ASSIGNMENT# 1

COMSATS INSTITUTE OF INFORMATION

TECHNOLOGY ISLAMABAD

ISLAMIC BANKING AND FINANCE (FIN549)

TOPIC: FINANCIAL CRISIS OF 2008

NAME: MUHAMMAD ALI ADIL MALIK

REG #: SP16-BAF-015
INSTRUCTOR: DR. SABEEN KHAN
 FINANCIAL CRISIS 2008
Causes:

 Synthetic Collateralized Debt Obligations

 Mortgaged Backed Securities
 Reckless ratings by Credit Rating Agencies
 Subprime Mortgage Loans
 Credit Default Swaps by Insurance Companies
 Non-Interference by government (No regulation or supervision of financial system)

Result:

 Financial Institutions Bankruptcy:

 New Century Financial
 American Home Mortgage
 Sentinel Management Group
 Ameriquest
 NetBank
 American Freedom Mortgage Inc.

 Financial Institutions Write Down (Total between $300-$350 US Billion):

 Citigroup by $24.1 B
 Merrill Lynch by $22.5 B
 Morgan Stanley by $10.3 B
 Bank of America by $5.28 B
 HSBC by $3.4 B
 CIBC by $3.2 B

 Total debt by top 5 US investment banks was more than $4.1 Trillion which was 30% of
USA’s nominal GDP for 2007.
 AIG was nationalized (government purchased 80% of its shares) as it could not afford to pay
up all the US mortgage defaults.
 Collapse of Financial System (Trading and Credit Market froze followed by Stock Market
crash).
 Economic Crisis (Job Loss, Recession, Low GDP growth.
 US Economy went into recession.

Solution:

Government’s interference by introducing:

 Troubled Asset Relief Program

 DODD FRANK LAW
History:

Back in 2000, USA and international investors started investing in USA housing scheme as they saw
low risk and higher rewards as compared to US Treasury Bonds. They did so by purchasing a security
created by large US investment banks known as Mortgaged Backed Securities (M.B.S).

M.B.S is created when said large investment banks/institutions, buy thousands of mortgages, bundle
them up together into a Special Purpose Entity (S.P.E), securitize them into a large pool and then
start selling shares of that pool to interested investors. M.B.S is convenient for investors because if
they started buying individual mortgages, it would be too troublesome and waste of precious time.
Therefore they buy pooled versions of such securities that provide a greater interest and principle on
maturity which is easier and less time consuming as compared to buying them individually.

At the time being, these provided investors with a higher rate of return as compared to other
investments and they seemed very less risky which is why they attracted a lot of investors.

As a result, this led to a series of events:

 Houses prices in USA started increasing.

 Lenders believed that even if the borrower defaults, they could just resell the house over
again for more money.
 Simultaneously, credit rating firms started backing up these securities by giving them AAA
ratings.
 This boosted investor’s confidence and morale to extent that it made them desperate to buy
more of these securities (M.B.S).
 In response to increased demand of M.B.S, lenders (investment banks) got greedy and
started created more of these securities which were not of same quality and were generated
artificially.

Essentially, mortgage was lent to candidates who had good credit rating and had steady jobs. This
guaranteed to the bank (lender) that mortgage would be paid back to it on time and with less to no
risk of default by borrower.

However, as mentioned above that banks got greedy and started to loosen their ‘standards’. They
started making ‘Subprime Mortgage’ loans. These are loans made out to borrowers with low
incomes and poor credit ratings.

This practice was further escalated when some institutions started using so-called ‘Predatory
Lending Practices’. These institutions gave out loans to borrowers WITHOUT even confirming their
income and offered ridiculous adjustment of mortgage payments that borrowers could afford to pay
initially, but would soon be out of their range to pay.

At that stage in time, these subprime lending practices were new to the market, meaning credit
rating firms didn’t have historical data that showed that these were becoming more and more risky
and was going to blow up in investor’s faces and crash the system in fact they showed these
practices as ‘SAFE BETS’.

This was followed by an even riskier product sold by investors known as Collateralized Debt
Obligations (C.D.Os) which was again given high credit rating by credit agencies.

Collateralized Debt Obligations are an alternative to M.B.S, also derived from SPE (Special Purpose
Entity) caters to both kinds of investors, one are the RISK AVERSIVE which say that the investment is
too risky e.g pension owners and second are those that say that the yield is too low e.g hedge fund
investors. So, in C.D.Os, the S.P.E is split up into ‘tranches’ in which all securities don’t cost or yield
the same, instead they are separated into DIFFERENT CLASSES. These classes can be Senior, Middle
(Mezanine) and Equity with the characteristics that Top to Bottom Risk and Yield Increases and
Payments are made in such prioritized order. In this way Senior (pension owners) are paid first and
get the returns for less risky investment while the Equity (Hedge Fund) investors are paid last (if at
all) and get the highest return as compensation for investing in the highest risk.

With the rise in careless lending practices that offered low interest rate (which was still unpayable by
low income borrowers) that drove housing prices higher and higher, these gave an illusion that M.B.S
and C.D.O were an even better investment.

Ultimately it reached its breaking point:

 Borrowers started defaulting as they could not keep up with the high pricing and the
periodic payments
 This put more houses on the market for sale but this time there were no buyers left.
 So supply of houses was high while there demand was low.
 This resulted in the steep fall of house prices. While this was happening, some buyers
mortgage became more than their house was actually worth. As a result they stopped
paying, which resulted in even more defaults that drove housing prices even further down.
 This all resulted in NO MONTHLY REPAYMENTS to the lenders of Subprime Mortgages.
 As money stopped flowing from C.D.Os to investors who had purchased them, Investment
Banks stopped buying Subprime Mortgages and the lender of Subprime Mortgages got stuck
with all the bad loans that they had accumulated all this time to the extent that some
declared bankrupt by 2007.
 Adding fuel to the fire were Credit Default Swaps (C.D.Ss) these that were basically sold as
insurance against the M.B.S and C.D.Os by insurance companies
 Moreover, these C.D.S were turned into securities that allowed traders to bet on whether
the prices of the mortgage would go up or down.

C.D.Ss is given by insurance companies, in it they take a small percentage of the interest as
commission fee that the investor is receiving from investing in a company that promises to pay back
the loan invested in it with said interest rate. In these situations, the company doesn’t have the best
credit rating which is why insurance companies (that do have the best credit rating) intervene and
give investors the confidence by backing them up with debt securities in the events if the company
obtaining the loan defaults. However since insurance companies are unregulated, they don’t
typically set aside a certain amount in case a default does occur and they have to pay the client back.
So they can continue to snowball their liabilities until a real default occurs in case of which they
don’t have enough funds to pay back the client.

This is what happened with AIG that had sold 10 Billion dollars’ worth of insurance policies without
real money to back it up.

This all resulted in the failure of the entire financial system. Stock Market crashed, trading and credit
market froze, economy fell into recession etc. At this point, the government intervened to solve and
arrange the crises. The Federal Reserves stepped in to make emergency loans to fundamentally
sound banks to prevent them from collapsing. This is known as Troubled Asset Relief Program
T.A.R.P, also known as BANK BAILOUT. They ended up spending $250 Billion to ‘bailout’ the financial
institutions that included AIG, General Motors and mortgage institutions. Later, Congress passed
$800 Billion into the economy in a bill form in January 2009. This was done via tax cuts and new
spending.

Lastly, in 2010 Congress passed a financial reform known as the DODD FRANK LAW. This increased
transparency of banks and prevented them from taking excessive risks. It set up a consumer
protection bureau to reduce these predatory lending acts by:

 Requiring financial products to be traded in exchanges that all market participants can
observe
 Putting mechanisms in place for large banks to fail in a ‘Controlled Predictable Manner’.