What caused the 2008 recession?
The US Fed had lowered interest rates after
9/11 to keep the economy going – to ensure that money was available for very
cheap to every American. The low interest rates combined with the Fed’s home
ownership policy encouraged more people to buy houses at low interest rates. The
intentions were not bad. As a consequence, the total mortgage debt was as its
peak by 2008.
As more Americans bought homes, the real
estate market boomed dramatically in the years between 2002 & 2008. Banks
were encouraged to give away more loans as the house prices grew and interest
rates were expected to remain low.
Subprime & Adjustable Rate mortgages
It is important to link subprime loans at
this point. This was an important financial innovation that allowed borrowers
to be able to qualify for loans who would otherwise not have qualified. In
another situation, prior to the 9/11 or even today, home loans at prime rates
would strictly be given only to prime borrowers. Subprime borrowers (with low
credit score/ other factors) would get higher interest rates (subprime rates)
which would most likely dissuade them from purchasing houses.
The growing number of subprime mortgages in
the mid 2000’s should have raised a red flag as the probability of default was
very high. But as the real estate market boomed, so did the subprime mortgages
as interest rates continued to be very low.
Adjustable-Rate mortgages also became
popular at around the same time – another financial innovation that enabled subprime
borrowers to buy more houses. ARM’s or variable rate mortgages is a type of a
loan where the interest rate applied on the outstanding balance varies till
loan completion.
While subprime mortgages & adjustable
rate mortgages (ARM) were instruments that helped the real estate boom, other
financial institutions devised another instrument to profit from these
mortgages.
Step in Mortgage Backed Securities (MBS)
Banks had massive receivables which were
the mortgages being paid monthly by the subprime borrowers. The banks, with the
help of institutions like Goldman Sachs, created Securities backed by these
receivables. The banks shifted the burden forward – which explains why they
didn’t care whom they were lending to (aka subprime borrowers).
In a sense, you can imagine all these
mortgages which were due to be repaid by new home owners, bundled together in a
big box; we’re talking about hundreds of thousands of mortgages – not a few.
This big box, let’s call it MBS, is now available for investors to invest in.
They can buy and sell small portions of the box in a similar manner as they do
with the equity. The ROI is linked to the probability of defaults. If a few
people don’t pay up, it’s not a big deal. The rate of interest will be same as
the floating rate of interest (as the loans were mostly ARM). However, if a lot
of people default at the same time, the impact would be huge.
Gradually, between 2004 & 2006, the
Federal Reserve, started increasing interest rates to balance inflation. This
increase led banks to also increase their interest rates which adversely
affected:
·
Firstly, the flow of new
mortgages to home owners which affected the overall money into real estate.
With higher interests, new mortgages had dropped steeply (first graph)
·
Secondly, it affected all
adjustable rate mortgages (ARMs) as the revised interest rates were higher
(borrowers expected the interest rates to remain low but as they had signed up
for ARM loans – they were not able to repay the increased ) sending panic waves
for the borrowers; Foreclosures saw a record high
·
As a consequence of the above
two, the housing bubble began to burst.
As the housing bubble burst, so did the MBS
and other exotic derivates. Hundreds of thousands of borrows defaulted
on their mortgages which lead to investors of MBS being trapped, losing
millions of USD. The MBS cornerstone was the booming real estate – which was no
longer valid.
Step in Credit Default Swaps (CDS)
A CDS is exactly what is sounds like, a
credit derivative where a buyer takes protection against defaulting due to an
unforeseen event. Thus, the risk is now shifted to an insurance company against
periodic payments to the company (just like a regular insurance cover). As part
of the CDS agreement, the seller must (if the buyer defaults) pay the buyer the
premiums & interests that would’ve originally been paid by the buyer. This
way, the credit default payments have been swapped.
CDS became quite popular in the early 2000’s
– and by 2007 – the CDS value stood at a staggering $62.2 trillion. But by
2008, as the Fed increased interest rates and the real estate bubble burst and more
& more borrowers were not able to pay back their loans, the CDS was badly
hit. Lehman brothers, one of the worst affected, owed a total of $600 billion,
out of which 2/3rd was covered by CDS. The Fed had to intervene to bail out
their insurer.
By 2010, the CDS outstanding was only $26.3
trillion, down 57% in just 2 years.
The Consequences
Financial institutions and banks like Bear
Stearns, and later, Lehman Brothers filed for bankruptcy. As MBS, CDS and other
derivates lost value, more investors lost value sending the stock market
crashing – with households losing 19 Trillion USD in net worth. Unemployment
went to a record high, the US Bureau of Labour Statistics reported that 8.7
million jobs were lost.
What did the Fed & Government do to bring the economy
back and limit further damage?
The Fed decided to reduce key interest rates
that would inject much needed liquidity and access to cheap money – much like
they did in the early 2000’s – which fueled the housing crisis.
Monetary Policy: The Fed also issued up to a massive 7.7 trillion USD in loans to
banks in a popular policy called Quantitative Easing. Quantitative Easing
is when a central bank purchases long term assets from the market by issuing
credit. The central banks typically create this credit out of thin air – only
the Fed has the power to do this in the USA. QE is often carried out when the
interest rates are already low – the only other way to increase money supply is
to print more money.
Fiscal Policy: The US Federal government also issued a 787 billion USD in deficit
spending under the American Recovery & Reinvestment Act. This was also to
revive the economy
The Dodd-Frank Act: Apart from the stimulus packages, the government introduced the
Dodd-Frank act to give the government more power over the regulation of the
financial sector.
Some economists believe that the 2008 Recession
was caused partly due to the Glass-Steagall being repealed in 1999. Banks were
now free to engage in both commercial and investment activities.
But after the 2008 recession, the Dodd
Frank act was enacted which again meant that the same banks were now going to
be under scrutiny by the government, to protect the taxpayers and consumers.
Recovery:
The economy did recover, gradually. By
2011, GDP reached its pre-Recession level – contributed by the flood of
liquidity by the Fed.
It took a couple of years for the stock
market to reach its pre-Recession levels – almost 4 years in fact, as you can
see from the last graph. Unemployment rate gradually reduced – but unlike the
stock market, it took longer for the unemployment rate to reach 4% - 4.5% (not
until 2015).
The 2008 recession is a stark reminder of what can happen when financial instruments are abused, and financial innovations are left unregulated.
Summary:
The Fed had lowered interest rates to fuel
the economy after 9/11. In the early 2000s, subprime loans became a popular
innovation that fueled banks to give out loans to subprime borrowers
(borrowers who were more likely to default) at adjustable rates (also an
important financial innovation). The mortgage debt was at all time high by 2007
end. Banks (along with financial institutions) created MBS so investors could
invest in these mortgages backed securities. Another important contributor was
CDS, which became popular during the real estate boom.
By mid 2000s, the Fed started increasing
the interest rate to stabilize inflation. This led to ARMs increasing the rate
leaving borrowers unable to repay loans. Foreclosures skyrocketed, defaulters
increased which led to the collapse of MBS – Mortgage-Backed Securities – which
were backed by loan repayments from subprime borrowers & also led to the
collapse of CDS – Credit Default Swap – ss defaulters increased, banks were not
able to live up to their CDS agreement.
Collapse of MBS, CDS and other derivates
led to further collapse of stock market and other financial institutions that
had invested in MBS, derivates of MBS & CDS. This subprime mortgages on US
homes led to the 2008 recession.
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