Monica Patel
ECON 4210
10/29/14
Problem Set 2
The 2007-2009 financial crisis originated in the United States, and was primarily caused by the introduction of subprime mortgages. In the years leading up to the crisis, new methods for evaluating risk surfaced and this allowed financial institutions to offer borrowers with higher risk a new type of mortgage, known as a subprime mortgage. These subprime mortgages were then bundled into various types of securities, all done with the intention to diffuse the risk by pooling assets. The financial innovation of the subprime mortgage and the financial engineering involved in bundling those individual mortgages were major players in the financial crisis. As the subprime mortgage market developed, the demand for houses increased and subsequently the prices increased. There was an increase in liquidity as a result of new cash flows into the U.S. Subprime mortgage brokers were not necessarily invested in accurately evaluating the default risk of the borrower, because the brokers …show more content…
The shadow banking system is nearly the same size as the depository system, but there are far fewer regulations. These financial institutions used mortgage-backed securities as collateral for short-term repurchase agreements. The value of the collateral they could put up decreased along with the value of mortgage-backed securities and CDOs. As the number of defaults increased, they could not borrow as much money with the same amount of collateral, so they turned to selling assets quickly, further lowering the value of their collateral. Substantial deleveraging added to the contraction of lending and therefore the decline in economic activity. The failure of major financial institutions, such as Bear Stearns, Lehman Brothers, etc., stemmed from these
ECON 4210
10/29/14
Problem Set 2
The 2007-2009 financial crisis originated in the United States, and was primarily caused by the introduction of subprime mortgages. In the years leading up to the crisis, new methods for evaluating risk surfaced and this allowed financial institutions to offer borrowers with higher risk a new type of mortgage, known as a subprime mortgage. These subprime mortgages were then bundled into various types of securities, all done with the intention to diffuse the risk by pooling assets. The financial innovation of the subprime mortgage and the financial engineering involved in bundling those individual mortgages were major players in the financial crisis. As the subprime mortgage market developed, the demand for houses increased and subsequently the prices increased. There was an increase in liquidity as a result of new cash flows into the U.S. Subprime mortgage brokers were not necessarily invested in accurately evaluating the default risk of the borrower, because the brokers …show more content…
The shadow banking system is nearly the same size as the depository system, but there are far fewer regulations. These financial institutions used mortgage-backed securities as collateral for short-term repurchase agreements. The value of the collateral they could put up decreased along with the value of mortgage-backed securities and CDOs. As the number of defaults increased, they could not borrow as much money with the same amount of collateral, so they turned to selling assets quickly, further lowering the value of their collateral. Substantial deleveraging added to the contraction of lending and therefore the decline in economic activity. The failure of major financial institutions, such as Bear Stearns, Lehman Brothers, etc., stemmed from these