“2008 Financial Crisis” is one of the major infamous global economic event, the world has witnessed, since the catastrophe caused by “The Great Depression of 1930”. It’s very occurrence was on such an intense scale that its fear still jolts the people who faced and watched it pass by, and even those who understands the very possibility of its recurrence in the wake of fast growing and correlated economies, and its only a matter of question of “when and at what scale?”
As a whole world, we struggled for almost five years to recover and stand back to be as we are today and yet even after all these years, many economies are still facing its after effects. The period saw some very disturbing events with people being fired every day across industries, cities and nations, people committing suicides with financial miseries, credit takers defaulting, businesses closing at a faster rate, investors losing money, governments struggling and nations going down.
With this inceptive view on the intensity and the scale of crisis, there is one question worth exploring for – What caused such a scale of economic meltdown and how did the signals go so unpredictable by the market analysts and observers?
“Unpredictability in economics is not a very strange phenomena, it’s just what builds up this unpredictability is the matter of great understanding”
Series of correlated activities since 2001 that led to the 2008 Global Economic Crisis
The scenario of crisis was build up and originated in the US market, before its effects rippled to other developed and developing economies across the globe. Said that, all this was neither built as an immediate market reaction nor in a short span but over a longer period of time than we know of. A deeper analysis into it dates back to more than eight years, and may be a little more than that, from 2008, the year of event’s occurrence. It was then the seeds of the crisis was sown, and the wave of activities carried out in the subsequent years cultivated the seeds into a poisonous shade that spread across the globe promising fortunes, development and dreams before engulfing it all.
In order to truly have a clear view on how US Housing Market played quite a substantial path in creating the crisis, and to be able to correlate the events that took place along this time frame it is very necessary to have a basic understanding on how the Housing Market functions – Housing Market – complex inter-connectivity of credit system
Legends : Supporting Event Main Event
1. Economic, Political and Social factors created pressure on the Federal Reserve to lower the interest rates
Economic : Continuous years of low market inflation accompanied with stable US market, and savings glut in the Asian region fostered high risk taking and paved the path to infuse more and more money into the US market.
Political: Growing pressure from the US senate on the then US President, George.W.Bush led government, to increase the rate of house ownership in United States with previous two government terms failing to do so.
Social : The 9/11 attack on the twin towers led to creating a possible circumstances of investments and business leaving US market.
All these different yet interconnected elements, put together, created pressure on the federal reserve to decide on lowering down the interest rates to build market inflation.
What is market inflation or deflation ?
Inflation / deflation is a cyclic process created to maintain the economic growth and regulate the market. Economy needs to maintain periodic inflation and deflation cycles in order to achieve the growth. When there is a continuous long-term low inflation prevailing in the market, it is the government’s responsibility to frame policies and central banks responsibility to adjust the interests rates to increase the cash flow into the market, creating market inflation.
In inflation cycle, cash flow into the market increases, with the federal bank infuses more cash into the market creating more and more money. With easy flow of money and expanding market, banks feel confident enough to lower down its interest rates making borrowing easy and cheaper. This increases the purchasing power of the consumer and fuels up the demand. As demand regulates the product prices, with the rise in demand, prices also soars up.
At one point the prices rise high above the purchasing power of the consumer, at this stage deflation cycle should follow with a similar pattern but in complete reverse direction. Starting with squeezing the flow of money into the market.
Low volatile market supported by low-interest rates increased the temptation and created profitable opportunity for “leverage market” players. In parallel, the US government’s plan to increase house ownership to wider audience led to banks relaxing the mortgage borrowing rules and making the whole mortgage borrowing process faster, easier and cheaper. This opened the doors for many to fulfill their dream of owning a house. The problem with the word “many” here was, these included even those with poor credit ratings and those who are not qualified enough for mortgage loans.
2. Increase in credit borrowing in mortgage market with the expansion of sub-prime mortgage lending
Previously mortgage loans operated on prime lending (lending only to the people with good credit history and to those who are qualified to borrow, with their economy promising loan payments). The prime mortgage lending covered only a very little population, and left out a large population of low incomers from the housing dream and that wasn’t a good idea for the government’s goal of increased house ownership. In order to achieve the increased house ownership rate, banks started with sub-prime mortgage lending (lending to people even with poor credit ratings and those who are not qualified for borrowing). Banks were confident on market and in worse situation over non-payment, the banks can easily label the owners defaulter and sell the mortgages to retrieve the loan amount.
3. Introduction of the new financial product, MBS bonds based on the mortgages
Sub-prime mortgage lending space started to grow in primary mortgage market and with that secondary mortgage market also started to expand rapidly with Mortgage Backed Securities (MBS) bonds.
MBS bonds generated instant liquid cash for primary market by trading on the mortgages from primary market in secondary market. These bonds were created to keep up the lending process going and avoid over reliance on public savings and asserts, and third-party loan companies.
Freedie Mae and Freedie Mac, US government charted institutions, played as investment bankers dealing with long-term security bonds in the form of MBS in the secondary mortgage market. MBS, as a security was new to the market and immediately started to prove quite profitable for the investors with a projection that housing prices will always be on an increasing trend, given there is always going to be more demand than the supply can achieve. Also with the market showing positive signs and government backing, these bonds were rated AAA bonds, there was no skepticism on profits MBS bonds could bring.
4. Rise in housing prices with increase in sub prime mortgage lending
The house ownership rate started showing a positive increasing trend, thanks to lower interest rate, sub-prime mortgage lending from bank and MBS in secondary market. With low-interest mortgage lending, as low as 0% people were happy enough to pay almost nothing and still have a home of their own. The house ownership started to rise like never before.
0% interest rate came with a concept of adjustable interest rates which meant that for the initial time period the loan would operate with 0% interest rate but post that the interest rate will adjust and fixes itself based on the market condition.
The period from 2001 to 2008 saw a huge rise in house ownership
As the demand for housing started to rise, the price started to rise up with the increasing demand, like any product in the market.
5. Expanding market for MBS bonds with private institutions heavily investing on the financial product
With house ownership on an unstoppable rise there were more and more mortgages available, creating a perfect arena for MBS bonds market. The profits the MBS bonds brought lured private institutions to start experimenting in this financial product space. The financial product makers believed strongly in the idea that property prices rise and drop independently in different US cities, which took a beating in 2008 crisis, creating a havoc.
As with the correlated mortgages, a single event will trigger all the mortgages under a MBS product to fail at once leading to whole MBS bond failing all together in paying the returns to the investors.
The high profitable return over the MBS bonds left investors crazy to invest more and more on these bonds, but to construct these bonds, there was pre-requisite requirement of more and more mortgages. This also played a crucial part in encouraging the banks to increase their activity of sub-prime mortgage lending.
The rise of synthetic CDO
The sub-prime mortgage lending made sure more and more mortgages are available to MBS creation, but that wasn’t just enough for the market, it needed more MBS bonds. Specially when the secondary mortgage market was generating such a huge amount of profits for everyone in and around the business, nobody wanted to ease out on it. The market started to feel the exponential rise of the derivative market and Synthetic CDOs started to become the new market strategy. What are these synthetic CDOs?
Unregulated and wrong practices across organisations surrounding MBS in derivative market:
1. MBS/CDOs were initially constructed by using prime mortgages, hundreds of them acting as securities underneath, which made sure these securities are AAA rated and safe.
2. However with the increase in subprime mortgage lending the same bonds were now constructed using the sub-prime mortgages which possessed a great amount of risk of default and non-payment, but these bonds were also branded as AAA ratings by the credit rating agencies and allowed into the market unregulated. Investors had no idea that what was being called as AAA was not a safe bet at all.
3. With synthetic CDO, the game lifted itself to whole new level of risk. A BBB and CCC trenches were pooled together and further split into AAA, BBB and CCC bonds. AAA rated bonds, which are more trusted for guaranteed return were now constructed with less guaranteed and no guaranteed return BBB and CCC bonds respectively.
Eureka!! What a profit earning strategy. Being hundreds and hundreds of them nobody ever knew what mortgages were backing these securities. Market was crazy for MBS bonds and financial institutions trading on these bonds were simply able to satisfy their demand. Was profit everywhere to everyone, just!! till every thing was smooth and fine.
As branded they were not truly AAA rated rather possessed huge risk which investors were not aware of, in fact no one outside was aware of anything that was happening till things became worse. The bigger problem with the rise and expansion of the MBS bonds was, the risk was no more curtailed to the investment banks rather it was out in the market right to explode on depositing banks, risking peoples life long savings and pensions; investors; businesses and stock market.
6. Exponential increase in housing rates with prices reaching sky-high and still growing at faster rate
In the wake of the rising sub-prime mortgage lending, demand in real estate market rose, and the housing prices started to rise higher and higher like never before. Banks started acting liberal, to be precise “careless” making loan borrowing process easier than ever, anyone with a wish of a home today could get it with minimal and simple paperwork.
This was a very dangerous affair that was going on, specially when the risk was no more contained by the banks rather spread to wide outside market, both in the national and global market in the form of investments on MBS bonds.
7. Adjustable rates on the mortgage loan kick in after a period of low or no interest towards the mortgage loan
The business strategy of attractive introductory interest rates and option for refinancing the mortgage loans eliminated people’s fear of their economic inability for loan payments. Specially with the attractive interest rates as much as 0% (under a clause of adjustable interest rates to kick in future).
Also, with the refinancing option, people always had the option to borrow a fresh loan to handle the increased interest rates while refinanced loan amount stays at low-interest rates period.
This was a very complex and deceptive credit loop in which the whole market was part of. This only works well when the market is stable and safe and banks are operating at low-interest and with regulated loan lending but proves fatal at initial signs of turbulence in the market stability.
As the adjustable rates started to kick in after the introductory offer of low interest rate, requiring house owners to start paying higher amount on mortgage loans many people, specially one under sub prime mortgage quickly started to default with their non ability to pay the payments.
8. House owners starts to default over the inability to pay mortgage loans with increased interest rates kicking in
With the adjustable interest rate kicking in, house owners found themselves in a tight spot. Some fled from the place leaving the house open, on which they borrowed the mortgage. While some just had nothing for banks to force payments. Some went on with refinancing, starting a fresh loan to pay the old loan payments. All accumulated there was the start of the trouble indication to the market. As days went off banks started to feel the heat, understanding what they have just created.
9. Bank downsizes the credit lending as the default rates starts to rise with refinancing taking a hit
As the default rates started to rise, there was lot of turbulence within the banks realizing the future implications of the situation that has been created over the past years. It was just not the loan default that was troubling, but also the things that this will lead to. The MBS bonds will fail with the rising default rate. Even the AAA bonds will not be able to guarantee return at this rate of defaults and the synthetic CDOs will fail at the initial level itself leaving investors with zero returns. The banks will lose its money and will have to sell the mortgages to repay money to the investors.
As an immediate step to curtail the situation from expanding, banks started to squeeze on lending. This hit the market and the mortgage loan borrowers very hard. Refinancing was no more an option for the people. Wrong move many would say, as it created panic in the market.
10. House owners apply foreclosure with housing prices falling below their mortgage borrowing
With banks squeezing on lending and higher interest rates and no option for refinancing, more and more people stared defaulting over the payments. The housing bubble which saw exponential rise in demand hit a hard break and the housing prices started to free fall from the peak that was never seen in history. The price fell to a level where the mortgage load amount was higher than the house valuation itself. Soon people started to apply for foreclosure (returning mortgages to banks and getting their name off the mortgage defaulter list). With the demand being standstill even banks wouldn’t be able to sell the mortgages in the market to generate cash for return for investors. Checkmate!!!
11. Banks stops lending bringing the market to still. Beginning the downward spiral of the economy
Banks hits hard stop on lending with increasing rates of default, foreclosure across the nation. Businesses which operate on credit based model took an immediate big hit with their whole business coming to stand still. There was heavy losses business were incurring on daily basis. While some big business houses were still sustaining and preparing safety measures, small business were breaking under this situation and shutting down.
<em>Fear was the bigger catalyst to the situation, banks, financial institutions and business started to squeeze themselves to isolate themselves from the market situation. The critical point that was ignored was, this was a complex interlocked system they were part of, isolating themselves would save them momentarily but will cause a quick economic meltdown creating a havoc in the global market, eventually effecting them.
12. Banks and other financial institutions announce bankruptcy. US government steps in to dilute the situation and thus begins the global recession
As the things started to unfold, rumors of Bear Sterns bankruptcy started to spread in the financial market. This was the first case for a big business house going down, Bear Sterns was one of the worlds largest and oldest investment banker, securities trading and brokerage firm (founded in 1923 and sustained the great depression of 1930), valued over 2 billion dollars. For long the news remained as rumors to the public but underground there was an emergency protocols and measure being undertaken. After days of negotiation with US Federal Reserve, FED agreed for an emergency loan for 28 days but later changed the decision and helped to negotiate a deal with JP Morgan chase. The firm was acquired with less the 7% of its market value of just two days before.
As the things started to deteriorate, another big big blow was delivered by AIG, an American multinational insurance corporation. spread across 130 countries and over 80 million customers it was simply “Too Big to Fail”. AIG as a business, covered insurance products for commercial, institutional, and individual customers, retirement services , mortgage guaranty insurance and mortgage insurance. The firm which was to final layer of protection of one money was itself in need to protection to survive the crisis. the failure of this would mean 80 million customers globally getting affected. This was too big and US government had to step-in to bailout the firm with an undisclosed loan amount, to hide the market exposure.
From here things were just downward spiral, like pile of blocks things started to collapse. Sooner the fourth largest investment bank in US, Lehman Brothers, operating in investment banking, equity and trading filed for chapter 11 (bankruptcy). After days of talks with the US government, failing to ink any deal, the firm with 158 years of rich history got shutdown. This was one of the big businesses that were considered simply “Too Big to Fail” but the amount of losses the firms were holding on its books were simply too much for the US government to invest the tax payers and public pension money.
There was a total global panic, with US government saving Bear Sterns and AIG there was a hope for the government to step-in at adverse situation but the government made it very clear with Lehman Brothers, that it will not be paying for the firms miscalculated, unregulated and malicious practices.
The word was out to the global media, the recession has hit and this time this is huge, uncontrolled and a complete vulnerable situation. Soon the national financial offices started to reach out to US Department of the Treasury for the brief on undiluted situation and the projection of the havoc this will cause. National leader were holding meetings to understand and cooperate with each other in this dire crisis.
While Bern Sterns, Lehman and Brothers and AIG were big players in the market, in parallel there were many small and big businesses, banks, investment firms, Insurance agencies shutting down its operations. There were huge job loses across the globe, the people on work visas soon returned. people lost their investments, savings with banks and other financial firms shutting down.
On an end note
2008 Financial crisis has led to massive jobs, lives and property losses. There were a lot of bad business strategies, unregulated market, irresponsible behavior that came out after the crisis. In the process, the crisis has also taught us some strong lessons to shape the world. Economies are no more isolated in this era, there is a strong inter-connection between economies across the globe due to the way the cash flows and businesses operate. This has been proved time again and again by the world events like the 1930 great depression, 2008 financial crisis leading to EU debt crisis, slowdown in Chinese economy. A single event effecting one of major driving nations of economy (US, EU, China) will eventually repel its effect on others. Nations should act and make decisions more responsibly. There is a need for a common platform for the world leaders to interact on major decisions and at the same time there should be a major body to monitor and regulate the economies across the globe in a transparent manner. Its high time, the nations give a deep thought and at the same time act upon this.