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Introduction

The financial crisis of the late 2000s is one of the worst


ever crisis occurred on the globe after the great
depression of 1930. It occurred due to the liquidity
shortfall of the banking sector in the America. This crisis
has yield to the bankruptcy of many small & large
financial institutions not only in US but all over the world.
The first seven years of the 21st century experienced the
highest level of economic growth for the last 30years.
Due to this the developing countries faced a great boom.
In went right till the half of year 2007 but then converted
into a bust. However these short lived successes were to
be followed by a period of not only instability but
uncertainty as well.
Causes of the crises:

Economists of the world gave numerous reasons for this
credit crunch but most of them came with the same
opinion that it started in US b/w year 1996 to 2007 when
people started buying expensive houses as getting loans
was so easy because of the excess money of the other
countries in US on the basis of mortgages and subprime
mortgages.
This lending of the money was in forms of
constructed credit securities allowing hedge funds to
banks and creating assets composed of mortgage and
corporate backed bonds and selling them to another
person so the risks are transferred to the borrowers.

The influence of housing bubble:

During 1996 to 2006 it was seen that the typical price of
US house raised by 124%. But houses started falling
down as the people were unable to pay the monthly
installments of the loans which resulted in the acquiring
of the homes by the loan provider(banks), as they start
selling the houses for recovering their loans but there
were no buyers in the market which means the quantity
supplied for the houses exceeded the quantity demanded
for the houses resulting the decrease in the prices of
houses. Due to this gradual decrease in the prices the
people who were paying their monthly installments of
their loans came to know that the value of their house is
much lesser than their monthly installment so they also
stopped paying the installments and sold their house.


$ub-prime lending:

The subprime mortgage is much risky as the loan is given
without any security or checking the historical record. In
March 2007 the value of US subprime mortgages stood at
$1.3 trillion. The level of subprime mortgages remained
in all time low of below 10% until in 2004 when it rose to
nearly 20% and staying that way until 2005-2006 when
housing bubble was at the peak.
contributed 40% of all subprime loans in 2007.
everage:

The term leverage refers to the usage of the borrowed
money to amplify the profits. Leverage is also considered
as one of the cause of this credit crunch. It can easily be
understood by this example that how it affected the
housing bubble. Through leverage, a person may put
20% down payment and get the loan of 80% of the value
of the new home. This means if the house costs
$1,000,000, the homeowner buys the new house with
$200,000 in equity in the house only. Similarly if the
price of the house rises by 10%, to $110,0,000. Now he
has $300,000 of equity and thus made a 50% gain on his
real investment. So the 10% price increase has turned
into a 50% gain to the owner of the house and this is just
because his is equity investment or original investment is
leveraged through the mortgage.
Thats the advantage of leverage that when prices are
increasing, gain on a house or any other investment can
be turned into a huge and big gain on the owners initial
investment.
But of course there is a drawback or dark side of leverage
as well. In the above mortgage example, this dark side
can easily be seen: if prices of houses or other assets fall
by 10% instead of increasing by 10%, the owner loses
50% of his equity. And similarly if the prices fall by 20%,
the entire equity of the owner is lost. Thus it shows that,
leverage magnifies both the gains and the losses on
equity investments and is much risky as its already
understood that greater is the return, greater is the risk.
Thus we can say that leverage is just like a genie of the
lamp. When prices of the asset are rising, leverage can
change a 10% return into a 50% return. In the period
leading up to the current crises, the genie was granting
wishes to the financial institutions and they earned huge
profits by expanding their leverage. When firms take
leveraged bets that pay off 9 times out of 10, they can
have long runs of seemingly amazing returns.
As after getting on the maximum point the down fall
started and problem occurred when the genie catches
you in a mistake. The downfall in prices of houses since
2006 and the downfall in the stock market have
combined with leverage to threaten the solvency of many
financial institutions. As the financial systems is so
integrated and inter linked - financial institutions borrow
and lend large sums with each other every day in normal
times-problems in a few banks can create a systematic
risk for the financial system as a whole.


#eferences:

1) lobal Financial Crises of 2007-08 By Charles I.
Johns.
2) Financial Crises of 2007 by Qayoom Qureshi.