Tuesday, February 2, 2010

Financial Crisis Understanding From the Ground Up (Part 3)

Traditional commercial Bank vs Investment Bank

The simplest definition among them is: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank does not.

A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC). We have mentioned the definition and how a traditional commercial bank makes profit in before. So, how about investment bank(I-bank)?

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. For example, if company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds).

Because commercial banks already have funds available from their depositors and an investment bank typically does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client. Besides, the investment banks also maintain broker/dealer operations, maintain markets for previously issued securities, and offer advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.


Most home buyers have to borrow money in order to purchase their home. Few have enough money sitting in the bank, or in other easily saleable assets, to pay the entire cost of the home at once. The home loan they receive is called a mortgage. Generally, A mortgage is loan you use to purchase a home, or some other piece of property. The amount you borrow is called the principal and each mortgage payment is a combination of principal and interest. The property remains in the possession of the borrower, but it may be reclaimed by the lender if the loan and interest are not paid as agreed. Mortgage or home loan is one of the major sources where commercial banks can generate profit.

Subprime mortgage

What is a subprime mortgage? Besides the conventional mortgage which we have just talked about, there is another kind of mortgage known as subprime mortgage. A subprime mortgage is a type of loan granted to individuals with poor credit histories, who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate.

Subprime mortgage crisis

As mentioned before, subprime mortgage present a higher risk because those borrowers are more likely to default on their loans since they already had financial problems before taking on the loan. Therefore, after a subprime loan is issued to homeowners, those issuing banks would sell these subprime loans to other investors, to compensate for the high risk. These investors include other banks, I-banks, funds and financial institutions. As subprime loans typically pay higher yields, so it had attracted a number of mutual funds and hedge funds to invest in them.

This kind of selling and re-selling of subprime loans or the subprime loans packaged products among the financial parties have created a very complex network of relationships. It can be imagined that, it is not easy to estimate the risks and the responsibilities of these products. Also, it is not easy to estimate how serious will the consequence be once there is problem in any party inside the network.

The story kept going. However, the bubble started bursting in 2006. In late of that year, many subprime mortgages have become delinquent as homeowners run into financial difficulty. A number of hedge fund companies and investment banks that invested in subprime loans incurred millions of losses

George C. (http://www.finance-database.com)

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