Question

The financial crisis that began in 2007 led to the failure of a historical amount of banks. Discuss what caused the financial crisis and why that caused such a large amount of banks to fail.

Answer 1

Financial crisis 2007

The large number of banks were in big trouble during financial crisis of 2007 and few of them became insolvent and later failed. The crisis happened on account of less credit worthy borrowers. These less worthy borrowers are also known as sub-prime borrowers.

The borrowers and loans were of following nature:

1)      Mortgage loan borrowers; Housing loan borrower

2)      Borrowers were with low FICO score or credit score

3)      Mostly retail borrowers

4)      Interest rate at initial years were very low and later period interest rates were surged up

5)      Borrowers brought up low or zero down payments (in many cases 100% loans were given)

Above all contributed to low quality of assets.

The commercial bank lending loans to these retail borrowers had very big incentive for lending low quality assets. Banks were able to create MBS pool (Mortgage Backed Securities pool) of its asset and that MBS pool were divided into traches or category of notes like AAA, AA rated traches. MBS pool was purchased by big investment banks like Lehman Bros. Banks lending to subprime borrowers were getting incentivized by investment banks, since these investment banks were purchasing MBS pool from commercial banks hence, banks were able to lend more. Banks were also able to ring fence these low-quality assets through special purpose vehicles. Finally, MBS tranches were traded in market by investment banks. Rating agencies rated AAA or AA to senior tranches of MBS pool of subprime loans and this was done without understanding the underlying risk of subprime market. Rating agencies had incentive to get fees for giving rating hence it led to morale hazard.

There were few correlation assumptions by banks and investment bankers that price of houses will never go down. This assumption has given false confidence to banks and investment banks that mortgage loan will be recovered to 100% wherever required. Things did not happen as per assumption, home prices started falling during 2007-08 and many home buyers defaulted due to the high interest charge. Many defaulted loans due to low cost homes available in market, this has pushed them to willful default of present home loans. When these defaults started happening then investment banks were in difficulty of raising funds against their MBS tranches (illiquidity) and that led to insolvency and later resulted in bank failure.