(The arrow show the movement of Funds.)
In a tradition banking setup ( like one that exist in India) Bank normally finance the loan to the borrowers from the deposits it receive. (If Mr A deposits Rs 1000 in a Bank banks keep say Rs 100 (say 10% as a reserve to meet the obligation) and lend out Rs 900 to Mr B. Mr B then pay to Mr C who in turns deposits it in a bank (same or other). The bank keeps 90 and lends out Rs 810 to Mr D. and this process goes on)
In some of the developed economy now the loan which a bank gives is formed into a bond (Mortgage bond) and sold in the bond market. (For banks the credit extended is an investment). This act as a supply extra fund for the banks. There is no problem with this business model. The problem started with the implementation. Many private players started extending loan to client who was rejected by the government banks based on the report of the home appraiser. These investments were clubbed with those credits given to people with better credit worthiness. As a result the bond as a whole got good credit rating and many investors bought them (including many Investment bankers like Lehman brothers). This also fueled the boom in the real estate market. The price of property showed abnormal growth.
Till the Real Estate industry was in boom this model was working great. If the home purchaser defaulted the bank could sell their property as it was mortgaged with the bank. When the real estate industry busted (i.e the market saw a correction in the price of the property.), the model showed its inefficiency.
Most of the banks who provided these loans did not do a proper check of the customers. As a result they did not even had proper document relating to property. They could not sell the mortgaged property at the price which would meet the demand of the bond holders. So the repayment to bond holders became difficult for these banking institutions. There were no buyers for these bond in the bond market as a result of this the bond became worthless. Many of the investor who had bought these bonds because of the high return had to write off these loans from their book.
The Price of property has come down by around 8 to 9%. As per some reports the total loss to major banks like City bank J.P. Morgan Chase, Bank of America and others were to the tune of $ 100 bn. A total of $ 500 Bn has already been declared. The estimated loss is round $ 1 trillion. US congress is working on $700 bn financial bailout plan. It is to be seen how many institution can this $ 700 bn can save from crisis.
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