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How did 'crisis' spread through the financial system in '07-'08? Specifically, what is the process by which a subprime mortgage impacts the health of the credit markets as a whole? An explanation in the context of securitization would be appreciated.
I understand that subprime mortgages are sold to special purpose vehicles but the process is muddled from there.
I don't need a mathematical explanation, a clear conceptual explanation would be perfect.
Thank you!
Essentially, there was a bank run in the repo market.
The repo market is where big institutions (like, say, Fidelity) deposit large amounts of cash for short periods of time with institutions like, say, Bear Stearns. Bear Stearns, in order to guarantee that it won't run away with the money, allows Fidelity to hold some valuable assets belonging to Bear Stearns in the meantime --- say some bonds.
Now Fidelity comes to believe that these bonds are worth only, say, 80% as much as it previously believed, and therefore asks for more bonds by way of collateral. So, at around the same time, does everyone else. But Bear Stearns only owns so many bonds, so it can't satisfy everyone. If you've ever seen "It's A Wonderful Life", you know what happens next.
That, at least, is Gary Gorton's story, and it seems very plausible and is widely endorsed. Of course there are many competing stories as well.
Anyone with an MBA will tell you that most industries have a leverage ratio around 20% to 50% on equity.
Having to much debt can destroy your business and having say 20 parts debt to 100 parts equity is as far most industries will go.
But the Banking system, run mainly by economists, 4 out the 5 top directors at Bear Sterns were economists, also at Lehman Brothers, has a leverage ratio between 1200 parts debt to 100 parts equity, 25 times more than industry.
How do these economists turned business men sleep at night?
By the Institution they themselves created, of a helping Central Bank, FDIC, allowing competitors to Interbank Lending, and so on.
This has two very undersirable effects.
Banking has more power than say 25 industries combined.
Banking is the more profitable than 25 industries combined.
Thanks to Government protecionism.
