Well Fargo and financial meltdown of 2008

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Well Fargo and financial meltdown of 2008

Q4) banks involvement in mortgage backed securities and derivatives

According to the basic definition, the mortgage-backed securities are a set of bonds that are supported by wide ranging collection of mortgage loans. several kinds of bonds comes under the section of mortgage backed securities, for instance, one of the most simplest category of MBS is mortgage payment paid by the owners of home(Ivashina & Scharfstein, 2010). MBS bonds are completely different from other bonds like government bond, treasuries as these bonds pays interest amount semi annually, and investors are provided with their principle amount at the time of maturity.

Banks are actively involved in the transaction of mortgage-backed securities; in fact, these institutions lured their investors to purchase house and other assets against these types of securities. The process of the creation of MBS securities from bank consist of following simple steps.

Bank provides loan to the owner of the house

The lender of the mortgage amount would have the option of either selling of the loan amount to government of private entity like bank. The bank will then invest this amount in some investment opportunity to earn the profit and most importantly, this process is generally not visible to the owner of the house.

The bank than stores the one or several mortgage loans into a separate pool which is then observed of generating regular amount of cash flows for the bank when the homeowner pay off its monthly installments.

Generated cash flow is than sell off by the bank in type of securities to its investors, and after the starting sell these mortgage based securities are introduced in the open market for trading purpose.

The payment of mortgage-based securities is a cyclic process, which is distributed from the bank to everyone involved in the transactions

Bank involvement in derivatives

In modern era, the trade market has witnessed phenomenal growth, and that has increased the probability of witnessing severe economic risk. Meanwhile, according to the trade analyst the probability of severe economic crises has increased because of increase involvement of large banks in the trade of all kinds of derivatives (Green & Wachter, 2005).

Modern bankers normally imagine that the level of increase or failure on derivatives is minimal as compare to their other products. For instance, one of the largest US bank” Wells Fargo” argues that prevailing concept is not ideal if perceived individually, however, it is of significance importance when bank conduct in-depth analysis of their risk quotient of every instrument. On the other hand, the meltdown of year 2008 has provided has with clear picture that it is extremely possible for bank to lose large portion of their investment in case of complete failure in trade of derivatives instruments(Cecchetti, 2008). Moreover, investors or public is not aware of the risk level of bank in derivative trading, nor it can be predicted by the experts and thus a huge failure in a trading can easily damage the global economy and can result in ...