India Markets closed

Revisiting subprime crisis: The triggers

Subprime meltdown in 2008 that rattled economies all over the world was primarily a result of two things – people’s insatiable thurst for home buying and bankers greed for money

In a couple of days from now, nine years back in September 2008, investment banking giant Lehman Brothers, filed for bankruptcy. It is known as the largest bankruptcy filing in the US history. The news sent the financial markets across the world into a tizzy in no time and by afternoon central banks of countries worldwide were busy thrashing out a solution to stem the free fall in the markets.

What the world saw after that was a protracted recession – second in magnitude only to the Great Depression of 1930s – that robbed millions of their jobs and savings and cost the world 10 trillions of dollars in losses.

So what led to Lehman Brothers, once an apogee of free market capitalism, roil economies and vanish from the global financial stage forever?

To find out, we need to go back another eight years, when circa 2000 the dotcom bubble, fuelled by investors betting big on new technology being developed, particularly online retailing that was emerging then, burst owing to many startup companies going bust. This triggered a mild recession.

Soon enough, the economy took another hit from the terrorist attack on the World Trade Centre, which annihilated the two buildings – tallest in the world then, and killed over two thousand people in September 2001. Concerns over a retaliatory war with Afghanistan (already the nation was in a full-blown military conflict with Iraq in the Middle East) took toll on the stock markets. And with the war eventually happening, resulting in bloated defence budgets, the recession deepened.

To stem the economic malaise, the Federal Reserve (central bank of the US) resorted to multiple interest rate cuts from 2001 to 2003 so as to induce households to borrow money to buy. The spending spree was slated to revive manufacturing and other sectors, which would subsequently spur the economy.

The biggest beneficiary of this rate cut, however, turned out to be the housing sector. With record low interest rates, applications for mortgage loans (those in which the property serves as the collateral) spiked. This, in turn, drove up home prices dramatically – it almost doubled in five years’ time after the rate cut.

And in this way, the stage was set for the next bubble, potentially even more dangerous for the economy.

Cashing in on the home-buying frenzy, some banks extended mortgages to those who wouldn’t otherwise qualify for traditional loans on account of poor creditworthiness or other factors. These loans were termed as subprime.

While initially the rates were kept affordable for such subprime loans to draw prospective home buyers, eventually they were increased drastically. Borrowers not in a position to make the higher payments once the initial grace period got over, were planning to refinance their mortgages after that to take advantage of the appreciating home prices.

The record low interest rates and consumers’ insatiable hunger for mortgages soon usurped the traditional banking model and gave rise to what is known as the “securitization food chain.” While in a traditional banking system home loans would be sanctioned carefully after a thorough background check, under the securitization food chain, banks no longer cared.

This is because of complex financial instruments created by investment banks that by all appearances, helped to mitigate the risk arising from indiscriminate lending to those with poor credit history. Those instruments, called Mortgage Backed Securities (MBS), worked something like this:

Banks would sell the mortgages of their clients to investment banks. These investment banks would then pool the mortgages, credit card debt and student loans and repackage them into what was called collateralized debt obligations (CDO’s), which is a type of MBS. These CDO’s were sold to investors all over the world based on their individual risk appetite. Essentially, investors in CDOs were supplying the loan amount to home buyers and were earning money off the interest payments of the latter.

In this manner commercial banks were passing on their risk to investors and bringing down liabilities on their balance sheets. Moreover, investment banks where making enormous profits by selling these CDOs to investors all over the world. Their executives were driven by near-term sales and bonus targets, and did not spare much of a thought about profitability and sustainability in the long run. And here is where the seeds of downfall were sown.

Lenders felt, in a worst case scenario when borrowers defaulted, they could always sell the house for more, since increase in home prices were showing no signs of letting up.

Investors in CDOs ranged from governments, common people and pension funds to commercial and investment banks themselves as well as hedge funds. In a low interest rate environment when treasury bills were giving just 1 percent returns, they lapped it up to make more money.

Insurance companies such as American Insurance Group (AIG) were key participants in the securitization food chain too. They insured theses CDO’s through credit default swaps (CDS) to protect the investors from losses in the event of a default with a lump sum payment.

Credit rating agencies such as Moody’s, Fitch’s Ratings and Standard and Poor’s were a part of the mix as well for they were paid by investment banks to give such complex and risky derivatives the highest rating, which implied they were safest bets.

With soaring home prices, high-risk mortgage borrowers who found it difficult to repay loans completely, sold their homes at a gain, paid off their mortgages and even made a profit. Some borrowed more against higher market prices hoping to rake in more moolah later. This was a ticking time bomb.

There was a construction boom in response to the heightened demand but this soon flooded markets with excess of units, bringing prices down. This coupled with an increase in interest rates to tame inflation in the economy resulted in defaults on mortgage loans, starting in 2007. Consequently, more houses were back in the market for sale and prices plummeted even more.

Home foreclosures rose as risky loan candidates were no longer able to refinance their houses to settle their mortgage debts or make higher monthly payments. Those who had the means to pay higher rates also walked away from their houses as it made no sense paying the high interest rate and principal when the prices for the homes had come down.

Big financial institutions stopped buying subprime mortgages to save themselves and subprime lenders were stuck with bad loans. The latter started filing for bankruptcy and MBS issued by them had their ratings downgraded to high risk.

Big investment banks and financial conglomerates couldn’t get off the hook either, despite having stopped lending to banks offering subprime lenders. The contagion spread and took down banking powerhouse Lehman Brothers in 2008, which then became emblematic of the excesses of capitalism and all that is wrong with it.

Other big institutions that paid the price for the subprime crisis they caused were AIG (it sold tens of billions of credit default swaps without money to back them up when things went wrong) and government sponsored Fannie Mae and Freddie Mac (in order to achieve government mandated targets of increasing home ownership, they had dealt in subprime mortgage-backed securities too) were seized by the federal government.