The Story Behind – Chapter 1 : The 2008 Economic Crisis

The Story Behind – Chapter 1 : The 2008 Economic Crisis

The 1980s—THE START OF IT ALL

What is a Bond? Well, A bond, also known as a fixed-income security, is a debt instrument generated for the purpose of raising capital. They are essentially loan agreements between the bond issuer and a financier, in which the bond issuer is required to pay a stated amount of money at definite future dates.

Since a bond basically represents a source of revenue which is fundamentally based on borrowed money, the Wall Street, in the late 1980s decided to create “bond-like” financial products which were sourced from different income sources which were based off debt, things like student loans, credit card and home mortgages.

Thus, a new kind of a bond in the form of the “mortgage bond” was born, which actually turned out to be a new financial product which were bought in and sold by the investment banks the likes of which include the Goldman Sachs, Merrill Lynch, Bear Sterns, JP Morgan and Morgan Stanley.

MORTGAGE BONDS – THEIR INHERENT PROBLEMS

The mortgage bond basically takes thousands of home mortgages which were purchased from lenders to bundle their income source which majorly were the monthly mortgage payments into a single financial product, which later, are bought and sold as a bond. Such bonds though have a couple of unique (and later on, crippling) problems based on the concept that the homeowners most often refinance their own debt during periods of low-interest rates, so as to prematurely repay the principal.

In order to address this concern, what Wall Street did was to structure these separate mortgage bonds into stacked layers which were called the “tranches” with the lowest layer representing the first N mortgages to be paid off early, and the topmost layer being the last N mortgages. Investors which were seeking higher and higher returns on their money while accepting more and more risks could now invest in these lower “tranches”, and those wishing lesser return with lower risks would instead invest in the higher tranches.

The 1990s—THE RISE OF THE SUBPRIME MORTGAGES

The major Wall Street firms by these time started to use the “subprime mortgages” to create mortgage bonds. These mortgage bonds were the mortgages having a higher risk, whilst paying even higher interest rates, and were made to the debtors having lower levels of credit. These structural “tranches” of the mortgage bonds which were built from the subprime mortgages, at this point, basically signified not only pre-payment but also the absolute default.

With the increasing demand from Wall Street to buy subprime mortgages, lenders were encouraged to place ever more subprime loans (since they were no longer at risk, if the loans failed), and began to push messages like, “refinance your home, unlock all that equity, pay off your credit card debt, and go on vacation.” Often, these lenders swayed those without credit and who can’t afford a mortgage at all to get one nevertheless. To induce these customers, a new type of mortgage was created, a variable rate one, which had extremely low (which were even zero, in some cases) initial interest rates, and which were later reset to higher levels.

These mortgages were grabbed en masse, not comprehending that the real estate bubble materializing around them was actually driven by their own actions.

The EARLY 2000s—THE RATING AGENCIES

Since the underlying mortgages degraded in terms of quality, the Wall Street’s mortgage bonds started to become naturally riskier, which common sense dictates, ought to mark them much more challenging to sell to investors. Why? Since the buyers of Wall Street products look upon the rating agencies, specifically Moody’s and Standard & Poors for assistance. Through those ratings by the agencies, the riskier the product is, the lower ratings they are given.

These rating agencies and the Wall Street have a fundamental conflict of interest. This is visible through the fact that the Wall Street is the one who pays these agencies to rate the investments. This conflict leads these rating agencies to rate these high-risk mortgage bonds sky-high ratings.The agencies would now use the models delivered to them by the Wall Street and rate the mortgage bonds based on the average credit scores (FICO scores) of the Borrowers. The Wall street started to structure the bonds containing both the high and low FICO borrowers, which then increased the overall bond ratings.

We’d need to get into a bit of information revolving around the FICO scores here.A FICO score is a type of credit score created by the Fair Isaac Corporation. Lenders use borrowers’ FICO scores along with other details on borrowers’ credit reports to assess credit risk and determine whether to extend credit. FICO scores take into account various factors in five areas to determine creditworthiness: payment history, the current level of indebtedness, types of credit used, length of credit history and new credit accounts. FICO scores range between 300 and 850. In general, scores above 650 indicate a very good credit history. In contrast, individuals with scores below 620 often find it difficult to obtain financing at favourable rates. Source: Investopedia.

The fact that the solvency of a bond which would compose of 10 borrowers having the score of 680 would be dramatically different to the one with 5 of them having 700 and 5 with 670 never occurred to the rating agencies since for the bond to fail, only a relatively smaller percentage of the total mortgages would need to default.

The 2000s—DESIRE FOR MORE PROFITS RISING TO INSATIABLE LEVELS. THE COLLATERALIZED DEBT OBLIGATION

Despite the boom in mortgage bonds, Wall Street’s desire for ever more profits grew stronger led them to focus on the relatively lower ratings of the bottom (riskiest) tranches of the mortgage bonds. They came up with a clever idea. If they could package the bottom tranches of hundreds of different mortgage bonds together, then on the principle of diversification, perhaps they could convince Moody’s and S&P to give higher ratings to the collection as a whole.

That’s exactly what happened, and the “Collateralized Debt Obligation” (CDO) was born. What in retrospect seems unthinkable, the rating agencies gave CDOs a rating of triple-A (AAA) — communicating a risk rating equivalent to US Treasuries. This was based on the premise that if one group of Americans began to default on their mortgages, it would be unlikely that other groups would.Just think about that.

These AAA ratings opened the door to a huge market for Wall Street firms — allowing them to sell CDOs to organizations such as state and private pension funds, whose bylaws prohibited them from investing in anything other than AAA-rated financial products.

2007—Mortgages being run out, moving towards using Credit Default Swaps

Come 2007, the mortgage market started to dry up, and the home prices started to stop inflating; while all the defaults were already scaling up. The Wall Street chose to have a blind eye towards the obvious, the continued to be still focused on the sales concerning the CDOs. But now, since the source of mortgages were falling down as mentioned previously, they had to collect something else to pack in those CDOs.

They found the answer lying within the credit default swaps, which were their income streams. The bank themselves started to see the credit default swaps and started to package the income streams from them. In the form of the insurance premiums into those CDOs.

2008 – The market collapses

The Investment banks by 2008 were making obscene volumes of revenue, but there was a sizeable amount of CDOs and Mortgage bonds awaiting to be sold. These also were on the liability side of the credit default swaps, which were already colossal in number and majorly sold and traded in between themselves. AIG’s liability end with the credit default swaps could net to billions of dollars. The Pension funds around the world, with even European countries having invested in them, had large-scale investments on the CDOs and the mortgage bonds.

And then it all collapsed down.

It started with the dropping down of the real estate prices. The Americans started to default en-masse on their mortgages. The investments banks started to check up on their losses on their CDOs and mortgage bonds, but it was already too late and it also led to the collapsing down of the credit default swaps being hedged. Bear Sterns started to fear insolvency, and once those reports surfaced, their stocks crashed, which in turn triggered the same for the other financial firms. The government intervened with helping the Lehman Brothers to go bankrupt while triggering even more panic in the market, leading to the freezing of the commercial lendings, and paralyzing the business in America and thus, all over the globe, like a domino effect. Many Americans and a significant number of Europeans lost their jobs, savings and retirement funds.

The US Government, in order to save the faces of AIG and other world’s largest financial firms from the collapse, bailed them out, paid off their debts and assumed their liabilities which placed this burden onto the rest of the American people which most likely, would still have an effect for generations to come.

In addition to that, In order to save their faces, and their assets, Bank of America merged with Merrill Lynch in a $50 Billion Buy-out.

And once this was all over, the executives of all these major wall street firms went home with billions of dollars of the tax-payers’ money in their wallets in the form of cash bonuses.

REFLECTING ON WHAT HAPPENED.

Gurmeet Singh is currently a student at Indian Institute of Technology (IIT) Kharagpur, majoring in Computer Science and Engineering. Alongside, he also is a Marketing and Business Consultant, currently working part time as an Analyst for Brands of Desire (A Brand management consultancy based in Gurgaon). He has a penchant for writing about Business, Technology, Marketing and sometimes also dabbles in the Entertainment field. His hobbies include Reading, writing (Obviously) and cooking and he hails from Meerut (NCR New Delhi).

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