Loss of $2 Trillion in global economic growth, that too from the failure of such a sector, which was considered too big to fail. What was the reason behind this global crisis? Could it have been stopped? What effect will this have on the future? Let’s know everything in depth about the incident which shook the world, the global financial crisis of 2008.
Overview of the Crisis
With the burst of the .com bubble, the US economy was heading towards recession in 2001. It had the biggest impact on technology and internet stocks. The stocks of market leaders like Adobe, Amazon, Cisco, Intel, and Microsoft, had gone down by 90%. For perspective, Nasdaq Index had come straight from its peak of 5100 to 1100 points. That too in just 2 years. A fall of around 80%.
It was a matter of those companies which were successful in facing this bad time. Lycos, Napster, Kozmo, Altavista, Pets.com, and many other such companies had to either sell their operations to a strong competitor or wind up completely. The GDP growth rate was averaging 4.5% between 1997 and 2000, it crashed to around 1% in 2001.
Along with the .com crisis, corporate accounting scandals, and the 9/11 terrorist attack caused significant damage to the economy. Federal discount rates which we can also call repo rate, in early 2001, was 6.5%. It dropped down to 1% in June 2003. The era of cheap money.
Housing prices bubble
America’s choice of investment was real estate. After the great depression of 1928, almost by 2006, housing prices were growing rapidly. Real estate was considered a very safe investment.
People were convinced that housing prices could never fall. This boom accelerated after the 2001 interest rate cuts. It is also worth noting that many of these people were also first-time home-buyers.
The general public of America took the most advantage of the all-time low-interest rates. Taking a loan to buy a house was a smart idea because housing prices were relentlessly going up. The brakes on this momentum came in early 2006. When housing prices showed negative growth for the first time in 77 years.
Next 3 years, from 2006 to 2008, housing prices collapsed by an average of around 30% across the country. The worst of the lot were those areas where foreclosure rates were high. But what is foreclosure? It is the action of taking possession of a mortgaged property that fails to keep up its mortgaged payments.
American banks and financial institutions started in the race to give loans. After all, what can be the problem in giving loans? Even if the home-buyers defaulted on their mortgages, they will simply sell that property in the market. And because property rates are rising rapidly they will only make a profit from foreclosure. The entire focus of the bank shifted from quality of loan to quantity.
Underwriting standards kept falling day by day. In this process, such loans were also generated knowingly by the banks which did not match their lending standard. It was a direct calculation, the higher the loan, the higher the incentive and bonuses. Bank started doling out high-risk NINJA loans. NINJA means no income, no job, no asset.
The situation was under control until 2003. Prime mortgage’s market share was steady at around 85% of the total loans underwritten. This share dropped to 64% of the total in 2004. 56% in 2005 and 52% in 2006, meaning that nearly half of the mortgage organizations in 2006 were of poor quality.
Securitization and financial engineering
The practice of securitization was at the heart of the global financial crisis of 2008. In simple words, securitization means selling different income-generating assets by bundling them. Originate to distribute. With the help of the OTD model, banks could sell their underwritten loans to third parties. This model was a win-win situation for all three parties.
Securitization is a very old concept. But the real boom in this market came after 2001. Non-agency residential mortgage-backed securities. RMBS almost became 3 times. From $1 Trillion to $2.7 Trillion between 2003 to 2007.
Collateralized debt obligations. CDOs which consist of lower-level tranches or less safe parts of RMBS grew even faster from nearly $300 Billion to $1.1 Trillion during this same period. It is quite clear that by the time 2006 came, the funding of most of the low-rated and high-risk loans was funded through securitization.
You will be surprised to know that approximately 85% of RMBS and CDOs were given AAA ratings by credit agencies such as Moody’s, S&P, and Fitch. Claiming they were as safe as US treasury bills. You must have understood by now that these securities were AAA-rated only on paper. In fact, many low-rated high-risk loans were also included in these assets.
Overleverage and mispricing of risk. If we talk about the housing bubble, then a feedback loop was made. As the sustained price in asset prices in mortgage-related products increase the net worth of banks which in turn failed to search for more leverage and further increased the demand for these assets. When the crisis hit, asset prices fell sharply. And the same feedback loop started working in the opposite direction.
This loop contributed to the freezing up of liquidity in the credit market. In late 2007, a lot of people started defaulting on their home mortgages. Basically, these were the people who got home loans at dirt cheap interest rates. But they never had the capacity to repay this loan. As per the US Federal Reserve, loan delinquency rates i.e. loans that have passed the due date jumped more than four folds from 5% to 22% between 2005 and 2008.
Investment banks were highly leveraged at the time of crisis. Lehman Brothers had a leverage ratio of 44:1. Yes, you heard it right. In other words, Lehman Brothers had issued a loan of $44 for every $1 it had as reserves. The way Lehman was structured, a little over 2% fall in the market value of its investments could wipe out the bank’s existence. And that’s exactly what happened.
On September 15th, 2008, Lehman Brothers filed the chapter 11, petition with more than $600 Billion in assets. The largest bankruptcy filing till date in the US history.
The aftermath of the crises
Strictly speaking, the great recession began in December 2007 and ended in June 2009, which makes it the longest recession since World War 2. Real Gross Domestic Product, GDP fell 4.3% from its peak in 2007, quarter four, to its trough in 2009, quarter two, the largest decline in the post-war era to date.
The unemployment rate, which was 5% in December 2007 became 9.5% in June 2009 and peaked at 10% in October 2009. Home prices fell approximately 30% on average from their mid-2006 peak to mid-2009. While the S&P 500 index fell 57% from its October 2017 peak to its roof in March 2009. The net worth of US households and non-profit organizations fell from a peak of approximately $69 Trillion in 2007 to a roof of $55 Trillion in 2009.
In all, the great recession leads to loss of more than $2 Trillion in global economic growth or a drop of nearly 4%. 4% is a used number by all matrices, mind you.
Too Big to Fail?
The recession of 2008 gave a strong reality check to the notion of being Too Big To Fail. US Federal Reserve was the first to respond by lowering interest rates from 5.25% in September 2007 to a range of 0-0.25% in December 2008.
Interest rates were already at their lower bound, the Federal Reserve did not have much scope to tamper with them. Instead, this time, they experimented with something unconventional. Quantitative Easing or QE. That is fine but what is QE?
QE consists of large-scale asset purchases by Central Banks, usually of long-maturity government debt but also of private assets such as corporate debt or asset-backed securities.
Let’s talk about fiscal response. After the collapse of Lehman, US President George Bush swung into action and give his approval to the $700 Billion Troubled Action Relief Program or TARP on October 3rd, 2008. Some experts believe that not bailing out Lehman Brothers was the biggest mistake of Ben Bernanke, the Federal Reserve Chairman.
Had this step been taken at the right time, then the entire financial sector could have avoided a collapse. And this liquidity crisis could never evolved into a financial crisis.
When this was asked to Ben Bernanke in an interview, then he said, “the only way we could have saved Lehman would have been by breaking the law and I’m not sure and willing to accept those consequences for the Federal Reserve and for our system of laws. I just don’t think that would have been appropriate. So, I wish we had saved Lehman but it was beyond our ingenuity and capacity to do it.”
But what about the $182 Billion bailout handed to insurance giant American International Group, AIG? Why was AIG rescued and Lehman left to fend for itself? It was not just AIG, a total of 991 companies received funds in the form of capital infusion or loans under the TARP program. It is very important to highlight that all these bailouts were happening from the funds of taxpayers like you and me.
To date, the US Federal Reserve has made a net profit of $109 Billion on these investments. Regardless of all, is it morally right to bail out private companies with public funds? What are your views on this? Do let us know in the comments below.
Disclaimer: The views presented in this article are only for informative and educational reasons. The article is not meant to give expert advice or suggestions for a specific security or product.