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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