Is This Complicated or What?
Sidebar article to The Credit Crisis and Moral Hazards Fall 2008 issue -- Starting with a mortgage, here is just one example of the shadow-banking system—a train of very widespread practices and credit derivatives. 1. Banks made loans to individuals who had no hope of repaying them from their own income. But it didn’t matter, because the loans were secured by mortgages on real-estate properties that were presumed to be increasing in value. The loans were made with affordable, low payments for a couple of years, after which the payments would reset to higher amounts. At that time, it was expected that the individual would refinance his mortgage based on higher property values and restart with another loan that had low payments. 2. Banks packaged these loans as assets, to secure bonds and similar financial instruments. The package included some good mortgage loans and some bad ones. Based on the percentage of expected defaults in the mix, the bonds could be rated AAA by private rating agencies, such as Moody’s, Standard & Poors, and Fitch, whose fees were paid by the same banks whose bonds they were rating.
Jun 9, 2011
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