By Shubham Goswami
In 2008, the world was witness to the greatest catastrophe in economic history. The crash of September 2008 brought about the world’s biggest bankruptcies, pulled over 30 million people to unemployment and pushed many countries to the edge of insolvency. Trillions of dollars of wealth were lost. It was the Financial Crisis of 1929 revisited.
Let us take a look at the real reasons behind this colossal meltdown.
‘Helping’ Every American Own His Dream House Was NOT Cool:
The culprit of the 2008 debacle seems to be the easy lending of the US housing market. The U.S. housing market was undergoing a major makeover. Interest rates were very low and so was the government regulation of those rates.
Virtually any Joe would qualify for a housing loan. Eerily, banks decided to be overwhelmingly lenient in providing loans. And guess what? There was no scrutiny of whether the borrower would be able to repay that loan. Financial institutions like Ameriquest went to the extent of providing what was called ‘Subprime’ loans to people who were ill-equipped to repay.
“Greed is good”: Decided the American Mortgage Companies –
Banks and Mortgage companies were investing in fraudulent practices to pump up their business. They sold complicated loans to low-income persons who were unaware of all the clauses of the loans, even if they included low teaser rates that would automatically ‘reset’ to higher values after a few months. Mortgages were provided to retired people, who were on a fixed income. While their income would never increase, the interest rates would!
The boiling question: WHO WAS GOING TO PAY THOSE LOANS?
The Public and Private Views of the Market Were NOT The Same:
The key players in the housing loan business like millionaire Angelo Mozilo were aware of the toxicity of the loans that they were providing. But they resorted to masquerade and reassured their customers, investors and rating agencies that their products were really altruistic! This exacerbated the situation.
From Mortgage Loans to Financial Securities: A rapid chemical reaction:
The mortgages were bundled with various other loans and moved to Wall Street where they were packaged into complex new financial products.
The mortgage market seemed to be a perfect one. Every participant, from the lender to the stock broker made a fortune. It was orgasm for a money-minded financier. But in reality, a cancerous product had been injected into financial institutions across the world.
The Financial Deregulation Bandwagon:
Privatisation was the new sexy. Canada, London and Iceland soon eased regulation. As in the United States, housing booms were triggered in these countries too.
The Financial Time Bomb Explodes:
Financial institutions like BNP Paribas soon noticed that many of their investment funds were filled with toxic financial securities that depended on the US housing market. Soon Bear Stearns, one of the top American investment banks felt the first tremors of the impending calamity, as it faced liquidity problems. But the greatest damage to the world economy came when Lehman Brothers went bust; ruining several people, whose savings and pensions depended on it. A firm which existed since 1850 and had survived the Great Depression of 1930 went bankrupt overnight.
The Subprime Crisis and Lehman
The housing market had two protagonists:
A: The Lender (Investment banks like Lehman)
B: The borrower
B borrows money from A in order to buy a house and is supposed to repay his loan to A at a certain interest. So far, so good.
Enter C, the credit default swap or CDS. These include the Hedge Funds that bear the risk involved in the transaction between A and B.
A and C bet money on B. Incase B turns out to be a defaulter, A gets its money back from C. If B repays, however, C makes money.
Now zoom out a little. Somewhere there are players D and E betting on C. Thus begins a whole chain of betters who bear a part of the risk involved in the initial transaction.
The problem in 2008 was that too many letters were linked to the initial transaction between A and B. Once the Bs started defaulting the system collapsed. The Cs were out of money. The floating cash had been replaced by houses! And the As (like Lehman) had to bear the brunt of it.
The bankruptcy of Lehman swept the globe, destroying jobs and wiping out the economic future of entire countries. It was a chain reaction that started with unrestrained lending in the housing market and slowly grew into a Tsunami that devoured the world.
Image Credits: Google Images
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Views presented in the article are those of the author and not of ED.