled with the credit rating agencies inability to
fairly rate such products that I will discuss next week
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