Understanding the 2008 Financial Crisis

Nicoli NattrassCentre for Social Science Research

University of Cape Town

January 2015

1. Introduction

An inverted pyramid of debt was built on a narrow base of booming US house prices. 1997-2006: US house prices rose 124% (from 3 to 5 times the average wage).

The quality of loans declined: by the mid 2000s, most new home loans were NINJA loans, typically with ‘teaser’ interest rates.

When interest rates rose from 1% in 2004 to 5% in 2006, the trouble began.

By 2007 16% of sub-prime adjustable mortgages were in default. As most had been ‘securitized’ and sold as complex derivatives, this affected the entire financial sector….

Assets previously believed safe were no longer trusted and banks stopped lending to each other. The UK nationalized Northern Rock in Feb 2008. In Sept 2008 the US took Fannie Mae and Freddie Mac (mortgage underwriters) into public ownership. A week later regulators let Lehman Brothers go bankrupt, owing $600 billion. Stock markets crashed…..

Huge tax-payer financed rescue packages (amounting to 80% of GDP in the US and UK) and the purchase of ‘toxic assets’ (of $1 trillion) by the Fed prevented the total collapse of the financial system.

But debt ‘de-leveraging’ by firms and households depressed demand, causing a recession.

Global trade fell by more than 20% and growth declined everywhere. Fiscal deficits expanded, sparking a sovereign debt crisis in 2009 (notably Greece and Ireland) and then a crisis for the EU and a corresponding shift to austerity policies. The economic legacy lingers today in low interest rates and mostly anemic growth.

Meanwhile, bank bonuses bounced back to pre-crisis levels (and were 29% higher in 2014 than in 2013).

http://www.newstatesman.com/politics/2013/06/unsqueezed-top-how-bankers-pay-has-already-returned-its-peak see also http://www.theguardian.com/business/2014/mar/11/banking-bonuses-rise-city-of-london

The Big Short: An evocative, sometimes laugh-out loud funny and very smart book on the financial crisis and some of the few investors that made money betting against sub-prime mortgage derivatives

How Markets Fail: A good introduction to economic theories and to the 2008 financial crisis. For those particularly interested in economics.

The Inside Job: Award winning documentary with a cynical and somewhat conspiratorial bent: ‘It was a Wall Street Government’

Mortgage: A loan from a commercial bank to a home-owner, for a fixed period. The home is collateral

Loan Interest payments

Least risky: Client has strong earnings, significant equity in the house

Most risky: no earnings, no equity (NINJA loans)

Securitization changed all this as mortgage originators could sell these assets on to investment banks

The mortgage is a bank asset because it has a stream of expected payments.

When banks evaluate clients, they offer lower interest rates to less risky clients.

Banks rarely loan the full value of the house because it is safer if the home-owner has a substantial economic stake in the house.

Mortgage Originators

Mortgage Backed Security (or mortgage bond) made up of pools of home loans

Interest financed payments to owners of different tranches of the mortgage backed security. Senior tranches get lower interest payments but are the last to take losses; the mezzanine tranche gets higher interest payments but is the first to take losses

Senior tranches (AAA rated)

Junior tranches (AA rated)

Mezzanine tranches (BBB rated)

Wall street investment banks

See The Big Short pages 126-8 on financial language

BBB rated tranches

Collateralised debt obligation (CDO) rated AAA

Mortgage bonds made up of pools of home loans

Mortgage bonds made up of pools of home loans

BBB rated tranches

Collateralised debt obligation (CDO) rated AAA

Mortgage bonds made up of pools of home loans

Mortgage bonds made up of pools of home loans

This CDO was also AAA rated!!! by rating agencies whose models had been ‘gamed’ by Wall Street

Incentives facing Wall Street traders

Starting with Salomon Brothers in 1981, the Wall Street partnerships became corporations. Shareholders expect high return on equity (ROE): “from that moment the Wall Street firm became a black box. The share-holders who financed the risk-taking had no real understanding of what the risk-takers were doing, and as the risk-taking grew ever more complex, their understanding diminished’ (Lewis, The Big Short, p.258).

Return on Equity (ROE) = Net Income Total Shareholder Equity

= Net Income x Sales x Total AssetsSales Total Assets Total Shareholder Equity

Net profit margin Asset turnover Leverage ratio

Return on Assets (ROA)

Net profit margin Asset turnover

Leverage ratio

=x x

= ROA x Leverage ratio

Royal Bank of Scotland (RBS) and Citi were the largest banks in the UK and the US respectively in 2007. Their leverage was around 50 when the crisis hit: They could absorb only $2 in losses on each $100 of assets.

Deregulation and risk

• 1990s: growth of derivatives

Side-bar: What is a derivative? • One of three main financial instruments (the other two

being debt and equity)• A derivative is a contract that derives its performance

from an underlying entity (‘the underlying’). It is used to insure, hedge and speculate. Common derivatives are futures, options (‘call’ and ‘put’) and swaps

• Most are traded ‘over-the-counter’ (off exchange). The ISDA (International Swaps and Derivatives Association) provides a standardized contract and rules to manage how and when payments are made

E.g. a LEAP (a ‘long-term equity anticipation security)

• It is an option to buy a stock at a fixed price for a certain amount of time.

• Jamie Mai and Charlie Ledley used LEAPS when they thought that stocks were under-valued because of some uncertainty and that their value would increase significantly later once that uncertainty had been resolved (Big Short, pages 113-4).

• This derivative allowed you to make a bet without having to buy the stocks upfront.

Deregulation and risk

• 1990s onwards, growth of derivatives and related financial innovation.

• 1999 Gramm-Leach-Bliley Act (Financial Services Modernization Act) which ‘allowed commercial banks and investment banks to combine and form vast financial supermarkets’ (How Markets Fail, page 7).

• 2000 Commodity Futures Modernization Act (to prevent the Commodity Futures Trading Commission from regulating ‘over-the-counter’ derivatives

• The US Securities and Exchange Commission (SEC) relaxed leverage ratios for the big investment banks and effectively stopped regulating the investment banking industry.

• All this was justified by an ideology of market efficiency that was blind to the incentives on Wall Street to drive up leverage and increase returns on assets through riskier lending…

Credit Default Swap (CDS)

• A CDS is a derivative which allowed investors to pay a premium in return for insurance against default on a particular asset (e.g. a mortgage bond or a CDO). They were good for shorting the market (you effectively paid a small premium each month (and you knew exactly what this ‘downside’ was) and your upside was very big.

• For example: It cost Michael Burry 200 basis points (2%) to buy CDSs on BBB rated tranches that would be worth zero if the underlying mortgage pool experienced losses of just 7 percent. This meant that on a CDS of $100 million he would pay $2 million a year with the chance of gaining $100 million when the loans went bad. (The Big Short, page 50-51).

Credit Default Swap (CDS)

• CDS’s transferred all the risk to the insurers (sellers of CDSs) – notably AIG. CDOs had typically comprised a mix of loans, credit card debt etc. but by mid 2004 they were 95% sub-prime mortgages. (‘Bait and Switch’, The Big Short page 71

• CDSs could be paired with CDOs, the package declared ‘risk-free’ and held off the bank’s balance sheet (The Big Short page 77)

• Some CDS’s were repackaged into (synthetic) CDOs and hence continued to ‘fuel the doomsday machine’

• 2006 Goldman Sachs started buying CDS’s against the CDOs they were selling to their customers

The Inside Job (Charles Ferguson)

• The Inside Job clip: 21.53-40.50

• Deregulation, powerful financial institutions, adverse incentives….

• A justificatory economic ideology that was opposed to regulation and which assumed that the ‘sophisticated’ financial companies and products were good for capitalism and for spreading risk.

• Warnings ignored and ridiculed.