Introduction
In 2008 the world witnessed the worst financial crisis since the Great depression in 1929. According to Jeffry Frieden professor in Harvard University, he stated that this crisis could have been prevented. But bad monetary policies and greed of some financial institutions led to this crisis. In this case study we will go in depth and find out what were these policies and institutions that resulted in the 2008 recession .
History
Let’s start from where it all started. In the late 1990s there was a dotcom boom in the US. Investment banks were pouring money like water into everything which had a dotcom behind it. Investment banks have shown recklessness by valuing webvan, a grocery company without a robust business model, valued at $1.2 billion after its IPO in 1999. There were many examples like the above one.
In 1999 the US government repealed Glass-Steagall Act. In 1933, lawmakers introduced this act to prohibit commercial banks from engaging in investment activities . After 1999 banks started making risky investment to increase their profits. Some people argue that repeal of the glass steagall act was a mistake because it allowed banks to grow too big.
In March 2000 it all came to an end, the dotcom bubble finally burst and the stock market crashed. The NASDAQ fell from 5048 to 1139. Next year 9/11 terrorist attack occurred. In the same year Enron was involved in a scandal followed by worldcom scandal in 2002. These events broke the faith of public and companies in the economy.
Interest rates
Consumers were spending less and less spending in the economy could led to recession. To avoid recession the federal reserve decided to cut the interest rates to 1%. As predicted with low interest rates spending increased in the economy but it also gave rise to speculation in real estate.
By 2003 everyone with good credit score already owned a home. For home loan lenders this wasn’t a good sign. Only to increase their profits margin banks started lending to people without having a good credit score, job, income or assets. These were called sub-prime loans. But it doesn’t make sense giving loans to people having no income source. Well the banks assumed that home prices would keep going up and they could make profits from selling houses if the borrower default. In fact home prices had never declined since Great depression.
Invention of CDO
Now this part is going to be a bit complex so pay very close attention.
On one side Mortgage lenders knew that these sub-prime loans were risky and they wanted to get rid of of these loans. On the other hand institutional investors were looking for a way to increase their returns. This is where the banks got an idea, they started offering Mortgage backed security (MBS). Basically MBS were collection of mortgage debt sold as shares and investors would get fixed income from MBS as the borrower paid his/ her loan interest.
Some money-grubbing bankers decided to combine MBS with some old financial tools to create new financial product. This financial product could make them billions, this tool is Collateralized debt obligation or CDO. A CDO is a financial product that is backed by Mortgage loans, auto loans , bonds and other assets. The CDO is divided into different levels known as tranches. These tranches indicate the levels of risks. The lowest tranches having high risk because when borrower pays interest and principal amount the upper tranches receive most of it and the remaining amount received by other tranches. So if someone defaults the cash will not be sufficient to pay all the investors and lower tranches bear the loss first. These CDOs were filled with sub-prime loans and sold to investors.
Everything was going smoothly and everyone was making lots of money. So the banks made more risky loans. Majority of people didn’t understood how these instruments works because of their complexity. But they had hope that credit rating agencies would clarify which investment was risky. But in order to make more money these rating agencies rated these CDOs AAA the highest rating. You might be thinking why they rated these CDOs AAA? Well if they had denied the banks to give AAA rating to risky investment banks would go to another rating agency to get highest rating and that rating agency would make millions.
Between 2000-2007 sub-prime loans included in the package increased from 5% to 36%.
The greed to make more money led to the invention of Credit default swap (CDS). CDS worked like an insurance against failed mortgage products. They made sure not to call it insurance, as it is regulated.
Bad policies
In October 2004 Securities and Exchange Commission or SEC decided to lower the liquidity requirements of Goldman Sachs, Merrill Lynch, Lehman brothers, Morgan Stanley and Bear Stearns. According to Kenneth Rogoff this decision was insane. It allowed banks to borrow more which significantly increased their financial leverage. In 2007 these banks reported net loss of $4.1 trillion equal to 30% of US GDP.
In the mid-2000s, interest rates in the US went up. This meant trouble for both banks and homebuyers. Banks had given out many loans with adjustable rates that started low. Homeowners enjoyed these low rates for a few years, but then the rates jumped to match the market. This increase made it tougher for people to afford their monthly payments. For example if a person is paying mortgage of $800 could go as high as $1500 after hike in interest rates.
source: ResearchGate
As the interest payments rose borrowers began defaulting on their loans, this resulted in decline in home prices. Now the value of homes were below their mortgage loans. Due to decline in home prices more number of borrowers defaulted on their mortgage loans. The prices of home decline further as the supply increased and demand decreased.
During 2008 more than 3.1 million homes were foreclosed.
In September 2007, Ameriquest one of the largest sub-prime lender dissolved. Later on one after another many sub-prime lender failed.
Investors were afraid of holding CDOs as the default rates increased and they wanted to get rid out these trash. In 2007 BNP Paribas and other europian banks announced that there is no buyers for these debt instruments. This announcement caused panic in the market.
Biggest failures
In March 2008 Bear Stearns went bankrupt, it was fifth largest investment bank and it also survived 1929 great depression. Bear Stearns was using high leverage to purchase MBS and other toxic assets. In May 2008 Bear Stearns was bought by JP Morgan for $2/share, earlier in the same year the share price was $170.
Lehman brothers was also over exposed to MBS. But surprisingly they made a profit of $489 million and stock rose by 40%. Later in 2010 report by court examiner revealed that Lehman brothers was using accounting tricks to show their financial positive.
Even 3-4% decline in Real Estate could wipe out their entire capital as they were using high leverage. By June they incurred a loss of $2.6 billion and stock fell by 73%. On 15 September 2008, the Lehman brothers declared bankruptcy.
During this time on one side Morgan Stanley and Goldman Sachs were selling mortgage securities and made million on the other side investors lost their money and the US entered into recession as GDP fell by 2.1%.
On September 16 2008, AIG the largest insurer in US was bought by federal reserve. The federal reserve did not stop here, it gave banks $700 billion to stop them from failing but big banks became larger after buying small banks. US government was using tax payer’s money to bailout banks and it resulted in protest against government and institutions and the invention of bitcoin. By 2009 the stock market fell by 50%.
Global consequences
There’s a popular phrase ” When America Sneezes, the World Catches Cold”. The world could feel the consequences of the mortgage crisis.
After Lehman brothers many banks around the world failed. In UK Lloyds acquired HBOS a and the UK government nationalized Northern rock, a mortgage lender. These are just a few examples of many.
Central banks of US, Europian union, Japan, Australia and Canada came together to pour cash in debt markets . In November 2008, IMF approved loans of Ukraine and Iceland to mitigate the damage.
Iceland’s economy went bust. The big banks collapsed and the stock market crashed by 80%. People were angry and blamed the government and the bank managers for being greedy. Iceland ended up having to pay the debts of banks that defaulted, which was more than $60 billion. Unlike the US, where the Lehman executives got to keep $2 billion even when their bank failed, Iceland held their bankers accountable and put them behind the bars. Portugal, Greece, Spain and Ireland couldn’t pay their debts. Due to this crisis 6 million people became unemployed and 8 million people lost their homes.
Scars
The economic crash caused a significant decrease in lifetime earnings for many adults in US, with some losing an estimated $70,000. Younger people have less employment opportunities. After 2008 the fertility rate in many countries has declined.
Source: International monetary fund
Since 2008, the economy hasn’t been growing as fast. Low interest made some companies invest in risky areas instead of improving their business. This meant less money for innovation.
Conclusion
Due to the hunger of financial institutions to make more money, bad policies and lack of oversight 2008 crisis took place. We can learn a lot of things from it and most important we should take a look at central bank policies. I hope you guys learn something valuable from this case study.
To know more about this crisis:
Lehman brothers collapse:
https://www.economicsobservatory.com/why-did-lehman-brothers-failbrothers-fail
Credit default swap
https://www.investopedia.com/terms/c/creditdefaultswap.asp
If want to to know why Japan hasn’t been growing for last three decades. Click the link below
https://geocrit.com/japans-lost-decades/