Obtaining loans is becoming increasingly difficult in the market. More and more mortgage lenders announce bankruptcy, which has led to the threat of a global credit crunch. The real estate market fell after years of record highs.
9/11 Crisis:
The market today is a byproduct of what it was 10 years ago. The reason for it could be because of a company or some falling behind or because of too much greed. Things became worse after the 9/11 attack as the world was already under a recession back then. To counter this, the Federal Response began cutting rates dramatically. This low rate was to encourage borrowing and to expand the money supply. Everyone was encouraged to buy, which succeeded and resulted in an economy increase in 2002.
Low Interest Rates:
By introducing lower interest rates, the real estate market attracted more buyers and the number of houses sold increased. Their prices increased by 2002. As rates were the lowest ever seen in many years, people saw it as an opportunity and purchased property as soon as possible.
Investment Principl:
The asset-backed security exists for quite some time and its base lies in a simple investment principle. Collecting assets and similar cash flows and bundling them together into one managed package that collects all the payments and pays all the investors on the managed package. This results in the real estate to act as collateral.
ABS:
Due to the increase in the real estate market, a new form of ABS was created, which gave loans to buyers with less-than-stellar credit and gave subprime mortgage loans. Subprime loans came with risks but were also placed into different risk classes. Each had its own repayment style. Upper tranches have higher value and would be given the first dollar that came into the security. Lower tranches has a higher coupon rate due to the high risk involved. The lowest tranch is the equity tranch and is a poor investment area.
The ARM:
With the reducing risk for mortgage lenders in subprime lending, they can come up new strategies for giving out a loan. They use a teaser rate which allows borrowers to initially get an affordable mortgage in which payment can reach the sky in a few years. By 2006 teaser loans and interest only loans started attracting homeowners. Soon borrowers did not even question terms and conditions and were thrilled by their ideas. Borrowers do not realize if the home value decreases it would leave the borrower with a much higher mortgage payment.
The crunch of easy credit:
By 2007, inflation threatened to increase the interest rate. New home sales stalled, and median sale prices gave them trouble. All of a sudden, CDO didn’t look so attractive to investors looking for investing. Soon the news of these problems was known worldwide. Many mortgage lenders, with no investment banks to sell their loans had to shut down their business, which resulted in the downfall of CDO. With all the financial risks, investors started much more aware of the risks. They tried to unwind any fixed-incoming security not paying a proper risk premium. They believed that subprime risks were no longer worth taking.
Three month Treasury bills were announced, which became the next new thing and yields fell 1.5% in a few days due to it. This percentage seems less to the naked eye but in terms of marketing it is a huge value. Many banks sold their assets and stocks to raise cash. Soon the equity averages worldwide reduced sharply in weeks. Banks in the U.S, Japan and Europe helped other banks compress the impact of the crunch by giving billions of dollars. The Federal Reserve also made it easier to get loans from them.
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