Debt Crisis 2008 Explained

Objective

In 2006, the demand for house loan was at its peak, banks were also ready to give loans to house owner as they assumed that the loan back by asset is safe. Soon it turns into a myth and the decent of the sky-high home prices in 2007 spread quickly to the overseas financial market following the U.S. financial sector. This phenomenon had an adverse effect on several entities like a) the biggest insurance company b) entire investment banking industry c) largest savings and loan d) enterprises chartered by the government to facilitate mortgage lending e) the largest mortgage lender f) two of the largest commercial banks. We will Study here the cause of such a big disaster and also try to figure out the loopholes in the system that lead to the life biggest crash of the stock market.

Reason

The major reason for such a crisis was the irresponsible mortgage lending. Even the people who were marked as the ‘Subprime” borrowers and had poor credit histories were given away loans, which lead to surge supply of mortgage loan, thus the interest rate fall and everyone was getting east loan against the high valuation of their house. These were the people who later on struggled to payback. In an attempt to control the situation, the financial engineers at the big banks put large numbers of them together in pools claiming that they will supposedly become the low – risk securities. Uncorrelation of the risks of each loan is the key requirement for the pooling of the loans to work.  The argument that the rise and fall of the properties present in the different American cities will be independent of one another formed the base of such decisions taken by the banks. However, this proved wrong and America witnessed a nationwide downfall of the house – prices.

Fault in System

As the bank was giving more and more loan, which was many folds larger than their assets, they even started selling the loans to investor and got more money to loan creating a leverage of 20 to 30 times the capital they had. As there was no strict regulation of maintaining certain level of capital adequacy ratio or leverage ratio, the greedy banks kept increasing their leverage to generate more and more profit for their shareholders.

The figure above shows that Subprime mortgages rose to nearly 20% as compared to below 10%(until the year 2004) in the year 2005-2006.

There was a trend of selling away the loans to a bank or the two government-chartered institutions (Fannie Mae or Freddie Mac). These institutions were created to provide money lenders with more money to lend in addition to buying up the mortgages. These were further sold out to the investment banks so that they could pool the mortgages and then back the securities known as collateralized debt obligations (CDOs), which were sliced into tranches by degree of exposure to default. These tranches were then very generously rated by the agencies the triple-A credit ratings. The investors were fooled and they made a mistake of buying these tranches. These agencies such as Moody’s and Standard & Poor’s were beholden to the banks that created the CDOs.

The above figure shows that U.S. households and financial businesses significantly increased borrowing (leverage) in the years leading up to the crisis

The insurance industry also got affected due to “credit default swaps”—in effect, insurance policies take a fee and in return, they ensure the debtors that the loss will be covered in case of mortgage holder default. This turn insurance into speculation as financial institutions bought or sold credit default swaps on assets that they did not own. About $900 billion in credit was insured by these derivatives in 2001, but the total soared to an astounding $62 trillion by the beginning of 2008.

Effect

All seemed bright and sunny until the housing prices kept rising. Despite of inadequate sources of regular income, the mortgage holders were capable of borrowing against their rising home equity as it was deemed to be safe because of the constant demand of credit against which anyone is ready to lend. The agencies that ranked the securities on the basis of their safety wrongly assessed the mortgage-backed securities to be relatively safe. Finally when the House owner started defaulting and the bank was not able to get an assumed price for those houses as demand drastically fall for the house after the boom cycle of real-estate. The end of the September month witnessed the foreclosure of 3% home loans and there was a leap of 76% in just a year. Another 7% of homeowners with a mortgage were at least one month past due on their payments, up from 5.6% a year earlier. Soon started the period of Fire sale where everything was at sale at very cheap rates. By the advent of the year 2008, a mild slump turned into a free fall and thus took birth the loss of confidence in mortgage-backed security.

The above figure shows how the subprime mortgages started to default i.e. Number of U.S. residential properties increased considerably to foreclosure actions by quarter (2007-2009)

Result

In 2008, the Bank of America bought the largest American mortgage lender, Countrywide Financial Corp. It was on the verge of insolvency. Another giant who was rescued by JP Morgan on a similar background was the Wall Street investment house, Bear Stearns. It too had a thick portfolio of mortgage-based securities.

The above figure shows how the banks have leveraged themselves on subprime assets thus increasing into exposure very high that even 10 to 15% slump of prices can make the bank insolvent.

The Subprime defaulters caused even a greater loss to the Fannie and Freddie as compared to the other mortgage companies. This forced the U.S. Department of the Treasury, to take over both of them on September 7 and replace the CEOs with a promise of $100 billion to each if necessary to balance their books. This step was taken in order to avoid the turmoil and failure that would have followed.

Following the suit of Bear Stearns, the share prices of the 2 more similar investment banks, Lehman Brothers and Merrill Lynch dipped. It was impossible to withstand the heat. On September 14, the succumbed to the pressures of the Treasury and was sold to the Bank of America at a half of its market value within the past year, $50billion. Lehman was declared bankrupted as it wasn’t able to manage to get a Bear Stearns-style subsidy a day after Merrill’s sale.

The American International Group (AIG), the country’s biggest insurer was the next in line in the hit list. It too faced a huge loss on credit default swaps. Since there was no normal channel left out to secure credit, a loan of $85 billion was granted on September 16 and an additional amount of $38billion more was provided by the treasury as it proved insufficient. In return, 79.9% of the equity interest in AIG was granted to the government.

Towards the end, the two companies that stood there were Goldman Sachs and Morgan Stanley. Its investors worried that they would be the next targets and so they began moving their billions to safer places. They chose to transform into an ordinary bank holding companies rather than going bankrupt. This was a respectable thing to do to come under the regulatory umbrella of the Fed. As a result, they got access to the Fed’s various kinds of credit for the institutions that it regulates.

Towards the closure of the frenetic September month, on 25th the country’s largest savings and loan company Washington Mutual (WaMu) which was based out of Seattle was sold to JP Morgan Chase by the federal regulators for $1.9billion. there was an agreement that the JPMorgan would absorb at least $31 billion also in WaMu’s losses. Finally, in October, the Fed gave regulatory approval to the purchase of Wachovia Corp., a giant North Carolina-based bank that was crippled by the subprime-mortgage fiasco, by California-based Wells Fargo. In November the Treasury shored up Citigroup by guaranteeing $250 billion of its risky assets and pumping $20 billion directly into the bank.

Conclusion

This collapse was the result of reckless and faulty risk management systems of the investment banks and also the lack of any strict regulation by the Fed to keep such high leverage in the financial sector in check. After 2008 Basel III came into effect to insure that banks should maintain a minimum capital adequacy ratio of 8% to cushion the sudden shock in the market. The leverage ratio was also determined to be maintained and strict regulation of banks by central banks was brought to effect.

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