The stagnant of the U.S. economy

"Suppose that a wealthy individual borrowed three million dollars from the bank, adding another million dollars of his own capital and invests it in one of fund baskets, which in turn invests in other hedge funds. This point has a leverage of 4 to 1. Suppose then that this basket of funds takes those four million dollars and borrows another $ 12 million from another bank, and invests in another hedge fund. Again, the leverage is 4 to 1 but the initial investment of 4 million has increased to 16 million. Imagine now that a hedge fund borrows another 48 million (again a four to one leverage) to invest a total of 64 million dollars in some high-risk stages of a CDO. Illustrating the power of exponential math, a tiny initial involvement of a million dollars has become the basis of a $ 64 million bet. " To make matters worse in 2003 the SEC (Securities and Exchange Commission) made capital requirements easier for investment banks. The debt by capital was at levels of 15 to 1 increasing levels from 33 to 1 and even more. This meant that with a fall of 3% of the value of their assets many organizations were to become insolvent.

The other key factor in this crisis was the "transfer or release of risks" that caused a major "systemic risk". There are four elements that permitted and encouraged this process.

Securitization, credit default swaps, the credit reporting agencies and system of compensation for banks.

Let's start with the securitization. The banks provide mortgages for 30 years, but most of the deposits they receive are short term. To resolve this problem they created securitization, which is what consisted of gathering groups of mortgages and sold them to investment banks, which in turn were put together with other groups of mortgages and loans and were sold to customers which were insured by CDS bought by these titles.

Although the securitization is good because it allows for extending the term of the loans, the danger of this mechanism is that the banks gave out 100% of the risks associated with the credits granted, and thus it was with the complicity of the rating agencies that such mortgages gave the highest ratings, stopped worrying about who they would lend to and started offering loans for up to one hundred percent of the value of the property and to people who in many cases could not cope with them.