Chapter 5 Notes - Chapter 5 Current Multinational Financial...

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Chapter 5 Current Multinational Financial Challenges: The Credit Crisis of 2007-2009 The Seeds of Crisis: Subprime Debt From 1995 to 2001, the Nasdaq index increased by a factor of more than 6, which is called the dot-com boom After the collapse of the dot-com bubble in 2000 and 2001, capital tried to find a safer target and began to flow toward the real estate sectors in the United States Some economists argued that much of the wealth accumulated from the equity markets during that period was now used to push the demand and prices of real estate upward The U.S. banking sector found mortgage lending highly profitable and saw it as a rapidly expanding market The mortgage lending business boomed due to the high demand The bright prospect of the housing price enhanced the value of collaterals for the mortgage In 1999, the U.S. Congress pass the Gramm-Leach-Bliley Financial Services Modernization Act, which repealed the Glass-Steagall Act of 1933 and eliminated the barriers between commercial and investment banks With the increase of the competition in the mortgage lending business, a growing number of the borrowers were with lower credit quality These borrowers who previously should be unqualified to borrow mortgages, and their associated mortgage agreements ( subprime debt ), carried higher debt obligations with lower income In traditional financial management terms, the debt-service coverage ratio, defined as the ratio of income available for servicing interest and principal payments of the debt, was increasingly inadequate The competitiveness created various mortgage forms to attract borrowers, e.g., Initially, borrowers pay floating rates, often priced at LIBOR, plus a small interest rate spread, and the loans would reset at much higher fixed rates within two to five years Borrowers pay interest only in early years with a initial interest rates far below market rates, and have substantial step-ups in payments after the initial period of interest-only payments Mortgage loans in the U.S. marketplace are normally categorized (in increasing order of riskiness) as: Prime (or A-paper) A-prime mortgages are conforming or conventional loans, meaning it would meet the guarantee requirement and can be resale to government-sponsored institutions, e.g., Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation) Alt-A (Alternative A-paper) The Alt-A loans are still with low risk, but for some reasons are not initially conforming, like borrowers with less than full documentation, higher loan-to-value (LTV) ratio, and more investment properties Subprime In principle, it reflects borrowers who do not meet underwriting criteria and have a higher perceived risk of default, normally as a result of some credit history, e.g., bankruptcy, loan delinquency, default, etc. Sub-prime mortgages are nearly exclusively floating-rate structures, and carry significantly
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This note was uploaded on 03/10/2012 for the course ACCOUNTING 5450 taught by Professor Brown during the Spring '12 term at Colorado Technical University.

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Chapter 5 Notes - Chapter 5 Current Multinational Financial...

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