PART 1:
Using the draw tools in Word, show what happened to the demand for housing by drawing the demand for housing in 2005, 2006, and 2009. This means you draw lines for the demand and supply of housing in 2005, 2006, and 2009 to the supply and demand graph and match what happens to the price in those years with what is show in the chart. Explain what caused demand to change over this period.
The graph below shows the demand of housing in 2005, 2006 and 2009 and how the price fluctuates.
The demand for houses rose rapidly during the end of the year 2005 given that people demanded more and larger homes, and as well prices fast. The promise from the government which is referred as a bond to make an interest payment on borrowed money and eventually pay back the borrowed money resulted in the rise of prices in 2005 and 2006. Given that a bond was an income in a way based on borrowed money, financial products from other debt-based income such as home mortgages were created as well as became a commercial product that was bought and sold by Wall Street investment banks. Ideally, the mortgages bond would collect many homes mortgages, purchased from lenders as well as packages their monthly mortgages payments into a financial product that could be bought and sold like a bond.
The price was determined by the mortgages bond relating to the fact that homeowners refine a lot of times their debt during periods of low interest. As a point of fact, Wall Street made mortgage bonds into stacked layers. Wall Street started to create mortgage bonds from mortgages of much higher risk, but paying higher interest rates made debtors of lower levels to increase the price of houses during the year 2006. The increase of demand from Wall Street to buy these mortgages with higher risk, lenders became more motivated to place more of these loans given the fact that they were in danger if the loans failed. The new category of mortgages became riskier and made them harder to sell to investors since it would affect their rating. The housing crisis continued because of this conflict and the aspect of rating agencies. Despite the boom in mortgage bonds, Wall Street desired for more profits through the rise of housing prices. Bankers were convinced that home prices would continue to grow since low-cost mortgages fuelled, even more, demand for houses from 2005 and 2006.
In 2009, the housing prices declined since local lenders started selling mortgages off to other financial institutions who packaged hundreds of mortgages together and then sold securities backed by those packages to other financial institutions and individual investors. Also, the idea of the government to step into the housing crisis and bailed them out by paying off their debts as well as assuming their liabilities resulted in a global economic slowdown of the housing crisis in 2009. Essential, the fact of the matter is, mortgage bonds have problems relating to refinancing of their debt during times of low interest.
PART 2:
If one wanted to speculate in the sub-prime mortgage bond market, explain the difference between buying a sub-prime mortgage, buying a sub-prime mortgage bond, and purchasing a sub-prime credit default swap (CDS) and how these financial instruments can be used to bet for profit.
A subprime mortgage is usually made to customers with inferior credit ratings. The lenders see that the borrowers have a higher chances of failure to pay on the loan. On the subprime mortgages, financial institutions habitually charge interest at the rate that is greater than conventional mortgages. The main reason as to why this happens is that compensation is offered for any risk. As a point of fact, borrowers with credit ratings lower than 600 will often be trapped with subprime mortgages as well as advanced interest rates that go in hand with mortgages. Subprime mortgages loans have made poor people feel wealthy by giving them cheaper loans to pay off the high-interest credit card debt.
On the other hand, credit default swap is an insurance policy designed against the defaults in the mortgages pool of mortgage bonds. Ideally, credit default swaps were financial instruments used as a hedge as well as protection for debt holders. Sub-prime credit default swap operates like an insurance company selling insurance. It is like an auto company selling car insurance. The seller of the credit swap on sub-prime is betting that the homeowner will not default on their mortgages. Therefore, buying a credit swap over selling over selling short is that creates more leverage.
For example, if an exchange was sold for $200,000 they might pay 100 times or $20 million if there are in fact enough defaults to activating the insurance payment. The seller of the credit swap on sub-prime mortgage bonds is betting that the proprietor will not default on their mortgages. The buyer of a credit swap on sub-prime mortgages is betting that the homeowner will fail to pay their mortgages.
PART 3
Explain the concept of leverage and how it applies to credit default swaps.
Leverage is the process of magnifying the effect. The markets for credit defaults swaps were over the counter as well as unregulated. The markets for credit defaults swaps were over the counter as well as unregulated. In most instances, contracts were often traded resulting in who stands at each end of the transaction (Kuhner 102). In leverage, there is the possibility that the risk buyer may not have the financial ability to abide by the contracts provisions thus making it difficult to value the deal. Essentially, however, the leverage that is involved in much sub-prime credit default swap transactions. The fact of the matter is, the possibility that massive defaults as well as challenges the ability of risk buyers to pay their obligations as well as add to the uncertainty.
Just like a lever can turn a little bit of force into a powerful mover, this leveraging has become small assets base into something that returns a lot of money. As a point of fact, most banks, as well as insurance companies, use the concept of leveraging based on credit default swaps to manage along with lessening their credit risk. A key feature of leveraging is that financial companies support the sub-prime credit default swap market as it allows them greater flexibility in managing their risks. To create this kind of leverage and basically for one dollar those people who leverage would in return acquire thousands of dollars.
Therefore, some of the examples that demonstrate how to hold apply to credit default swaps include the following; (1) if Joe thinks that your house looks good, but he is worried that it could burn down. Then, he buys fire insurance policy on it under the same terms. He will receive 200,000 if he pays 2,000 each year so that if the house burns down. Jacob, Henry, Roger as well as Jack do the same thing, but their motivation is different. Insurance is bought because of the risk of fire.
PART 4.
Consider the players described in The Big Short. These include the large Wall Street firms and insurance companies AIG, Deutsche Bank, Lehman Brothers, Merrill Lynch, Bear Stearns, Citibank, and Charlie Ledley of Cornwall Capital, Steve Eismann of FrontPoint Partners, Michael Burry, Greg Lippman, etc. Describe the nature of speculation in the sub-prime mortgage market and identify who was betting on what.
Greg Lippman was betting heavily on the downfall of mortgage bonds. Lippman during the crisis he offsets losses on mortgage investments at Deutsche Bank with wagers against subprime debts. Ideally, Greg Lippman wanted to buy his billion dollars in credit default swaps. Goldman Sachs, Lehman Brothers, Citigroup and the big Wall Street firms-Bear Stearns, had the same goal as any manufacturing business(Lewis 121-125). The big Wall Street firms that may have sold credit default swaps did not have a sense of urgency. Deutsche Bank, as well as Goldman Sachs, did not seem to care which bonds were picked to bet against whereby both were dealers of credit-default swaps and came up with an ingenious solution. The incompetent bets which were made by Goldman Sachs resulted in millions of broke Americans would repay their home loans. Those people who ran funds that specialized in mortgage bond trading were the ones least likely to see anything but what they had seen for years. The insurance company was another party on the other side of the bets for credit default swaps. It is evident that AIG became a huge swallower of those risks, and it was almost like they were being paid to ensure events were extremely unlikely to occur.
For instance, Charley Ledley saw that credit swaps were just a financial option to pay a small premium and if subprime borrowers defaulted on their mortgages was too good to be true. Charley believed that buying credit default swaps were too good to be true given the fact that the best way was to make money on Wall Street. On the other side, Eismann used the data presented by subprime mortgage originators as well as discovered that the mortgages pools behind sub-prime mortgage bonds were way risky than investors were led to believe. As a point of fact, Eismann of FrontPoint Partners had no trouble betting against subprime. However, some investors in these subprime mortgage bonds thought that they had lower default risk and opted that the bonds were safe. Most importantly, Michael Burry was ideally the man who did his homework in an extensive manner given that the housing bubble was loaded up with credit default swaps against subprime mortgages lending. Michael Burry believed that the credit default swap would solve the biggest problem he had while transacting his businesses of betting. Burry felt almost confident that these mortgages bonds would go bad. Michael believed that he had to place his bets immediately before the housing department of the United States market woke up and restore sanity. To some degree, he felt that someone on Wall Street would eventually notice the significant increase in the riskiness of subprime mortgages as well as raise the price of insuring them accordingly.
PART 5.
In the end, U.S. taxpayers ended up paying almost a trillion dollars to bail out various Wall Street financial institutions. What role did government regulation of financial markets play in the events described in The Big Short? Consider the Do-Nothing Policy discussed in lecture and applied it to the facts mentioned in the Big Short.
It is evident the United States government paid in full many of the submarine mortgage loans. Sub-marine mortgages do not meet the requirements of creditworthiness and are not guaranteed by the government. The mortgage bond based on the pool of government guaranteed loans which were free of risk, but if the homeowners fail to make a payment, the banks just sell the homes at a loss. If not the intervention of the government, all the big firms on Wall Street as well as banks that were part of the crisis would have entirely discredited and others lost their jobs.
Some of these financiers were using the government to enrich themselves. The government of the United States was willing to allow the bankers to fail, but it was less a solution and more a symptom of a dysfunctional financial system. The intervention of the government was of great importance because banks were mostly critical to the success of the U.S economy. Ideally, the strategy which was discussed in lectures was of great significance in the sense that it required no action other than taking care of the immediate problem. The government approach considered the task of planning for the future level of population in the world. The ‘do nothing’ policy guarantees that we will eventually sink into utter chaos particularly in the case of the housing bubbles. Therefore, there is the need to seek for solutions to very obvious problems that the growing problem will only get worse as our population continues to grow.
Work Cited
Lewis, Michael. The Big Short. New York: W.W. Norton, 2010. Print.
Kuhner, Timothy K. Capitalism V. Democracy: Money in Politics and the Free Market Constitution. , 2014. Print
