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Breaking down the 2008 Recession

It’s been more than a decade since the 2008 recession but a lot of people still don’t know what actually caused it, just like a lot of people do not know what caused the great depression. It’s important to learn and understand these, as they give you insights into what happens when financial instruments are abused and the government may or may not do its part and the importance of economic policies and how they can effectively bring countries out of tough times.



What caused the 2008 recession?

The US Fed had lowered interest rates after 9/11 to keep the economy going – to ensure that money was available for very cheap to every American. The low interest rates combined with the Fed’s home ownership policy encouraged more people to buy houses at low interest rates. The intentions were not bad. As a consequence, the total mortgage debt was as its peak by 2008.



As more Americans bought homes, the real estate market boomed dramatically in the years between 2002 & 2008. Banks were encouraged to give away more loans as the house prices grew and interest rates were expected to remain low.

Subprime & Adjustable Rate mortgages

It is important to link subprime loans at this point. This was an important financial innovation that allowed borrowers to be able to qualify for loans who would otherwise not have qualified. In another situation, prior to the 9/11 or even today, home loans at prime rates would strictly be given only to prime borrowers. Subprime borrowers (with low credit score/ other factors) would get higher interest rates (subprime rates) which would most likely dissuade them from purchasing houses.

The growing number of subprime mortgages in the mid 2000’s should have raised a red flag as the probability of default was very high. But as the real estate market boomed, so did the subprime mortgages as interest rates continued to be very low.

Adjustable-Rate mortgages also became popular at around the same time – another financial innovation that enabled subprime borrowers to buy more houses. ARM’s or variable rate mortgages is a type of a loan where the interest rate applied on the outstanding balance varies till loan completion.

While subprime mortgages & adjustable rate mortgages (ARM) were instruments that helped the real estate boom, other financial institutions devised another instrument to profit from these mortgages.

Step in Mortgage Backed Securities (MBS)

Banks had massive receivables which were the mortgages being paid monthly by the subprime borrowers. The banks, with the help of institutions like Goldman Sachs, created Securities backed by these receivables. The banks shifted the burden forward – which explains why they didn’t care whom they were lending to (aka subprime borrowers).

In a sense, you can imagine all these mortgages which were due to be repaid by new home owners, bundled together in a big box; we’re talking about hundreds of thousands of mortgages – not a few. This big box, let’s call it MBS, is now available for investors to invest in. They can buy and sell small portions of the box in a similar manner as they do with the equity. The ROI is linked to the probability of defaults. If a few people don’t pay up, it’s not a big deal. The rate of interest will be same as the floating rate of interest (as the loans were mostly ARM). However, if a lot of people default at the same time, the impact would be huge.


Gradually, between 2004 & 2006, the Federal Reserve, started increasing interest rates to balance inflation. This increase led banks to also increase their interest rates which adversely affected:

·         Firstly, the flow of new mortgages to home owners which affected the overall money into real estate. With higher interests, new mortgages had dropped steeply (first graph)

·         Secondly, it affected all adjustable rate mortgages (ARMs) as the revised interest rates were higher (borrowers expected the interest rates to remain low but as they had signed up for ARM loans – they were not able to repay the increased ) sending panic waves for the borrowers; Foreclosures saw a record high

·         As a consequence of the above two, the housing bubble began to burst.

As the housing bubble burst, so did the MBS and other exotic derivates. Hundreds of thousands of borrows defaulted on their mortgages which lead to investors of MBS being trapped, losing millions of USD. The MBS cornerstone was the booming real estate – which was no longer valid.

Step in Credit Default Swaps (CDS)

A CDS is exactly what is sounds like, a credit derivative where a buyer takes protection against defaulting due to an unforeseen event. Thus, the risk is now shifted to an insurance company against periodic payments to the company (just like a regular insurance cover). As part of the CDS agreement, the seller must (if the buyer defaults) pay the buyer the premiums & interests that would’ve originally been paid by the buyer. This way, the credit default payments have been swapped.

CDS became quite popular in the early 2000’s – and by 2007 – the CDS value stood at a staggering $62.2 trillion. But by 2008, as the Fed increased interest rates and the real estate bubble burst and more & more borrowers were not able to pay back their loans, the CDS was badly hit. Lehman brothers, one of the worst affected, owed a total of $600 billion, out of which 2/3rd was covered by CDS. The Fed had to intervene to bail out their insurer.

By 2010, the CDS outstanding was only $26.3 trillion, down 57% in just 2 years.

The Consequences

Financial institutions and banks like Bear Stearns, and later, Lehman Brothers filed for bankruptcy. As MBS, CDS and other derivates lost value, more investors lost value sending the stock market crashing – with households losing 19 Trillion USD in net worth. Unemployment went to a record high, the US Bureau of Labour Statistics reported that 8.7 million jobs were lost.



What did the Fed & Government do to bring the economy back and limit further damage?

The Fed decided to reduce key interest rates that would inject much needed liquidity and access to cheap money – much like they did in the early 2000’s – which fuelled the housing crisis.

Monetary Policy: The Fed also issued up to a massive 7.7 Trillion USD in loans to banks in a popular policy called Quantitative Easing. Quantitative Easing is when a central bank purchases long term assets from the market by issuing credit. The central banks typically creates this credit out of thin air – only the Fed has the power to do this in the USA. QE is often carried out when the interest rates are already low – the only other way to increase money supply is to print more money.

Fiscal Policy: The US Federal government also issued a 787 Billion USD in deficit spending under the American Recovery & Reinvestment Act. This was also to revive the economy

The Dodd-Frank Act: Apart from the stimulus packages, the government introduced the Dodd-Frank act to give the government more power over the regulation of the financial sector.

Some economists believe that the 2008 Recession was caused partly due to the Glass-Steagall being repealed in 1999. Banks were now free to engage in both commercial and investment activities.

But after the 2008 recession, the Dodd Frank act was enacted which again meant that the same banks were now going to be under scrutiny by the government, to protect the tax payers and consumers.

Recovery:

The economy did recover, gradually. By 2011, GDP reached its pre-Recession level – contributed by the flood of liquidity by the Fed.

It took a couple of years for the stock market to reach its pre-Recession levels – almost 4 years in fact, as you can see from the last graph. Unemployment rate gradually reduced – but unlike the stock market, it took longer for the unemployment rate to reach 4% - 4.5% (not until 2015).

The 2008 recession is a stark reminder of what can happen when financial instruments are abused and financial innovations are left unregulated.


Summary:

The Fed had lowered interest rates to fuel the economy after 9/11. In the early 2000s, subprime loans became a popular innovation that fuelled banks to give out loans to subprime borrowers (borrowers who were more likely to default) at adjustable rates (also an important financial innovation). The mortgage debt was at all time high by 2007 end. Banks (along with financial institutions) created MBS so investors could invest in these mortgages backed securities. Another important contributor was CDS, which became popular during the real estate boom.

By mid 2000s, the Fed started increasing the interest rate to stabilize inflation. This lead to ARMs increasing the rate leaving borrowers unable to repay loans. Foreclosures sky rocketed, defaulters increased which led to the collapse of MBS – Mortgage Backed Securities – which were backed by loan repayments from subprime borrowers & also led to the collapse of CDS – Credit Default Swap – ss defaulters increased, banks were not able to live up to their CDS agreement.

Collapse of MBS, CDS and other derivates led to further collapse of stock market and other financial institutions that had invested in MBS, derivates of MBS & CDS. This subprime mortgages on US homes led to the 2008 recession.


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