What happened in the case of US Financial crisis was also related to haircuts. Normally, At the initiation of loan contract, a Bank takes up a collateral and grants a loan considering the type and the value of the collateral. The value of the loan granted depends on the type of collateral and the Haircut (as explained in my previous post).
Now, with the passage of time, the value of collateral changes depending on market conditions. If the value of collateral decreases to less than the value of the loan, then the bank is in a serious risk if the borrower defaults.
In the case of US financial crises of 2007, there were many mortgage borrowers. People took up mortgage loans. Mortgage loans refer to the loans taken against a real property(mortgage) as collateral. Property prices were rising and so the banks were more than happy to give loans against these collaterals. Haircuts were low as they were supposed to bear low risks. But when the property prices plummeted (because of many reasons, will explain some other day), the value of the collateral decreased to less than the value of the loan and the banks, even if sold the collaterals that they had were not able to recover the loan amounts. (it is a different fact that because of huge supply of these collaterals from banks, prices of collaterals decreased further more and resulted in huge losses to banks)
Now, with the passage of time, the value of collateral changes depending on market conditions. If the value of collateral decreases to less than the value of the loan, then the bank is in a serious risk if the borrower defaults.
In the case of US financial crises of 2007, there were many mortgage borrowers. People took up mortgage loans. Mortgage loans refer to the loans taken against a real property(mortgage) as collateral. Property prices were rising and so the banks were more than happy to give loans against these collaterals. Haircuts were low as they were supposed to bear low risks. But when the property prices plummeted (because of many reasons, will explain some other day), the value of the collateral decreased to less than the value of the loan and the banks, even if sold the collaterals that they had were not able to recover the loan amounts. (it is a different fact that because of huge supply of these collaterals from banks, prices of collaterals decreased further more and resulted in huge losses to banks)
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