History repeats itself with greed, now the Big Banks own the homes

Crossville TN

Description

Records show that the riskiest loans originated in 2004–2007. Over the years, the proof of assets and income were de-emphasized. In the beginning, loans required full documentation. Eventually, it led to low documentation and finally to no documentation at all. A mortgage product that gained wide recognition was the no income, no job, no asset verification required (NINJA) mortgage. These loans are also referred to as liar loans. The ultimate result was loans being disbursed to people with poor credit rating. By 2006, 60% of the mortgages purchased by Citigroup were defective. By 2007 these defective mortgages increased to over 80%. Between January 2006 to June 2007, over 9,00,000 mortgages issued revealed that only 54% of the loans met their originators’ underwriting standards. The analysis additionally showed that 28% of the sampled loans did not meet the minimal standards of any issuer. This was on behalf of 23 investment and commercial banks, including seven too big to fail banks. Beginning of the Fiasco Few experts saw the bubble coming. But nobody believed them. People were not ready to accept the idea that the housing prices can ever go down. It was a truth too harsh to accept. Initially, the default rate was around 4%. As the default rate kept rising and reached 8%, the MBS system collapsed. The crisis started with the fall in housing prices. More and more people became fearful. And with that, the default rate in these loans skyrocketed. Eventually, the CDOs failed to return investors their money.‌‌ The case of Bear Sterns, Lehman Brothers, Merrill Lynch & AIG 2008 Financial Crisis – The Housing Bubble (with Books and Timeline) Created August 24, 2021 Author Deepika Khude Category Movies and Books The 2008 financial crisis is one of the worst economic disasters ever The economy went into recession. It caused the biggest recession since the great depression of 1930. It is also referred to as the global financial crisis (GFC). The crash made several families go homeless. It resulted in a massive stock market crash. Investors lost their life savings 2008 Financial Crisis Retirement accounts were lost. Their home values crashed. Housing prices fell by approximate 31%. The banks started going bankrupt. The stock market wiped out almost US $8 trillion in United States alone from late 2007 to 2009. Millions of people lost their jobs. By October 2009, unemployment went up to 10%. Economists failed to predict the crisis. And what happens when the world’s strongest economy collapses? The global economy collapses. There was a ripple effect. The Indian stock market saw a fall of over 50% in the year 2008-09. On 3 March 2008, the Sensex fell by 900 points and settled at 16,677. 2008 Financial Crisis On 24 October 2008, the BSE Sensex fell to 8701. It was a fall of 1070 points in a single day. The National Stock Exchange’s Nifty ended at 2,557.25, down 13.11 per cent or 386 points. The BSE Midcap closed 8.38 per cent lower and BSE Smallcap Index ended 7.66 percent down. But what led to the world economy collapsing this badly? What triggered this? Let’s find that out! In this article: Brief about the 2008 financial crisis The banks, CDOs, and the risk associated with loans The role of Credit Default Swaps (CDS) The Credit Rating Agencies and the insurance companies Beginning of the debacle Did anyone make profits out of this fiasco? The big short – Book & documentary Four books based on 2008 financial crisis Timeline to 2008 financial crisis How to identify and avoid stock bubble? Brief about the 2008 financial crisis The 2008 financial crash involved – Investment banks Insurance companies Credit rating agencies US Federal Banks Investors and the people of the USA The crash occurred during the presidential transition. George Walker Bush left the White House and Americans welcomed Barack Obama. No one ever remembers Bill Clinton's campaign promise, "It's Your Right to Own a Home". It took 8 years of risky Big Bank lending to drop it in the lap of the next president. Let us understand their roles in the crises. We begin by how the events unfolded which shattered the economy. To understand the meltdown, we need to go back to the root where it all began. After the 2000s’ dot.com bubble burst, the US equity market was on a bearish run. In an attempt to revive the economy, Federal Banks in the US started to lower their interest rates. The Federal Reserve lowered the federal funds rate target from 6.5% to 1.0% between 2000 and 2003. Lower interest rates encourage borrowing. More borrowings increases the purchasing power in the hands of the borrowers. This increases consumption. Ultimately, liquidity enters the market and revives the economy. 2008 Financial Crisis So how did this lead up to the housing bubble? The simplest answer is the bank’s "greed to increase revenue" at minimal risk. Let’s understand this in detail. The banks, collateralized debt obligation (CDOs), and the risk associated with advances – The banking system is full of risks. They may face default risk, liquidity risk, provisional risk, etc. When banks issue loans, they have to bear credit risk. It means that the borrower might not be able to repay the loan money. To safeguard the system, they need to set aside a percentage of funds on the loan amount. It is known as a provisional amount. Banks cannot use such provisional funds for any other operation. This reduces a bank’s capacity to lend. Recommended Read: How to analyse a bank and its business model To bypass this risk factor, Collateralized debt obligations (CDOs) were "created". The earliest use of CDOs was in 1987. Drexel Burnham Lambert, a former investment bank, created the CDO. Let’s understand CDOs and its functions and why is it one of the reasons which triggered the downfall. First of all, what is a CDO? It is a structured financial investment product. It is backed by a pool of assets. These assets are essentially debt obligations. It include mortgages, loans, or bonds. Retail banks created CDOs because they were looking to sell them to investors. The reason being they wanted to reduce their risks on the debt obligations (loans) they issued. This instrument helped the banks shift the risk to investors. Investors bought them to enhance their returns. Investors would even trade these CDOs in the debt market. Banks redirect the payments received on the loans and advances to the investors. The investors hedge against default using the collaterals. This also determines the CDO value. For the 2008 financial crisis meltdown, our focus is precisely on the mortgage backed CDO. It is also known as Mortgage Backed Securities (MBS). A mortgage-backed CDO owns parts of many individual mortgage bonds. On average, it owns parts of hundreds of individual mortgage bonds. So basically, mortgage bonds are nothing but thousands of individual mortgages. CDOs became vehicles for refinancing mortgage-backed securities. 2008 Financial Crisis Before the 2008 financial crisis, investors considered CDOs a very safe investment instrument. They reduce risk by diversifying across many mortgage bonds. To sell these CDOs, banks divided them into various risk levels or tranches. Senior tranches have the first claim on assets. Hence, they are the safest risk levels if some of the underlying loans default. Whereas, junior tranches are at the riskiest level. To attract investors, these tranches offer higher interest rates. However, there was fear and doubts in such instruments in investors’ minds. To safeguard investors, the bankers created Credit Default Swaps (CDS). Credit Default Swaps (CDS) is a type of credit derivative. In simple words, it protects bondholders against downgrade or default by the borrower. It is essentially an insurance contract against defaults. A bondholder (investor) pays a regular series of cash flows to a credit protection seller. The investor will receive a payment only if the bond issuer (borrower) defaults. This protects the bondholders. Blythe Masters created the credit default swap. She is a former executive at JP Morgan bank. It was done to reduce their own risk against a credit JP Morgan bank extended to Exxon Mobil Corporation. CDS is a type of financial instrument that insures loans against default. Think of it as insurance against a default. It allows investors to avoid credit risk. This became rapidly popular across the industry. The banks started dealing with CDS in case a borrower fails to repay the loan. Additionally, they no longer need to maintain the provision in proportion to the loan. From 2004 to 2008, the CDS market increased in size. It went from US $6 trillion in 2004 to $57 trillion in June 2008. 2008 Financial Crisis This is where things started to tumble. The US equity market was not giving good returns compared to debt instruments. Whereas, CDOs were not only giving good returns but they were also safer. The credit rating agencies like Moody’s and Standard and Poor’s (S&P) rated them AAA. CDO was a new concept and the market was largely unregulated. One can trade them over the counter or between the banks but not on exchanges. The chairman of the Federal Reserve cut the target federal funds rate to 1% in 2003. The rates were at a high of 6.5% in 2001. The availability of easy credit motivated banks to increase lending. They started providing housing loans to borrowers. Their careless mistake was that they loaned money to those who would not qualify for these loans. These products were "immensely" profitable for banks. On the other end, the housing prices were on a rise. This resulted in the growth of mortgage-backed derivatives around the world. The Credit Rating Agencies and the insurance companies The American International Group (AIG) speculated with the CDOs. AIG is the biggest Insurance company in the USA. They provided insurance to investment banks if the instruments were to default. People started acknowledging the fact that these products are insured by AIG. Consecutively, credit rating agencies like Moody’s and S&P continued rating them as high as AAA. Other players like Lehman Brothers, Morgan Stanley, Bear Stearns, Citi Group, Goldman Sachs all jumped into the CDO market. They started selling more and more of these products. The housing prices kept rising. But now, they reached a point of saturation. The house buyers with good credit scores and history were fewer. Eventually, the profits started to decrease. This is when the bankers became puppets of their greed. They began issuing loans to those who didn’t have a reliable credit history. The probability of them not being able to repay the loan money was high. In hindsight, people were being robbed without a gun by the dream of a house with easy loan money. Now you may be thinking that rating agencies must have downgraded the ratings of these CDOs. But sadly, that was not the case. The underlying loans were given at very high interest rates. But people kept taking such loans. Since the housing prices were increasing more than the interest rate on these home loans. Records show that the riskiest loans originated in 2004–2007. Over the years, the proof of assets and income were de-emphasized. In the beginning, loans required full documentation. Eventually, it led to low documentation and finally to no documentation at all. A mortgage product that gained wide recognition was the no income, no job, no asset verification required (NINJA) mortgage. These loans are also referred to as liar loans. The ultimate result was loans being disbursed to people with poor credit rating. By 2006, 60% of the mortgages purchased by Citigroup were defective. By 2007 these defective mortgages increased to over 80%. Between January 2006 to June 2007, over 9,00,000 mortgages issued revealed that only 54% of the loans met their originators’ underwriting standards. The analysis additionally showed that 28% of the sampled loans did not meet the minimal standards of any issuer. This was on behalf of 23 investment and commercial banks, including seven too big to fail banks. Beginning of the Fiasco Few experts saw the bubble coming. But nobody believed them. People were not ready to accept the idea that the housing prices can ever go down. It was a truth too harsh to accept. Initially, the default rate was around 4%. As the default rate kept rising and reached 8%, the MBS system collapsed. The crisis started with the fall in housing prices. More and more people became fearful. And with that, the default rate in these loans skyrocketed. Eventually, the CDOs failed to return investors their money.‌‌ The case of Bear Sterns, Lehman Brothers, Merrill Lynch & AIG 2008 Financial Crisis All the big banks were filled with these toxic CDOs and MBSs. The decline in housing prices triggered a chain reaction. First in line was Bear Sterns, the then fifth largest. They were an 84-year-old investment bank in the US. Bear Sterns suffered massive losses. Two of their hedge funds were filled with toxic mortgage-backed back securities. With the crash, they lost all their value. In January 2007, their share price touched $171. In a matter of just 14 months, it dropped to $30 on 14th March 2008. American International Group was the top insurer of CDOs in the country. They also had mutual funds, pension funds, and hedge funds that had people’s money invested in CDOs. Its downfall was directly related to Americans. To stop the situation from getting any worse, the federal reserve acquired a 79.9% stake in AIG for $85 billion. In September 2008, Lehman Brothers filed for bankruptcy with $639 billion in assets. They were then the 4th largest bank. This true story is not just a look at banks that were too big to fail. It is the definitive story of the most powerful men and women in finance and politics. They grappled with success, failure, ego, greed, and, ultimately, the fate of the world’s economy.