Of the many stories told in US history, the 2008 financial crisis is one notable event that a big population of the country will resonate with. The story is told of an economy that rendered itself too big to fail, thanks to the preceding years of economic bloom. In financial terms, the 2008 crisis is an intriguing case that everyone has their own version despite the overwhelming research conducted on the crisis.
However, some aspects of the crisis are as clear as the day, such as the existence of a housing bubble, and the ramifications caused by overconfidence on this bubble. There is also a unanimous admission of a lax regulatory system, whose trend in the posterior years was hell-bent towards deregulation of financial institutions. SEC reduced the net-capital ratio, the Fed consistently weakened the federal fund rate, paving way for a lending hemorrhage.
Financial regulators aside, the US public economy by itself knowingly marched towards the guillotine, enjoying on its way the goodies fetched from feel-good deals like the subprime mortgages and the resultant Mortgage-Backed Securities (MBS). Before we go any further, how about some background on these advancements?
Build-up to 2008 Financial Crisis
We might not have a specific date to the beginning of the financial crisis loom. We, however, mark some events that can be attributed to the fall of the US economy.
The US Federal Reserve’s role in the 2008 crisis was monumental. As the ultimate oversight body, the Fed carried the blame on taking some financial deregulation measures, and remaining unhinged when lenders and banks went berserk on an unsecured lending spree.
In the beginning of the 21st century, the Federal Reserve scantily anticipated a financial recession, and quickly averted the situation by cutting the fund rate, explained as the interest rates charged on bank-to-bank transactions. Over the period of 2001-2004, the Fed cut the rate four-fold, from 6.5 to a low of 1.75 percent.
Banks snatched the opportunity to lend themselves, but now the lending was greatly incentivized. The public took these loans owing to their cheapness, amassing important assets such as houses. It is believed that this is how the housing bubble came to happen.
- Subprime Lending
At a reduced cost of loan and an increased liquidity at their disposal, lenders became less rigid to customers, giving loans to underly qualified borrowers, otherwise known as subprime customers. Lending decisions were made more easier upon the advent of the housing bubble.
Due to the sudden surge in the demand for houses, banks could now issue mortgage loans on the security of the profitability of these mortgage houses. Mortgage lending became a rich plunder for banks, in that at the prevailing house demand borrowers could refinance the mortgages or in case of a default, banks could resell the houses at a good profit margin.
Subprime mortgages gave birth to another baby; increased and diversified securitization. Subprime mortgages seemed to be profitable, and other sectors were now sanctioned by the SEC to dig into the fray and diversify their portfolios in the housing bloom. Investment banks advanced to a bigger role in finance, becoming securities firms and insurers at the same time.
These banks came to be deemed as “too big to fail”, in that their collapse would disrupt the entire financial market. One of them was the infamous Lehman Brothers, whose collapse marked the height of the financial crisis. AIG, a grandiose insurance firm, also took part in the murky mortgage securitization, offering a diverse portfolio of security for mortgage loans. These included Mortgage-Backed Securities (MBS), and Credit-Default Swaps (CDS).
- Mortgage-Backed Security (MBS) is a financial instrument that bundles up several mortgages into one asset, breaking them down into financial instrument units before trading them as market securities. These securities became popular in that era as they were supported by the rising demand of houses, and the profit margins that come by. Banks were the manufacturers of MBSs, and they sure did benefit from it. The MBS market was so big, owing to the promising trajectory of the housing bloom. Mortgages sold through MBSs fetched banks a lot of money that increased their liquidity and so their profits. Banks reinvested these slack funds back into the mortgage industry in droves, further entrusting their survival on a profitable yet risky asset. To solve this, the market introduced yet another instrument; Credit-Default Swaps.
- Credit-Default Swaps were a further securitization of mortgages, whereby investment banks, hedge funds, and banks bought these swaps for insurance against customer default on mortgages. Mind you, banks had now transferred the burden of default to the firms by selling them the Mortgage-Backed Securities.
The housing bubble was now ready to burst. Inflation was now at its highest, and the Federal Reserve came in to salvage the situation by increasing interest rates. This move had direct implications to every end of the chain. Loans at higher interest rates meant mortgages now became uncharted waters. House owners who anticipated profits were set aback by the surging interest rates.
Borrowers defaulted in droves. Banks that had invested heavily on MBSs had to throw in the towel. They immediately filed bankruptcy as their over-valued mortgage assets could not offset their obligations. Insurance firms were the worst hit, as the Credit-Default Swaps were triggered by the massive defaults. Firms like Lehman Brothers and AIG were overwhelmed and had to call it a day.
Impact and Economic Resurge after the Crisis
The financial crisis of 2008 was not just a US affair. As a world leader, any impact on the USA economy would be felt in almost every corner of the globe. Same case happened with the Global Recession of the1930’s. The crisis experienced in the US spread its wings to the global expanse.
The US, though, felt the worst brunt of the crisis. Gross Domestic Product (GDP) plummeted in a matter of months, going to a record low of -2 GDP in 2008. This steep disrupted every pillar of the economy. A record 10 million people lost their jobs in the US alone during this time, just showing how the “too big to fail” institutions’ failures were catastrophic.
And what did the government do? In as much as there was a lot of politicization of the crisis, the same government that had paved for the crisis was the ultimate savior. The Federal Reserve executed massive bailouts, nationalizing many banks and institutions, so as just to shield its people from losing their money in the crisis.