Now we will check how all the big players came into the picture and took so much exposure in the market. As the housing market price was continuously increasing and lots of people have started to take the benefit out of it, all the big banks and investment banks have also developed new schemes and investment vehicles to increase their exposures. Now we will see how did this happen.
The banks have looked into the sub prime lending to increase their exposure in the rising housing market. The competition was so high among the big banks that the credit rating of the customer became irrelevant and the interest rate touched the new record high. Banks were confident that even if the customer gets default, they will get the house and sell it at much better profit easily as the price was increasing like anything.
So all the banks had started lending in huge amount (in billions); without even checking the credibility of the customer and price of the house. Their main aim was to take more exposure amid huge competition. Now we understood why did the banks have so much exposure in the sub prime mortgage lending. The sub prime lending rate touched around 10-11% interest rate, sometime around 15% for almost default credit rating of the customers.
Now we will check how come big investment banks like Lehman Brothers’ and Merrill Lynch took so much exposure in the crisis. When the banks have increased exposure in the sub prime mortgage lending sector, they needed more money and for that they had approached to the big investment banks. The big investment banks had decided lend money to the banks at a high interest rate (less than the prime lending rate) to supply the huge liquidity that the banks want. So Lehman Brothers and Merrill Lynch money came into the sub prime mortgage market. The amount of money had been increasing every day and the exposure touched almost trillion US dollar.
How did Lehman Brothers’ get so much money?
Lehman Brothers’ wanted to increase the exposure and was putting huge amount of money. To get the liquidity it has created some mortgage backed securities through some securitization process and sold them to the investors around the world. The input money of the securities are coming from the mortgage principal and interest payment by the huge number of customers.
Exposure widened to the whole world…
Lehman Brothers’ was the biggest investment bank that time and their mortgage backed securities have received the stable and safe rating from the global rating agencies with much higher yield compared to US government bonds with the same credit rating. Higher yield had attracted many investors around the world including all global big banks, different financial institutions and even Governments of different small countries. The total exposure of only Lehman Brothers’ touched a whopping USD 700 billion dollar at that time with the total exposure of USD 4 trillion. FromIndia, ICICI bank had couple of million dollars of investment. These complex derivative and financial instruments enabled Lehman Brothers’ and many global investors to earn huge amount of money out of sub prime mortgage lending.
AIG in the picture?
With the big global banks and investment banks, different insurance companies mainly US insurance giant AIG had also increased their exposure via a derivative instrument called Credit Default Swap, through which AIG provided insurance on the default of the sub prime mortgage loans with a very high rate of premium. The insurance was done considering a very less percentage of default or non-payment of the loan amount. Their exposure in the CDS of mortgage backed securities touched USD 400 billion at that time.
The money flow became like this:
Global investors or financial institutions -> Investment Banks -> Banks or mortgage lenders -> Sub prime mortgage customers.
Means the monthly principal and interest payments made by the customers were going to all the global investors across the world. The basis of this payment was the houses they have bought in the US to gain profit out of the price increase.