The 2008 Financial Crisis
The ramifications of the 2008 financial crisis swept across the globe: millions lost their jobs, long-standing companies went bankrupt and many countries are still dealing with the fallout today.
The consequences are well established, but what exactly went wrong? For the purposes of this article one fundamental cause will be covered: poor business practices. Mortgage lenders misrepresented their products to both people loaning money and the institutions that bought those loans (more on this later). The result was a catastrophe for everyone.
Let’s start by going over some of the fundamental tenets of mortgages and leveraging.
Mortgages
Mortgages are loans that people take to buy a house. The lender repays the loan by making regular payments to the lender until the principal – the original loan amount – plus interest is covered.
The greatest risk for the lender is that the borrower will stop making payments – either because they cannot pay or choose not to. Lenders will protect themselves against this risk by assessing borrowers to ensure they are capable of repaying, and may also seize the mortgaged house (called a collateral) if repayments are not made.
Another important point is that the value of the house is separate from the value of the mortgage. Mortgages are a transaction, with both the borrower and lender looking to profit. The lender makes money from interest added on top of the principal. The borrower makes money from the value of the house rising higher than the value of the loan (the mortgage) taken out to pay for the house in the first place. The borrower may then sell the house for a profit.
These two simple concepts are a root cause of the financial crisis:
Lenders should only loan money to qualified borrowers who can repay
The value of a mortgage is static while property values are dynamic
Leverage
Leveraging can be summed up as the practice of borrowing money in order to make more money. For instance, banks make a profit by borrowing money – the money held in bank accounts are technically loans to the bank – and lending it to others. Since these borrowers pay a higher interest rate then the bank pays on its own loans, the bank makes a profit.
Of course, the bank also has its own money that it can lend out. But if it only lent out the money it has on hand, it would not be able to make as many loans – less loans means less profit. That is the power of leveraging: by borrowing money, the lender can make a greater profit then they otherwise would have (even after accounting for interest cost).
Leverage operates on the assumption that transactions work as they are intended to. If something goes wrong – the borrower does not repay – the bank will not only make a loss, but will be short of money that must be repaid. A bank that uses too much leverage could be forced into bankruptcy if too many people want their money back.
Prime Mortgages
Initially the mortgage market operated as normal. People took out loans from mortgage lenders and dutifully repaid them over time. Lenders would screen these people beforehand to ensure they were capable of repaying. Thus mortgages were only lent to qualified people – known as prime mortgages.
The housing market at the time was booming: prices were rising, interest rates were low and demand was growing. This gave the mortgage lenders an idea. Instead of collecting the mortgage repayments themselves, they could repurpose the mortgage as a financial product and sell it to banks.
In other words, mortgages became an investment; institutions bought them with the promise that they would provide a steady stream of income and a good return. The income would come from homeowners repaying their loans. Meanwhile the mortgage lender would make money from fees attached to the selling of these products.
Using a similar philosophy, the bank bought these mortgages and repackaged them into financial products known as Collateralized Debt Obligations, or CDOs. The CDOs were then sold – again with a fee attached – as investments to financial institutions such as pension funds and hedge funds.
These CDOs became very popular as investment vehicles. Everyone involved – the mortgage lender, the banks and investment funds – got a good return on their money and wanted to buy even more CDOs. Soon demand began to outstrip supply: investors wanted more CDOs, but everyone who was qualified to own a mortgage already had one.
The Subprime Mortgage Crisis
In an effort to create more mortgages to sell, mortgage lenders began lending to unqualified borrowers. These were risky loans given to people who were unlikely to repay them, known as subprime mortgages.
Why would mortgage lenders do this? Normally lenders have an interest in ensuring that a borrower is able to repay. But since these mortgages were meant to be sold to someone else, mortgage lenders no longer cared if the loan was actually repaid; if the homeowner defaulted after the mortgage was sold, then it was someone else’s problem.
Subprime mortgages were essentially bad loans disguised as credible investments – often because they were misrepresented by the people selling them. As these mortgages permeated through the financial system – from mortgage lenders to banks and investment funds as explained previously – it was only a matter of time before the system began to unravel.
The Housing Market Collapse
Homeowners began to default on their mortgages. Initially the lenders were able to recoup their losses by seizing the house and putting it on sale – the “collateralized” part of CDO. But as an increasing number of homeowners defaulted on their loans, more and more houses were put on sale. Housing prices began to drop due to the oversupply of properties on the market.
This created a problem for the homeowners still paying off their mortgages. As I have mentioned earlier, the value of a mortgage is separate from the value of the house itself. Falling housing prices soon meant that the value of a house went below the value of the mortgage taken to pay for it; essentially the house was now no longer worth the payments that homeowners were obligated to make.
Homeowners responded by simply walking away from their mortgages. Default rates for mortgages – both prime and subprime – shot up, which in turn affected the CDOs held by financial institutions. CDOs were bought with the promise that homeowners would provide steady income; however as people defaulted on their mortgages, this flow of income soon dried up.
The Credit Crunch
The result was a catastrophe for everyone.
The banks were now holding on to worthless CDOs that they could not sell; the investment funds had caught on to the scheme and knew that the CDOs would not provide any income. This was an especially dangerous situation for banks because they were leveraged – they had borrowed money (sometimes in the billions of dollars) to buy these CDOs, hoping to make a profit – and no longer had the money to repay.
Meanwhile mortgage lenders were now holding on to dangerous subprime mortgages that the banks would no longer buy. Investment funds were in trouble too: they had already invested millions of dollars into these CDOs and now they were worthless. Since investment funds manage the assets of other people, this meant that pensioners and other investors also lost their money.
The financial system began to implode. Banks that had invested heavily in CDOs began to fail, such as Northern Rock in the UK followed by Bear Stearns and Lehman Brothers in the US (Bear Stearns was actually bailed out, but that is a story for another article). As the banks went bankrupt, individuals and companies that held accounts at these banks also lost money; like a set of dominoes, businesses went bankrupt and panic ensued.
The repercussions spread across the world, often in unforeseen ways. People around the world lost their jobs as companies closed down overseas factories; many international banks stopped lending money and the credit system froze. Some countries went bankrupt (Iceland) while others are still dealing with the repercussions today (Greece).
