The Great Recession: Explained
By Samarth Singh
On October 15, 2008, the Dow Jones Industrial Average crashed by 7.87%, the ninth-largest single-day market drop in history until then. On December 1 of the same year, America entered a recession. Between 2007 and 2009, the market dropped a total of a whopping 61.8%. Known as the Financial Crisis of 2008, this event was a disaster long in the making.
The story begins all the way back in 2003. The market was just recovering from the dot-com bubble. Federal Interest Rates had dropped to just 1% in June 2003. Since loans were so cheap (lesser interest had to be paid), more people took loans - even those with no credit history or low credit scores. Such borrowers, who do not have an adequate history of repaying loans, are called subprime borrowers. Subprime borrowers carry a very high credit risk - that is, they may default on the loan and not repay the principal (causing a loss for the lender).
Loans given to subprime borrowers are called subprime loans. These loans have higher interest rates because they are more likely to cause a credit default. Risk in debt obligations and interest rates are directly proportional. The riskier the loan, the higher the interest charged on it. In the early 2000s, the market for subprime loans emerged and grew. A fifth (20%) of loans given in 2005 and 2006 were given to people who otherwise were not eligible for credit.
But why would banks give loans which are so risky?
Even in normal times, banks do not actually keep the loans they give. Banks resell these loans to other, usually bigger, financial institutions. In the 2000s, these loans were mortgage-backed securities. Mortgage-backed securities are backed by assets, making them less risky because the principal can be recovered in case of a default. Here, real estate was the asset backing the loan, so it seemed alright to provide risky credit because even in case of a default, the house could be sold off to recover the principal. Collateralised Debt Obligations (CDOs) were also issued. Multiple risky assets are combined in CDOs and, due to the benefit of diversification, their rating is higher than the loans alone. By 2005, mortgage-backed securities were the collateral for half of the CDOs. Very risky loans were, in some ways, rebranded to make them appear more reliable.
Every bank has to keep some percentage of their total funds as liquid cash - known as a capital requirement. This ensures that the bank has enough funds in case of a sudden spike in withdrawals. Thus, the bank cannot invest a large portion of its funds. However, in 2004, capital requirements were relaxed for five big investment banks on Wall Street. This increased investments by these banks and improved their risk-taking capacity.
Long story short, unsafe investments seemed safe at a time when several risky bets were being made.
The government's actions in the years before the recession aimed to grow the economy. More investments and cheaper credit normally do boost spending. Most of the loans given were used to invest in real estate. After the dot-com bubble burst, investors were not so enthusiastic about technology, instead shifting their focus to the housing market. As loans became cheaper, more and more people bought houses. This increase in demand increased the price of homes in the US. Seeing this growth, even more people wanted to invest in homes, increasing the demand, therefore increasing the price as well as the number of people investing in real estate.
This situation is what economists commonly call an economic bubble. An economic bubble bubbles when the market values a commodity well above its intrinsic (or actual) value. The price of the commodity keeps rising until the market realises that its actual value (which by the time the bubble ends, is way lower than what most have paid for). Read more about economic bubbles here. The real estate industry was growing, but it was in no way proportional to the market. The problem was, like most bubbles, most people did not realise that they were in a bubble. Low interest rates had sent the market into a seemingly unsuspecting upward spiral. It seemed like nothing could go wrong since most of the loans were mortgaged backed and could be recovered in case of a default.
So how did the housing bubble burst?
By June 2006, the Federal Reserve began charging higher interest on loans at around 5.25%. Because the interest rate was higher, fewer people were taking new loans and spending money when compared to before. Thus, the growth in the housing market slowed. Fewer people were buying new homes. Due to a drop in demand, the prices of homes in the US fell by 19% between 2007 and 2009. The bubble had burst - people were no longer bullish about the real estate industry.
Three-quarters (75%) of the subprime loans issued during the 2000-2005 period were adjustable-rate mortgages. Such mortgages do not have a fixed interest rate, and the interest paid on the loan typically fluctuates with the interest rate set by the Bank of England. As interest rates rose, subprime borrowers faced increased interest payments. They struggled to repay their loans, leading to a rise in instances of credit default.
The drop in prices of homes meant that in many cases, the value of the house in 2008 was less than what it was bought for. This is typical of any economic bubble. Those who fuel the growth of the bubble eventually end up facing losses. However, for banks, this posed another problem. The mortgage in the mortgage-backed security was now worth less than the loan itself. Say, for example, a subprime loan was given in 2005 for a particular house. There was a credit default in 2007. So the bank would try to recover its principal by selling the house. The problem is, the house is not worth as much in 2007 as it was in 2005. The loan given was of a higher amount than what can now be recovered.
With no way to recover their loans, several subprime lenders and banks collapsed. 50 mortgage companies had filed for bankruptcy by April 2007. By the end of that year, 100 mortgage companies were either shut down, sold or suspended operations.
But just the collapse of small regional banks could not cause such a prolonged recession. These events of 2007 were the beginning of trouble for major financial institutions on Wall Street: Lehman Brothers and Bear Stearns.
Bear Stearns was a hedge fund established as early as 1923, and it was one of the top five names on Wall Street. Its assets combined were worth $11.1B. However, it failed in 2007. To know why that happened, it is important to look at its investment structure. The firm borrowed money from investors to acquire CDOs, which offered returns higher than the costs charged to the investors, allowing them to generate a profit. Note that, at that time, CDOs were designed to bundle high-risk credit and present them as safe investment options. Additionally, to mitigate the risks associated with CDOs, Bear Stearns bought Credit Default Swaps (CDSs). A CDS functions as a form of insurance for a loan; an investor selling a CDS believes the loan will not default. Should the loan default, the investor selling the CDS is obliged to repay the specified amount. Conversely, an investor purchasing a CDS uses it against potential risks. However, the volume of CDSs purchased was not proportionate to the number of CDOs. So when subprime mortgages began to fail, the CDOs followed suit, leading Bear Stearns to incur significant losses.These issues escalated until they became unmanageable, prompting the firm to file for Chapter 15 Bankruptcy on 31 July 2007.
Lehman Brothers was a bank. It had acquired 5 mortgage lenders in 2003 and 2004. The bank issued more mortgage-backed securities in 2007 than any other bank. These loans were worth $85B which was four times its shareholders’ funds. If things ever went south, the bank did not have enough funds to recover.
And history knows that things did go south.
Affected by the same subprime mortgage crisis, even Lehman Brothers started to face losses. In the second quarter of 2008, they booked losses of $2.8B. The Bear Stearns collapse did not help either. Investors and hedge funds started to question the bank. Its share price fell by 48% in just one day (March 17, 2008) because investors believed that the firm might fail. In September 2008, stocks of the company plunged even more. Hopes of a deal by selling a part of the bank was also abandoned. Left with no funds, Lehman Brothers filed for bankruptcy on September 15, 2008.
Bear Stearns was bailed out by the US Government. However, it refused to do so with Lehman Brothers. Interest rates were lowered again to reduce the effects of the economic downturn. $1488B (or $1.48T) was spent on bailouts - but it did not help.
American markets went into turmoil. The recession that followed is still called The Great Recession by investors. $17T of household wealth was lost. 8.8M jobs were lost. The recession not only affected the USA but also several other countries across the world.
The world learnt much from the Great Recession. Reforms were implemented to avoid repeating the same mistakes. Nonetheless, the events still leave a lasting impression on those who were affected by them.
Sources:
https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp
https://www.investopedia.com/news/10-years-later-lessons-financial-crisis/#toc-1-too-big-to-fail
https://en.wikipedia.org/wiki/Collateralized_debt_obligation#Subprime_mortgage_boom
https://en.wikipedia.org/wiki/List_of_largest_daily_changes_in_the_Dow_Jones_Industrial_Average
https://www.investopedia.com/articles/economics/09/investment-bubble.asp
https://en.wikipedia.org/wiki/Subprime_mortgage_crisis#January_2007_to_March_2008
https://www.investopedia.com/terms/h/housing_bubble.asp#toc-housing-bubble-example
https://www.investopedia.com/terms/c/cdo.asp
