the financial crisis of 2008 simplified
TRANSCRIPT
The Financial Crisis of 2008 SimplifiedBy: Economyria
Introduction
• What is a financial crisis?
• A financial crisis is a crisis which critically affects the functioning
of the financial system
• Financial system includes banks, mutual funds, investment banks
etc.
• In a financial crisis, the financial assets (like shares) lose its
nominal value
Immediate Trigger of the financial crisis of 2008
• Burst of the Housing bubble:
• A bubble is when the price of an asset increases above their
legitimate intrinsic worth.
• In a bubble, the price of the asset does not correspond to its
fundamental value. (eg- the fundamental value/ intrinsic worth of
pen is Rs 20. But, price rises to above 1000.)
• From the 1990s until February 2007, prices of houses in the US
increased by a staggering 130 %. (Housing Bubble)
• This bubble eventually had to burst
Housing Prices in the USA
What caused the bubble/ housing price rise?
1. Low interest rates
• During the period from 2000 to 2003, Federal Reserve lowered
interest rates from 6.5 % to 1 %.
• It was done to combat the negative impact of the the Dot-com
bubble burst (2000)and the Sept 2001 attack at the WTC.
• People began to take more loans (home mortgage loans) to buy
homes. Demand for houses increased
What caused the bubble?
2. Global saving glut: • There was surplus savings in China, Japan & the middle-eastern
oil exporting countries.• It flowed into the US economy (safe investment)• It kept interest rates in the United States low• They invested in the housing market as well through complex
financial assets
What caused the bubble?
3. Government policies to provide housing to all
• To provide housing to all, Government introduced policies to
encourage people to take more home loans
• One of the policy was that no income tax will have to be paid on
the interest paid on home mortgages/ loans
What caused the bubble?
4. The Great Moderation (1980s to 2007):
• Economy stable
• It was period of low inflation and stable growth.
• Willing to take up more risks than ever.
• Households (and financial institutions) became highly leveraged
(took more loans)
Consequences of the Housing Bubble
• It led to decline in mortgage/ loan standards
• Financial institutions (banks) began to lend to sub-prime borrowers
(people with low-credit worthiness)
• It brought more people into the housing market and price increased
further
• Began to use a different type of mortgage called Adjustable rate
mortgage
Consequences of the Housing Bubble
• The standard mortgage in the US has a maturity of 30 years with a fixed
interest rates
• But, Banks began to give out loans with adjustable/ flexible interest rates
• The initial interest rates were too low (1 %) and after 2 or 3 years, the
interest rates reflects the market interest rates. (teaser loans)
• After 2 or 3 years, refinance into a standard mortgage.
• Refinance means taking new loan to repay an existing loan
The Burst of the Housing Bubble
• By September 2007 prices declined by 25 % due to
the following reasons:
1. Decline in demand for houses
• Housing market became saturated and hence there was a
decline in demand of the houses in spite of the easy
home loans.
Housing Bubble burst
2. Fed started increasing the interest rates from 1
% to 5.25 % (June 2004 to June 2006).
• People no longer had access to cheap home loans
• Demand for houses decreased
• Hence, prices declined
Consequences of the Housing Bubble Burst• As the housing bubble burst, people began to default on their
home mortgage loans
• Adjustable Rate Mortgage holders could not refinance.
• They also defaulted on the loans
Consequences of the Housing Bubble Burst
• It resulted in Foreclosure. Foreclosure means the banks
started selling off the collateral (houses) to recover
their loan
• But, as house price low, banks could not recover their
loans and suffered losses.
• This was essentially called a sub-prime mortgage crisis
How a housing crisis became a financial crisis?
• The bubble could have been restricted to the
housing market. But, it spread to whole of the
financial markets due to the following reasons:
1. Use of complex financial instruments
2. Use of commercial papers
How a housing crisis became a financial crisis?
3. Poor risk management by the financial
institutions.
4. Lack of adequate regulations
5. The regulators were not concerned about the
financial system as a whole
Use of complex financial instruments
1. Mortgage backed Securities
• Home mortgage loans are assets for the banks.
In return for these loans they get monthly
interest payments and the principal
• They sell these assets to other financial
institutions.
Use of complex financial instruments
• Banks are the originators of the loans
• The financial institutions who buy these
mortgages aggregate the mortgages into
homogeneous pool.
• Pooling is done to reduce and diversify risk.
Use of complex financial instruments
• They cut this homogeneous pool into tranches (parts/
slices)
• Then they issue securities backed on these assets.
• These securities are called mortgage backed securities
• If an investor buys these securities, they receive
proportionate share of principal and interest
Mortgage Backed Security
Use of complex financial instruments
• These securities can be traded like shares
• This process is called securitisation
• The pioneers of this process were the private corporations
established by the Government. (Fannie Mae, Freddie Mac).
• They served as an intermediary between the originators and
the ultimate holder of the mortgage
Use of complex financial instruments
• Investors in MBS include pension funds, insurance companies, foreign
banks and wealthy individuals.
• It is also retained by the financial institutions in their own account
• MBS became a popular investment option as the interest rates in US
were very low.
• To comprehend the seriousness of the situation, Fannie and Freddie
owed nearly $5 trillion to investors in mortgage obligations.
Use of complex financial instruments
2. Collateral Debt obligations
• Similar to MBS
• All debts like auto loan, credit card debt, education loan etc. are
pooled together and securities are issued backed on these assets
3. Credit Default Swap:
• It is an insurance instrument.
Use of complex financial instruments
• A mortgage backed security investor can buy CDS to insure it
against losses.
• The USA’s largest insurance company called AIG issued CDS
in return for a premium.
• Came under a lot of pressure after the bubble burst as AIG
could not make good the losses incurred by the MBS holders
Use of complex financial instruments
• Investors and FIs around the world invested in MBS and CDOs
and bought CDS.
• Value of these securities tied to housing prices declined
• Therefore, the crisis could not be restricted to the housing
market in the US
• It spread to other parts of the financial institution and it became
a global crisis
Use of Short term Funding or commercial paper
• Commercial paper is a security that is issued by large companies
to meet their short term funding requirements
• It has a maturity period of less than 3 months and traded in
money market funds
• As it is a short term funding instrument it is vulnerable to runs.
• The collapse of Lehman brothers was a direct consequence of
using commercial papers for funding
Use of Short term Funding or commercial paper
• Lehman Brothers was an Investment bank which invested
in MBS
• As MBS suffered losses, Lehman Brothers could not roll-
over its debt.
• It defaulted on its Commercial Papers
• Lehman brothers’ default led to the failure of the oldest
money market fund.
• Fed had to inject funds to restore faith.
Poor risk management by the financial institutions
• Risk was spread throughout the system
• Because of complexity of the financial instruments,
financial institutions were not sure about their risks.
• There was uncertainty in the financial system and people
found it difficult to figure out which institution is actually
exposed to the housing market.
Poor risk management by the financial institutions
• Runs began as financial firms and investors pulled
funding from any firm thought to be vulnerable to losses.
• Maturity mismatch.
• Banks lost confidence in each other.
Lack of Regulations
• Rise of Shadow banking system.
• Investment banks (like Lehman brother and bear sterns)
and Hedge funds did not have same regulatory
requirements as commercial banks.
• As important as Commercial Banks in lending.
• No financial cushion to absorb losses. (increased leverage)
Lack of Regulations
• Run on the shadow banking system.
• Shadow banking system also means unregulated activities by
regulated institutions.
• Financial institutions used off-balance sheet vehicles, example-
loans were shown as assets in the books but after it was sold off
not mentioned in the books. .
• Credit rating agencies: AAA ratings
Not concerned about the stability of the FS as a whole
• Individual regulators for different agencies
• Increased financialisation: (debt > equity) and financial
markets dominate the real economy
• The above factors interacted with each other and caused the
financial sector to become increasingly fragile. It was a
systemic crisis.
Not concerned about the stability of the FS as a whole
• There was a breakdown of trust in the entire financial
system.
• Nobody was willing to lend to each other.
• There was an extreme credit crunch and it affected
other sectors of the economy which were heavily
dependent on credit.
The Crisis
• Credit crunch. Credit market dried up.
• Huge pressures on key financial firms Bear
Sterns, Fannie & Freddie Mac, Lehman Brothers,
Merill Lynch, AIG etc
• Interconnected financial market.
The Crisis
• Threatened the collapse of the entire financial institutions
• Bail-out to prevent the failure of systemically important financial
institutions (SIFI) or Too Big To Fail
• Housing crisis- MBS lost value- Investment banks- MMF-
Insurance company
• To big to fail means failure disastrous to the greater economic
system.
The Aftermath
• It led to a world-wide recession with high unemployment
rate. Economy slowed 7 % in the first quarter of 2008
recession.
• Stock markets tumbled.
• Euro-zone debt crisis: Portugal, Ireland, Greece, Spain,
Cyprus. Incurred a lot of debt to bail-out financial
institutions. Read about the Greece Crisis in this article (
http://economyria.com/the-greece-debt-crisis-explained/)
The Aftermath
• Decline in credit availability
• No investors confidence
The Aftermath
• Governments responded with fiscal stimulus, monetary
policy expansion (Quantitative Easing)
• Institutional bailouts (financial support)
• Basel III capital and liquidity standards adopted by
countries worldwide: international banking standards.
Increased CAR. To 11.5 % from 9%)
The Aftermath
• Quantitative easing is an unconventional
monetary policy tool which was used by the
Central bank of the USA (Federal reserve)
• The federal reserve had to resort to quantitative
easing because the conventional monetary
policy tools had become
The Aftermath
• In quantitative easing, Federal reserve bank
buys Government bonds and other financial
assets from commercial banks to inject cash
into the economy. Read this article to know in
detail http
://economyria.com/quantitative-easing-demysti
fied/)
Thank you
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About the Author
• Alumnus of Shri Ram College of Commerce
and Delhi School of Economics
• Currently working as an Assistant
Professor
• Founder of the blog: Economyria
(http://economyria.com/)