The global financial of the year 2007 to 2009 has been the most serious financial crisis since the Great Depression. Most countries in the world had been adversely affected, with many experiencing a recession. Even some smaller countries were threatened with bankruptcy. The International Monetary Fund estimated that the loss to global wealth is not less than 15 trillion US Dollar (other sources even estimated a loss three times that high), 59 million people lost their jobs worldwide, and governments poured trillion of dollars in their economies in order to stabilise them. The financial crisis was triggered (or – according to some analysts – even caused) by a real estate crisis in the US which came along with a dramatic rise in mortgage delinquencies and foreclosures. In the following, banks and financial markets were adversely affected by the crisis, with several teetering on the edge of bankruptcy. When the US investment bank Lehman Brothers filed for bankruptcy on September 15 in 2008, the already distressed financial market started to experience a period of extreme volatility and a further eruption of the crisis took place. Sharp reductions in the value of equities and commodities worldwide were the result. However, when the largest stock market indices reached their trough in March 2009, they started to recover quite rapidly. In the second half of 2009 most countries declared that the crisis was over and their economies recovering.
The Road to Crisis
That banks and financial markets on the whole world were adversely affected by the US real estate crisis was due to the practice of securitising US-American real estate mortgages. With securitisation, asset classes are available (mortgage backed securities (MBSs) and collaterised debt obligations (CDOs)) that can be easily traded on capital markets; and international investors had a big appetite for MBSs and CDOs. In the years prior to the crisis there was excess capital globally (interest rates were low, especially in the United States) and especially demanded were low risk investments that paid better returns than government bonds – and MBSs (but also CDOs) were considered as safe investment. However, loans of various types – not only mortgages – were easy to obtain as interest rates were low and underwriting standards lax. This increased housing demand and this in turn the house prices. The increasing prices caused people to buy a house not only with the aim of house ownership but also for speculative reasons (“house flipping”). This further created more demand and further increased the prices. Yet, in contrast to the rising house prices, the average household income did not increase with the same pace – an important indicator that indeed a bubble was building up. In order to prolong the housing boom the US housing finance industry reached out for new target groups: people with low credit score, without (stable) income, and without assets. As also these “subprime” mortgages were securitised they ended up as well in the portfolios of international investors. However, once interest rates began to rise and housing prices started to drop moderately in many parts of the United States, refinancing became more difficult. Defaults and foreclosure activity increased which in return increased the number of houses on the market. The oversupply of houses and lack of buyers pushed the house prices down till they really plunged in early 2007. The bubble burst.
Causes for the Crisis
A series of factors caused the breakout of the crisis, factors which emerged over a number of years. The policy of the US Federal Reserve, the housing boom, mortgage lending practices, securitisation practices, and inaccurate credit ratings – all of them have their part in the crisis.
In the wake of September 11th and the burst of the dotcom bubble the US Federal Reserve reduced its key fed funds rate to 1 per cent in 2003 (and kept it on this level until summer 2004), the lowest it had been since 1958. Yet, with an inflation rate between 2 and 3 per cent, it was cheaper to lend money and to create value than to save. That the Fed kept real short term interest rates so negative for so long is considered today as excessive. Although inflation stayed in line, the Fed fostered with its policy the development of a housing bubble. When the Fed raised the funds rate significantly between July 2004 and July 2006, interest rate resets of adjustable rate mortgages were made more expensive for homeowners. As this provoked an increase in defaults and foreclosures and as asset prices (thus house prices as well) generally move inversely to interest rates, this is considered as one cause to the deflating of the housing bubble. This argument has to be qualified however, as (long-term) mortgage rates in the United States remained low, even after the Fed started to raise the interest rates. This was brought about by Americans borrowing huge amounts abroad made possible by capital or savings from abroad pushing into the United States.
Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fuelling a housing market boom and encouraging debt-financed consumption – which in return increased housing prices. The housing finance industry did its best to support and prolong the boom by loosening qualification guidelines for mortgages. Subprime mortgages and other exotic mortgage products – like the so called “ninja loans” (no income, no job, and no assets) – aimed at people who would normally not qualify for a mortgage: people with bad credit history, migrants or unstable income – thus high-risk borrowers. However, an analysis of 130 million home loans made over the past decade revealed that subprime mortgages were indeed not only issued to low-income, minority and urban borrowers. In fact, risky mortgages were made in nearly every corner of the United States, from small towns in the middle of nowhere to inner cities to affluent suburbs. Subprime mortgages did indeed become the mainstream as home prices accelerated across the country – but not the household incomes – and a growing number of affluent families turned to high-rate loans to buy expensive homes they could not have qualified for under conventional lending standards. Yet, in addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, for example, the median down payment for first-time home buyers was only 2 per cent with 43 per cent of those buyers making no down payment whatsoever. But also borrowers had an incentive to take out risky loans with a high loan-to-value ratio. First, the buyer was (and still is) able to deduct interest on the first one million USD of a home mortgage, and second, a mortgage is typically nonrecourse debt secured against the property. For a nonrecourse loan the borrower is not personally liable, so that the lender’s recovery is limited to the collateral in the case of default. Notwithstanding these two points, someone who finances its home without down-payment takes full risk on – and especially in conjunction with higher risk borrowers this almost inevitably results in a rise in mortgage delinquencies and foreclosures.
The reason why banks and other mortgage lenders loosened their underwriting standards so much can be clearly accounted to the characteristics of securitisation. The process of securitisation involves that the mortgage lender does not keep the loan on its balance sheet but sells it to the capital markets – and with it the associated credit risk as well. This principle is called “originate-to-distribute” and it clearly reduces the incentives for careful selection and control of debtors, giving advantage to lax distribution of credit. The reason, however, why (international) investors considered the securities backed by such loan pools as low risk investment must be attributed to the rating agencies’ overly optimistic credit rating. MBSs and CDOs based on risky subprime mortgage loans were usually given investment grade ratings. These ratings were believed justified because of risk reducing practices, such as credit default insurance and equity investors willing to bear the first losses. Yet, the data that rating agencies used to estimate the risk was flawed and the agencies suffered also from conflicts of interest, as they were paid by the investment banks for the ratings that issued and sold the securities.
Furthermore, securitisation enabled financial institutions to move assets and liabilities off-balance sheet into entities in the shadow banking system. The shadow banking system (notably money market funds and investment banks) operates with essentially no regulation, pays no deposit-insurance fees, and is not saddled with mandated social missions imposed by legislation. Henceforth, moving assets and liabilities off the balance sheet enabled financial institution to circumvent minimum capital ratios, thereby increasing lending, leverage and profits (during the boom). Another way to increase their short-term profits was to borrow money and to invest the proceeds at a higher interest rate by issuing large amounts of debt and investing the proceeds in MBSs. So, rather than dispersing the risk (the intentional idea of securitisation), the risk became manly concentrated in the (international) banking system itself. Furthermore, many financial institutions were over-leveraged and under-capitalized, with some investments banks having a leverage ratio of over 30 per cent in 2007. Yet, highly leveraged companies are particularly exposed to changes in credit conditions, as in the face of a crisis they are forced to use deleveraging in order to lower the risk of default and mitigate their losses by having to sell their (maybe illiquid) assets on a large scale at unreasonable (low) prices.
The US-American government has also its share in the crisis. First, the government supported deregulation as well as the growth of the financial industry and it did not reform the outdated regulatory framework. Second, increasing homeownership was a prime goal of national state administrations. There is even clear evidence that politicians leaned on the mortgage industry, especially Fannie Mae and Freddie Mac (the GSEs), to lower lending standards. Several politicians, especially Congressmen, have used the GSEs to further their own agenda. Thus, politicians began to rely on the GSEs for political and financial support, and the two GSEs relied on them to protect their profitable special privileges.
Consequences and Lessons Learned
The consequences of the crisis are profound. Several trillion US dollars of global wealth have been lost (at least 15 trillion US dollars). Governments all over the world had to stabilise their economies with large stimulus programs. Furthermore, several banks that were considered as “system-relevant” were nationalized, received guarantees or capital replenishments by their national government. The depth and breadth of the crisis has lead to the conviction that the international financial system needs to be reformed in order to avoid further crises. International policymakers have declared that banks shall be required to hold more and better quality capital. Furthermore, the introduction of countercyclical buffers is suggested so that financial institutions have to retain a greater proportion of profits in good times to build capital which can be consumed when growth collapses. For large, system-relevant banks the minimum capital requirements shall be especially demanding. Besides, it is proposed that the over-the-counter derivatives, which are so far negotiated outside of the regulated markets, have to be traded in future on an exchange. It is also suggested that the so far largely unregulated shadow-banking-system will be subject to thorough regulation. The policymakers work also towards greater disclosure and transparency of the level and structure of remuneration for managers including an alignment of the compensation with long-term value creation and financial stability. Finally, countries which fail to meet regulatory standards or are considered to be “tax havens” might have to expect countermeasures in the future.
However, though the crisis has not yet ended, large parts of the financial industry have resumed practices which were responsible for the emergence of the financial crisis. And it remains to be seen whether policymakers can agree upon decisive changes in the international financial architecture. And clearly, the US-American housing finance system has to be reformed with the aim to increase stability, sustainability and consumer-orientation.
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