A central bank or reserve bank or monetary authority is the institution responsible for managing currency, supply of money and rates of interest of a state or formal monetary union and monitors commercial banks. Unlike commercial banks, central banks possess a monopoly on increasing the monetary base in the state and control the printing of the national currency notes and coins.
Central banks can be considered the lender of last resort to the commercial banks at times when financial crisis strikes. Most central banks have supervisory and regulatory powers to make sure of the solvency of member institutions, to prevent bank runs and to discourage unfair practices by member banks. In most countries, central bank works independently with no or little political interference.
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SEE ALSO: What Is Central Bank?
Subprime mortgages are the mortgages that are issued to those borrowers who have low credit score and bad credit history. Subprime mortgages are issued to those individuals who have a FICO score of 640 and below. Individuals with low credit score and bad credit history, often have tough times while availing loans and if approved, have to pay high interest. This is because loans sanctioned to individuals with bad credit history are considered risky.
In the early 2000’s, interest rates on housing loans were quite low. To increase American house ownership, the Federal Bank helped individuals with low credit score to qualify for home loans as well. This made the quest to own an American house rise exponentially amongst the low and mid income sections. This move by the Federal Bank attracted investments in the real estate sector. Real estate investments from sub-prime borrowers rose considerably. Even the well-off Americans started investing more in real estate.
Housing prices rose exponentially. To control this, the Federal Bank hiked the interest rate over a dozen times. This situation meant the economy was heading towards serious inflation. By the end of 2004, the rate of interest was as low as 2.25% and by mid 2006 it touched 5.25%. Due to the steep hike in interest rate, real estate (housing market in specific) came crashing down. As the housing market crashed, subprime mortgage lenders started laying off employees, if not, they had to file for bankruptcy or lock down entirely.
A credit default swap CDS, is a financial swap agreement that sellers of CDS would compensate buyers in the event of default or other similar events. In short, sellers of CDS insure the buyer against reference asset defaulting.
By mid 2007, more than USD 45 Trillion was invested in CDS. This was more than the amount of money invested in US stocks, mortgages and US treasury bills combined. The US stock market held USD 22 Trillion and US treasury held USD 4.4 trillion in CDS.
CDS on Lehman Brothers debt started the 2008 financial crisis. The investment bank had a debt of USD 600 billion, out of which USD 400 billion was covered by CDS. The organizations that sold CDS were Pacific Investment Management Company, American International Group and Citadel Hedge Fund.
When Lehman Brothers declared bankruptcy, AIG did not have sufficient cash in hand to cover swap contracts. The Federal Reserve came to the rescue and bailed them out. To make things worse, banks utilized CDS to insure financial products that were very complex. Banks traded CDS in unregulated markets and buyers had no relation with the underlying assets. Most buyers did not understand the risks. When buyers defaulted, CDS sellers like Municipal, Ambac Financial Group Inc, Bond Insurance Association, and Swiss Reinsurance Co were seriously affected.
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