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For the past several months we have been hearing about the Credit Crisis which has driven major banks and financial companies to the verge of bankruptcy. The details of the crisis started emerging in mid 2007 and spilled into 2008 causing a major chaos in the global financial market. The question that arises from this is how and where did it all start and why did the banks get affected?

During the late 90’s and early 2000 there was a major boom in the Housing Industry in the US. The reasons were mainly because of attractively low interest rates and rising house prices. The Mortgage companies ( mortgage/ loan originators) in their eagerness to make more money during the boom period,  started to give loans to people without considering  if  the person who takes the loan has the capacity to pay it back. This in broad terms means credit worthiness.

Now why did the mortgage companies disburse loans without considering the quality of the loan ?

When a mortgage originator disburses a loan, it becomes an asset in their books and so it is converted into a financial instrument/ security using a process called Securitization. This instrument is then traded with other investors (Banks/Financial Institutions) that are looking to invest the money they have.

These investments give a steady flow of cash to the bank or the financial institutions and also prove to be a good way to make money for the mortgage originators. So the mortgage originators started to disburse loans without considering the quality of the loans.

During mid 2000 the Fed had to increase the rates to help the economy and interest rates in housing loans also increased.  When the interest rates started increasing, people stopped paying back their loans, and this in turn led to loss of returns for the banks/ financial institutions that had invested in the securities.

The increase in the default of payment led to many houses on mortgage to be auctioned . This resulted in a major reduction in the value of the investments that were done by the investment houses. The magnitude of the crisis increased by multiple times because of  Credit based derivatives like Credit Default Swaps, Collateralized Debt Obligations etc.

Credit based derivatives are financial instruments that are derived from an existing financial instrument. These are traded by different entities based on the credit ratings of these instruments. Higher the credit rating of an instrument, lower is the risk component so the chances of default goes down.

If an instrument/ security has a defaulted mortgage component in it, either the whole instrument/ security is deemed to have been defaulted or there would be a significant drop in the credit rating of that instrument. Since the number of the defaults in the mortgage sector was alarming, it led to losses in the credit derivatives because of defaults or loss in credit ratings. The investment banks and other banks traded using  these credit based derivatives . When they traded among themselves, these instruments / securities changed hands multiple number of times between these investment houses.

These created problems while valuation of these instruments and it lead to major losses when these were written off .

All through 2008 and majority of 2007 these investment banks and houses started reporting losses because of trading these Credit based derivatives, leading to a collapse of the banks and institutions involved in it.

If you go through the list of financial institutions that filed for bankruptcy or on the verge of it, mostly happen to be the American and the European investment banks that traded amongst each other. When the banks and financial institutions took a major blow because of this crisis, the core of American Industry got hit and this in turn created ripples that were felt globally

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