A Perfect Storm: Reflecting on the Financial Crisis of 2008

A Perfect Storm:
Reflecting on the Financial Crisis of 2008

Blake Rasmussen

Texas Tech University

Where It Began

There are several distinctive moments for which a strong argument can be made as the start of the 2008 financial crisis. Some experts argue that the pivotal moment was the failure of Lehman Brothers, which resulted in a run on financial institutions, while others blame the crisis on the housing bubble that burst in 2007, following years of skyrocketing prices in that market. Digging deeper than the macro issue of the housing bubble, the true cause of the financial crisis can be traced to banks’ incredibly risky policies regarding how and to whom they made large real estate loans and the insatiable greed that drove them to adopt these practices. In this analysis of the perfect storm that facilitated the financial meltdown, I hope to explain the issues that led to the financial collapse, the implications of the subsequent bailout of failing financial institutions, and examine what has to be done to prevent a crisis like this from happening again.

Financial Instruments that Led to Crisis

Mortgage-Backed Securities

Mortgage-backed securities (MBSs) are created when banks package mortgages together and sells them to a Government Sponsored Entity such as Freddie Mae and Fannie Mac, who in turn sell the securities on the open market. Through this process, monthly payments “pass through” the bank that made the initial loan onto the owner of the MBS, a third-party investor. Mortgages are amortized over their lifetime, meaning that the monthly payments include both principal and interest. Because of the amortization, MBSs differ from traditional bonds that typically only makes interest payments, with the principal being repaid in its entirety at the bond’s maturity date. In addition to the expected monthly cash flows, investors that own MBSs also receive unscheduled payments of principal that is repaid early due to refinancing, foreclosures, or house sales. These premature payments make it difficult to predict the maturity of MBSs, a problem that traditional bonds do not have, making them more risky by default. In addition to the unique risk of prepayment, MBS are also subject to risks more typically associated with traditional bonds such as credit and default risk.

Credit Default Swaps

A credit default swap (CDSs) is essentially an insurance policy that allows speculators to bet against default on loans or bonds held by others. They are not always used in a speculatory fashion, as they can also be used to mitigate risk related to a loan held by the owner of the CDS. A fairly new concept, CDSs are primarily a mechanism to speculate and are mostly unregulated, a combination of factors by which they become a potentially dangerous financial instrument. Speculators simply pay insurance premiums against the underlying loans or bonds and wait for them to default, resulting in a large payout by the insurer.

Market Conditions Leading Up to the Crisis

Rapid Increase in Subprime Mortgages and the Perpetual Cycle

After jumping more than 6% in 1999, housing prices in the United States increased rapidly and steadily throughout the early 2000s. As investors and banks saw property values appreciating so quickly, real estate became recognized as a seemingly safe and highly profitable investment. Adding more fuel to the fire, the Federal Reserve slashed interest rates in reaction to the recession of 2000-2001 and the economic implications of the September 11th terrorist attacks leading to a very low interest rate environment, making loans seem less risky to borrowers.

Wall Street firms were eager to get involved in the expanding housing market. These investment banks were attracted to high-return MBSs, leading to very high demand for these securities. As the market hungered for more and more MBSs, banks saw an opportunity to increase the supply of MBSs by increasing the amount of Subprime Mortgages they were issuing. Because pooling mortgages for sale removes all risk for banks, credit underwriting standards slipped and more unqualified buyers were being approved for loans that they would never be able to afford. In the absence of risk, banks were only restricted by the pace they were able to make loans. Lenders began using deceitful tactics to convince Americans to take out mortgages they were unable to afford to increase their production of MBSs. Unfortunately, Americans, with an unquenchable desire for consumption (evidenced by an average savings level of less than 1%, compared to the average rate of 30% in China) widely accepted these newly available mortgages, with some choosing to give up equity in homes they already owned just to take advantage of the easily available funds.

Credit Ratings Agencies and Conflicts of Interest

All types of securities that trade on the open market in the United States are rated in terms of risk by ratings agencies, most prominently by Moody’s Investors Service and Standard & Poor’s. There are several flaws with this system that lead to misinterpretation of their ratings and a jaw-droppingly large conflict of interest between the agencies and Wall Street investment banks. In theory, these agencies are meant to provide an independent rating of the riskiness of a security. In practice, however, the credit agencies rely on Wall Street investment banks as their customer base, leading to a conflict of interest between their two primary interests: accurately assessing the riskiness of securities and serving their customers, the issuers of the securities.

Bonds and securities with structured cash flows like MBSs are popular with pension funds and life insurance companies, who typically will not invest in poorly rated securities. As investment banks focused on growing their market share and boosting earnings with the newly popular MBSs, it became apparent to credit ratings agencies that rating these securities poorly could potentially drive away their profits. This resulted in what is referred to as an agency conflict. The ratings agencies consistently rated MBSs at their highest rating, essentially assigning them the same level of perceived risk as U.S. Treasury bonds. The explanation of this extremely low assessment of risk was the unfounded assumption that MBSs were well diversified, assuming that if one group of Americans began defaulting on their mortgages, the rest of the country would remain unaffected.

The Perpetual Cycle and the Beginning of the End

As the demand for MBSs grew, banks acted accordingly. Prime mortgages, mortgages that meet traditional underwriting standards, dropped to 64% of mortgages issued in 2004, and proceeded to decline to only 52% of the market in 2006 as banks continued to make mortgage loans to practically any willing borrower. Investor confidence, continually growing demand for mortgages and MBSs, and the low amount of perceived risk led to a vicious cycle that caused housing prices to grow into a dangerous bubble.