The US Banking Collapse – Explained

Shambhavi Kumar

The US Banking Collapse 

The US banking collapse was caused by various factors, some of the major ones

  • Shadow banking – there were a large number of entities that were functioning in the financial system but were not categorised as ‘banks’ but directly or indirectly affect the way the banks functioned. Since these entities were not banks, they did not fall under the regulatory framework of banking regulations and hence created a situation of shadow banking that played a major role in the US banking collapse; 
  • Sub-Prime Lending which led to Sub-Prime Mortgages – the banks started to request the brokers to bring more people to take mortgages against their houses and the banks started providing loans to people who met no eligibility criteria for getting such a loan; 
  • Mortgage Backed Securities – the banks started selling their mortgage to other banks, while some banks started buying mortgage from various other banks and created a mortgage pool known as a MBS. These MBSs were sold to investors, who further securitised these MBSs;
  • Collateralise Debt Obligations – the MBSs were divided into three categories (i) Low Risk; (ii) Medium Risk; and (iii) High Risk. High risk MBSs were those cases in which a default meant that the property was to be sold and the money from such a sale was to be used to pay off the mortgage. Since the property market was booming, during the time, hence, this practice giving yielding huge profits; and
  • Over Leveraging – banks had highly leveraged themselves to make profits by the above MBS model. The bank generally checks the financial health of the company by analysing (i) the debt to equity ratio; (ii) the debt to earnings ratio; and (iii) the debt to asset ratio of the company. A high leverage is a major risk factor and a bank itself should never put itself in a position where it is highly leveraged. But all such precautions were ignored.  

Once the amount of sub-prime mortgages started increasing the defaults started increasing and the number of houses in the market kept increasing and the property market in the US was on the decline. This meant that the houses being recovered by mortgage default, that were increasing, were unable to be sold. The credit rating agencies that were rating these banks and loans were also funded by the banks and hence hide the actual issues. The insurance agencies also insured such mortgages without any appropriate checks into these mortgages. There was a complete credit freeze, and assets were wiped out. The US economy shrank completely and the Government had to pass a Bailout Bill to avoid an unprecedented economy crash. 

The above situation was caused by lenient regulations and regulatory gaps in the banking laws. Such a massive collapse could have been avoided if appropriate precautions were taken and appropriate funds were maintained.

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