On September 15, 2008, the global markets faced with the inevitable financial crisis after America's fourth largest bank, Lehman Brothers, filed for bankruptcy.
Markets tumbled, unemployment rose and the whole world was on the brink to witness another turmoil.
The Origins Of The Financial Crisis
The 2008 financial crisis finds its roots in 2000, when the US Federal Reserve slashed its interest rates from 6.5 percent in May 2000 to 1.75 percent in December 2001.
The Fed continued to slash rates all the way down to one percent in June 2003, an all-time low in 45 years.
This paved the way for Americans to pursue
‘The Great American Dream’ to own a house. The US government also encouraged home ownership.
Since the liquidity in the economy was so high, and the rates too low, individuals with no income, job or assets also bought houses. This was the
Individuals bought 2-3 houses, some even condos, which they could have never afforded.
In the US, a person needs a credit score of 600 or more to avail a loan, but banks and mortgage brokers even lent out money to individuals with a credit score less than 600 or none at all with little or no reason to worry about loan repayment or a down payment.
They were known as subprime borrowers, and the loans, subprime mortgages.
According to the website Investopedia, a
subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings.
As a result of the borrower's lower credit rating, a conventional mortgage is not offered because the lender views the borrower as having a larger-than-average risk of defaulting on the loan.
Lending institutions often charge interest on subprime mortgages at a rate that is higher than a conventional mortgage in order to compensate themselves for carrying more risk.
The lenders made profit on these sales. The investment banks went a step ahead and bundled good loans with toxic loans into
collaterised debt obligations (CDO) and sold them off to investors, making money in the process. The banks became the ‘middleman’ between the buyers and the investors.
Rating agencies such as Standard and Poor’s gave such toxic bundles AAA ratings, implying these CDOs highly stable and unlikely to default.
In October 2004, the US Securities and Exchange Commission (SEC) relaxed the net capital requirement for five large US-based investment banks – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Sterns and Morgan Stanley.
Government regulated mortgage lenders Freddie Mac and Fannie Mae had loaned about $3 trillion worth of mortgage credit. As long as the home prices continued to climb, these securities were not considered risky but highly profitable.
The US Housing Market Crisis
By June 2006, the Federal Reserve had raised its rates to 5.25 percent, resulting in
‘the beginning of the end.’
Homeowners were defaulting at high rates as all of the creative variations of subprime mortgages were resetting to higher payments while home prices declined.
Homeowners were upside down - they owed more on their mortgages than their homes were worth - and could no longer just flip their way out of their homes if they couldn't make the new, higher payments.
Instead, they lost their homes to foreclosure and often filed for bankruptcy in the process. Nobody in the US was buying homes and the home prices started to flatten and the entire system of credit default swaps engaged.
Credit default swaps (CDS) were nothing, but an insurance against a default in these toxic securities. And who insured these? American insurance company AIG. People smart enough started hedging against CDS’ on the thought that the US housing market will go bust. And it did. The Beginning Of The End
In August 2007, the market realised that it had no way to solve the subprime crisis on its own and many small mortgage lenders filed for bankruptcy.
Bear Stearns was bought by JP Morgan Chase due to its huge losses resulting from its involvement in having underwritten many of the investment vehicles directly linked to the subprime mortgage markets.
On September 7, 2008, the US government had to bail out Fannie Mae and Freddie Mac, as these government backed mortgage lenders reported huge losses from heavy exposure to the collapsing subprime markets. The financial markets were down 20 percent from the October 2007 peaks.
A week later, Lehman Brothers filed for the largest bankruptcy in the US history at the time, having been exposed to the subprime mortgage market extensively.
The next in line was Merrill Lynch, US’s largest brokerage company. However, the Bank of America bought Merrill Lynch.
Treasury Secretary Henry Paulson proposed that a Troubled Asset Relief Program (TARP) of as much as $1 trillion be made available to buy up toxic debt to ward off a complete financial meltdown.On October 3, 2008, the US Senate passed a reworked $700 billion TARP plan and renamed the Emergency Economic Stabilisation Act of 2008.