2007-2008 financial crisis summary

The 2008 financial crisis was a global crisis triggered by low interest rates in the mortage market,
eventually causing a housing bubble that popped.

Definitions related to the crisis are mentioned in the glossary and numbered in increments of 1.

There were 4 main reasons as to why the market crashed in 2008:

1. The devotion to the Efficient Markets Hypothesis(1) led investors astray, causing them to
ignore the possibility that securitized debt(2) was mispriced and that the real-estate bubble
could burst.

2. Wall Street compensation contracts were too focused on short-term trading profits rather than
longer-term incentives. Also, there was excessive risk-taking because these CEOs were
betting with other people’s money, not their own.

3. Investment banks greatly increased their leverage(3) in the years leading up to the crisis,
thanks to a rule change by the U.S. Securities and Exchange Commission (SEC).

4. Credit companies such as Standard and Poor misrepresented the risk attached with mortgage
backed securities

Events and analysis:

• It is interesting to note the effect of the dot com crisis on the 2008 crash. In 2000 and 2001,
after the dot com crisis(4) the US government was fearful of another recession. To keep
recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in
May 2000 to 1.75% in December 2001. This was highly beneficial for liquidity in the economy,
and general cash inflows. What was detrimental was that due to extremely low interest rates
everyone started to pounce on the opportunity to take out loans, even when they couldn’t afford
it. These loans were of course appealing when they didn’t even have significant down
payments.

• It is interesting to note the role of credit agencies in the 2008 financial crisis aswell. Prime
mortgage securities at the beginning were issued by Fannie and Freddie enterprises sponsored
by the federal reserve: these were generally considered safe by money managers.However, non-
prime private label mortgage securities were neither made up of loans to borrowers with high
credit ratings nor insured by a government enterprise, so issuers used an innovation in
securities structure to get higher agency ratings.They kept pooling debt and quickly divided
these securities into tranches, which each had its own stream of revenue. The senior tranches
with the most revenue got the highest AAA rating. Members in the securitization industry had
quickly realised that they needed AAA ratings so as to offer these securities to financial
specialists. Venture banks in this manner paid attractive expenses to the rating agencies to
acquire the ideal appraisals. This meant that people that were relying on Standard and Poor to
assess risk and product quality(of security) were blindly trusting the securities and pooling their
money into these same failing securities.

• Come 2003, the government kept slashing interesting rates and they now stood at 1%, the
lowest rate in 45 years and of course more loans followed

• Also in 2003, banks decide to repackage these low interest loans into collaterized debt
obligations (5)

• Soon enough 2004 was here, the Securities Exchange Commissions decided to relax the net
capital requirement, which is the amount of liquidity a bank must have at a certain point. This
was done for Lehman Brothers, Morgan Stanley, Bear Stearns, and Merrill Lynch. This allowed
these banks to leverage up to 30 or 40 times their initial investment, this meant that they were
 using even more borrowed capital in asset investments. Why was this detrimental? These banks
were now increasing monetary risk without any safety net to fall on in terms of liquidity. If an
asset you purchased with cash falls in value, you can only lose as much as you spent: and in
most banks’ case in the financial crisis, the homes and the mortgage backed investments they
had made were only falling in value, hence their leverage up to 30 or 40 times was now
increasing even more bank debt.

• June 30,2004 onward the government started realising they were lending money to people that
simply couldn’t pay. They now decided to raise the interest rates on loans to disincentive more
of the same people to take loans. By June 2006, the Federal funds rate had reached 5.25%.
This interest rate stayed stagnant till August 2007. What policy makers failed to realise was that
now it would be even more difficult to get the money back for the loans they had already given.

• By 2004, home ownership had peaked at 70%, and the demand that was increasing in the
house market was now exhausted because of high interest rates employed in June 2004.
Gradually, supply increased. Supply and demand were now in equilibrium, eventually slowing
appreciation of homes. Home investors soon figured the risk and started selling out, which
caused a chain effect with other buyers making them also sell. Mortgage backed securities were
now being sold off in mass, hence mortgage defaults and foreclosures rose to significant levels.

• Defaulting mortgages in 2004 now had become the elephant in the room. The value of the
homes that banks had financed were now excruciatingly low, for example if a bank like Lehman
brothers had given a loan for a house costing $100,000 initially, it had dropped to $30,000.
Most of the houses the banks had loaned out, were now the bank’s responsibility due to
mortgage defaults. Now banks could not even liquidate these assets as there were little to no
buyers. This not just took a toll on mortgage backed securities, but also the reserves banks had.
Investment had reached new lows because banks were crippled with monetary debt as very
less loans were being paid back(so no interest rate gain). They also did not have many plans of
recourse as other banks were afraid to lend to other banks, fearing they would run out of
liquidity sources themselves. Investment was now extremely low in the market and there were
more sales than buys in the market to gain more liquidity , the DOW started to crash
significantly.

• Financial firms and hedge funds such as Bear Sterns and Merrill Lynch owned 1 Trillion dollars
of failing mortgage backed securities as of 2007. This caused a global crisis in context of
mortgage backed securities. Merill Lynch soon seized 800 million dollars in assets from two
Bear Sterns hedge funds, because bear sterns had stopped redemptions in two of its hedge
funds.  In essence, bear sterns was not making any repayment of money market fixed-income
securities at or before the asset's maturity date. Bear sterns could not afford to accommodate
redemptions as it was in a liquidity crisis itself, accommodating redemptions would mean they
would be losing a big part of their not so growing liquidity(Bear sterns owned 100s of billions in
failing mortgage securities already). As mentioned before, banks were afraid to lend to other
banks hence bear sterns didn’t have a choice.

• August 2007, the interbank market freezes completely, largely due to amidst fear of unknown
banks tied in the same crisis. Northern Rock, a British Bank approached bank of England due to
a liquidity problem. So we can see that the crisis had spread to Europe aswell.

• Come 2008 governments all over the world started to coordinate in an effort to increase
liquidity. This was done to revive the interbank market, as that was the toppling factor for
multiple economies.

• However, Lehman Brothers filed for bankruptcy, and Bear Sterns was taken over by JP Morgan,
and Merrill Lynch was taken over by Bank of America. Huge banks were now toppling.

• By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%.
Central banks in China, England, Canada started doing the same in order to get liquidity and
cash flows in the economy.

• Come December 2008, the fed had cut interest rates to 0%, aiming for more liquidity in the
economy.

• The US government then came out with a 700 Billion Dollars bailout. It bought mortgage backed
securities which caused the entire crisis, and it also bought distressed assets or toxic assets.

Glossary:

1. Efficient markets hypothesis: The efficient-market hypothesis (EMH) is a hypothesis

2. Debt securitization is the process of packaging debts from a number of sources into a single
security to be sold to investors.

3. Leverage is the process of using someone else’s money and investing it

4. The dot-com bubble was a stock market bubble caused by excessive speculation in Internet-
related companies in the late 1990s

5. A collateralized debt obligation (CDO) is a collection of pooled assets that generate income,