2008 Financial crisis: Housing Bubble Explained

This blog addresses the 2008 Financial crisis in the US that caused the biggest recession since great depression of 1930.

In 2008, the housing market crash in the US caused the biggest recession since the great depression of 1930 leaving millions of people unemployed, made a thousand of families homeless, and the economy went into recession. This resulted in stock market crash where investors lost their money and the banks got bankrupt. This crash occured when there was a presidential transition from George Walker Bush to  Barack Obama. This crisis was so massive that it wiped out $11 trillion of the US economy and caused havoc around the world. During this crisis, the most affected countries were the United Kingdom and Western Europe. They lost billions in this crisis.

This economic meltdown involved Investment Banks, Insurance companies, Credit rating agencies, US Federal Banks, Investors and the people of the USA. Let us understand their roles in the crises and how the events unfolded which shattered the economy.

If we search for the root of the crisis we need to go back to early 2000's when the Federal bank- apex body of the banks in the United States started to lower their interest rates.

“Dot.com Bubble,” US equity market saw a bearish run and in an attempt to revive the economy, the Federal Reserve System lowered the interest rates from 6.8% in the year 2000 to 1.6% in 2004 which increased the consumption, consequently people started buying bigger and more homes.

The Banks and the risk associated with loans

The banking system has an-age old problem of risk when a bank gives a loan for house or anything they have to bear the risk that borrowers might not be able to repay the loans, and also they need to set aside some capital concerning the loan amount. This reduces a bank’s capacity to lend and to bypass this problem the banks invented “Credit Default Swaps”.

Credit Default Swaps: “it is a type of financial instrument that insures a loan against default”. Now the banks have insurance in case a borrower fails to repay the loan, also, now the banks won’t need to keep the capital in proportion to the loan.

Collateralise debt obligation

Initially CDS started on big corporate loans by J.P Morgan and then they applied it to consumer mortgage related credit risk. The US equity market was not giving good returns and interest rates on other debt instrument were low because of rate cut by the federal reserve. The CDOs were not only giving good returns but they also sounded safer as the rating agencies such as Moody’s and S&P rated them AAA.

Debt Obligation is a type of derivative product whose value is derived from a bundle or pool of different securities. The CDOs contain thousands of insured loans pooled together to make one product. These can also be traded in the debt market. CDOs helped the banks to shift the risk to investors.

The CDO market was new and unregulated, these products were traded “over the counter” or between the banks, and not on exchanges. These products were immensely profitable for banks and the increase in housing prices caused explosion in the growth of mortgage backed derivatives around the world.

The Insurance Firms and the Rating Agencies

Biggest Insurance company in the USA the American International Group speculated with the CDOs by providing insurance to investment banks if these instruments were to default. After acknowledging the fact that these products are insured by the AIG rating agencies mainly Moody’s and S&P rated them as high as AAA of course by taking a fat fee.

Other players like Lehman Brother, Morgan Stanley, Bear Stearns, Citi Group, Goldman Sachs all jumped into the CDOs market and started selling more and more of these products. The housing prices kept surging upward, but now the house buyers with good credit history were less, and profits started to decrease, and from here, the banks became puppets of their greed and begun to offer loans to those who don’t have reliable or any credit history, hence these people were unlikely to repay their loans, but in reality, these people got tricked by the dream of a house and were “robbed without a gun” because of so much debt pressure they had to give up their house and saved money.

Tranches and the Risk-Return Matrix

Now you may be thinking that rating agencies must have downgraded the ratings of these CDOs but NO! the banks divided these securities in different tranches from AAA to C. The safest of investment were categorised as AAA giving low returns and the riskier investment rated as BBB, BB or C were giving more returns.

But why is it so? The start of subprime lending and these product were even more profitable than prime CDOs because the underlying loans were given on very high-interest rates from somewhere around 15% to even 20% interest per anum. But people were still buying these loans because the house prices were increasing more than the interest rate on these house loans and if they were to default on their payments they would sell the house, pay to the bank and still book the profit.

Beginning of the Fiasco

Some expert saw the bubble coming and said that the wall street us flirting with disaster but nobody believed that the housing prices will ever go down. Initially, the default rate was low around 4% and it just had to reach around 8% for the MBS system to collapse. The crises started with the fall in housing prices around the country as fewer and fewer people were buying houses and the prices started to drop suddenly. And with that, the default rate in these loans skyrocketed consequently, the CDOs failed to return investors money.‌‌

A parallel effect can be observed in the stock market from mid 2007 to early 2009 let us see the chart to understand the impact‌

as the housing prices started to decrease all over the country, more and more people became fearful, and we can see a steady decline in S&P 500 from mid-2007 till the end of August 2008 after that many catastrophic events pushed the market down south.‌‌

The case of Bear Sterns, Lehman Brothers, Merrill Lynch & AIG

The decline in housing prices triggered a chain reaction and first in line was Bear Sterns, an 84-year-old and then 5th largest investment bank in the US suffered losses because two of its hedge funds filled with toxic mortgage-backed back securities lost all their value. In January 2007 its share price touched $171, and in 14 months period, it dropped to $30 on 14th March 2008. Following that, federal Reserve initiated a rescue through JP Morgan who agreed to buy bear sterns at $2 per share and paid $236 million to subsume the whole entity on 16th March 2008.

After the case of ailed Merrill, a rumour spread across wall street and among investors that Lehman could be next. Hank Paulson a Goldman Sachs executive and then treasury secretary who had investment bankers view that “market rewards and market punishes” and had an idea that all the big banks like Lehman, Citi and Merrill are filled with these toxic CDOs and MBSs. And he was right and on 15th September 2008 Lehman then 4th largest bank with $639 billion in assets “Lehman Brothers” filled for bankruptcy and this time the government didn’t intervene like bear sterns, and there were few reasons for that.

• There was no buyer for Lehman as a potential patron Bank of America purchased Merrill instead.
• $639 billion of assets and $613 billion in debt proved too much for anyone to intervene.
• Treasury Secretary Hank Paulson wanted to clear the notion that whatever will happen, the government will rescue the banks and wanted all banks to reduce their CDO exposure.

American International Group was the top insurer of CDOs in the country and investors who were mutual funds, pension funds and hedge funds that had people’s money invested in CDOs. Its downfall was directly related to retail Americans and could have been a more catastrophic event and to stop that the Federal reserve acquired a 79.9% stake in AIG in exchange of $85 billion loans.

The end note

The CDO business was immensely profitable because of rising prices of properties but when the prices started declining the greed played its role; investment banks were getting the commission, credit rating agencies deliberately oversaw the problems, insurers were making profits, investor’s pockets were increasing and people were getting bigger houses thinking that there is no risk. All this happened because there were no regulations in the market and despite warnings, the Bush administration didn’t react or those who were making profits from it somehow got successful in avoiding the regulation. Many of these big institutions thought that they can avoid the risk by using CDOs but in the financial system “the risk cannot be removed, it can only be moved from one table to another”

In the end, greed and absence of regulations, as well as economic scenarios like low-interest rates and the recent tech bubble, contributed to the crises of 2008 which shattered the global economy.