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Americans refinanced their homes

The mathematical models and simulations that the banks relied upon did not predict a scenario where defaults would become so numerous that even the top tier AAA‐rated tranches would be affected. Sub­prime market collapse As the housing sector continued to inflate due to the appetite for housing by Americans, the sub‐prime sector continued to also grow. Commercial banks entered what they considered a buoyant market that could only rise, many Americans refinanced their homes by taking out second mortgages against the added value to use the funds for consumer spending. The first sign that the US housing bubble was in trouble was on the 2nd April 2007 when New Century Inc the largest sub‐prime mortgage lender in the US declared bankruptcy due to the increasing number of defaults from borrowers. In the previous month 25 sub‐prime lenders declared bankruptcy, announcing significant losses, with some putting themselves up for sale.

This was in hindsight the beginning of the end. The crisis then spread to the owners of collateralised debt who were now in the position where the payments they were promised from the debt they had purchased was being defaulted upon. By being owners of various complex products the constituent elements of such products resulted in many holders of such debt to sell other investments in order to balance losses incurred from exposure to the sub‐prime sector or what is known as ‘covering a position.’ This second round of selling to shore up funds and meet brokerage margin requirements is what caused the collapse in share prices across the world in August 2007, with the market getting into a vicious circle of falling prices, leading to the further sales of shares to shore up losses. This type of behaviour is typical of a Capitalist market crash and is what caused world‐wide share values to plummet. What made matters worse was many investors caught in this vicious spiral of declining prices did not just sell sub‐prime and related products; they sold anything that could be sold. This is why share prices plummeted across the world and not just in those directly related to sub‐prime mortgages.

International institutes who poured their money into the US housing sector realised they will not actually receive their money that they loaned out to investors as individual sub‐prime mortgage holders were defaulting on mass on such loans this resulted in all those who took positions in the housing sector not being able to pay the institutes they borrowed money from. It was for this reason central banks across the world intervened in the global economy in an unprecedented manner providing large amounts of cash to ensure such banks and institutes did not go bankrupt. The European Central Bank, America’s Federal Reserve and the Japanese and Australian central banks injected over $300 billion into the banking system within 48 hours in a bid to avert a financial crisis. They stepped in when banks, such as Sentinel, a large American investment house, stopped investors from withdrawing their money, spooked by sudden and unexpected losses from bad loans in the American mortgage market, other institutions followed suit and suspended normal lending.

Intervention by the world’s central banks in order to avert crisis cost them over $800 billion after only seven days. Credit Crunch Banks across the world fund the majority of their lending by borrowing from other banks or by raising money through the financial markets. The borrowing between banks is undertaken on a daily basis in order to balance their books. As the realisation dawned that sub‐prime mortgage backed securities existed across the banking sector in the portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stopped offering loans, some only offered loans at very high interest rates and most banks stopped lending to other banks to shore up their books. As no bank really knew how much each bank was exposed to the sub‐prime crisis many refused to lend to other banks, this led to a credit crunch whereby those banks who made the majority of their loans from borrowed money found credit was drying up. The first indication that this housing crisis was not just going to affect the US and would spread to the wider global economy was the effective collapse of Britain’s Northern Rock. Northern Rock was the 5th largest mortgage lender in the UK and funded its lending by borrowing 80% from the financial markets.
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