The Financial crisis of 2008 or the Great Recession is the biggest economic event in the world after the Great Depression of the 1930s. This series explains the crisis in a very simplified way. This is the second article in the series. (Read the first part here: The Financial Crisis Explained- I)
The sub-prime mortgage crisis could have been restricted to the housing market in the United States. But, it spread to the financial markets and to the whole of the world and became a global financial crisis.
Why did the housing bubble spread to the financial markets?
There were several reasons behind the spread:
- Availability of complex financial instruments like mortgage-backed securities and credit default swaps. It enabled investors and financial institutions around the world to invest in US housing market.
- Poor risk management by the financial system
- Use of commercial papers
- Lack of adequate regulations
Availability of complex financial instruments
- Mortgage-backed Securities (MBS) and Collateral Debt Obligations.
- Home mortgage loans are assets for the banks. In return for these loans,they get interest payment regularly and principal at the maturity of the loan.
- Banks can sell these assets to other financial institutions. (transferring the stream of payments as well)
- Banks are known as the originators of the loans/ assets
- They aggregate all the mortgage loans into a homogeneous pool. Pooling is done to reduce and diversify risk.
- They cut this homogeneous pool into tranches/ slices.
- Then they issued securities backed by these assets. This security is Mortgage-backed security.
- These securities can be traded like shares
- This process is called securitisation.
- If an investor buys MBS, they receive a proportionate share of principal and interest.
- The pioneers of this process were the private corporations established by the Government. (Fannie Mae, Freddie Mac). They were referred to as Government-sponsored enterprises. They were the largest packagers or aggregators of the loans,
- They served as an intermediary between the originators (bank) and the ultimate holder (investor/ buyer) of the mortgage.
- Investors in MBS include pension funds, insurance companies, foreign banks, wealthy individuals. It is also retained by the financial institutions in their own account
- MBS became a popular investment option as the interest rates in US were very low.
- To put things into perspective, Fannie and Freddie owed nearly $5 trillion in mortgage obligations. It was placed into conservatorship by the US Govt. Conservatorship is a legal term in which financial affairs looked after by the Government.
2. Collateral Debt obligations
- It is a security backed by assets other than the mortgage loan. The examples of the assets are auto loan, credit card debt, education loan etc. For CDOs, auto loans etc. are pooled together and securities are issued backed by them
- It has the same mechanism as MBS described above.
3. Credit Default Swap: (CDS)
- It is an insurance instrument. A mortgage-backed security investor can buy CDS to insure it against losses in the security.
- The USA’s largest insurance company called AIG issued CDS to Mortgage-Backed Security (MBS) investors in return for a premium.
- AIG came under a lot of pressure after the bubble burst as it could not make good the losses incurred by the MBS holders.
Investors and Financial Institutions around the world invested in MBS and CDOs and bought CDS. Thus, housing crisis spread to the financial market.
Poor risk management by the financial system
The risk was spread throughout the system because of the complexity of the financial instruments. The financial system was unsure about the risks undertaken and there was no certainty in the system. Wide-spread runs began on financial firms and banks as investors pulled funding from any firm thought to be vulnerable to losses. There was a complete loss of confidence in the financial system.
Use of commercial papers: (CP)
- Commercial paper is a security that is issued by large companies to meet their short-term funding requirements. (It has a maturity period of less than 3 months and is traded in money-market fund).
- As it is a short-term instrument, it is vulnerable to runs.
- Lehman brothers collapsed due to excessive use of CP for funding.
- Lehman Brothers had huge exposure to the housing market through the complex securities explained above.
- After the expiry of 3 months maturity of CP, Lehman could not roll-over its debt (continue with the debt) as investors lost faith in it. It defaulted on its CP obligations.
- Widespread defaults resulted in the failure of the oldest money market fund (MMF) in the USA
- The USA had to inject funds in the MMFto restore faith. On Sep 15. 2008, Fed had to intervene in 2 MMFs
Lack of adequate regulation:
The rise of Shadow banking system: Investment banks like Lehman brother and Bear Sterns and the Hedge funds did not have the same regulatory requirements as commercial banks. They became as important as Commercial banks in lending, but unlike banks, they had no financial cushion to absorb losses.
Commercial Banks were required to maintain large capital which acted as buffers to decrease fragility. But, since Investment banks remained outside the purview of regulations, they assumed a lot of debt (became leveraged). They borrowed money for short-term (commercial papers) and invested them in long-term assets. There was a maturity mismatch. Investors began to withdraw funding and there was a run on the shadow-banking system.
The excessive debt led to financialization (debt > equity) and financial markets began to dominate the real economy.
Credit rating agencies were also not regulated properly. They gave AAA ratings to the risky MBS and CDOs.
Regulators gave insufficient attention to the stability of the financial system as a whole. Though there were individual regulators for different agencies, there was no authority to look at the financial system as a whole.
The above factors interacted with each other and caused the financial sector to become increasingly fragile. It was a systemic crisis.
There was a breakdown of trust in the entire financial system. Nobody was willing to lend to each other. There was an extreme credit crunch in the economy and it affected other sectors of the economy which were heavily dependent on credit. Banks lost confidence in each other.
There were huge pressures on key financial firms like Bear Sterns, Fannie & Freddie Mac, Lehman Brothers, Merill Lynch, AIG and as the financial market were interconnected, it threatened the collapse of the entire financial institutions.
What were the steps taken by the Fed to contain the crisis?
Governments responded with fiscal stimulus and monetary policy expansion
- Many systematically important financial institutions (SIFI) were bailed out
- Quantitative easing (Read about QE in this article Quantitative Easing: Demystified)
This financial crisis led to a worldwide recession with huge unemployment and falling stock prices. It contributed to the euro-zone debt crisis as well. Read about it here: /the-greece-debt-crisis-explained/
I hope this series has cleared your questions about the financial crisis. Please feel free to comment.