2008 Financial Crisis (Subprime Crisis) : The Housing bubble burst
The crisis that shook the global economy and led to a worldwide recession.
Have you watched the Oscar winning movie The Big Short (2015) directed by Adam McKay? I am sure you must have, but the complexities involved in financial crisis must have led you to some confusion like what is Collateralized Debt Obligation (CDO), What is Credit Default Swap (CDS) and what is Mortgage Backed Security (MBS) and a lot more. In this article, we will decode the causes of this financial crisis and know what grave repercussions it had on the global economy.
So let’s start understanding this financial crisis, but before that, we have to understand a few technical jargons involved in this crisis, which will help us understand this crisis in depth.
Mortgage-Backed Securities (MBS):
So we will understand this technical jargon with a simple example. For instance, a loan seeker goes to a neighbourhood bank to raise a home loan to buy a house and let’s suppose he wants to take a loan of $100,000 at a 5% interest rate for 30 years. The bank will evaluate his financial metrics, such as his income, credit score, etc., and give him a loan. These loans are known as conforming loans which are as per the guidelines of the bank.
But here’s one interesting thing the bank does: it doesn’t want to wait for 30 more years to get the money back with interest and wants cash immediately, so it sells its mortgages to a larger investment bank, and now the borrower has to give money to the investment bank. Because mortgages are regarded as safe investments with good value, the investment bank purchases the mortgages. But here a question arises: what benefits does a neighbourhood bank get from doing all this? It has the following benefits:
Immediate cash
Fees such as title fees, appraisal fees, etc.
Now, the investment bank also doesn’t want to wait for 30 more years to get their money back from borrowers, so they incorporate a company and put the mortgage loans in the company. Let’s suppose they repackage 1,000 mortgages of $100,000 each, so it totals $100 million of total mortgages with the new company started by the investment bank and named it “BIG Mortgage Corp”. Now, BIG Mortgage Corp. issues 1 million mortgage bonds to hedge funds, HNIs, and other investors. Each bond will pay back $100($100M/1M bonds) and $5($5M/1M bonds) to the investor, so BIG Mortgage Corp. issues each bond at $105 to the investors. Why will investors be satisfied with this deal? Because they are getting a total of $250 (100$ + $5/year interest x 30) over the lifetime of this bond, it is a good deal for the investors. This is known as MBS (Mortgage-Based Security).
Collateralized Debt Obligations (CDO):
Collateralized Debt Obligations (CDOs) are nothing but MBS classified into different tranches, such as Equity: higher risk, higher return; Mezzanine: moderate risk, moderate return; and Senior: lower risk, lower return. These were the actual tranches that were used during the 2008 financial crisis.
Credit Default Swaps (CDS):
In layman's terms, CDS are referred to as insurance on CDO, which covers the losses if any occur due to the default of the mortgage. CDS short (bet against) the MBS market. They pay out if the value of an MBS drop. CDS are sold to owners of CDOs so that they can cover their losses, but interestingly, they can also be sold to those who don’t own CDOs.
The 2008 Financial Crisis:
So after understanding all these terms, we can now understand the 2008 financial crisis in detail. Michael Burry, hedge fund manager at Scion Capital, had observed and predicted this crisis in 2005 itself after going through all the mortgage data in detail. So he buys CDS and short (bets against) the market in the hope that the mortgage market will decline and there will be defaults in payments. And that's exactly what happened in 2008: the mortgage market collapsed, and he earned almost 500% returns for his investors, hence profiting from one of the worst financial crisis of all time.
So how it happened? What were the causes? Let’s understand it in detail. During 2000–2007, a housing bubble was created in which the banks provided excess debt with adjustable interest rates to the public without verifying their background, creditworthiness, or income. Moreover, the credit agencies rated these mortgage bonds as AAA (safe). Soon in 2008, the public started defaulting on their mortgages due to high interest rates, and the whole market collapsed. The CDO value decreased almost to nothing. CDS owners who shorted the market earned great returns, and investors who were hoping that the mortgage market would continue to rise went bankrupt. Lehmann Brothers, one of the biggest investment banks in the US, went bankrupt as they were under a $600 billion debt, of which $400 billion was covered by CDS, which they sold to investors like Michael Burry in the hope that the mortgage market would continue to rise and they would earn a heavy premium. Many other investment banks went bankrupt. The bank’s insurer, American Insurance Group(AIG), lacked sufficient funds to clear the debt, and the Federal Reserve of the United States needed to intervene to bail it out.
The US economy was hit badly, and it impacted other countries, such as India, as well. This soon resulted in a worldwide recession. Unemployment was at its peak, and people were homeless in the US. Stock markets crashed, and businesses were struggling in the US because they were not granted loans as the majority of the banks were out of money. This led to a decrease in US GDP of 4.3%, making this the deepest recession since World War II. It took multiple years for the global economy to stabilise after this crisis. Many new laws regarding CDS were made, and as usual, the government agencies reacted strongly after the damage was done.
So that’s it for this article. I hope you found it useful. Subscribe to my substack for more interesting insights on financial matters.