Golden Investment Fund……………………………….………………………...28

A growing tendency of mortgage-backed securities began to develop. The homeowner would get made a conforming loan by the loan originator who would sell the mortgage to Fannie Mae and Freddie Mac to recover the cost of the loan. The agency would pool the loan into mortgage-backed securities and sell the securities to investors such as pension or mutual funds. However, these subprime loans had higher default risk. Thus emerged a strong trend towards lowor no-documentation loans that called for little verification of the borrower's credit ability. These subprime borrowers began to purchase houses by borrowing as much as the entire purchase price. Adjustable Rate Mortgages was another trend which would offer low initial interest rates but would eventually reset to the ongoing market interest yield. With the deregulation of the derivative market by the US Government, investment banks carved out Collateralized Debt Obligations with AAA-rating. CDOs contained a number of debt obligations. Their design concentrated the risk on one class of investors leaving the other set relatively protected. The demand for CDOs increased manifolds which was the result of the introduction of Credit Default Swaps by American Insurance Groups. CDS was an insurance against default. This further encouraged the investors to buy subprime loans because CDS helped in credit enhancement by insuring their safety. This led to unsupportable exposure to default risk as most investors did not have sufficient capital to back the obligations. Despite the risk the financial product was AAA-rated. This was a result of the rating agencies being paid by investors to dramatically underestimate the risks. By 2007, the systematic risk had grown tremendously. Many large financial institutions would borrow shortterm funds at low interests in order to finance highyielding long-term illiquid holdings gaining from the interest rate differences. This not only necessitated their need to refinance their positions constantly but also made them highly leveraged with little capital as a buffer against losses. Besides, there was a rising trend of CDOs and over-the-counter exchange of CDS contracts with limited information of the trading partners' credit exposure. Such new financial models were brimming with systematic risk. The problems of the financial system were ready to spill over and disrupt the real side of the economy. Unfortunately, in 2006, the Federal Reserve increased the interest rates. This left lenders with a limited capital which they chose to hoard instead of lending out to customers thus aggravating funding problems in the country. By the fall of 2007, housing prices fell and the highly leveraged loans drowned. The property was worth less than the loan balance forcing many homeowners to abandon their homes as well as loans. The mortgage default rates surged and the crisis shifted into higher gear. CDOs provided far less protection than was anticipated. As the housing prices fell, defaults further increased and the much hoped-for benefits could never be materialized. Many investment banks began to totter. The crisis peaked in 2008 with Fannie Mae and Freddie Mac being put into conservatorship. Merrill Lynch was sold to Bank of America. Lehman Brothers announced bankruptcy. The government, however, reluctantly lent to AIG on the grounds that AIG held massive amounts of CDS contracts and that its failure would destabilize the banking industry. The US Treasury proposed to purchase mortgage-backed securities. Lehman had borrowed significantly by issuing commercial papers. The customers withdrew their funds and the short-term financing market eventually got shut down. This made banks unable to extend loans