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What was the purpose of your visit to worldbank. Did the layout and navigation of the new site help you locate what you were looking for? Yes No. Do you have any other feedback on the new version of our website? If you are willing to be contacted in the future to help us improve our website, please leave your email address below. Which of the following best describes your career field or organization? This one could be worse. John Lawrence: Inside the financial crash.
The financial crisis of was about home mortgages. Hundreds of billions of dollars in loans to home buyers were repackaged into securities called collateralized debt obligations, known as CDOs. In theory, CDOs were intended to shift risk away from banks, which lend money to home buyers.
In practice, the same banks that issued home loans also bet heavily on CDOs, often using complex techniques hidden from investors and regulators. When the housing market took a hit, these banks were doubly affected. In late , banks began disclosing tens of billions of dollars of subprime-CDO losses.
The next year, Lehman Brothers went under, taking the economy with it. The federal government stepped in to rescue the other big banks and forestall a panic. The intervention worked—though its success did not seem assured at the time—and the system righted itself. Of course, many Americans suffered as a result of the crash, losing homes, jobs, and wealth. Yet by March , the economy was on the upswing, and the longest bull market in history had begun. To prevent the next crisis, Congress in passed the Dodd-Frank Act.
Under the new rules, banks were supposed to borrow less, make fewer long-shot bets, and be more transparent about their holdings. Congress also tried to reform the credit-rating agencies, which were widely blamed for enabling the meltdown by giving high marks to dubious CDOs, many of which were larded with subprime loans given to unqualified borrowers.
Over the course of the crisis, more than 13, CDO investments that were rated AAA—the highest possible rating—defaulted. After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation.
A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. The majority are held in CLOs.
The two securities are remarkably alike. The bottom layer is the riskiest, the top the safest. If just a few of the loans in a CLO default, the bottom layer will suffer a loss and the other layers will remain safe. If the defaults increase, the bottom layer will lose even more, and the pain will start to work its way up the layers.
The top layer, however, remains protected: It loses money only after the lower layers have been wiped out. Annie Lowrey: The small-business die-off is here. Just as easy mortgages fueled economic growth in the s, cheap corporate debt has done so in the past decade, and many companies have binged on it.
Check out the full table of contents and find your next story to read. Despite their obvious resemblance to the villain of the last crash, CLOs have been praised by Federal Reserve Chair Jerome Powell and Treasury Secretary Steven Mnuchin for moving the risk of leveraged loans outside the banking system.
Like former Fed Chair Alan Greenspan, who downplayed the risks posed by subprime mortgages, Powell and Mnuchin have downplayed any trouble CLOs could pose for banks, arguing that the risk is contained within the CLOs themselves.
These sanguine views are hard to square with reality. A more complete picture is hard to come by, in part because banks have been inconsistent about reporting their CLO holdings. From the September issue: Frank Partnoy on how index funds might be bad for the economy. I have a checking account and a home mortgage with Wells Fargo; I decided to see how heavily invested my bank is in CLOs. These are investments a bank plans to sell at some point, though not necessarily right away.
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Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Banking Banking Basics. Table of Contents Expand. Table of Contents. What Happens When a Bank Fails. Uninsured Deposits. Bank Runs. Avoiding Bank Failures. By Justin Pritchard. Justin Pritchard, CFP, is a fee-only advisor and an expert on personal finance. When American authorities blackball foreign banks, they may be forced out of business.
This could occur because the bank is located in a rogue country or the bank could be engaged in illegal activities such as money laundering. Proprietary trading. This newest and soon to be banned bank business created huge exposures for banks.
For the most part, proprietary businesses generated large profits. But regulators believe the possibility of large losses more than offsets the profit potential. Basically, the business included investment in unhedged derivatives, large blocks of marketable securities, exotic instruments and illiquid investments. Non-bank activities. Over the years, banks have dabbled in non-traditional businesses looking to improve profitability.
Experiments with real estate investment trusts, leasing companies, consumer finance companies and non-bank foreign subsidiaries were mostly unsuccessful and resulted in huge losses. Risk management decisions. They measure risk from every conceivable perspective including interest rate risk, foreign debt risk, investment risk and much more.
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