Financial Markets Assignment (The Big Short)

1.
The 2007 Housing crisis, also known as the subprime mortgage crisis, was a financial crisis that
began in the United States and ultimately had a global impact. The crisis was rooted in the
housing market, where a combination of factors including lax lending standards, speculation,
and a housing bubble led to a surge in home prices.
In the early 2000s, the US housing market experienced a significant boom, driven by a surge in
demand for homes, low-interest rates, and easy access to credit. As home prices continued to
rise, lenders began offering increasingly risky loans to borrowers with poor credit histories,
including subprime mortgages with adjustable interest rates and low initial payments. These
loans were bundled into mortgage-backed securities(which were thought of by Lewis Renary)
and sold to investors around the world, who believed that the housing market was a safe and
lucrative investment. These securities were often given high ratings by credit rating agencies,
even though the underlying mortgages were risky. As demand for housing continued to
increase, prices rose rapidly, creating a housing market bubble. This bubble was fueled by
speculation and risky lending practices. In 2006, the housing market began to slow down, and
prices started to fall. As the housing market began to decline, many homeowners found
themselves unable to make their mortgage payments, and defaults and foreclosures increased.
This led to a downward spiral as more homes went on the market, driving prices down further
and causing more foreclosures. As homeowners began to default on their mortgages, the value
of the securities backed by these mortgages also plummeted, causing significant losses for
investors. The losses suffered by investors in mortgage-backed securities had a ripple effect
throughout the financial system. Many financial institutions that had invested heavily in
mortgage-backed securities suffered huge losses and some, such as Lehman Brothers, went
bankrupt. The crisis and the resulting tightening of credit led to a severe economic downturn,
with rising unemployment, falling home prices, and declining consumer confidence. In response
to the crisis, the US government took a number of steps, including the Troubled Asset Relief
Program (TARP) which provided bailout funds to financial institutions, and the Dodd-Frank Wall
Street Reform and Consumer Protection Act, which aimed to strengthen regulation of the
financial sector to prevent a similar crisis from occurring in the future.
2. Mortgage backed securities (MBS), collateralized debt obligations (CDOs), and credit default
swaps (CDSs) were financial instruments that played a significant role in the 2007 Housing crisis.
Here’s how they did that:
Mortgage-backed securities (MBS): These were securities that were created by bundling
together individual mortgages and selling them as a package to investors. Banks and other
financial institutions would pool thousands of individual mortgages and create MBS that could
be sold to investors. The idea behind MBS was to spread the risk of default among many
investors, making the investment less risky. However, the underlying mortgages were often
subprime mortgages that were given to borrowers with poor credit histories and low income. As
defaults on these mortgages increased, the value of MBS plummeted, causing significant losses
for investors.
Collateralized debt obligations (CDOs): These were securities that were created by bundling
together MBS and other debt instruments and selling them as a package to investors. CDOs
were divided into tranches, with each tranche representing a different level of risk. The higher-
risk tranches offered higher returns but were more likely to default. CDOs were often given high
ratings by credit rating agencies, even though they were made up of risky debt instruments.
When the underlying mortgages started defaulting, the value of CDOs also plummeted, causing
significant losses for investors.
Credit default swaps (CDSs): These were insurance-like contracts that allowed investors to
protect themselves against the risk of default on MBS and other debt instruments. CDSs were
essentially bets on whether a particular debt instrument would default or not. Investors who
bought CDSs would receive a payout if the underlying debt instrument defaulted. However,
because there was no regulation on who could buy or sell CDSs, some investors were able to
buy CDSs on debt instruments that they didn't own. This allowed them to profit from the default
of those debt instruments, even though they had no stake in their success. This created a
perverse incentive for investors to bet against the housing market, which contributed to the
crisis.
3. Credit rating agencies played a significant role in the 2007 Housing crisis. These agencies were
responsible for evaluating the creditworthiness of mortgage-backed securities (MBS),
collateralized debt obligations (CDOs), and other financial instruments. They assigned credit
ratings to these securities based on their assessment of the likelihood of default.
However, the credit rating agencies were criticized for their role in the crisis for several reasons:
The credit rating agencies were paid by the same companies that were issuing the securities
they were rating. This created a conflict of interest, as the agencies had an incentive to assign
high ratings to the securities to keep their clients happy like that one guy eating sushi from the
movie.
The credit rating agencies were criticized for assigning overly optimistic ratings to MBS and
CDOs, even though many of these securities were made up of risky subprime mortgages. The
agencies failed to account for the risk of default, leading investors to believe that these
securities were safer than they actually were.
Even when it became clear that the subprime mortgage market was deteriorating, the credit
rating agencies were slow to adjust their ratings on MBS and CDOs. This delayed the recognition
of the risks associated with these securities, and allowed the market to continue operating
under the illusion that these securities were safe.
Overall, the failure of the credit rating agencies to accurately assess the risk of MBS and CDOs
contributed to the widespread losses suffered by investors in these securities.

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