Ethics and Financial Crisis of 2008 Essay Example | Topics and Well Written Essays - 1250 words

Ethics and Financial Crisis of 2008 - Essay Example The instruments used to create debt in the economy were subprime mortgages. These mortgages were given to people who do not have collateral for their borrowing and were given without banks assessing their sources of income. They were given on the basis of credit score. Hence, in case these people go bankrupt, banks had no avenue to recover their investments. Since, the Financial System in the USA is not independent this created a â€Å"domino effect† situation. When the largest investment bank in the universe Lehmann Brothers collapsed, many other institutions in the US started feeling the pressure. Many had to write off their investments in Lehmann Brothers and they started to crumble. In order to assess why this happened, a study of risky and unethical instruments that were prevalent in the US Financial System at that time is needed. (NY, 2009) Credit Default Swaps are one of the most risky instruments that were common in the United States of America’s financial syste m prior to the 2008 financial crises. This instrument was used by lending companies to hedge their investment against credit risk. If one party need loan, the lender usually asked an insurance company to hedge their loan in the case of credit event against a periodic fee. This looked really bright and it was considered that it was going to increase the level of investments in the economy. For example, if A needs a loan and have a credit rating of B+. B lends loans and lends only to companies with a credit rating of AAA. The third party C with a credit rating of AAA will tell B that it will insure A against a periodic payment. Suppose A agrees and lend $2 Billion to A. It is also important to assume that insurance companies have limited assets. Suppose C has assets worth $3 Billion. It can be assumed that in case of bankruptcy of A, B can recover his investment through C. This looked fine, but what started happening was that companies like started insuring the loans that were as big as 10 times of their assets. Now in case credit event occurs, then they were unable to repay the lender. That was only a speculation that borrowers won’t default on loans. However, if loans that were more than the assets held by C default, then there is no way C can pay A. This would lead to a collapse. Not only A and C will collapse, but A will also go down due to high level of non-performing loans. Similarly, all the debtors of A will also lose their money and domino effect will be created. This is what happened prior to the crises started. The instruments were so risky, that they lead to the fall of the whole Financial System of the United States of America. The reason of failure of these instruments was the high systematic risk that was present in this type of securities. Since, it is impossible to diversify this risk, there was no way that the insurance companies could predict which companies would do well and which would fall down. Since, these instruments could not be diversified it lead a collapse of the whole financial system of the United States of America. (Money Monitoring, 2011). MBS or Mortgage Backed Securities were another fancy term used in the era prior to the 2008 financial crises. Mortgages were given on the premise that the property prices have been rising in the economy. So even if the