by Vanshita Chandwani
A crisis that showed first signs of development in 2007 and went on well into 2009, finds its roots in 2005.
At first glance, the crisis seems to have emerged with mortgaged assets, depreciating and weakening the financial backing of the banking institution leading to the world banking system on the verge to collapse.
While what triggered the crisis was a drop in the value of assets mortgaged leading to banks like Lehman Brothers having to file for bankruptcy, the crisis was also a result of financial liberalization and reduction in regulation.
Fiscal Policy of the Fed
Cheap credit facilities and rising prices of property made properties a lucrative investment but a one-way bet.
Inflation caused due to rise in oil prices reduced the real income (purchasing power of the income) of households.
The Fed continuously increasing interest rates, from 2003 on these home-loans to ease the overheated property market, led to defaults and foreclosure of loans in the absence of an incentive to pay for a net negative return.
The gap between the income and the debt of households widened.
The Fed continuously increased interest rates from 2003 on these home-loans to ease the overheated property market and this led to defaults and foreclosure of loans in the absence of an incentive to pay for a net negative return.
Neither the monthly payments nor selling the mortgaged house was affordable. This phenomenon had rendered the entire previous bank lending to turn into bad loans. The banks now had no financial security only to be saved by state intervention.
Mortgage-Backed Securities’ (or MBS’) from boom to bust
The trouble that banks landed themselves into was due to a fundamental flaw in the underlying structure of their work.
The introduction of Mortgage-Backed Securities revolutionized the housing industry.
This was popularized by banks in lieu of acts such as the Commodity Futures Modernization Act and Community Reinvestment Act for their vested interests of financial gain.
The Community Reinvestment Act forced banks to lend in subprime areas whereas the Commodity Features Act made the sale of these derivatives unregulated.
Investors buy these MBSs which allows them to receive the value of these assets in the form of interest payments and principal amounts. They need not be sold completely to one person, i.e an investor may buy only a part of it.
Americans took loans to buy houses in huge numbers creating an asset bubble. An asset bubble is when assets such as housing, stocks, or gold dramatically rise in price over a short period that is not supported by the value of the product.
These MBSs were then sold to corporate firms and financial institutions. They also formed hedge funds, pension funds, and mutual funds.
Investors had invested a great deal in these as these were insured by a product called credit default swaps.
However, when the prices of these mortgages fell, the insurance companies did not have enough cash flows to honor the swaps, and all institutions lost money leading to the financial crisis of 2008.
The deep freeze of the inter-bank market
Faith in these institutions was lost as Bear Stearns was acquired by JP Morgan Chase, Merrill Lynch was bought by Bank of America, and Fannie Mae and Freddie Mac were taken over by the U.S. government.
Uncertainty had set in amidst investors. The major problem that this posed was that inter-bank lending was now frozen in fear of receiving MBS’ as collateral. This pushed the entire financial system on the edge of collapse.
Crossing the borders
A lot of money that had flown into the economy as capital after the Russian Debt Crisis and the Asian financial crisis was also invested in these MBS’s.
Oil-producing countries and countries with a surplus in trade had injected a lot of money they had earned into the U.S. financial system which had been directed towards these securities.
The financial innovation of mortgage-backed securities along with collateralized debt obligations enabled international investors to invest in the US.
The dependency of the world market on the dollar made the crisis spread far beyond the border of the States. Once a major financial institution of the U.S. landed themselves in trouble, other countries started taking a hit too.
De-regulation removed artificial barriers, allowing broader participation, but this broad participation also caused the contagion to spread, notably to Europe.
It would be unfair to say that this was not anticipated.
Warren Buffet had warned,
“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Another warning had come in from the then chief of the IMF, Raghu Ram Rajan in 2005 who had said that the financial system was at risk of a “catastrophic meltdown”.
2007 was a jolt to the complacency that had set in amidst governments and financial institutions with regards to the macroeconomic volatility of nations.
Structural changes that were deemed to be enough to absorb financial shocks, control inflation, and stabilize employment rates in the past did not measure up.
What ensued was a balance of payment crisis, a crash in the stock market, the disappearance of liquidity, and finally the Great Recession.
Absence of liquidity
One of the biggest concerns as expressed in Rajan’s paper: ‘Has Financial Development Made the World Riskier?’ started to become more evident as Banks started to become unable to provide liquidity in the time of crisis.
The funds that the banks were retaining within themselves were dwindling as time passed.
The banks had been moving towards illiquidity rapidly as all their mortgage securities were incessantly losing their liquidity. These banks were dependent on short term funding from the market.
Giants like The Northern Bank, Royal Bank of Scotland, and BNP Paribas had to resort to the government for emergency funds in lieu of complete evaporation of liquidity as money markets had withdrawn money from the banks.
Unemployment and fall in income levels
The decline in global GDP stood at 5.1% and the global unemployment peaked at 10%.
The States lost a significant part of its GDP which implied retrenchment at a massive scale.
8.7 million jobs were shed in the US alone, as stated by the U.S. Bureau of Labor Statistics. Households lost a net worth of $19 trillion as the stock market plunged, as stated by the U.S. Department of the Treasury.
Unemployment levels in the U.S. doubled from 5% in 2007 to 10% in 2009, and the Poverty rate in the United States rose from 12.5 percent in 2007 to 15 percent in 2010.
Aftermath in Europe
While 2009 officially marked the end of The Great Recession in the U.S., its doom could be felt for a longer duration.
Beginning 2010 through 2014, smaller European nations continued seeing national debt delinquencies.
European Union had to bail out countries like Ireland, Greece, Portugal, and Cyprus with loans and other cash investments.
The economic slowdown surged throughout the country owing to the large investments it had made in MBS’. Throughout Europe, banks were nationalized.
Unequal distribution of wealth
Post the recessionary phase of the economy, the income gap increased causing the rich to become richer and the poor become poorer.
From 2009 to 2011, the net worth of the richest 7% of households increased by 28% while that of the lower 93% declined by 4%.
Economists mentioned how certain strata of the society would always remain poorer than their previous generations even in the post-recession economy.
How it haunted the entire decade
Lower fertility rates, historically high levels of student debt, and diminished job prospects lingered for years to come. It had drained individuals financially to such an extent that private investments remained low.
Small businesses that did manage to survive were scarred forever and had to squeeze their operations. The infantile start-ups were the most vulnerable and the unavailability of credit impeded many from ever being born.
The fall in output was so steep that it took countries like the UK until 2017 to completely move past its productivity crisis.
Decline in demand
In such a situation, with stocks plummeting by 57%, it was only natural that the aggregate demand of an economy would decline.
What made it worse was that at this point lending could not have been used as an effective measure to raise the demand in the economy.
With financial institutions balancing on eggshells and fighting for survival, trading was affected. The economic activity in the country had greatly reduced.
Since the crisis started at the top of the pyramid with the ‘too big to fail’ ventures failing, the effect had trickled down to the lower hierarchies as well.
This clearly left only one option: the state had to become the knight in shining armor and come to everybody’s rescue.