About the paper
The year 2007-08 was a nightmare for the US economy. It was after 80 years of the Great Depression that the United States was facing a financial carnage that was eroding billions, leaving people unemployed and creating a junk in the cash vault of the economy. With back to back failure of the monetary policies of the Federal Reserve and bankruptcy filings by the biggest companies in the country, the eminent economists and members of the Federal Reserve were evaluating the reasons for the economic impotency and discussing the best possible ways to counter the situation. However, amidst all those overnight round table discussions, the financial crisis brought in the repercussions for the entire financial industry and as a consequence, the commercial banks and the securities were the worst affected. It is considerable that while these two financial institutions were adversely affected by the credit crisis, however, the reason for them been affected by financial crisis was different. Therefore, in this paper, we will be unfolding the events and the reasons that uprooted the financial stability of commercial banks and securities, and how they were impacted in a different manner during the credit crisis.
In other words, while we agree that the epicenter of the financial crisis was the burst of the housing bubble, but the reason of failure of commercial banks and securities is entirely different and this paper will unfold those events that changed the fate of these financial institutions.
Commercial banks and their failure: Unfolding pre-crisis events
The failure of commercial banks can be attributed to deterioration of conditions in the real estate sector, a process which started in early 2006 and lasted till 2010. Even though we identify the burst of the housing bubble as the main cause of the failure of commercial banks, however, it is important to identify the series of events that led to the massive debacle of the banking system of the entire economy.
The whole process started when at the peak of the housing bubble the real estate prices grew against the fundamental value on account of huge demand for real estate units, and this herd behavior amongst the investor community gave birth to wrong incentives in the commercial banks, who rather than understanding the real truth behind housing bubble, adopted financial innovation to support the growth. One part of this financial innovation was the development of sub-prime mortgages and securitization of mortgages.
On account of relaxed regulations, commercial banks adopted lean standards while issuing mortgage loans and as a result, these banks showed no hesitation in proliferating the sub-prime mortgage market. Important to note, Subprime mortgages are issued to individuals with poor or no credit history in lieu of charging higher interest rates from them, which was usually two to four percent higher than the prime rate. However, commercial banks, rather than showing a pragmatic approach adopted paranoia and relentlessly issued mortgages to sub-prime borrowers and in some cases with incomplete documentation too. Consequently, the sub-prime market exploded and surged from 9 percent in 2002 to 25 percent in 2005. In short, a quarter of mortgage loans issued commercial banks were bad loans with high probability of default. In addition to sub-prime mortgages, commercial banks went a step ahead and created ‘Alt-A’ mortgage category as part of which mortgage was issued to home buyers who had defaulted in the past. Henceforth, after creating a corpus of high-risk loans through sub-prime mortgages, banks were now creating dead or liar loans in the form or Alt-A loans as part of which buyers were granted 100% mortgage loans and no down payment, and ironically, these buyers had the worst credit history. While every commercial bank had its own modus operandi of dealing with mortgage request, there were some banks who also issued mortgages that required borrowers to pay only interest payments on their mortgages, and yes! This was all happening in the most powerful economy of the world. At the peak of the housing bubble, 40 percent of the mortgage loans were made up of sub-prime and Alt-A loans.
However, what may turn our readers skeptical here is why were commercial banks taking such a big risk and issuing dead mortgages to borrowers with a defunct credit history? The answer lies in yet another financial innovation process called Securitization that also brought investment banks and securities firm into the brewing tsunami of financial crisis. Important to note, securitization is a process as part of which a financial institution can transform its illiquid assets into marketable securities and thus create an off-balance sheet financing channel. This whole process was an incentive for commercial banks to assume more risk in mortgage lending as once the mortgage was issued, they were pushing the default risk on the investors by bundling these loans and securitizing them in the form of mortgage backed securities(MBS). In addition to transferring the risk, banks were also earning fees from the issue of MBS. In short, aggressive creation of illiquid assets and then turning them into marketable securities through the process of securitization was the core incentive for commercial banks to create sub-prime and Alt- A loans even when they knew that the borrower would be unable to meet the terms of the mortgage payments. The commercial banks just had to ensure that they create maximum mortgages to be bundled and sold in secondary markets as mortgage backed securities(MBS). Ironically, the buyers of these mortgage based securities were large securities firms and investment banks, who despite of having a team of highly professional teams could never forecast what was underlying those MBS securities that they were purchasing in millions from commercial banks. Henceforth, it was the securitization process that brought investment banks and securities firms to become part of the ‘soon-to-occur’ financial crisis.
Before, we explain as what happened eventually to the commercial banks, let us now see how those investment banks and securities firm intensified the effect of the financial crisis.
Investment Banks and their failure: Unfolding pre-crisis events
While commercial banks gave birth to the financial crisis by first pooling mortgage loans backed by sub-prime borrowers and then securitizing them into MBS, Investment Banks made sure that the financial crisis explode and create ripples in the whole financial system. Important to note, investment banks, who were carried away with increasing housing prices, re-securitized the mortgage backed securities and created new and more complex financial instruments known as ‘Collateralized Debt Obligations(CDO)’, which was backed by mortgage backed securities(MBS). CDO’s offered returns on the basis of tranche selected by the investor. In other words, CDO payments were based on tranches which offered different returns and risk level to the investors. Moreover, since these were the new kind of financial instruments, credit rating agencies had little base or information on which to analyze these financial instruments and since default rates on mortgages were very low, credit rating agencies issued high ratings to CDO’s that were backed by mortgage backed securities, which were nothing but composed of bad and high-risk mortgages.
The paranoia and ignorance did not stop here. Soon after, investment banks and securities firms created yet another instrument called ‘’Structured Investment Vehicle’’. SIV’s were independent companies whose assets were CDO’s. In other words, securities firms and investment banks now restructured CDO’s and ironically, this financial instrument allowed the banks to sell off their shares in bonds against SIV and thus keeping their liabilities off from the balance sheet. In this way, banks were now able to fabricate their balance sheet by showing lower than actual leverage.
Things did not stop here as bankers in the greed f earning short-term gains were ignoring the fact that they were dragging the economy to a financial hurricane. As a result, they next created credit default swaps(CDS), which was actually an insurance sold to investors against any bond default issued by major banks. However, even if they were sold as insurance kind products they actually were not insurances because even CDS were backed by mortgage backed securities (MBS) and unlike insurance they did not have any liquid fund backing up the claims. By the end of 2007, CDS market peaked $42 trillion and even small firms and local government now starting selling their bond since their credit would be backed by the firms issuing CDSs on their bonds.
Meltdown Began- End of Housing Bubble
Just as the bubble created dynamics that tended to be self-perpetuating, the dynamics of the crash were also self-perpetuating, but in the opposite direction. By June, 2006, abundant supply and increase in Federal Rate halted the whole celebration. Commercial banks now understood that they had been excessively lax with their lending standards and accordingly, they became stricter with the lending procedures and started asking for a down payment as high as 25% from mortgage seekers. Excessive supply and dampen demand plummeted the real estate prices and from here, the mortgage default rates peaked. By the advent of 2008, house prices were down by 20 percent and in cities like Las Vegas and Los Angeles, prices were down by 30 percent. As expected, with fall in house prices and halt in job-creation because of increased Federal interest rates, default rates started surging and as expected, subprime and Alt-A borrowers were the leading defaulters.
The spread of defaults in the subprime market led to a massive decline in the valuation of MBS, which were backed by sub-prime mortgages. Needless to say, commercial banks were now facing worst ever financial turbulence. The continued flow of housing units supply and increasing default rates left the commercial banks crippled and short of liquidity.
However, this was just the beginning, the next victims were the investment banks and securities firms who had given birth to derivative instruments that were based either fully or partially on MBS. With the fall in value of MBS, the by-products of MBS such as collateralized debt obligations (CDO) and credit default swaps(CDS) also witnessed meteorite like fall and the companies that owned MBS and other derivative instrument based on it, went bankrupt on account of the credit squeeze that hit the entire US financial market. To name a few, Bear Stearns and Lehman Brothers were the first and worst affected financial firms on account of the credit crisis. Lehman Brothers, once a gem of the Wall Street, had written an inventory of securitized subprime assets and with the subprime market exploded with high default rates, the company reported a loss of $2.8 billion in 2008 and sold assets worth $6 billion. As a result, the stock of the company lost 75% of its value and the company eventually filed for bankruptcy protection in September, 2008. Similarly, Bear Sterns, which also held large inventory of subprime mortgage-backed securities lost 90% of its stock value in just two days during March, 2008 and the company was eventually sold to JP Morgan Chase and the then CEO of Bear Stearns, James Cayne saw his stake plunging down from $1 billion to $61 million.
Difference in collapse of commercial banks and securities firm
On the other hand, investment banks and securities firm were significantly affected because of multiple re-structuring of mortgage-backed securities issued by commercial banks. These firms gave little to no attention to the quality of assets underlying the mortgage-backed securities and in lieu of short-term profits and fees, they compromised with the whole US economy.
Conclusion
Unfolding and learning about the dramatic events that lead to financial carnage in the United States, we can conclude that even though the central element was the housing bubble, however, the paranoia and irrational exuberance surround the bubble and which was fueled by the so called ‘Cowboy Financing’, got the entire economy into the trouble. While commercial banks were highly confident of minimal default rates and were shielding their risk exposure by securitizing their assets by issue of mortgage backed securities, securities firms in the name of financial innovation, used re-securitization of MBS issued by commercial banks and created instruments that were being backed by subprime mortgages only.
In short, while commercial banks initiated the process, securities firms proliferated the process to even more dangerous levels and eventually to crash in a way that placed an unprecedented strain on the US and then the global economy.
References
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