It is said that a mix of near zero interest rates resulting in a home-buying frenzy and greed of bankers for hefty bonuses that made them lose sight of the long-term sustainability of the system, triggered a global recession in 2008.
It began with dozens of banks collapsing and Wall Street firms and hedge funds that dealt (either sold or invested) in risky Mortgage Backed Securities (MBS) incurring enormous losses. While the US financial sector took the first hit, soon enough the global economy was staring at a downturn too.
The events unfolded somewhat like this: Stockholders who learnt about the bad loans immediately withdrew their money from the stock markets. As a result, markets nosedived worldwide. The Dow Jones Industrial Average in the US, for example, shed almost 33 percent in 2008.
Overburdened with bad assets and desperate to hoard cash, banks stopped lending – even to those with a good credit history and healthy businesses or other banks. The markets effectively dried up. Subsequently, manufacturing received a hammer blow and unemployment started rising. This brought down investments and demand for goods within the US. Soon enough, the contagion spread and reverberations were felt in far flung countries, almost two continents apart.
But, it was Europe that bore maximum brunt on account of its exposure to the real-estate linked securities in the US and also because of the vices of its own banking system and lax governance. From London to Berlin, faltering banks had to be rescued everywhere in Europe, which plunged into a deep recession after that.
Other nations having trade and finance linkages with the US were affected too, as their exports to the US declined. In China, for example, the manufacturing sector received a blow when US demand slowed drastically. Thousands of migrant workers lost their jobs.
All of this served to crimp growth worldwide. Things got harder and harder as almost every sector got affected.
Cement and construction materials were the first casualties of the tapering off of the construction boom resulting from the subprime meltdown. Other affected sectors were automotive, mining, travel and tourism, home furnishings, and even newspaper and printing. In fact, automotive behemoths Chrysler and General Motors had to be bailed out just like the investment banks on account of car sales tanking considerably on the back of rising joblessness.
Meanwhile, to stave off a full-blown crisis, the US government had already injected about $200 billion into mortgage giants Fannie Mae and Freddie Mac to help them cope with mortgage default losses. It coughed up another $85 billion to rescue American International Group (AIG) as it was considered too big to fail – numerous institutional investors were either invested in or insured (investment banks which had their CDOs insured by AIG were at the risk of losing millions of dollars) by AIG.
The government bought toxic debt plaguing banks to prevent them from collapsing. Overall, such bailouts and similar other programmes ran into trillions of dollars of taxpayers. The Federal Reserve also cut the key interest rate to 1 percent to stimulate the economy. It refused, however, to rescue Lehman Brothers which acquired by Merrill Lynch, Nomura and Barclays. Many other weaker and smaller banks such as Bear Sterns were gobbled by bigger players, which in effect, made the banking sector in the US more concentrated post the crisis.
While the aforementioned stopgap measures were undertaken by the government to calm down jittery markets and prevent the recession from spiralling out of control, other long term measures were undertaken as well to overhaul the banking system and prevent a repeat of such a large-scale financial fiasco.
Rules were framed requiring financial institutions to hold larger amounts of better quality capital. Prior to the crisis, capital requirements for banks were low and the assets which met regulatory requirements were of low quality. This left banks vulnerable and unable to weather risks they undertook or absorb losses that follow.
Further, institutions involved in malpractices that served to precipitate the crisis were probed – from big banks of the likes of Royal Bank of Scotland, Goldman Sachs, HSBC, JPMorgan, etc., to rating agencies of Moodys’ and Standard and Poor’s. Most of them were fined huge sums.
Goldman Sachs was said to be selling CDOs on one hand and simultaneously betting against those by buying CDS (Credit Default Swaps meant to cover losses incurred on account of investing CDOs in case of foreclosures). Government sponsored mortgage giants Fannie Mae and Freddie Mac also came under fire for encouraging loose lending standards.
Spotlight fell on other unhealthy banking practises too such as the astronomical bonus packages doled out to banking executives. It is said that nine of the financial firms that received most of the federal bailout money, paid their traders and bankers bonuses of over $1 million each in 2008.
Under pressure from regulators, some of the banks did put rules in place to hold traders and managers responsible for losses and compensate for it. But, those were too insignificant to make a real difference in the system.
And now, 10 years on from the start of the subprime meltdown, the banking industry is still not said to have recovered and things remain little changed when it comes to unhealthy practises despite more regulations in place.
Our former Reserve Bank Governor Raghuram Rajan, who was chief economist of World Bank between 2003 and 2006, had warned about the pitfalls of having complex financial instruments such as MBS and CDS way back in 2005. And he was not the only one. A lot of other world renowned economists felt and expressed the same as well. But no one took them seriously, until it was too late.