Great Recession or Great economic Bubble of late 2000s is considered as the biggest and the most brutal financial crisis after the Great depression of 1930s. The crisis had been developing for a while, but its adverse impact could not go unnoticed by the middle of 2007 and into 2008. Due to the fall of financial institutions in USA the whole world was affected. And as the cliche goes, whenever the US sneezes, the world catches a cold and clearly all over the world, stock markets have trembled, large financial institutions have collapsed and declared bankruptcy and few have been bought out, and governments everywhere have had to come up to rescue these institutions and bail out their financial systems.
We shall try to understand the history of this cataclysm and technical terms shall be defined while we are on the go.
Credit Crisis is a worldwide financial fiasco where in you would find terms like subprime mortgages, collateralized debt obligation, frozen credit markets and credit default swaps used quite invariably. Here everyone except may be ones involved in fraudulent activities is affected. Basically the credit crisis brings 2 groups of people together, the home owners, who represent their mortgages, which represent the houses, and investors, representing their money, which represents huge institutions like pension funds, insurance companies, sovereign funds, mutual funds, etc. These two groups are brought together by some financial institutions like banks and brokers like:” Bear Stearns Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers.” And some financial conglomerates like “Citigroup, JP Morgan” and insurance companies like”AIG, MBIA, AMBAC” and rating agencies “Moody’s, Standard & Poor’s, Fitch”, etc.
In the US, traditionally the investors would go to the US Federal Reserve to buy treasury bills, which are believed to be the safest investments (AAA rating). But in the wake of the dot-com bubble Federal Reserve chairman, Allen Greenspan lowered the interest rates down to 1% to keep the economy strong, which meant very less returns for the investors. But on the other hand this meant that the banks on the Wall Street could borrow from the federal bank for only 1%. Added to that, general surplus of money from other countries created abundance of cheap credit which made borrowing money easy for banks. This lead to something called the leverage.
Leveraging is to borrow money to amplify the outcome of a deal. In simple terms say I am going to buy an article and sell it to another person at a higher price to gain profit, but the profit is limited by the number of articles that I can buy. Hence if I borrow huge amount of money and buy these articles in bulk and sold them, I would have created more profit, even after returning the money that was borrowed with the interest. Hence essentially I would have created something out nothing!! Or so it seems. This is a major way how banks make money.
In November 1999, U.S. President Bill Clinton signed into law the Gramm–Leach–Bliley Act, which repealed part of the Glass–Steagall Act of 1933. This repeal basically reduced the separation between commercial banks (which traditionally had fiscally conservative policies) and investment banks (which had a more risk-taking culture). Hence now the deposit banks could collaborate with investment banks. Which meant the banks could take more risky choices with the deposited money of the people.
So Wall Street now has a lot of credit from the abundantly available credit and grows rich and then pays it back.
Fueling the bubble- Due to the 1% interest rule that was made by Allen Greenspan, huge amount of money gushed into the system, hence increasing the amount of money, with relatively lesser growth in supply of products, creating a case of higher supply than demand. Hence the prices of the houses and commodities started to rise and there was a huge need for money for people who wish buy new houses.
Meanwhile, the investors, who saw very less profits from the treasury bills (1% as described earlier) wished get a piece of this open goldmine. The banks made a proposition of connecting the home owners and the investors through mortgages- For a family that needs a house and would like to get a loan, with a down payment, would approach a lender, who in turn gives the family a mortgage. Now the family is happy for getting a house as the mortgage prices had always been raising. Before the bank came up their proposition the above was the scenario and the lenders were very careful in choosing the people to whom they lent their money to, that is, to those who met certain financial background standards. Such mortgages are called Prime Mortgages. The banks came up with the idea of securitization where in the money lender would be secured from the defaults of the house owners as the banks would buy these mortgages at a satisfactory price and take upon themselves the risks involved. Hence now the lender could give out loans without any risks and make profit. The investment banker on the other hand, borrowed a lot of money and bought thousands of these mortgages. Hence the banker gets his monthly income from all these home owners. Then these banks made a complicated financial innovations called CDOs – Collateral Debt Obligations these are basically complex derivatives in which the collateral (something pledged as a security for loan) included not just mortgages but other loans like auto loans, credit card Debt, commercial mortgages, corporate buy-out debt, student loans ,etc. to reduce the risk of defaulting involved in the mortgages. Hence all these Debt- obligations were turned into complicated financial articles and sold to the investors. This is where the rating companies came into the picture. They would have to rate these different CDOs into different categories based on the risks (like the defaulting by house owners) involved, with best rating being AAA. Hence depending on their ability to take risks, investors from all over the world put their money into these banks and bought these CDOs. Higher the risk involved, higher the rate of profit. This attracted more and more investors but the number of people who wanted such mortgage loans and met the standards of loan payment, started becoming scarce. To overcome this hurdle the banks introduced something called Sub-prime Mortgages in which there was no need of proof of income, no down payment what so ever. Their idea behind this was that if ever the house owners were to default and leave their house the banks or the people who owned the mortgages/CDOs would come into possession of the houses and due to the then inflating housing bubble the prices of the houses were ever rising, hence the returns from selling the house would compensate the loan anyway. Hence now these banks started collecting such sub-prime mortgages from the lenders and created their complex CDOs and sold them to their investors. Everyone is making money and everyone is happy.
In 2004, the U.S. Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. Which means the financial companies could borrow huge amounts of money leading to overleveraging. At some point it went to values as high as 33:1(meaning 33 parts of the money is borrowed while 1 part was invested by banks).
Another major thing to note: As early as 1997, Federal Reserve Chairman Alan Greenspan fought to keep the derivatives market unregulated. With the advice of the President's Working Group on Financial Markets, the U.S. Congress and President allowed the self-regulation of the over-the-counter derivatives market when they enacted the Commodity Futures Modernization Act of 2000. Derivatives such as credit default swaps (CDS) can be used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008
Due to the zero security policy of the banks it was seen that the amount of money invested on a house by the owners was around just 0.7%, that is, 99.3% was from the sub-prime mortgages and quite obviously after a point such owners could not payback their loans and defaulted. This meant that now the banks started to own houses as a part of their monthly income, reducing their liquidity. After a point the large number of defaults in the scheme of sub-prime mortgages and due to the growing housing bubble there was more supply of houses than the demand, leading to plummeting of the prices of the houses. This caused an interesting problem to those owners who paid their mortgages in a timely manner: because of foreclosure of the houses in their neighborhood the price of their houses also reduced drastically, which meant that they were paying mortgages at a much higher price than the actual price of the house. Hence they too forfeited. At this point the banks owned a pile of worthless houses, and quite obviously no one wanted to buy those toxic CDOs. On the other side the investors and lenders all over the world also, owned such toxic CDOs. The Share prices started to crash, when there is no money in the system just illiquid worthless houses, leads to the freezing of the credit markets. As Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003 the whole system collapsed bringing down other economies with it.
There was another ticking bomb: the AIG, one of the biggest insurance companies started a policy called Credit Default Swaps. Credit default swap (CDS) is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee") to the seller and, in exchange, receives a payoff if the loan defaults.
In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). This worked out fine for AIG in the initial stages as there were many CDOs moving around in the system. Hence many started buying CDSs on things that they did not own. Ethically it meant that everyone is waiting for the CDOs to collapse. There has also been an allegation on the investment banks that they not only sold toxic CDOs but also bought CDSs against those CDOs, which meant that they were betting their money on the CDOs to fail. When finally the CDOs started to fail innumerably, AIG went bankrupt. Fall of such huge financial institution means fall of an economy as a whole. Hence the US Government had to come to the rescue of such institutes to bail them out.
Major reason to be unable to interpret the dangers of the CDOs then, was the complexity involved in understanding the CDOs. The investors could not evaluate the risks involved in such investments hence couldn’t warn themselves and others from the impending danger. The inaccurate ratings of the rating companies like Fitch, S&P’s, Moody’s had a major role to play in misleading the investors of the world.
Declaration of bankruptcy by Lehman Brothers is marked as the beginning of the peak of the Great Recession of late 2000s. The immediate effects of the crisis shall be addressed in the corresponding blog entry……
References:
http://www.youtube.com/watch?
-Prateek S Kolhar
Movie: Inside Job, Zeitgeist-2
other lectures on www.youtube.com
other lectures on www.youtube.com
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