The calamity on Wall Street this past week proved that old school banking is dying. If in a span of only a few days, Lehman was able to file for chapter 11 bankruptcy, Bank of America was able to strike a buyout deal of Merrill Lynch, the Fed’s bailout of AIG and the potential merger of Morgan Stanley and Wachovia, then what could happen over the next few months or years if we don’t acknowledge the deep rooted problem of our current crisis? The future is hard to predict but that does not mean we can't take away anything from this crisis and try not to stave off the next one.
It all started in late 90s when there was growing optimism about a real estate boom. Mortgage lenders capitalized on the opportunity by making it easier for borrowers with shaky credit to take out a loan. A majority of these borrowers took out adjustable rate mortgages, which meant that they paid a low interest rate in their first two to three years. After those first few years, their rate would readjust to match their expected climb up the corporate ladder and rising salary. For this type of mortgage, borrowers paid more interest after readjustment than prime borrowers who took a fixed-rate mortgage. Because of this high risk, returns for lenders and investors were also high. Hungry for more assets, these lenders and investors believed subprime mortgages would be a quick way to build capital but in the long run they depleted their capital faster than they could gain it.
The role Wall Street bankers played in this crisis was by slicing mortgages into CDOs (short for collateralized debt obligations). “In simplest terms, a CDO is an arrangement that raises money primarily by issuing it’s own bonds and then invests the proceeds in a portfolio of bonds, loans or similar assets.”[1] Essentially, the assets in a CDO are supposed to be diverse to avoid a situation in which a risky asset might devalue an entire portfolio. However, Wall Street put all their marbles on any security that would be directly affected by defaulted subprime mortgages.[2]
This week was an eye opener for Wall Street, but I feel that this is the last major wave of busts for the banks. They are too vulnerable right now to do anything but wait for the government to bail them out. After the government’s thrice intervention, I do hope Wall Street operates more responsibly and that the government starts to monitor their actions...
[1] “CDOs in Plain English” http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf
[2] http://online.wsj.com/article/SB119871820846351717.html
1 comments:
Would you say it was it greed or opportunistic ignorance and naivety?
I wonder what business schools are telling their students these days, now that there are no more investment banks
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