When Hell Bells Toll!
Financial players could literally feel them, the shock waves on September 15, 2008 when Lehman Brothers went bankrupt. The tumour of the subprime mortgage crisis was now a worldwide reality that had transformed into the cancer of global economic crisis. Soon, it would worsen into the Great Recession! Mortgage backed securities (MBS), collateralized debt obligations (CDO), credit default swaps (CDS) and other complicated financial jargon went viral.
The repercussions were disastrous and immediate, more so because the failure was unexpected. After all, Lehman Brothers was the seemingly ‘too big to fail’, fourth-largest investment bank in the United States.
Mass hysteria took over as people lost faith in the financial system. Sheer and sudden panic froze the interbank market, where banks lend each other, because they feared not being paid back. Deprived of credit, businesses and banks could not operate as borrowing rates shot through the roof. With little money flowing, the economy slowed down to a snail’s pace.
Stock markets tumbled to their worst since the 1930s as investors tried selling all assets and shift to government bonds, the safest investment. Ripples spread to Britain, Germany, Japan, Russia, China, Canada, Brazil, and other major economies. Companies went broke. The dollar was shaken. The U.S. alone lost half a million jobs in October 2008 and would lose another 8.8 million before things normalized. Bank runs became common in the U.S. and Europe.
Faltering of Bear Stearns’ two hedge funds in June 2007, then the fifth largest investment bank in the U.S., had sent similar distress signals in U.S. markets. Having drawn flak for supporting the takeover of Bear Stearns by JP Morgan Chase in March 2008, the U.S. Treasury refused to bail out Lehman Brothers.
As early as August 2007, it was amply clear that the U.S. financial market could not clean its own mess. Things went rapidly downhill after September 15, 2008. Economic growth fell in the U.S., Europe, East Asia and almost all other regions of the world with 2009 being the worst year for most. Unemployment rate scaled new summits as housing prices tanked and foreclosures took the roof away from over many families, literally!
Banks apart, insurers, hedge funds, mortgage-to-security convertors, and many other players in the financial world went under. Federal U.S. government bailed out the American International Group (AIG) and took control of Fannie Mae and Freddie Mac. Elsewhere, Bank of America took over Merrill Lynch as Indymac Bank failed. Goldman Sachs and Morgan Stanley, the two surviving investment banks, converted to commercial banks.
Heavy losers across the Atlantic included the German banks viz. Landesbank Sachsen and IKB; and the Union Bank of Switzerland (UBS). Uncertainty caused a run on the British bank, Northern Rock. Governments of France, Benelux, Iceland and many others similarly bailed out troubled financial institutions.
Causes: Systemic & Human
So what went wrong? After all, how could mortgage backed securities (MBS) – one of the main accused in the crisis, which comprised only 3% of the U.S. financial assets – bring the mighty global economy to its knees? The other accused being collateralized debt obligations (CDOs) and credit default swaps (CDS).
The answers lie in systemic and human failures as well as the financial contagion inspired by globalization:
- Human Emotions: specifically speaking, greed, fear, herd mentality, and the craving for free lunches. Throughout this article, we will be emphasizing the impact of these emotions. For, the mind is where it all begins!
- Political Compulsions: Clinton Administration’s insistence on making mortgages available even to undeserving borrowers, something continued by the Bush Administration.
- Excessive Liquidity: on account of low Federal funds rate, inflow of funds from Asian investors looking for safe investment in the wake of the 1997 Asian Financial Crisis, and the Security Exchange Commission (SEC) slashing capital adequacy requirements for five investment banks.
- Financial Innovation & Deregulation: ensured that regulators were miles behind financial innovations such as MBS, CDOs, and CDS.
- Globalization: and the increased coupling of economies means that turmoil quickly spread across the world.
With a view to promote affordable housing, the Clinton Administration enforced the Community Reinvestment Act of 1977, which required banks to lend to low and middle income groups. Regulators forced banks to issue subprime mortgages. Subprime lending is providing loans to people with poor credit history, improper income records, and / or unacceptable loan-valuation ratio. The Bush administration continued the same policy. Good politics is often bad economics. Here, it delivered apparently free lunches, the bill for which was later footed by the whole world.
The Asian Financial Crisis of 1997 made investors from emerging economies direct funds into U.S. markets, a perceived safe investment destination. Massive capital inflows created demand for U.S. Treasury and Agency bonds. Governments issue bonds to raise money. But with the Clinton administration running budget surpluses and in little need of funds, treasury bonds lost some sheen. Private banks and financial firms then channeled the incoming capital into mortgages, which were turned into bonds named MBS and CDOs that could be easily traded in financial markets. Mortgage lenders sold their mortgages as MBS and CDOs. Now, the mortgage borrower owed money to the CDO / MBS buyer.
Being based on mortgages, CDOs and MBS would continue to rise in value so long as housing prices kept climbing and mortgage borrowers did not default. Rising demand for MBS and CDOs created the need to issue more mortgages. It was this need and the mentioned political arm twisting that inspired subprime mortgages regardless of the borrower’s repayment capacity. Greed was making its presence felt.
CDOs are multi-sliced securities, with each slice or tranch representing similar loans. The multi-layered structure fooled even credit rating agencies into awarding them an AAA rating. Moreover, credit agencies had based their ratings on past data when mortgage defaults were rare. Most importantly, credit agencies had received fat fees for advising on how to create MBS and CDOs. The conflict of interest (read: greed) is clear!
Banks and other lenders were only too happy to convert mortgages into CDOs because the exercise delivered lucrative securitization fees. Why bother with paltry interest earnings then? Precisely, why they disregarded lending standards. The conversion also benefited lenders because CDOs transferred risk of default to CDO-purchasing investors and made available fresh funds to issue more loans. Greed again.
Although CDOs boosted liquidity, liberated capital, and created fresh jobs, they produced a housing bubble. CDOs were a financial innovation. Hard pressed by London that was competing hard with New York as a financial center, U.S. authorities diluted stringent financial regulations. Fear is acutely infectious and made regulation fall miles behind financial innovation.
But if the demand for MBS and CDOs inspired the creation of subprime mortgages, the Federal Reserve’s cheap money policy of 2000-04 made mortgages cheaper. The 9/11 terrorist attacks, dotcom bubble crash, accounting scandals, and the mild recession of 2001 had raised the specter (read: fear) of an economic slowdown. To stimulate the economy, the Fed progressively slashed the federal funds rate from 6.5% in May 2000 to 1% in June 2003. By 2006, subprime lending made up about 15% of the outstanding housing loans in the U.S.
In October 2004, the lowering of the net capital requirement by the SEC for five investment banks viz. Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers allowed them to leverage (borrow for investment) to 30-40 times the invested amount. The move further hiked liquidity.
Result: housing prices skyrocketed, well beyond their true worth. Shooting prices triggered speculation whereby people obtained mortgages to purchase houses only for selling them later at higher prices. Many borrowers were incapable of repaying. But mortgages were cheap and readily available. Greed, naturally, took over. Speculation worked so long as housing prices maintained their upward trajectory.
As early as 2004, U.S. home ownership had maxed at 70%. The Fed then started to hike the federal funds rate from June 2004, which hit 5.25% in June 2006 and stayed there till August 2007. With no more home buyers and mortgages getting expensive, housing prices started waning, triggering the U.S. Home Construction Index to slip by 40% in 2006. And with it, CDOs and MBS started losing value. The hounds of hell had broken loose! Now, fear took over as everyone looked to dispose MBS and CDOs.
Meanwhile, financial giants such as Goldman Sachs, Morgan Stanley, and Deutsche Bank as well as smaller financial firms were cleverly playing a double game – while singing praises of CDOs and selling them as safe investments, they were also betting against these very CDOs through Credit Default Swaps (CDS). That way, they prospered when CDOs lost value. And, they were perfectly aware of the CDOs’ shaky foundations. Although CDS are a common technique to hedge risk, the said players went further and legally maximized and fast tracked returns from the falling CDOs and MBS. Again, greed!
CDS are an insurance purchased for protection against default on loans or bonds such as CDOs and MBS. The purchaser pays premium to the seller. In case of default, the purchaser gets paid by the seller. Unlike an insurance policy, the buyer can sell his CDS. Financial innovation was at play again and CDS were unregulated till 2009.
Lehman Brothers had covered $400 billion of their $600 billion debt through CDS purchased from American International Group (AIG), Pacific Investment Management Company, and Citadel. When Lehman Brothers went bankrupt, it activated the CDS. But the issuers did not have the money to honor the CDS contract. If CDS sellers do not have enough to cover their contracts, CDS spread and aggravate systemic risk instead of serving their purpose of mitigating it. Lehman Brothers is only one example of how unregulated CDS caused a risk contagion.
The same herd mentality that had launched MBS and CDOs to the top, now made them worthless. Financial institutions overexposed to these securities collapsed, and so did those who did business with them and there were many such – the infection went globally viral. European banks had purchased almost a third of the MBS from the U.S. East Asians were more interested in U.S. Treasury bonds but they too were exposed to these securities.
Central banks across large parts of the world cut interest rates to boost liquidity while their governments bailed out banks and financial firms in deep water. But, this was too little, too late. It would take years before things got better.
Humans are creatures more of emotion, less of logic. And, markets operate on sentiment, also called perception or expectation. The effect of human psychology on markets is evident in that the possibility of a certain event creates consequences regardless of whether the said event occurs. Precisely why herd mentality often causes wild market swings. Add greed, fear, and the appetite for free lunches, and the recipe for disaster is complete. Systemic flaws are often a reflection of these emotions. But if these issues begin in the mind, then, the mind is exactly the spot to check them.
Indrajeetsinh Yadav @ Falcon Words has written this article. Falcon Words offers stellar content on Finance, Economics and a whole range of other subjects. Write to us at email@example.com or call us at +91-9822052945 for exceptional content customized to your specific requirements.