Topic: 2007-08 Financial Crisis

Submitted to: Sir Khurram Amin

By: Muhammad Munaj Azhar
Roll no: BUSC51F20R010
Program: B. Com (Hons) 7th Reg
Course: Financial Reporting Analysis

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 Background:
1996 dot.com bubble in the U.S for this returns in technology companies were high, but for
2000-02 this dot.com bubble burst resulted in severe downfall in stock market, people ignored
further investing in stock market and already existing investors also tried to cash-out their stocks
investments.

In 2001, interest rates in the U.S also went down to only 1% so at that time people didn’t
consider it safe to keep their money in banks as well as investing in stock markets.

Investors were now looking for investment opportunities where their investing assets remained
safe and they were also able to gain profits from them.

Investment in Real estate:

At that time real estate rates were increasing and the government also encouraged people to
invest their money in the housing industry or to take loans which were available at lower interest
rates to build their own houses. People saw this great opportunity and started investing in real
estates by taking loans from investment banks.

When more and more investors were investing in real estate this gave a boom to real estate for
that reason prices of real estate went up.

Causes of Mortgage sector crisis:

Financial deregulation:
“Glass Steagall act” says that commercial banks, investment banks and insurance sectors
cannot work together. (Because these sectors have different rules and regulations).

But in 1999 “Gramm-Leach Bliley act” was introduced after which commercial banks, investment
banks and the insurance sector worked together. Which in return caused the collapse of the
world economy.

What actually happened:

Prime families ⏩ Brokers
Prime families (buyers of homes contact brokers about loan borrowing) Brokers prepare
complete documentations and contact with commercial banks to lend money to families for
homes. Commercial banks demand security against loans. Prime families gave mortgage
papers as securities to commercial banks, because commercial banks have many mortgage
securities for earning extra earnings.

Commercial banks designed CDO’s (collateralized debt obligations) against mortgage

documents and sold them to investment banks against commission. Investors those invested in
investment banks demand securities for them. Investment banks gave AAA rating CDO’s from
U.S well known credit rating agency Moody’s and then insured them from U.S well known AIG
agency (American International group).

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Because AIG saw these as AAA rating CDO’s, investment banks provided CDO’s to worldwide
investors against their investments. Investors saw CDO’s as a great investment opportunities for
this they demanded investment banks to issue more CDO’s to them but investment banks not
designing them, so they shift their demands to commercial banks, but for designing CDO’s
commercial banks needed mortgage documents for this they shifted their demands to brokers to
enter more borrowers for loan.

For this brokers start capturing subprime borrowers (those who are not fulfilling the criteria of
loans) brokers gives loan to those people who don’t have fixed monthly incomes.

Explanation:
Loans that were given to subprime borrowers were at adjustable interest rates (increasing
repayment amounts time to time) but when repayment amounts started to exceed in 2007 due
to increase in interest rates causing subprime borrowers to default one by one.

So commercial banks started auctioning homes of subprime borrowers for that reason supply of
homes increasing in the market caused the prices of homes to decrease. Prime borrowers
(those who have good credit worthiness saw this (their loan amount is greater than actual price
of homes) they also declare bankruptcy.

Which creates a large mess in the banking industry. Because banks were not able to obtain
actual worth of houses due to low demand in the market and CDO’s available at Investment
banks also went down to zero value because no houses were sold at fair price. Lehman
brothers investment bank went to default during this crisis.

Crisis with Insurance Company:

AIG paid $99 Billion to investors against CDO’s

Effects:
1. Loses in world-wide trade
2. Failures to banks and financial institutions
3. Credit crunch

(Federal reserve chairman “Alan Greenspan” stopped lending loans to the business
public which resulted in a downfall in the overall U.S economy).

Causes:
1. Subprime mortgages (cheap lending to low credit worthy customers)
2. Financial Deregulation

(Commercial banks, Investment banks, Insurance agencies worked together to

obtain profits which results in severe crisis)

3. Globalization

Inter-linked countries also faces severe damage

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