The credit crisis of 2008

Many factors contributed to the financial collapse of 2008. The details behind the credit crunch can be summarized as follows:

The main driver behind the whole crisis can be attributed to the low cost of borrowing. With the United States’ economy seriously underperforming in 2001, the central bank began a policy of lowering interest rates, aiming to revive a stalled economy. The Fed lowered the federal funds rate, the interest rate banks charge each other, to its lowest point in 2003. With low rates abounding, this helped fuel the real estate market and speculation in the real estate market. The end result was that the value of the home rose dramatically.

Banks and mortgage lenders saw this as a time to make money. They jumped into a frenzied real estate market with both feet and began lending to unqualified borrowers. This was the beginning of what we call the subprime mortgage market. To hide these subprime mortgages as much as possible, these subprime mortgages were bundled with more creditworthy loans and sold as a package to the investment community. Because these bundled loans masked the subprime components, they were able to induce insurers to buy unregulated insurance policies against the bundles, known as credit default swaps. The CDSs guarantee the investor that these subprime loans will be paid. Since these loan bundles were now, as it were, insured, credit rating agencies were quick to rate them as AAA, the highest possible rating that can be given to a debt instrument.

The packaged loans, known as Collaterized Debt Obligations (CDOs), were then sold to investors. While there was an underlying insurance policy for these CDOs, the CDSs were not covered by the insurance industry and did not require the insurers to carry the necessary capital to pay out the insured, should the need arise. CDSs are purposely created outside the confines of the insurance industry so that they don’t have to be subject to the rules and regulations of the insurance industry. These CDSs were dreamed up by math “gurus” hired by Wall Street and became a $50 trillion industry.

When house prices started to fall, housing construction went into free fall. The FED reversed the course of several years before and started raising interest rates. This interest rate hike had a direct impact on the adjustable rate mortgage market, which in turn had a negative effect on many of the subprime mortgages issued. For many homeowners who weren’t very qualified to begin with, the freefall in their home prices resulted in them having a mortgage that was higher than the price of their home. There were many bankruptcies.

With the number of foreclosures on the rise, credit rating agencies that had incorrectly rated CDOs as AAA began downgrading their subprime loan ratings to junk levels. The investment banks, commercial banks and pension funds that bought these CDOs saw a large drop in their holdings. Many of these CDOs defaulted. The owners of these CDOs could no longer sell them on the open market, causing the debt market to freeze.

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Since Wall Street’s accounting mechanisms require their constituent companies to “market value” the value of their investments, they were forced to write down the value of their CDO holdings, as they were, in effect, not worth the paper they were printed on. Thus, the free-falling values ​​of these instruments created a free-falling value of the investment companies that held this debt.

These investment bank write-offs caused these companies to become undercapitalized as billions of dollars worth of worthless CDOs were written off. The asset-to-capital ratio of many banks soared as investment companies grew in debt. In addition, both Fannie Mae and Freddie Mac, who owned more than $5 trillion in mortgages, became extremely overextended and were effectively taken over by the government.

At the same time as this mortgage collapse, the prices of oil and other commodities around the world began to rise, reflecting the increased productivity and economies of Asia. At its peak, oil reached an unfathomable $148 a barrel.

As the crisis worsened, more bank failures and mergers took place, including IndyMac (failure), Countrywide (bought by Bank of America), and Bear Stearms (failure).

Lending continued to decline as banks felt too much risk lending to other banks for fear of the inability to repay loans despite government efforts to encourage lending. Furthermore, many investors began to withdraw money en masse from uninsured money market accounts.

The government failed to restore confidence in the financial markets. This was further illustrated by the bankruptcy of Lehman Brothers, the purchase of Merrill Lynch by Bank of America and the government’s acquisition of insurance giant AIG.

Then the government approved an $850 billion bailout and injected some of that money directly into the ailing banking system. The purpose of this was to try to encourage banks to resume lending, in order to jump-start the economy.

House prices continue to fall. Banks have so far lost $1 trillion in bad debt during this credit crunch, and some believe that number will double before things return to normal. Until then, lending will be tight, with borrowers less able to borrow and requirements to get a loan tightened significantly. A deeper recession is likely as we move forward, with a chance of moving into a deep depression similar to that of 1929.