The Terrible Two: Collateralized Debt Obligations & The Subprime Market
In the summer and fall of 2008, the financial sector of the United States, better known as Wall Street, started to crumble. On July 11, IndyMac, the United State's largest mortgage lender, suffered to credit issues. With tumbling home prices and rising foreclosures, the company was seized by federal regulators. The two big mortgage giants Fannie Mae and Freddie Mac were hurt by pressures of tight credit as well and were placed into conservatorship on September 7, 2008. The weekend of September 13-14, Lehman Bro.thers declared bankruptcy because they were unsuccessful in finding a buyer, causing ten banks to create emergency funds of at least $70 million to hedge risks of Lehman's closure. Bank of America bought out Merrill Lynch. The insurance company AIG received a bailout of $85 billion from the Federal Reserve on September 17. On September 25, the biggest bank failure in history occurred when JP Morgan Chase bought out Washington Mutual. As a result, the economy is in recession. According to the U.S. Department of Labor, the unemployment rate is at 6.5% and the Consumer Price Index is -0.1 o/o. Stock prices have plummeted and the financial catastrophe has spread globally. The reasons for this crisis are varied and complex. One huge catalyst for our economic turmoil is due to investment practices in collateralized debt obligations (COOs) along with the subprime mortgage market. Subprime lending is the practice of lending mortgages to borrowers that are not creditworthy. As a result, these borrowers usually become delinquent in making their payments, and tons face foreclosure. Traditionally, lenders bore the credit risk on the mortgages they issued but that has changed with financial practices that allow lenders to sell the right to receive payments on the mortgages they issue through COOs like mortgage-backed securities (MBS). Government policies and competitive pressures for many years prior to this crisis have encouraged high risk lending practices. Increases in loan incentives have mislead borrowers to agree to outrageous mortgages in the belief that they would be able to refinance to more affordable terms, but were corrupted by adjustable rate mortgages (ARM) leading to defaults and foreclosures. In this document, we will discover how COOs and the subprime market has brought chaos to the financial markets, as investments related to housing prices declined extremely in value, placing financial institutions, government-sponsored enterprises, and millions of people at risk.
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