Demystifying the 2008-09 Financial Catastrophe

The Global Financial Crisis during 2008-09 is one of the worst economic meltdowns in history since the Great Depression during the 1930s and made an impact all over the world across all the countries. This crisis led to negative growth rates, widespread unemployment, deflation, and pressure on public revenues ultimately leading to the Great Recession. This blog explores the prime causes, the major players involved, the total cost, and the policy reforms brought in to undermine the crisis. The understanding of the working of Collateralized debt obligation (CDO) and Credit default swap (CDS) derivatives is pertinent to understand this review and hence, if you are new to fixed income and credit derivatives, it is recommended you go through the “Jargons Explained” section present at the end of this blog before going further.

Background and causes that led to the crisis

The crisis was years in the making since the early 2000s when investors in the US and from abroad were on an investing spree in the housing market as they could gain from high interest paid by borrowers on mortgages than from minimal interest rates offered by treasuries or bank deposits. These mortgages were assumed to be very safe and of low-risk profile as banks always collateralize the housing loans and also the prices of the houses were steadily rising. So, it is rational that investors assume in case the borrower defaults, they can sell the house and make money.

The main cause that led to the collapse or the point where things began to go wrong was when banks started engaging in subprime lending. In fact, this crisis is also termed a subprime mortgage crisis. Generally, it is very difficult for a person to get a mortgage if one has bad credit or does not have a steady job. But things started changing when banks began giving loans to people with poor credit ratings making the loans very risky which were assumed to be having a low-risk profile. The proportion of the subprime mortgages rose from below 10% to around 20% from 2004 to 2006.

Going deep into the facts, by 2008, there were 28 million subprime or Alt-A (between prime and subprime) mortgages and out which 20.4 million were on the books of government agencies such as Fannie Mae and Freddie Mac who bought the mortgages from banks in the secondary market and issued MBSs on them. From the financial regulation point of view, some of the experts’ state that the Community Reinvestment Act (CRA) of 1977 which was enacted to cater to the credit needs of low and moderate-income neighborhoods resulted in predatory lending practices such as subprime lending through the Federal Reserve Board found that there is no connection between them as 60% of the subprime loans went to high-income borrowers. Nevertheless, CRA did contribute to the crisis but was very small.

Now, you might be wondering how and why institutional investors bought the risky mortgage-backed securities in the first place as they were based on subprime mortgages. Here come the rating agencies which were the prime accused exacerbating the financial crisis. The three big rating agencies, Moody’s, Standard and Poor’s, and Fitch control nearly the entire market even today and gave outright AAA ratings which is the highest and safest investment-grade rating to worthless MBS which rightly graded would fall under the junk category. The rating agencies are very critical to the financial system as they help reduce the information gaps regarding investment products between the lenders and borrowers but instead, they gave false confidence to the investors that they were safe for investing ultimately drawing severe criticism from every corner.

Going further, financial markets need to be systematically regulated which did not happen with the derivatives market in the case of the United States. The key person responsible for this is Mr. Alan Greenspan who is a former chairman of the Federal Reserve. He is renowned to play an incumbent role in downsizing the effect of the 1987 stock market crash. His approach of minimal regulation over the multi-trillion-dollar derivatives market regarded as one of the primary causes of the crisis. Some experts also claim that the repeal of the Glass-Steagall Act of 1933 (enacted to address the stock market crash of 1929) by former US President Bill Clinton in 1999 increased the deregulation of shadow banking ultimately leading to the fiasco in 2008.

Finally, the players present at the other end are the ones who provided credit derivatives (CDS). The investment banks who bought MBSs did not want to bear the risk of default, so they ended up entering into Credit Default Swap (CDS) agreements (insurance). AIG (American International Group) is a finance and insurance company, is spread across the world and was on the path of becoming the first trillion-dollar US company. It issued too many policies (CDS) based on statistical data on claims but as the housing bubble burst, it realized that it issued too many that it cannot honor with its current assets which led to its collapse till Fed came to its rescue as it is regarded as too big to fail financial institution.

To sum it up, people started taking home loans as interest rates were low and as the housing market was booming, banks indulged in subprime and predatory lending as they were confident of demand for MBSs. The mortgage finance companies such as Fannie Mae and Freddie Mac purchased the mortgages from banks. They bundled the mortgages and issued securities (MBS) on them which were bought by institutional investors such as pension funds and investment banks like Lehman Brothers and Bear Stearns. These institutional investors, as they wanted to transfer the risk of default, they bought insurance i.e., CDS from AIG. AIG enjoyed free money in the form of premiums at the beginning till the housing bubble burst i.e., borrowers began defaulting. When the bubble burst, institutions became cautious about the risky subprime mortgages and as a result, banks were unable to sell the ones they already had thus forcing them to absorb the losses from defaults.

US reaction and the cost of the crisis

How much did the United States government spend in its efforts to come out of this crisis? Initially, the Federal reserve stance was against the government bailing out the wall street but after witnessing the AIG running out of money on September 15th, 2008, and on the same day, the collapse of Lehman Brothers, one of the largest and oldest banks in the USA, severe financial problems in Fannie Mae and Freddie Mac and Goldman Sachs and JP Morgan trying to become commercial banks so that they can obtain saving deposits made the government realize that bailing out is inevitable.

The government immediately enacted the Emergency Economic Stabilization Act on Oct 3, 2008, which created the Troubled Asset Relief Program (TARP). The TARP initially gave the treasury the purchasing power of $700 Billion but later changed it to $475 Billion. The whole aim of this is to increase the liquidity in money markets and secondary mortgage markets to reduce the burden on institutions owning worthless MBSs and it also allowed the government to buy equity in banks and other financial institutions. The TARP bailout was not really an expense on the taxpayer account because the government later sold the securities it bought at a gain of 900 million and deposited them back into the account.

A brief overview of the total costs is given in the below chart.

Source: Congressional Budget Office

Policy reform (Dodd-Frank Act)

The democratic party came to power in 2009 and thereafter, focusing on the areas that led to the crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act which is widely renowned as Dodd-Frank Act was passed by the Obama administration. This brought significant changes in financial regulation majorly to protect the interests of investors and consumers and to prevent future bailouts to banks and other financial institutions.

This act created a Financial Stability Oversight Council (FSOC) to make sure that the banks, hedge funds, and companies do not become too big to fail like AIG and also gave power to break up companies that pose a financial threat to the economy. It also created the Office of Financial Research (OFR) to maintain economic stability and to increase investor confidence and market discipline.

The power of the Federal Deposit Insurance Corporation (FDIC) was increased to take over the distressed banks and in turn, sell them to the creditors and shareholders to make them absorb the losses rather than using taxpayers’ money bailing them out. This act also made a regulation called the Volcker rule which states that banks whose main source of funding is deposits should not involve in proprietary trading and if they want to enter into high-risk trading, they need to create a separately capitalized subsidiary for that purpose.

It tightened the supervision on rating agencies who acted irresponsibly while giving ratings to the MBSs that were based on subprime mortgages. It also improved the supervision on insurance-type credit derivatives such as Credit Default Swaps which played a major role in facilitating the crisis and also on corporate governance in banks addressing the subprime lending. This policy ultimately tried to fill the voids present in the regulations in the financial industry which triggered the financial crisis.

Jargons Explained

The financial instruments deeply involved in the crisis are Collateralized Debt Obligation (CDO) and Credit Default Swap (CDS). CDOs are derivative securities that are backed by a pool of loans and other assets that act as underlying and serve as collateral in case the loan goes into default. The CDOs are referred to as mortgage-backed securities (MBS) when mortgages (property loans) are underlying. For example, a bank makes home loans, and to transfer the risk, it sells them to another financial institution (Ex: Fannie Mae) who creates a special purpose entity (SPE) to sell MBSs based on the mortgages purchased. Thereafter, institutional investors such as pension funds, hedge funds, and mutual funds buy these MBSs or other types of CDOs (Retail investors cannot buy CDOs directly).

Credit Default Swap (CDS) is also a financial derivative that acts as insurance against non-payment. Through this, the buyer can avoid the consequences of a borrower’s default by shifting some or all that risk onto an insurance company or other CDS seller in exchange for a recurring periodic fee. As a result of which, the buyer of CDS receives credit safeguard, while the seller of the swap guarantees the creditworthiness of the credit security.

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Article contributed by Rohit