Prof Altomonte explains how and why some of the biggest financial institutions fell on their knees.
Let's begin by understanding how it all started. Home owners took loans from banks to build their houses. Traditionally, the loans were provided based on the ability of the borrower to repay on the basis of his financial stability and affluence. Later, bonds (Collateralized Debt Obligations) were created on these loans which were unlikely to be defaulted. These bonds were available for purchase in the open market. As the demand for these bonds increased, banks became less stringent while disbursing these loans. This led to the creation of sub-prime loans which are loans that are given at higher rates to people who were unlikely to be able to pay them off.
The bonds became shakier as more and more sub-prime loans were introduced. Enter Credit Default Swaps. Now these CDS- an insurance policy against the housing market, allow the people to bet against the system Investment banks create the bonds and sell it and at the same time buy protection through CDS. In the end there is a giant web where everyone has insurance against the risk of somebody else. So as more people default on the bonds, it creates a ripple effect that wipes out 5 trillion dollars of wealth, 6 million people lose their house and 8 million people lose their job all over the world.
Now what can we learn from this?
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