Financial crisis explained
2008 Global Financial Crisis
The Global Financial Crisis (GFC) stands as one of the most seismic economic event of the 21st century. It was a financial cataclysm that unfolded in the latter part of 2007 until early 2009. It sent shockwaves through the world’s financial markets, precipitated widespread banking collapses and ultimately triggered a global economic recession of profound magnitude.
The GFC can be attributed to various contributing factors. This monumental downturn was not the result of a single isolated cause but rather emerged as a consequence of a convergence of elements, each playing a distinct role in precipitating this crisis.
I / Causes
Greed is deeply rooted in human nature and can lead individuals to make irrational decisions driven by the desire for greater profit. Within the context of the GFC, greed manifested itself in several ways:
A / Lending practices
Greed drove many financial institutions and individuals to take on exceedingly high levels of risk in pursuit of larger profits.
To put things simply, when you’re looking to buy a house you need to get a mortgage from a bank that assesses your credit worthiness. If you have a history of borrowing and repaying money, you’re considered a prime borrower vs subprime borrower for someone who has a low/inexistant credit score.
The recession of 2001 led the Fed to lower interest rates to boost the economy. Lower interest rates means lower cost to get a mortgage and hence lower cost to buy a house which in turn leads to higher prices for houses. As a result, borrowers took advantage of low interest rates and rushed in to get cheap loans. Within this cohort of borrowers, many of them were considered subprime.
Lenders often overlooked the borrower’s capacity to pay back its loan. Why? Given house prices kept increasing, lenders believed that if borrowers struggled to pay back the loan, they could refinance or sell their house at a higher price and hence be able to pay back the loan. Which is why lenders would make loans to borrowers that couldn’t even meet down payment requirements.
B / Excessive Risk-Taking
Not only that, bank lenders would also bundle mortgages into Mortgage-Backed Securities (MBS) which helps diversify risk and would sell these to investors. The main reason being banks need continuous liquidity and mortgages are very long-term and highly illiquid and selling it to investors give the bank cash that they can use to issue even more loans.
It’s easy to see here how things have gone wrong so quickly. However, it doesn’t stop here. Bank lenders would also put in some lower credit mortgages within the bundles while the credit rating agencies would still rate them as safe investments. Meaning investors would buy these MBS thinking they are safe bets (as described by the rating agency) but they wouldn’t know that quite a few of these loans are issued to subprime borrowers.
To compensate for the risk of default, banks sought out insurance called Credit Default Swaps (CDS). Most of these CDS were provided by AIG. This meant that if borrowers stopped paying their loans, AIG would step in and make these payments. The assumption again would be that favorable market conditions would ensue and AIG could just sell the borrowers house and pay back the loan.
C / Compensation Structure
The compensation structures within many financial institutions incentivized excessive risk-taking. Employees were often rewarded with substantial bonuses tied to short-term financial performance. This encouraged individuals to pursue strategies that would generate immediate profits, even if those strategies carried significant risks.
II / The Catalyst
House prices in the United States reached their peak in 2006. Due to a substantial demand for houses, there was a swift increase in the supply of newly constructed homes, resulting in a decline in house prices. Some homes saw their prices drop to such an extent that borrowers found themselves in a precarious "underwater" situation, where their remaining loan amount exceeded the house's current value. In such circumstances, borrowers were more inclined to default on their loans.
As a consequence, certain mortgage bundles started experiencing significant losses, causing investors not to receive their expected payments. These investors turned to AIG for recourse, but AIG had overextended itself and lacked the necessary funds to fulfill its obligations because the depreciated house prices were insufficient to cover the outstanding loan balances.
Consequently, investors grew less interested in acquiring MBS and actively sought to sell their securities. This, in turn, resulted in depressed MBS prices with a lack of potential buyers.
Numerous foreign banks had invested in MBS as a means of participating in the flourishing US housing market. This interconnected the US market situation with financial systems and economies in other countries.
This catastrophe was marked by the bankruptcy of Lehman Brothers in September 2008. Investors rapidly withdrew their funds from banks and investment funds, setting off a state of panic in the global financial markets. A collective rush to sell assets ensued, businesses became considerably less inclined to invest, and consumer confidence plummeted. These factors culminated in one of the most severe recessions since the Great Depression.
AIG, alongside many other institutions, received a bailout from the Federal Reserve. The question of why Lehman Brothers did not receive similar assistance remains unanswered, but the Fed's concise explanation was that Lehman lacked sufficient collateral to qualify for a government loan. In total, $700 billion was requested from Congress to bail out various institutions and industries. This served as a temporary solution. The longer-term solution for fixing the financial system was implemented through the Dodd-Frank Act in 2010.
III / Fixing the Financial System
The Dodd-Frank Act was enacted in the US in 2010 as a piece of financial regulatory. It aimed to address the vulnerabilities in the financial system that were exposed during the GFC. Dodd-Frank was designed with several key objectives to create a better financial system:
Strengthening Financial Stability:
Systemic Risk Oversight: Dodd-Frank established the Financial Stability Oversight Council (FSOC) to monitor and address systemic risks that could threaten the stability of the U.S. financial system.
Orderly Liquidation Authority: The law introduced a mechanism for the orderly resolution of failing financial institutions, reducing the likelihood of future "too big to fail" scenarios and the need for taxpayer-funded bailouts.
Enhancing Consumer Protection:
Consumer Financial Protection Bureau (CFPB): Dodd-Frank created the CFPB, an independent agency responsible for enforcing consumer protection laws and regulations in the financial industry. The CFPB works to prevent predatory lending practices, improve transparency in financial products, and address consumer complaints.
Mortgage Reforms: The legislation imposed stricter underwriting standards, such as the "ability-to-repay" rule, which requires lenders to ensure borrowers have the means to repay their mortgages. It also banned certain risky mortgage practices, like prepayment penalties.
Increased Transparency and Accountability:
Derivatives Regulation: Dodd-Frank introduced regulations for derivatives markets, requiring standardized derivatives to be traded on organized exchanges or through clearinghouses, enhancing transparency and reducing counterparty risk.
Volcker Rule: Named after former Federal Reserve Chairman Paul Volcker, this rule prohibits banks from engaging in proprietary trading for their own profit and restricts their investments in hedge funds and private equity funds. It aims to prevent excessive risk-taking by banks.
Improving Regulatory Oversight:
Increased Capital and Liquidity Requirements: Dodd-Frank raised capital and liquidity requirements for financial institutions, reducing their risk of insolvency and strengthening their resilience during economic downturns.
Enhanced Regulatory Oversight: The law granted expanded regulatory authority to agencies like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to oversee various aspects of the financial industry.
Reducing Conflicts of Interest and Rating Agency Reforms:
Dodd-Frank aimed to address conflicts of interest among credit rating agencies by establishing rules to prevent issuers of financial products from shopping for favorable ratings.
Whistleblower Protections:
The law introduced enhanced whistleblower protections and incentives to encourage individuals to report violations of securities laws and regulations.
While Dodd-Frank introduced significant reforms and enhanced regulatory oversight, opinions on its effectiveness in creating a better financial system vary. Supporters argue that it has made the financial system safer and more transparent, reducing the likelihood of another financial crisis. Critics contend that it has placed excessive regulatory burdens on financial institutions and stifled economic growth. Regardless of differing views, Dodd-Frank represents a comprehensive attempt to address the weaknesses and regulatory gaps that contributed to the GFC and aims to create a more stable and consumer-friendly financial system.