When we study about the modern economy, one of the major episodes that we surely undergo is the ‘Financial Crisis of 2008’. It was this recessionary period, that almost brought the whole world to a standstill. Now, we know that teh crisis was related to teh US housing market crisis, but the details are a little too complex. So, in this blog, I would be decoding the whole episode which left tens of millions of people losing their savings, jobs and…their homes.

How it all started?

When it comes to investing, the US is considered one of the most secure destinations, and people are assured that if they have invested there, markets will be ‘stable’ in the country. On those lines, in 2007-08, those looking for low investment and high returns started investing in US ‘Housing Markets’ (I will explain this in detail below), and there were two broad reasons behind it.

Firstly, the rate of interest offered by US Treasury Bonds was very low, so teh housing market looked like a very preferable option to the investors. Secondly, home prices were rising high and high at that time. So, the investors thought that even in the worst case, if the borrowers default on their loans, they will sell the house at a high price.

The US Housing Dream (Photo:Forbes)

Understanding the Housing Market System

Earlier, if a person took loan , he had to repay it to the lender he borrowed from. But, now those lenders were converting the mortgages into bundled securities and then selling them to investment banks. From there, the investment banks combined the investment bundles and other loans. This combined bundle known as Collateralised Debt Obligations (CDOs), were then sold to investors. So, now, when the home buyers paid their mortgages, the money went to lenders across the world.

Traditionally, geting a loan happened to be tedious task. If you had bad credit or didn’t have a steady job, it was very difficult to get the loan. Actually, around 8-10 people from the lending institution ‘interrogated’ a person, till they were satisfied of his ‘repaying’ abilities. But all of this started to change by the time of 2000s. Now, what started happening, attracted by the high housing prices, the lenders saw ‘more opportunities’ of earning profits. They instructed the banks to provide more housing loans. The number of mortgages from 2000 to 2003 nearly quadrupled. Subprime lending increased from nearly $30 billion to $600 billion in 10 years. Hundred of billions was floating in the economy, and the process of skyrocketing formed the largest financial BUBBLE in history.

A still during the 2008 crisis (Photo: Outlook India)

Not just that, the lenders were ‘making sure’ that even ineligible borrowers do get loans, by giving them loans at ‘adjustable’ and ‘affordable’ interest rates. This phenomenon is known as Subprime Mortgages. Although, it does provide affordable loans, but also poses a high risk of the situation going out of hand very far. This further drove the housing prices even higher, which only made these mortgage-backed securities look like even better investments. The investment banks were preferring subprime loans because they carried higher rates of interest, which posed a higher chance of profit for them

Slowly lead all the borrowers who deserved to get loans as per their credit record and income, had the loans. But, even after that the institutions kept on following the ongoing trend of providing mortgages. But, now it meant that the loans will be given to those who don’t qualify for the necessary standards. And…that’s exactly what happened. Loans were now being granted to even those with poor credit records and low income, which meant they had ‘lesser’ chances of being repaid. These investments were no longer safe, but the lenders kept on pouring more and more money.

The Role of Credit Rating Agencies

The disaster that took place, can’t be fully described without discussing the appalling role played by the credit rating agencies. Before lending to the firm, the credit rating of a firm is checked to look at its credibility. Similar was the case with these CDOs. Surprisingly, most of the firms had got an AAA rating (the best possible rating) from the agencies. The simple reason behind it was that the agencies were being BRIBED by the investment agencies to keep their ratings high, irrespective of their financial health. This further propelled the investors’ confidence in CDOs. This system was nothing but a ‘Ticking Time Bomb’.

Credit Rating Agencies (Photo: Investopedia)

And…the BUBBLE bursts

Finally, a time came when people had to pay back their loans. But, as we saw that, most of the borrowers didn’t had the money to back their loans. So, it put more and more houses back on the market for sale. This meant that supply went high, but there was no longer the necessary demand to absorb that. As a result, home prices started collapsing. The worst-case scenario that was imagined, the situation turned even more ‘worse’ than that.

Many were left with mortgages much higher than that what their houses were worth of. At this point, many big institutions stopped buying subprime mortgages, and several big lenders declared bankruptcy. Stock markets and the US economy crashed badly. As the saying goes, when US sneezes, the whole world catches cold. All this MESS had created such a vicious web across the whole financial system, that when things went bad it made the matter worse for the whole system.

Lehman Brothers (Photo: CNBC)

The Big Companies amid crisis

A major reason for the disaster to turn out so big was also the role of some American giant companies. The most surprising name on that list was that of the Lehman Brothers. The reason for this being the most surprising name was that it was able to survive even the Great Depression of the 1930s. As we saw, the reason it continued to have top-notch ratings despite ill financial health, was “negotiations” with the rating agencies.

Some more examples,  are Goldman Sachs purchased CDOs worth $6 billion, and later fearing any default, it also insured itself for $150 million. Eventually, Goldman Sachs even started ‘specifically selling’ CDOs in such a way that the higher losses the customers made, the more money the firm made. Another big name, the American International Group (AIG) did sell a million dollars of these insurance policies, without the money to back them up. Traders used to bet huge amounts of money on whether the values of mortgages would go up or down.

The RAGHURAM RAJAN Connection

Raghuram Rajan, one of the greatest economic minds in the country, was the International Monetary Fund (IMF) chief in 2005. He was one of the first people in the world who predicted that a collapse like this can happen. In a paper, that he delivered at the Jackson Hole Symposium, the most elite banking conference, he pointed out his concerns and scepticism about the system. The audience included central bankers from around the world, including the then-Fed chairman Alan Greenspan.

His paper was titled, “Has Financial Development made the World Riskier?”, and the conclusion he came up with in the paper was a resounding ‘Yes’. He pointed out that there are ‘incentives’ for short-term profits, but no accountability or penalty for future losses. It will lead to taking risks posing a high danger for the firms and even for the whole financial system. Incidentally, many institutions were enraged by teh paper and accused Rajan of being “jealous” of the market prosperity. But, as history has it, Rajan was right.

By the way, this is just one of the many incidents to showcase what a brilliant mind he is. Also, it poses the question, of why the current regime let him go from the RBI Governor and the financial leadership of the country. Well…the answer is, some “people” are immune to good advice.

Raghuram Rajan after exit as RBI Governor (Photo: Scroll)

Revival and Correction

To combat the situation, the US government took a series of steps. Trouble Assets Relief Program (TARP) was enacted, which allocated $700 billion to shore up the banks. Congress also passed a huge stimulus package in 2009, pumping $800 billion through tax cuts and new spending. Through these stimuli, the US government made sure that all the big companies and banks are able to survive to get closed. The reason behind this was that if such big institutions fall, they also sink a huge part of the economy.

The treasury also conducted ‘stress tests’ on the banks. All this, removed much of the panic from the economy. Now, this episode brought a round of reforms as well. A big reform was the Dodd-Frank Law, which brought transparency and prevented banks from taking this high level of risk. It established a consumer protection bureau to stop predatory lending, which required financial derivatives to be traded in exchange that can be observed by market players. And it brought a mechanism for large banks to fail in a controlled predictable manner.

Lessons from the Crisis

There are not one but many lessons, the chapter holds. Firstly, the reason the big institutions were able to get themselves ‘highly rated’ was because they had acquired uncontrolled power. The US, despite how successful it is, is also one of teh BIGGEST Crony-Capitalist countries in the world. Experts have pointed out that teh crisis that burst in 2008, had its seeds sown much during the 1980s, when too much Unfortunately, India too seems very well on that track. This lesson teaches why too much power can be dangerous.

Secondly, it is strongly alleged that then-Fed Chairman Alan Greenspan had several powers to control the messy system, but he didn’t. Several shortcomings were pointed out even during the process of revival of the economy, and also while bringing up of regulations to control such situations. This shows why we need ‘strong’ and ‘competent’ people at the central bank and financial leadership, who can ‘independently’ take decisions that are right for th nation. At a time, when the world is again facing a crisis-like situation pertaining to several factors, we should keep these lessons in mind while we look towards securing our economy for any episode even mildly similar to this.

“If they’re too big to fail, they are too big” -Alan Greenspan