Were CDO's & CDS, the real cause of the Great Recession? The Role CDO's & CDS played in The 2008 Crisis! (#81)
CDO's & CDS have played a vital role in The Great Recession. I've discussed 'bout this alot in alot my recent articles....
Here are a few:
Lehman Brothers Bankruptcy! Case Study! (Upcoming on— 2nd June 2022) [STAY TUNED!!!!]
Today, we'll talk about, the role CDO's & CDS played & specifically of, If CDO's & CDS were the one's that caused the Great Recession....
But before that, I'll first talk about what CDO's & CDS really are...., But if you already know what they are then you might click here & skip to the part of the article where I'll discuss about, If CDO's & CDS were the real cause of The Great Recession?!
So; let's now talk about....
What Are CDO's & CDS?
Let's start from the very beginning!
So; it was the time period of early 2000's; the Dot Com Bubble had just bursted, which means the Stock Market was on a Downfall & there weren't many people willing to invest in Share Market due to low opportunities. Banks interest rates were low, too....; So, investors weren't willing to keep their money in Banks either.
During that time, the Housing Market of U.S. was growing rapidly.
Many people were taking Home Loans, as of the interest rates being low.
Long Story short;
Many people started taking Home Loans.
Investors started paying more attention to this & thought of these Loans/Mortgages the Bank were giving away as a great opportunity for Investing!
& hence; so the people//investors started demanding these Mortgages in order earn passively every once in a while from the loan borrowers.
Investment Banks saw this as an Opportunity & with the help of the large Capital they owned; they decided to buy several mortgages from the Banks!
After they bought the Mortgages, they created a complex Financial Derivative known as CDO's (Collateral Debt Obligations).... The Investment Banks got these "CDO's" rated by the Credit Rating Agencies.
The Credit Rating Agencies were such agencies that used to study an Investment & estimated how safe the Investment is by rating them!
The "AAA Rating" (triple—A rating) was the highest rating a Financial Derivative can get!
After all this; the Investment Banks made these CDO's publicly available!
& the Investment Banks were sold out of CDO's in no time!
But, there was still a lot of Demand for CDO's in public!
So, the Investment Banks demanded Banks for more Mortgages!
But the thing was that the Banks had already given out the loans to those individuals who were capable of repaying them!
Now; quick explanation of how Banks give out loans....
So, banks tends ro check an individuals Credit History & also stuff like— if the individual have a job that can meet the loan, etc., etc. & basically after studying all these details only; the Banks tends to give loans!
& now, in this case, teh Banks had already given out Loans to those individuals who were capable of repaying them.
But, the Banks still started giving out loans to those individuals who were incapable of Loan Repayment!
Actually, Banks had became Greedy as they wanted to earn more commission from Investment Banks.
& also banks somewhere knew that if a borrower fails to repay teh loan, then the Banks can sell the house immediately to recover the money; So they had a leading role!
SPOILER: THAT IS NOT REALLY WHAT HAPPENED!!
& so the Banks now had the Mortgages of these Sub Prime Loans.
These Low Quality Loans are known as Sub Prime Loans!
Now; these Mortgages were risky, indeed!
Well, Banks sold these Mortgages to Investment Banks & the Investment Banks still got these Mortgages a — AAA Rating & then sold the CDO's to Investors!
Almost 70% of these CDO's were AAA Rated!
Like this, the Risk was first transferred by the Banks to Investment Banks & then from Investement Banks to the Investors!
Now; meanwhile all of this going on between Banks to Investment Banks, Credit Rating Agencies & Investors...., there were Insurance Companies feeling left out....
So, Insurance Companies just casually introduced teh world to CDS (Credit Default Swaps)....
CDS were like an insurance for the CDO's!
Which means if an Investor bought a CDS & in case the CDO's fails that means the people owning CDO's do no get the loan's repayment then in that case; the Insurance Companies will be the one to pay off the loss!
One thing about these CDS were that the people who did not owned CDO's can also buy these!
Many people thought that CDS was just a waste of time...., because teh CDO's were literally aaa rated!
& even Insurance Companies believed the same....!
After selling CDS, teh Insurance Companies were giving out bonuses to their employees; unaware of how much of a loss can be caused to their Companies incase CDO's really do fail!
Insurance Companies really made a lot of money in Commission!
& so did the Investment Banks, Banks & the Credit Rating Agencies did!
It didn't lasted for long when the defaults began!
Which means the people who took the Home Loans started defaulting!
Whenever a borrower fails to do a loan repayment, it is known as a Default!
Some time passed by & their were several people defaulting now!
Banks had no other choice then to put up the houses for sale to recover money to pay the Investors/CDO owners who did not get what they paid for!
But now the thing was that; the Banks could not find any buyers for the Homes.
Due to alot of houses being up there for sale & little to no buyers...., the demand was low while the supply was high & so it caused the house's prices to go down!
Now, after this almost everyone who first was trying to repay the loan & get their homes back had completely stopped repaying the loans & that was because, Now the Loans that they had to repay were way more than there homes were really worth in Market at the time!
This caused the entire system to kind of entirely freeze.
On the other hand; the Insurance Companies paid billions to those who owned the CDS & many Insurance Companies were on the verge to go Bankrupt & some really did!
And then it was a total mess you know its a DOWNFALL!
Right Now.... Back to this article's Topic....
So right now, this was about the role CDO's & CDS played in The Great Recession!
Now, let's try to sum up the real cause of the 2008 Crisis!
So, now, talking 'bout
Were CDO's & CDS the real cause of The 2008 Crisis?
Well, if the Mortgages (that were the underlying asset for the CDO's) were not sub-prime; in other words not risky then the CDO's wouldn't have felled tragically, as they did!
You see, CDO's were like Derivatives which had Mortgages as an underlying Asset.
So hence the Risk Carrying Mortgages in a nutshell were directly responsible for low quality CDO's & when the investors bought these.... They just did not received the loan repayments // what they paid for.... So there money was lost & like this there were many CDO's failing all across the Country & the Downfall came when many Investment Banks were left with these Risk Carrying CDO's; The system if Banks freezed due to no money circulation & people lost their jobs because of Companies going Bankrupt like— Investment Banks; Insurance Companies, etc.!
READ: What Are Derivatives? The 4 Types Of Derivatives!
So it was basically the Bank's fault as they did something was told risky & made a huge mistake that caused nit only the CDO's to go down but the entire Economy!
CDS on the other hand really were just an insurance.... Anything that is risky like almost every investment; few of them do have back ups.
CDS were a back up for CDO's!
So I conclude if the mistake didn't took place things wouldn't have went too far & Economy would have welcomed a new Investment Environment!
Anyways; so that's it for today!
I hope you enjoyed reading this article!
Let Me Know what are your views on this topic, in the Comments down below....
&
Thanks For Reading!
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