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The impact of the current financial crisis cannot be overemphasized. Bear Sterns was sold to J.P. Morgan Chase at a huge discount, Merrill Lynch was bought over by Bank of America, Lehman Brothers has filed for bankruptcy protection, Goldman Sachs and Morgan Stanley have converted into bank holding companies and most recently, Washington Mutual Bank was shut by the federal Office of Thrift Supervision. The repercussions resulting from the subprime crisis are so great that the U.S. Congress is planning a US$700 Billion plan to buy out the distressed mortgage-backed assets.
Looking forward, what lessons can we learn from this “once-in-a-half-century, probably once-in-a-century type of event” so that we can prevent another crisis of such magnitude from happening again?
To answer that question, we must first look at the causes of the crisis. The roots of the problem can be traced back to increased sub-prime lending during the U.S housing boom. Lenders were willing to make loans to borrowers with high credit risk as they were confident that the U.S housing boom was going to last and that gave them protection against defaults. However the good days did not last. As interest rates increased, many borrowers found it hard to refinance their loans and as a result, forced to default on their payments. Delinquency rate rose to 21% in January 2008 and 25% in May 2008. With increased foreclosures, the housing prices started to plummet. Till here, the situation looked localized and deemed unlikely to have a significant impact on the broader economy. However there is more than meets the eyes.
While lenders are busy making loans to home owners, there is another activity going on within the investment banks – securiti ...