Today, almost seven years after the financial crisis that threw America into upheaval in 2008, the effects are still being felt. In September 2008, the collapse of Lehman Brothers, a global bank, nearly caused the collapse of the financial system of the entire world. What resulted was the worst economic downturn seen by the world since the Great Depression, 80 years ago. The event has been called the Global Financial Crisis and the 2008 Financial Crisis; the period following the collapse became known as the Great Recession.
While the 2008 Financial Crisis had many causes, the most immediate trigger for the Great Recession originated in the bursting of the U.S. housing bubble. The United States housing bubble affected the housing market in more than half of the states in the country. Shortly after housing prices peaked in 2006 to 2007, increased foreclosure rates led to a sharp decline in value in 2008. In December 2008, the Standard & Poor's Case-Shiller Home Price Index reported the greatest drop in house prices in the history of the credit rating company.
The bursting of the housing bubble had a direct and immediate impact on almost all aspects of American economic life. Not only did it affect home valuations, it also impacted U.S. mortgage markets, real estate, hedge funds, home builders, and foreign banks. The crisis instigated a federal bailout of the housing market so that homeowners who were unable to pay their debts would not be totally ruined. Over 900 billion dollars was allocated to financial “rescues” in 2008 alone. Over half of that sum went to Fannie May and Freddie Mac, both government-sponsored enterprises (GSE), and the Federal Housing Administration.
What precipitated the bubble bursting? Most financial analysts agree that it was wide scale, irresponsible mortgage lending by banks to prospective home owners. First of all, loans were handed out to people who had no reasonable expectation of paying them back. This is a practice known as subprime lending (it is also called near-prime or non-prime lending). Subprime loans are given to people who potentially will have a difficult time maintaining the schedule of repayment, such as people who have low credit ratings or who are chronically underemployed. These loans are offered at a rate that is above prime, which means that they usually carry a higher rate of interest than the prime rate associated with conventional loans. Over the lifespan of a longterm loan, this can lead to a surplus of tens of thousands of dollars in interest payments compared to a prime rate loan.
In addition to mortgage loans, lenders were overeager to hand out other types of loans to under-qualified applicants, including credit card and automobile loans. These loans became incredibly easy to obtain. The American public took on a debt load greater than at any other time in history.
The borrowers of subprime loans struggled to repay their debt. Although there were many indications that these borrowers might default on their loans in the future, the subprime mortgages were still dealt out. The banks issuing these loans found out a way to capitalize on this financial risk by turning the mortgages into what they thought were low-risk securities. This was accomplished by putting large numbers of the mortgage loans into pools. “Pooling” is a way to hold mortgage loans in trust as collateral. A mortgage pool can then be used to back a more complex type of financial instrument, such as a mortgage-backed security or collateralized debt obligation.
The mortgage lenders were making the assumption that by putting the subprime loans into pools, they were safeguarding themselves from financial ruin. The logic was that property markets in different cities in the United States would wax and wane at different times, independently of one another. The fall of the property market of one American city would be buffered by the rise of the property markets of others. However, things did not work out that way. In 2006, a housing-price slump began that went from border to border, affecting nearly all American housing markets at the same time. In effect, the banks and lending institutions had been gambling with money they didn't have.
The entire situation was complicated beyond comprehension by a process euphemistically called financial engineering. Financial engineers had used the subprime mortgage pool to back collateralized debt obligations (CDOs). The CDOs were divided into tranches, or portions. Each tranche was distinguished by the degree of exposure to the risk of default, with some tranches being “safer” than others. The investors who bought these “safer” tranches did so because they trusted the credit rating assigned to them by credit ratings agencies like Moody's and Standard & Poor's. These tranches came with a triple-A credit rating, the highest possible rating. Such a rating guarantees that the security will easily meet its financial obligations.
However, the credit ratings agencies' assessments of the securities were far from unbiased. The agencies had been paid by the the banks that created the CDOs to appraise them. Therefore, the CDOs were appraised at a much greater value than they should have been. Like a school that engages in grade inflation to appease a demanding district, the agencies generously handed out the triple-A rating to too many undeserving candidates.
The buyers of these securitized products had sought them out because they believed them to be exceptionally creditworthy. During the prime years of subprime lending, interest rates were low, and these types of instruments were thought to provide higher returns. Why the interest rates were low at that time is a subject of debate to this day. Some people accuse the Federal Reserve of forcing short term interest rates too low, in turn bringing down the longer-term mortgage rates. Others blame the low rates on the propensity to save rather than invest in emerging markets. The interest rates would have then been driven down when the savings went into relatively safe government bonds.
A financial climate in which interest rates are low makes it more difficult for lenders to turn a quick profit. This is probably what spurred the hedge funds, banks, and other investors to look for assets that were riskier. Greater risk implies a more dire chance of failure, but also a better chance of high returns. The subprime mortgages made it profitable for lending institutions to borrow more in order to increase their investments. With the assumption that the eventual returns on the investment would far exceed the amount borrowed, this seemed like a very good idea. Repayment rates had seemed stable for a long time, so investors thought that it was worth it to try their luck with borrowing in money markets to buy longer-term, higher-yield securities. (Of course, history tells us that this was a mistake.)
The turning of America's housing market initiated a chain reaction that brought to light the vulnerabilities in the financial system that had blossomed over the years. Mortgage-backed securities and CDOs suddenly lost all their value and turned out to be worth nothing, in defiance of their triple-A ratings. All assets became suspect under the new financial conditions, making it difficult to sell them or use them as collateral for short-term funds. Many companies, including major global financial institutions, that had invested heavily in CDOs went bankrupt as a result. Lenders were required to reassess the value of their instruments at a much lower price then anticipated, thus acknowledging significant losses and undermining the viability of their counterparties. In addition, the safeguards that were meant to mitigate risk instead made the risk even greater. For example, a type of financial instrument called a credit-default swap was commonly being used to hedge risk. In a credit-default swap, a seller agrees to compensate the buyer in the event that a third party defaults on its loan. Since defaults and losses on loans began occurring with alarming frequency, many sellers were left without the ability to reimburse their buyers.
A series of factors over the preceding decades had led to the U.S. financial system becoming so fragile. One factor was lack of regulatory oversight. Starting in the 1970s and continuing to present day, the stance of the U.S. government toward economy was one of deregulation. This was meant to encourage business and promote the growth of the economy. The result was that banking institutions became free to conduct business as they pleased. During this time, the banks also became less transparent in their practices. They were no longer forced to disclose information about the activities they were undertaking to any sort of regulatory body. Had such regulatory oversight been enforced in the years leading up to the 2008 Financial Crisis, the wide-scale issuance of subprime loans might have been avoided.
Since the financial aspect of American life had been largely free from regulation for decades, policy makers were not adequately informed about the increasingly significant control that financial institutions, such as hedge funds, money market funds, and investment banks, had over the economic safety of the country. These institutions make up what is now referred to as the shadow banking system. Though they are subject to monitoring and regulation by government agencies, they conduct business in such a way that their practices are obscured to their investors and to regulators. Before the financial crisis, they were subject to even less regulation than they are today.
The activities of shadow banks are largely thought to be the primary instigators of the 2008 Financial Crisis and the resulting period known as the Great Recession. These banks relied on the use of off-balance sheet entities to finance their investment strategies, meaning that they hid their liabilities from central banks and other government institutions in order to borrow more money. This ultimately led to the downfall of the entire system.
With the hindsight we have now, it is easy to see that a grievous disregard for financial responsibility was made at every step in the chaotic process that brought us to 2008. From providing loans to people who were ostensibly unable to pay them back, to using clever financial engineering to create high-risk securities from these loans, to issuing exceptional credit ratings to these dubious securities, every entity involved in the process is at fault for the crisis that transpired in 2008. The hedge funds and investment banks that were involved in this process are responsible for the crisis, as well as the United States government for failing to enforce sufficient regulations to prevent these shady dealings. The American public is still paying for these transgressions today, and will continue to pay for them for many years to come.
Works Cited
“Crash course: the origins of the financial crisis.” The Economist. 7 September 2013. Web. June 29 2015.
“Two top economists agree 2009 worst financial crisis since great depression; risks increase if right steps are not taken.” Reuters. 30 September 2009. Web. 29 June 2015.
Holt, Jeff. “A Summary of the Primary Causes of the Housing Bubble and the Resulting Credit Crisis: A Non-technical Paper.” The Journal of Business Inquiry 8.1 (2013): 120-129. Web.
Figures
Figure 1: Greenstone, M. and Adam Looney. “The Long Road Back to Full Employment: How the Great Recession Compares to Previous U.S. Recessions.” Brookings.edu. 6 August 2010. Web. 29 June 2015.
Figure 2: Looney, A. “Unemployment and Earnings Losses: The Long-Term Impacts of the Great Recession on American Workers.” The Hamilton Project. November 2011. Web. 29 June 2015.
