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Leveraging on the bubble in sub-prime crisis

During 2004 to 2007, further to the drop in interest rates, many investment banks opted to leverage on the situation as they found it beneficial to raise large amounts of debt at cheaper rates and invest in mortgage backed securities on the impression that housing boom will continue.

During the boom the traders in Wall Street were eying on the bonuses available end of year and not the long term impact on the firm or the market. According to the New York State Comptroller’s office, Wall Street executives have bagged in bonuses totaling @23.9 billion in 2006.

Though profitable during boom, it had adverse impact on such institutions during drop in housing rates and increase in mortgage delinquencies and foreclosures.

After an SEC ruling in 2004 which relaxed the amount that can be raised as debt by investment banks, debt issuances multiplied. Leveraging by top five US investment banks rose phenomenally to over $4.1 trillion for fiscal year 2007, which is about 30% of US nominal GDP of 2007. These were the 5 banks which crumble under the weight of the crisis. One of them viz. Lehman Brothers went bankrupt. Two of them viz., Bear Stearns and Merrill Lynch were sold of at dead low prices.

Two more viz. Morgan Stanley and Goldman Sachs converted themselves into Commercial Banks to avail financial support from the Federal Reserve succumbing to stringent regulation.

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