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In the beginning, the subprime consumer start borrowing with poorly furnished information at point A. The mortgage lender is only concerned about the amount of loan he can broke and underwrite because he knew Commercial Bank is willing to buy at point B. Sometimes, Investment Bank can either buy from the Commercial Bank the mortgages at point C or buy direct from Mortgage Lender. During normal banking activities, Commercial Bank and Investment Bank engage in Inter-bank lending or Commercial Bank will get Investment Bank to raise capital via the stock or bond market at point D. The Federal Reserve will also engage in the financial market by changing the Central Bank Lending rate and supervise lending and financing activities at point J and point K. After the investment bank buys the mortgages from Commercial Bank or Mortgage Lender, it will structure these mortgages and get them rated by the credit rating agency at point F. The Credit Rating Agency will grade these commercial papers into 3 tranches in ascending order of high risk and high return at point G. AAA bond represent the lowest risk bond while the CCC bond represent the highest risk bond.

Initially the investors will only buy AAA and BBB bonds so the investment bank created Special Investment Vehicles so that they can keep the CCC bonds until someone wants them. Some SIV will structure these CCC bonds into a pool of funds and get the credit rating to rate their funds. These funds will eventually be sold to the Hedge funds at point H. On top of selling these commercial papers to investors, Investment Banks also sell derivatives that serve as insurances on these CDOs at point E. As the mortgages get packaged and sold in this way, the consumer continues to pay these investors in the same manner. The subprime crisis started when the mortgage exceeded the value of the properties and so the consumers stop paying. Once this happen the investors started dumping these commercial papers. Instead of expecting price falling to a state of equilibrium, the market for subprime collapsed. At the same time, investment banks started having trouble to pay out the insurance that they have sold to investors.  With no value in these commercial papers and no insurance claim, lots of funds collapsed. The commercial bank started freezing lending for fear of further default and the credit market freeze. When business cannot rollover the debts with credits from the commercial banks at point L, they started firing staff which are consumers that stopped spending at point M. Now the wall-street crisis has become a main-street crisis.

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One thought on “Appendix A1: Systematic failures that setup the subprime crisis

  1. Pingback: Asian Financial Crisis and Subprime Crisis: A brief comparative study | Andrewanalysis's Blog

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