Here is a brief description of the current problem in the US financial system.
a. It started with the subprime mortgages, which saw high default rates
b. The value of the "asset backed securites" and the "collaterialised debt obligations" linked to these mortgages dropped significantly
c. The problem spread to the other sectors. Many "special investment vehicles" and hedge funds had been set up to use borrowed money, i.e. "leveraging", to invest in higher risk assets to earn a margin. These SIV and hedge funds could not refinance their borrowings, as the lenders got scared.
d. Investors starting to withdraw their money from hedge funds, SIV and the investment banks.
This led to the collapse of Bear Stearns. There was fear that they have to sell their illiquid assets at depressed prices, causing a collapse of the entire global financial system.
The US Fed, under the chairman Bernanke, came out with a plan to provide up a 6 months facility for investment banks to allow them to borrow from its "discount window" i.e. at the Fed discount rate, by pledging their illiquid assets.
Some experts believe that this plan is working and that the markets will stabilise and recover from now. This is expected to solve the "liquidity crunch". Let us hope that they are right!
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