Blog

A Decade Review: What was happening in 2008?
By admin March 23, 2018

 

In 2008, the world was experiencing the largest and most destructive financial crisis since the Great Depression. This financial crisis was triggered by the bursting of the housing market bubble in the United States which caused serious consequences both in the US and around the world. The aftermath of the financial crisis included the Dow Jones Industrial Average index dropping roughly 8000 points; the bankruptcy of Lehman Brothers, a prestigious financial entity; and, government bailouts for thousands of companies such as AIG, GM and Chrysler. Across the Pacific Ocean, the government of China had to provide 4 trillion RMB to sustain its economic growth rate. Several years later, people finally understood what was going on in 2008 to cause the Great Recession. It is a story about profit-chasing and overconfidence.

From 2001 to 2005, the United States housing market had experienced its golden age. The prosperity of the US housing market could be largely credited to the extensive use of Mortgage Backed Securities (MBS) and Collateralized Debt Obligations (CDO). MBSs can be seen as a package of mortgage loan contracts, each of which has its own rating. To understand MBSs, there is a need to pay attention to the rating system of mortgage loans. For instance, if someone has a perfect job, which not only covers their monthly bills but also allows them to save a great amount of money each month banks believed that the possibility for them to breach their mortgage loan contract was extremely low so the contract would be rated as AAA, or the best quality contract. Then, another person has a lower paying job, barely covering their monthly bills and would still be given a mortgage loan contract but theirs would be rated from A to B. Surprisingly, people who might have trouble of sustaining their monthly payments still accessed to mortgage loan contract at the time. This type of contracts was rated as BBB or as a “subprime mortgage loan contract.” MBSs have their own rating system too. The more AAA contracts that a MBS included, the better its rating was. For example, if a MBS contains 65% AAA mortgage loan contracts, it will be rated as AAA.

Banks love MBSs because it not only significantly improves the banks’ liquidity but also reduces the risk of default. Here is how MBS works. Think of a micro bank that only has 1 million U.S dollar to lend. In the past, banks are the end user of mortgage loans. Using this micro bank as an example, in the past, if one person signed a $1 million mortgage loan contract with the micro-bank, it would transfer $1 million to this person in a short timeframe and wait for the monthly payments for the next 20 or 30 years. Once doing this, the bank could not sign another contract for a period of time due to the lack of money to lend. With MBS, everything changed. Now, if one person signs a contract with this micro bank, it will give them $1 million like before, but it immediately sold the contract to bankrupt remote trusts such as Fannie Mae and Freddie Mac with a 2% service fee as well. The bankrupt remote trusts would then sell these MBSs to investors such as hedge funds. Then, the micro bank could start to identify another client immediately because it now had 1 million and 20 thousand dollars cash in hand.

But what if a bank could not find enough AAA contracts to form high quality MBS? The short answer is: bundle the rest and call it CDO. In the US housing market, a typical CDO contains hundreds of or even thousands of A, B or BBB level mortgage loan contracts. Surprisingly, this type of CDO can still be rated as AAA. This is possible because logic that banks used is that even though the possibility of a single contract to default is high, the possibility that all the contracts default is low. Unfortunately, their logic ended up proving to be over confident.

MBS and CDO also brought potential moral hazard problems. Slowly but surely, banks realized that the financial situation of their clients does not really matter. What matters was the number of clients. Profit-chasing instinct impelled banks to issue a great number of sub-prime mortgage loan contracts from 2001 to 2005. Meanwhile, banks claimed that most of the MBSs they sold were AAA level. Mediators such as Fannie Mae and Freddie Mac believed what banks said. Investors believed what Fannie Mae and Freddie Mac said. And all three rating organizations, Standard & Poor’s (S&P), Moody’s, and Fitch Group, all supported the banks’ conclusions because they were afraid of losing clients and revenue.

When investors realized that those MBSs and CDOs were not as good as they were supposed to be and the bubble in the housing market was about to burst, it was too late. Then the housing market and the financial market collapsed. People not only in the United States, but all around the world suffered. Somebody called this financial crisis a system failure but the question remains if it was rather due to overconfidence and profit-chasing.

For more information:

http://arno.uvt.nl/show.cgi?fid=129767

http://pages.stern.nyu.edu/~sternfin/pschnabl/kacperczyk_schnabl.pdf

https://www.thirdway.org/memo/your-cheat-sheet-for-the-big-short

https://www.theguardian.com/business/2008/dec/28/markets-credit-crunch-banking-2008

https://www.thebalance.com/auto-industry-bailout-gm-ford-chrysler-3305670


Thanks for sharing !


Comments are disabled.