The Financial crisis 2008 or the Great Recession is the biggest economic event in the world after the Great Depression of the 1930s. This article explains the causes and consequences of the financial crisis in a very simplified way.
[You may also read- The Great Depression of the 1930s explained]
What is a financial crisis?
- A financial crisis is a crisis that severely affects the functioning of the financial system. [The financial system consists of banks, mutual funds, investment banks, pension funds, etc.]
- In a financial crisis, the financial assets (like shares) lose a part of their nominal value.
What was the immediate trigger of the financial crisis of 2008?
- The immediate cause of the crisis was the burst of the housing bubble in the United States.
What is a housing bubble?
- In economic terms, a bubble is when the price of an asset increases above its true intrinsic or fundamental value.
- Example: If the intrinsic/ fundamental value of a pen is Rs. 20, but due to some reasons the price increases to Rs. 20000, it is a bubble
- In other words, a bubble is when the price of the asset does not correspond to its fundamental value.
- As kids, we all have made soap bubbles and know that they eventually burst.
- From the 1990s until February 2007, prices of houses in the US increased by a staggering 130 %. This was a housing bubble.
- The bubble eventually had to burst.
Why did the price of houses in the USA increase? What was the cause of the Housing bubble?
The price of an asset is determined by the forces of demand and supply. The reasons for the increase in price were:
- Low-interest rates: During the period from 2000 to 2003, interest rates in the USA were lowered from 6.5 % to 1 %. It was done in response to the Dot-com bubble burst in 2000 and the Sept 2001 attack at the World Trade Centre. Due to low-interest rates, people began to take more loans to buy homes (Home mortgage loans). The demand for houses increased and hence its price.
- Another reason for low-interest rates in the US was the global saving glut: Savings flowed from China, Japan, Germany & the oil-exporting middle-eastern countries into the US economy as the USA was considered to be a safe investment. This increase in the supply of funds in the US-led to a decline in interest rates. People borrowed more to buy homes and the prices increases
- Government policies to encourage home loans like income tax-deductibility of interest paid on home mortgages also led to an increase in demand for houses
- The Great Moderation (the 1980s to 2007): The period of 1980s to 2007 in the US was a period of low inflation, low-interest rates, and stable growth. Due to the stability of the economy, people became complacent and they were willing to take up more risks than ever. Therefore, lenders lent more and households borrowed more.
Why was the housing bubble disastrous for the economy?
- The housing bubble led to a decline in mortgage standards (Home mortgage loan is a loan in which you take a loan to buy a house and keep the house itself as a mortgage/ collateral. Mortgage means ‘girvi’ in Hindi). Financial institutions (banks) began to lend to sub-prime borrowers (subprime borrowers are the borrowers with low creditworthiness).
- There was an assumption that prices will always rise, and if the sub-prime borrowers are unable to repay their loans, banks can sell the houses and recover the loan.
- Reckless lending by banks brought more people into the housing market.
- House prices rose further and US households became leveraged (leveraged means they borrowed more relative to their income).
But, the bubble burst eventually (prices came crashing down)
By September 2007, prices declined by 25 %. The reasons for the decline were:
- The housing market became saturated. Everyone who needed a house had one. So, there was a decrease in the demand for houses.
- Fed raised interest rates from June 2004 to June 2006. Home loans became expensive (reversed its earlier policy of lower interest rates)
What were the consequences of the burst?
- As prices of houses fell, people began to default on their home mortgage loans. As their homes were worth less now (due to reduction in price), they no longer had the incentive to repay their loans which became very expensive (due to the increase in interest rates)
- Widespread defaults resulted in Foreclosure. [Foreclosure means banks had to sell off the houses kept as collateral/ mortgage to recover the loans.]
- But, as house prices were low, banks had to suffer losses on the mortgage home loans as they could not recover the loans fully
- The rise in foreclosure pushed down prices further as the supply of houses in the market increased.
- This was essentially a sub-prime mortgage crisis
- The borrowers could not refinance the loan as the interest rates were increased by the Federal Reserve in 2007.
- The standard mortgage in the US has a maturity of 30 years and has a fixed interest rate. But, in Adjustable Rates Mortgages, which grew in popularity, the initial interest rates are too low (1 %) and after 2 or 3 years, it gets aligned to the market interest rates. They are also known as teaser loans.
- Therefore, after 2-3 years, the borrowers used to refinance into a standard mortgage. [Refinance means taking a new loan (standard mortgage) to discharge an existing loan (adjustable rates mortgage).] But, borrowers could not refinance as the market interest rates increased due to an increase in interest rates and, hence, they defaulted on the loan
This bubble 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 the 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 payments 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 the 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. Examples of the assets are auto loans, credit card debt, education loans, 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, the 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 fewer than 3 months and is traded in the 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 into the MMF to restore faith. On Sep 15. 2008, the Fed had to intervene in 2 MMFs
Lack of adequate regulation:
The rise of the Shadow banking system: Investment banks like Lehman Brothers 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 the 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 was interconnected, it threatened the collapse of the entire financial institutions.
[You may also read: What is LIBOR and why is it going away?]
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 post has cleared your questions about the financial crisis. Please comment and let me know 🙂
[You may also read- 1997 Asian Financial Crisis Explained] & The Trade War Between the US and China]
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I had also taken a course on Financial Crisis 2008 explained on Unacademy.