2008 Financial Crisis – Causes and historical context

My friends and I walked out of the Big Short several years ago feeling like a group of global financial crisis experts. We were shocked, how could no one have seen the collapse coming? It all seemed so clear.

Many an economics and finance course later, I see that the layers of complexities to the 2008 financial crisis are innumerable. I’ll try to summarize some of the causes and historical contexts in this article to provide a greater-than-Big-Short level analysis.

To understand the GFC, you must understand mortgage backed securities (MBS), however complex they may seem. This is because the initial trigger for the crisis was reliance by major banks, particularly those in the United States, on mortgage backed securities as collateral. The repeal of financial regulations, most prominently the 1999 removal of the Glass-Steagall Act, and limited oversight of the shadow banking sector aided in the creation and rapid growth of risky assets such as MBS.

MBS are financial assets with a claim on a pool of mortgages.  Payments of principal and interest received from the mortgages are passed through to investors.

Who would invest in a pool of mortgages of unknown quality?  Well, the pool of mortgages were typically repackaged and sold to investors in discrete slices (called traches), with investors in the junior slice bearing most of the (default) risk that they would not be repaid.  These repackaged securities were called collateralized debt obligations (CDOs).  The senior slices of a CDO were considered to be safer because they had first priority on cash flows received from the pool of mortgages in the event of default.

The MBS market boomed due to a general consensus that property prices would always go up, mortgages were extremely unlikely to fail on a large scale, and the fact that credit rating agencies were willing to give AAA-ratings to the senior slices of CDOs even if the underlying pool of mortgages were all “subprime”.  Subprime being the politically correct way of saying “complete garbage”. Subprime borrowers typically had a low ability to repay due to deteriorating lending standards. Mortgage originators often lent the entire purchase price of a house without asking for documentation to verify the borrower’s income, assets, and employment status.

MBS were being used as collateral for interbank trading, thus essentially underpinning the entirety of the financial system in the US. Once the housing market began to collapse, mortgages defaulted, and MBS began to fail. Banks applied steep haircuts to the market value of these securities making it unviable to use them as collateral, and this led the financial system to freeze up.

As discussed in my previous article, the failure of Lehman Brothers made the crisis real. The 4.5% Dow Jones Industrial Average collapse following Lehman’s failure was the largest stock market decline since the aftermath of September 11.

As the old saying goes, “when the US sneezes the whole world catches a cold”. Be it through directly holding CDOs or having interests in US banks or firms affected by the CDO collapse, foreign banks and financial institutions were hit. Additionally, monetary policy from the United States usually has a major transmission effect to the rest of the world [pdf], but as the GFC was not caused by high interest rates it could not be fixed by a reversal of US monetary policy. A reduction in the Federal Funds rate (the target interest rate of US monetary policy) was intended to make it cheaper for banks to borrow, and get the financial system going again by making it more profitable for banks to lend. However, on October 6^th 2008, the Federal Reserve also began paying interest to banks on their excess reserves stored at the Fed, and the quantity of these reserves reached over $1.5 trillion. In an uncertain economic environment, there was a flight to quality.  Banks would rather store their money at the Fed than lend it to finance potentially risky projects. Money became stagnant, and cross-border capital flows dramatically reduced. Thus, through the combination of the dampened transmission channel of US monetary policy and huge levels of risk aversion due to CDO failures, the financial crisis became global.

Another cause of the crisis was banking system fragility, a major cause for concern in times of economic instability. This is because even if an individual bank is sound, difficulties faced by the overall banking sector can put all banks at risk. In the United States, there was a large and lightly regulated shadow banking sector.  This allowed investment banks, such as Goldman Sachs, to circumvent banking regulations while essentially operating as banks. These shadow banks were able to invest heavily in high risk assets and had lower capital requirements than national and state banks. Historical lessons from the Great Depression show that the failure of bank assets can lead banks to panic and sell those assets, further deflating their prices. To conserve capital, banks institute a lending freeze, and bank balance sheets contract as existing bank loans are repaid. With less bank credit available, prices continue to fall. Lower prices lead to declining profits and lower employment, leading to a pessimistic downward spiral for the economy.

Regulation may constrain growth, but it also reduces risk. Effective regulation can prevent humanity’s limitless greed from pursuing huge risks in pursuit of short term profits.  This is especially true in the banking sector where short term profits are privatised, and losses are often born by the taxpayer.

The GFC mimicked many of the crises of the past. To pursue a greater academic understanding of crises, take a look at Diamond and Dybvig’s influential model of bank runs [pdf] which shapes much of our understanding of crises today. Their studies surrounding bank runs and liquidity show that asymmetric information is a major factor contributing to bank runs. Essentially the haircuts applied to the value of CDOs was driven by information asymmetry. The fundamentals of these instruments were unknown to the purchasers of CDOs. It was extremely hard to value the mortgages that actually made up the instruments, and as such confidence was lost in the instruments and a bank run formed. The bank run which began in the US then transmitted to the wider world, and the GFC was upon us.

Dean Franklet is a third year economics and finance student at the University of Canterbury where he is President of the largest commerce society on campus. Spending his life in Texas and then New Zealand with a few other stops along, he gives a unique global viewpoint to portray in his writing.

Image: Pexels

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