Banks Bundled Bad Debt, Bet against It and Won

Banks Bundled Bad Debt, Bet against It and Won

The article briefs about the credit crises that happened in 2008 due to bubble burst in housing market fueled by credit derivative products like Collateralized Debt obligation (CDO)  and Credit Default Swaps (CDS). Most Investment Banker formed a cartel wanted to capitalize gain on the growing prices in housing market by a pool of such illiquid assets into bonds though securitization route. Securitization is a process where in various class of illiquid assets are pooled together such as mortgages of home, auto loans, project loan, credit card etc. and sold in small lots to large investors in the form of bonds, pass through certificate, Mortgage Backed Security (MBS) and Asset Based Security etc. the bond is secured with the value of collateral in the pool and repayment is generally matched with the receiving cycle of the asset.   Thus to investment Bankers, Hedge Funds and even banks started promoting credit derivative instrument which offers attractive return to the investors. However the derivative products were not bad product as such but the bad assets were bundled together and sold through such Instruments in the market. Further credibility of credit rating agency also came into picture as they rated such papers in the market which became the prime selling point for investors who were attracted with higher returns on secured papers. They accepted the higher valuation proposed by the Issuer and failed to conduct effective due diligence in a transparent manner which has resulted in loss for many investors and institutions.  This has also led to winding up of Government Sponsored institutes like Fannie Mae (The Federal National Mortgage Association, FNMA) and Freddie Mac (The Federal Home Loan Mortgage Corporation, FHLMC) who were responsible to develop secondary mortgage market  through securitization of assets primarily real estate in form of MBS.

Thus the aim was to provide local banks with federal money to finance home mortgages in an attempt to raise levels of home ownership and the availability of affordable housing. But on account of over valuation of the house, more loans was disbursed by the banks to the household and these assets were pooled and sold in the market. Once the borrower failed to repay the installment, the coupon of such bonds also were defaulted and thus the entire housing bubble burst out leading to filing of bankruptcy of large institution like Lehman Brother, and bail out huge insurance agencies and banks such as AIG and Citi.

From the above discussion we may draw conclusion that ABS, MBS and other such products are good products for investors as well as help in enhancing liquidity into the banking system provided the valuations of such products are realistic and appropriate due diligence is carried out in a very transparent manner.

United States Security and Exchange Commission must lay down proper policy and procedure in terms of carrying out fair valuation and framing clauses for protection of interest of investor. SEC must ensure regular monitoring as well as trading of such products in the market.

Thus the above suggested measures could revive investor confidence and the most faith in ABS market can be restored. 

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