Today I thought of writing about the global economic crisis of 2008.As a student of finance, we must know how it all started, what went wrong and where are we now. I have tried to explain the crisis in a very simple yet informative manner.
So to begin with, whenever someone asks about the 2008 crisis, most of us have a vague idea about Sub-prime loans, mortgages and the housing bubble, but very few of us really know how deep the cut was. This crisis was not created over-night, it was a buildup of years of greed and on breach of trust. Investment bankers are one of the culprits to have fuelled the bubble but they were not the only culprits. It was a joint collaborative effort from all the major players of the financial markets.
Traditionally, the Investment banking model was like this: Partners would bring in money, invest it in assets as per their risk appetite and reap the benefits or bear the loss. But during 1980s, Investments bank went public in the US and now had more money to play with and during that period began the process of de-regulation. Saving and loan companies were allowed to gamble with public deposits with minimum regulation. Wall street lobbied for more financial freedom and Allan Greenspan was appointed as chairman of America’s central bank-The federal Reserve by the then President Ronald Regan and was re-appointed by Presidents Clinton and George W.Bush. Consolidation of financial sector was taking place and the financial market was being dominated by few players who were getting bigger day by day and more powerful. Banks liked monopoly power and knew when they are too big; they will be bailed out in case something adverse happened.
During 1990s, there was internet bubble. Investment banks promoted internet companies which they knew would fail. In public they gave green signal to buy where as in private, they regarded the stocks as “piece of junk”. This caused a loss of more than $5 trillion by 2001 to the holders of these stocks. Now the investment banks were getting greedier and they engaged in cooking of books, money laundering and defrauding customers. The in-famous Enron fraud, where in likes of citi group, JP Morgan and Merrill Lynch helped to conceal the fraud, were fined with $385 million.
And during 1990s, a financial product called Derivatives was introduced. However it made the market more unstable, contrary to what bankers and economists believed. Now bankers could bet on virtually anything- stocks, weather, crops, you name it and t was there to be bet. But the US government did not regulate derivatives under the pressure of lobbying from powerful banks, even though Commodity Future Trading Commission was formed.
Now the financial market was dominated by:
a. Five Investment banks: Goldman Sach, Morgan Stanley, Lehman Brothers, Merill Lynch, Bear Stearns
b. Two financial congolomerates: Citi group and JP Morgan
c. Three securities Insurance companies: AIG,MBIA,AMBAC
d. Three rating agencies: Moody’s, Standard and poors, Fitch
And linking them all was the securitization food chain.
In the old system, borrowers would borrow money from lenders and make mortgage payments over a period of time. Lenders were careful in lending the money as it would take decades to be repaid.
But now a new system emerged, where in more players were involved and it gave birth to what we know as securitization.
Home buyers took loans from banks. Bankers preferred to give sub-prime loans as they carried higher interests and would boost their profit margins. The bankers then sold these loans to Investment bankers, who would package all sorts of loans-commercial mortgages, corporate buy-out debt, car loans, student loans, credit card debt into a financial instrument called Collateralized debt Obligation(CDOs). Rating agencies were paid to give the highest possible rating to these instruments and these CDOs were sold to investors. Now the banks did not care if the borrower had sound credit back-ground or not. Rating agencies had no liability in case their ratings proved to be wrong. Thousands of sub-prime loans were combined to create CDOs which still received AAA rating from rating agencies. And at the same time AIG was selling a large quantity of another derivative product called Credit Default Swaps (CDS). Investors who had purchased CDOs also purchased CDS from AIG for a premium. In case the CDOs defaulted,AIG would make good for the losses. On the other hand, speculators too purchased CDS to bet against CDOs which they didn’t own, defying the very basic principle of insurance-you can insure against something only if you own the thing. And AIG was paying huge bonuses to its executives with the premium it received as CDS was unregulated and AIG did not have to set aside any money to cover potential losses.
And a massive bubble was being created. Since anyone could get a loan, house prices sky rocketed and within a 10 year period, sub-prime loans increased from $30 bn to $600 bn a year. Wall Street bonuses were at an all time high. Lehman Brothers was one of the largest underwriter of sub-prime loans: $106,444,600,000.It’s executives were paid huge bonuses. However it was not real profit but money created by the financial system and booked as income. But Securities and Exchange Commission (SEC) conducted to major investigation of investment banks during the bubble. Infact Investment Banks were lobbying with the SEC to relax the norms on leverage so that they could borrow more to buy more CDOs and the leverage ratio was as high as 1:33, which meant even a small 3% correction of the securities would wipe out the entire capital of these banks. Huge Bonuses were given for short term profits instead of risk adjusted performance based compensation.
And by 2008,this bubble had started to burst. Bear Stearns ran out of cash and was acquired by JP Morgan Chase for $2/share backed by $30 bn Fed guarantee. Freddie Mac and Fannie Mae, 2 giant mortgage lenders were taken over by Fed and Lehman Brothers announced a record loss of $3.2 Bn and it too went bankrupt.Myrill Lynch was acquired by Bank of America and on 17th September 2008, AIG was taken over by US government which cost $150 Bn of Tax payers money. World stock crashed on fears of a global recession. So this is how greed brought a cardiac arrest to the global financial market and we are still recovering from the melt-down. Who knows another bubble is ready to explode?
And as someone has rightly put:
“Why should a financial engineer be paid 4 times a real engineer? A real engineer builds bridges and financial engineers build dreams and when these dreams turnout to be a nightmare other people pay for it.”