Introduction
In this blog, I’ll try to explain the events that led to the 2008-2009 financial crisis or the 2008 Stock Market Crash.
The Great Recession of 2008
The Great recession refers to the global economic trumoil that occurred between 2007 and 2009. This led to a loss of almost trillions of dollars and affected the lives of many people directly and indirectly. It led to a lot of people losing their jobs and investors loosing their investments. The global recession started in the United States during 2008. It began with the bursting of the United States housing bubble in 2005-2012. To understand what led to the housing bubble burst, we need to understand some complex macroeconomic terms. Let us try to understand them one by one and follow through to the entire story.
Mortgage Backed Security (MBS)
Securities refer to a tradable financial asset. For example in the case of stock market a stock is a security. For a company, it’s stock is backed by it’s fundamental value. Similarly, mortgage backed security refers to the security derived from mortgages (mortgages support or back this security). Mortgage is a term used to refer to home loans. This MBS or Mortgage Backed Securities were used as a financial asset by the investment bankers in the US. MBS was seen as a high fixed income low risk investment asset. To get a better understanding of how this was used as a financial asset, let’s take the following example.
Suppose we have a large sum of money and want to invest it, some of the options available to us are either depositing it in an FD (low returns) or investing it in mututal funds or the stock market which is said to be high risk but gives a high return. It is during this time that a bank contacts us and says someone has taken a loan from this bank for building a house with his land as collateral. He has a good relationship with the bank and is said to repay the loan. There is a contract between the bank and this person where the person pays a fixed interest to the bank for a given time period. The bank proposes an investment option to us where the contact between the bank and this person will be transferred to us, but we have to pay the lumpsum amount that he has taken as loan to the bank. The amount paid by the person will be transferred to us (he will be paying an average interest of 10-12%). The banks benifit is the fees during the transactions and the amount paid as loan returned very easily.
Applying this example to a large scale, where a bank gives home loans to a large number of credible people and collectively pool them into a security/contract and sell it to us as an investment option. The bank will also rate these loans through a credit rating agency. Bank gurantees that all these are AAA rated loans. Since there is a credible bank which only issues loans after doing all verification and a credit rating agency which cross checks it and gives it a rating, the security provided will be a very safe option for investing. Even if the loan somehow defaults (ie, the person doesn’t pay the loan) we have the property as collateral and the bank will sell this and pay back our investment money.
Who came up with MBS
This idea of using Mortgage Backed Security was introduced by Investment Banks in the US. In the whole process the Bank which issues the loan can be termed as Lender. The person who invests the money is the Investor. The person who takes the loan is the Borrower. The whole process is facilitated by Investment Bankers. When the investment banks were analysing the market, they could see that there were a lot of lenders issuing loans. Once they issue the loan, the lender has to wait till it is repaid. So, instead of the loan sitting idle with the lender, the investment bankers came up with an idea of giving these loans to the investors and thereby generating benefits for both the investors and lenders and in this process some commission to the investment banks.
- The lenders benifited from this as once they sold the loan to the investment banks who inturn sold it to the investor, they would get the whole loan amount back and could issue another loan with this money.
- The retail investors saw a high income low risk investment opportunity in the MBS.
- Investment banks collected a fee from both the lender and investor thereby earning money.
This was a win-win situation for everyone. However, like every good idea there were some chances of failure in this idea as well.
How did the MBS Collapse
In the year 2000, there was a dotcom bubble burst in US which led to a crash of the stock market and a lot of companies went bankrupt. In the early 2000’s there were no investment oppportunities for retail investors as the stock market had crashed. The good investment option available were US treasury bills where investors could only get low interest rates. To revive the market, the interest rates issued by banks was reduced and thus a lot of people started taking loans to build houses. There was a housing boom in the early 2000’s as a lot of people started to build houses and the real estate prices went up. Retail investors saw the real estate as a good investment opportunity. Lenders could get more transactions as a lot of people were taking loans for building houses. Investment bankers identitied an opportunity in the increasing loans issues by lenders and the investment interest of retail investors in real estate. Investment bankers went to lenders and started purchasing the loans from them. They collected and pooled these loans to form Mortgage backed securities and started selling them to retail investors. Investment bankers benefited most from this opportunity. As more and more retail investors wanted to purchase MBS, the investment bankers introduced new something called CDO (Collateralized debt obligation).
CDO is a financial security consisting of MBS, vehicle loans, personal loans etc. Even after issuing CDO’s the surge in retail investors wanting to invest in MBS did not stop. However, there were limited number of MBS. So the investment bankers went to the lenders and asked them to issue more loans, through which they could create more MBS and sell it to retail investors. Lenders would also only benifit from this so they started giving loans to everyone without doing proper background check, credit ratings, and whether the person would be able to repay the loan. Due to the pressure from investment bankers lenders started giving loans to ineligible people. This inturn led to low quality loans being pooled into MBS and being sold to retail investors. These low quality loans were termed as Sub Prime Loans. The credit rating agencies were paid by investment banks to give AAA rating to the sub prime loans. So, even very low quality loans were sold to retail investors as AAA rated loans. It was during this time that certain insurance firms came up with Credit Default Swap (CDS). Credit Default Swap was an insurance introduced on CDO’s and MBS’s by certain insurance and financial companies. People would pay a premium as insurance on the MBS and CDO’s purchased from investment bankers to insure them incase of failure. As MBS and CDO’s were seen as the most safe investment, the insurance companies never though that they would fail and thus would get a lot of profit by selling CDS. Companies like AIG started selling CDS. Some of the retail investors started buying CDS. Things went up even higher when people started using CDS as a trading instrument - based on how the prices of MBS and CDO’s moved people started betting using CDS. Billions of dollars started flowing through the market based solely based on these MBS and CDO’s. As time went by, most of the loans inside the MBS were sub prime loans that would default for sure. Most of the sub prime loans were issued on a variable rate of interest ie, the interest rate increases by each year. People were unable to repay these loans. In the 2007-2008 period, the loans started to default one by one so, the lenders sold the collateral ie, the property and started giving back the money to retail investors. But as the defaults started to increase, so did the number of houses to be sold. As the supply of houses to sell increased and demand stayed the same, this led to decrease in real estate prices. So, even after selling the houses they could not pay back the retail investors.
As the prices of real estate started going down, the people who took large sums of loans to buy the houses could see that their house wasn’t worth the amount of loan taken to purchase them (Even selling the house couldn’t repay the loan). So a large amount of people started to stop repaying loans and this led to a large scale default of home loans/mortgages. Thus, the value of Mortgage backed securities went to 0. Retail investors lost 100’s of billions of dollars. The ones most affected by this were the investment banks who had purchased a large amount of loans to make the MBS and CDO’s. Even though they sold many of them to retail investors a large amount of the MBS holding were with investment banks. The money used to purchase loans from Lenders was also mostly other loans. The investment banks had a lot of outstanding loans and MBS assets which had 0 value. They had a liquidity crunch. The insurance companies who issued CDS also were affected as they had to pay the insured sum to the people who purchased the CDS because the MBS had failed. This was when the problems came to limelight and was identified as a major issue. It started affecting banks, investment banks, housing market etc. As the banking system crashed it started affecting the US economy as a whole. Banks couldn’t issue loans and thus businesses were affected. This led to the stock market crashing and people going jobless and homeless. The US economy crashed and thereby led to a global recession.
Conclusion
In simple terms, a person wanting to build a house took a housing loan from a bank. Seeing this process as profitable to many instruments, a lot of things like MBS, CDO, CDS were derived from these loans. These became the biggest things in the economy. A failure to pay back the loan led to the collapse of all the things related to this. Imagine this on a large scale and that is how the housing market bubble burst in the 2008 thereby leading to a global recession.