US Economy: Trends in the Banking Industry

US Economy: Trends in the Banking Industry

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Setting the Background
During the turn of the 21st century, things were looking extremely bleak for the U.S. economy. The dot-com bubble left major technology companies – and their employees, in complete financial shambles. This stock market crash caused the loss of over $5 trillion in the market value of various companies from 2000-2002. In addition, the events of September 11th accelerated this recession. Although the $40 billion insurance loss was one of the largest insured events, it didn’t even compare to the subsequent events that occurred. Most major U.S. securities exchanges closed down (even the London Stock Exchange and various others worldwide), airline and aviation suffered increased costs due to grounded flights, and massive losses were taken in the tourism industry that employed 280,000 people in New York alone. Overall losses amounted in the hundreds of billions.
Subprime meltdown
In response to these catastrophic events, the Federal Reserve began cutting interest rates dramatically, with the fed funds rate dropping down to 1% in 2003. As lower interest rates continued to become the norm, the real estate begins to look much more attractive as many home buyers were able to purchase homes that offered low introductory rates and minimal initial costs. The vast majority of these buyers were betting that they could refinance their mortgages to lower rates due to price appreciation. However, home prices soon stopped increasing at breakneck speeds. As prices of homes began to decline in early 2006, many homeowners simply could not refinance to lower rates. As interest rates slowly rose, monthly payments increased on adjustable rate mortgages. Many homeowners discovered that they could not afford these higher payments, and simply had to default on their loans.
Mortgage Backed Securities
So how did these events affect the investment banking industry, and ultimately Campbell and Bailyn’s operations? Prior to the crisis, there was a new financial product being spun on Wall Street – mortgage backed securities. The concept and flow of these asset-backed securities was fairly simple:
1) An originator (who issues the mortgages) groups the cash flows from the mortgages into a large pool. There can be hundreds of individual mortgages within this pool.
2) The originator sells this bundle to an investment bank.
3) The investment bank requests that individual tranches of this pool get analyzed by a reputable credit agency (Moody’s, FitchRatings) and then assigned a risk level.
4) The investment bank sells these individual tranches for varying prices to institutional or retail investors depending on the riskiness of the debt.

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This creates an asset-backed security in which the underlying real estate acts as collateral. However, as mortgage payments began to dry up due to homeowners defaulting, these securities began to quickly drop in price since the cash flows from mortgage payments are what back the value of the security. This creates huge difficulties for any sales group with exposure with this particular debt instrument to sell the product, as they are essentially trying to sell something that will suffer large devaluations going forward. As time progressed, institutions worldwide came to a halting realization: these “bulletproof” securities were incredibly unsafe, thus spurring a large number of investors attempting to unload their positions at whatever price possible. With this, the price of the mortgage-backed securities plummeted, and investment banks were forced to write down large losses on the securities they were holding.

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