Exactly How the Financial Crisis Started

Many people don’t understand the fundamental reasons why the US financial system is failing and the reasons behind the day to day volatility. In this post, I try to explain to you how this mess happened.

It all started about a decade ago when banks started redlining urban centers which immediately disqualified people from obtaining mortgages in the hypothetical red areas. The problem began when banks thought the solution to redlining was with sub-prime mortgages. Banks deceitfully offered significantly discounted interest rates that would eventually skyrocket after an initial 2 year term. In some cases, the principal was higher after the two year period! The problem was that loans were being granted to people with very poor credit ratings, including to people with Loan to Value (LTV) ratios of more than 88%, compared to the maximum current cut off of 75% which is arguably also pushing it. Another problem was that people were able to provide their own income which was never verified. If you’re wondering why people would take the loans, we can generalize with these main reasons: the banks deceitfully didn’t disclose the teaser rate wouldn’t last, the loan seemed so affordable it was basically free money, and people wanted to own their homes and didn’t have another alternative to get a mortgage.

So, what did the banks do with all of these loans? They grouped the loans into Mortgage Backed Securities (MBS) which were bought by various investment banks who converted the MBS into new financial instruments called Collateralized Debt Obligations (CDO). The banks originally developed MBS because they are only required to hold 1.6% of capital for mortgage backed securities, compared to 4% to hold a mortgage. The CDO instruments were then setup in the Cayman Islands to avoid taxes where they were then artificially rated by credit agencies who received most of their income from structured finance products. The real problems were for firms that invested in CDO securities based on the artificial ratings. Essentially, as people began to default on their mortgages because of the new high rates after the initial 2 year term and falling home values, the CDOs failed along with the firms heavily invested in these securities.

In recent events, on March 5 2008, $20 billion hedge fund Carlyle Capital missed its margin call (its positions totaled less than the allowable threshold), and In June 2007, the Bear Sterns sub-prime hedge fund also failed. More recently, ex Bear Sterns executives Cioffi, Tannin and a third Bear Sterns executive are being sued in a civil case by the Bank of America for understating the hedge funds performance by drawing the bank into a $4 billion investment. There is also talk now that the Fed will buy $600 billion in troubled mortgages to avoid further decreases in home values. Furthermore, Lehman Brothers investment bank recently went under after a $3 billion loss, all because of the credit crisis that resulted from very risky bad loans that were made in hopes of high returns by banks. All of this also resulted in runs on backs (people rush to take their money out) which was further adding to the problem. As businesses and people could not get credit, these problems spilled over to the real economy. Companies such as GM who need cash cannot get loans and they are in risk of going under. So, we can expect now with the bailout of cash injections that the financial crisis will subside within 2 years as the peak of defaults end.

I hope you now better understand the events that have caused this credit crisis better and the reasons behind why the banks did this: which are clear, they gambled with extremely risky loans hoping to earn substantial profits (they probably even knew they would be bailed out because the positions would be too big to fail, which served further as an incentive to take on these risks).

In an upcoming post I will give a detailed analysis about GM, how its doing and where its going and how its being affected by the credit crisis.

If you have any questions about the financial crisis, please do not hesitate to post them in the comments and I will try my best to answer you.


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Hercules holds a B.Comm Finance from Ryerson University in Toronto, Canada. He is a Chartered Financial Analyst (CFA) level 3 candidate. He was previously a contributor at FiLife, a finance website owned by Dow Jones and IAC. Write to hercules@business2press.com
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  • Paxalot

    It was the sub-derivatives that caused the problem. The derivatives on derivatives. The bets on bets that had no actual mortgage behind them.

  • cybexg

    Both the article and the first response are WRONG.

    A better explanation is that the utilization of strategic practices (collectively known as hyper competitive methodologies) coupled with the lessening of competition inducing mechanisms has created a distorted, virtually non-rational market. This in turn promotes great inefficiencies, huge power imbalances and, ineffective (and non-beneficial) exploitations.

    Now here’s my question; why are so many of these types of articles incorrectly focusing on a single cause to a multi-national, multi-component problem? For that matter, why are so many of these types of articles usually based upon economic models 30 years out of date with modern business strategy?

  • steve

    why is it always the evil corporations, or the evil banks, or the evil fossil fuels suppliers, or Walmart… they HAD TO HAVE something to do with this??

    Why isn’t it the Mark to market accounting, the legislation that mandated “subprime” loans, or irresponsible BORROWERS, who knew they had no means to repay the loans at the current terms, much less if they went up? are they blameless.
    how about it’s more like a record skipping. this same thing has played out MANY times before. greed cycle, and stupidity collide. and the minions cast out blame like piss in the wind, it covers all, but does nothing to stop the fire. Keep putting your faith in the Government and watch Rome burn. The Bailout is a farce, and will kick us while we’re down. History repeats, and should be looked at for guidance, not as crusty old guys in wigs who’s ideas are of no use. wisdom of the ages might be needed to solve a problem if HISTORIC proportions.

  • Greg

    Intersting article. Too bad it does not explain that the HUD was the primary reason the banks expanded the subprime markets to begin with.

  • Greg

    Intersting article. Too bad it does not explain that the HUD was the primary reason the banks expanded the subprime markets to begin with.

  • Greg

    Intersting article. Too bad it does not explain that the HUD was the primary reason the banks expanded the subprime markets to begin with.

  • Rediculous

    Yeah, the people who signed the paper and got the loans had no fault in this. Blame it on the banks.

    What idiot wrote this. When will people take credit for their actions? Most people signing the ARMs knew they would adjust and KNEW they couldn't afford the house they were buying.

    This isn't the banks fault. It's people like this author blaming everyone except the individual- nobody taking responsibility for their decisions or the results of them anymore; that's the problem.

  • Rediculous

    Yeah, the people who signed the paper and got the loans had no fault in this. Blame it on the banks.

    What idiot wrote this. When will people take credit for their actions? Most people signing the ARMs knew they would adjust and KNEW they couldn't afford the house they were buying.

    This isn't the banks fault. It's people like this author blaming everyone except the individual- nobody taking responsibility for their decisions or the results of them anymore; that's the problem.

  • Rediculous

    Yeah, the people who signed the paper and got the loans had no fault in this. Blame it on the banks.

    What idiot wrote this. When will people take credit for their actions? Most people signing the ARMs knew they would adjust and KNEW they couldn't afford the house they were buying.

    This isn't the banks fault. It's people like this author blaming everyone except the individual- nobody taking responsibility for their decisions or the results of them anymore; that's the problem.

  • http://business2press.com Hercules K

    people should be held for their actions, at the same time, the bank, who has the knowledge, experience, and power, should have a higher standard of care for the people who want a loan – I definitely agree people should be responsible, at the same time, I also think the banks shouldn't have encouraged sub prime mortgages as they did

  • http://business2press.com Hercules K

    people should be held for their actions, at the same time, the bank, who has the knowledge, experience, and power, should have a higher standard of care for the people who want a loan – I definitely agree people should be responsible, at the same time, I also think the banks shouldn't have encouraged sub prime mortgages as they did

  • http://business2press.com Hercules K

    people should be held for their actions, at the same time, the bank, who has the knowledge, experience, and power, should have a higher standard of care for the people who want a loan – I definitely agree people should be responsible, at the same time, I also think the banks shouldn't have encouraged sub prime mortgages as they did

  • Rediculous

    Sub prime mortgages were extremely useful for certain situations. It was the mis-use of them that was a problem. Some people with poor credit can manage their money, but those aren't the ones foreclosing.

    When New York went bankrupt in '75, it was because people intentionally misused the system in place for welfare while playing within the rules.

    We're seeing the same thing here, an intentional misuse of the system. The lending system wasn't designed with what happened in mind; still everyone blames the designers insead of the misusers.

    The people that were fixated on a house, and refused to acknowledge the fact that they couldn't afford it are a great example of misusing the products.

    You can't blame a gun manufacturer or gun store for how someone uses their product, so why blame the bank or broker for misuse of theirs?

  • Rediculous

    Sub prime mortgages were extremely useful for certain situations. It was the mis-use of them that was a problem. Some people with poor credit can manage their money, but those aren't the ones foreclosing.

    When New York went bankrupt in '75, it was because people intentionally misused the system in place for welfare while playing within the rules.

    We're seeing the same thing here, an intentional misuse of the system. The lending system wasn't designed with what happened in mind; still everyone blames the designers insead of the misusers.

    The people that were fixated on a house, and refused to acknowledge the fact that they couldn't afford it are a great example of misusing the products.

    You can't blame a gun manufacturer or gun store for how someone uses their product, so why blame the bank or broker for misuse of theirs?

  • Rediculous

    Sub prime mortgages were extremely useful for certain situations. It was the mis-use of them that was a problem. Some people with poor credit can manage their money, but those aren't the ones foreclosing.

    When New York went bankrupt in '75, it was because people intentionally misused the system in place for welfare while playing within the rules.

    We're seeing the same thing here, an intentional misuse of the system. The lending system wasn't designed with what happened in mind; still everyone blames the designers insead of the misusers.

    The people that were fixated on a house, and refused to acknowledge the fact that they couldn't afford it are a great example of misusing the products.

    You can't blame a gun manufacturer or gun store for how someone uses their product, so why blame the bank or broker for misuse of theirs?

  • http://sweethomeimprove.com Sweet_Home_Improvement

    Great post, really help me alot. Thanks.

  • http://www.club-penguin.org/ Club Penguin Cheats

    People should realize that if you have not got the money to buy something then wait till you do have the money. Unless you no how to use a credit card then stay right away from them.

  • http://www.ResumeBuilderPlus.com Resume

    For me irresponsible BORROWERS are the one to blame in this situation

  • Resume

    For me irresponsible BORROWERS are the one to blame in this situation

  • Nisha chauhan

    plz give me answer as soon as possible i m waitting 4 u r answer,,,,,,,,,,,,,,,,,,,,,,,,,,

    on ” Financial crisis is not man made”

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