A Perfect Storm: A Summary and Analysis of the Financial Crisis of 2008
Name: Scott Dorfman
Class:IDP4U101 – 2009/2010 –Honours Thesis
Date: Thursday December 17, 2009
Teacher: Rob Cotey
Living in a capitalist society means that there will be inevitable periods of time when the economy is weak. It can be seen in history many times; most specifically in the last century. One of the strongest examples was the great depression that began in 1929. The economy was devastated and it took many years for a full recovery. In 1973,an oil crisis led to a serious fall in the economy.[1] In addition to these situations, there were countless others that occurred in the 1900’s.
With the number of economic collapses throughout history, one wonders why it isn’t easy to predict them. There are several varying factors that differentiate each of these unique situations. In 1973, there was a drastic increase in the price of oil[2] that was a major cause of the recession. Towards the end of the 1950’s the U.S. entered a recession that was a result of a major change in Federal Reserve policy.[3]The US Government reduced the money supply which led to higher interest rates and slowed spending.[4]
It seems almost ironic that the crash of 2008 came at a time when the economy was said to be very strong.[5] This made it particularly difficult to predict and many experts failed to do so. Federal Reserve Board Governor Donald Kohn said in 2005:
A couple of years ago I was fairly confident that the rise in real estate prices primarily reflected low interest rates, good growth in disposable income, and favorable demographics. Prices have gone up far enough since then relative to interest rates, rents, and incomes to raise questions; recent reports from professionals in the housing market suggest an increasing volume of transactions by investors, who... may be expecting the recent trend of price increases to continue. Even so, such a distortion would most likely unwind through a slow erosion of real house prices, rather than a sudden crash.[6]
His evaluation of the state of the market was that even if the US economy began to fail, it would be a slow fall, instead of an instant crash. In 2007, the Federal Reserve chairmanBenjamin Bernanke stated, “The impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained”.[7] His assessment of the economy was that any problems that had arisen had already been dealt with.There were others however, who foresaw the crash of 2008 and were attacked for it. Economist Peter Schiff predicted the crash in April 2007, when he said, “We're just at the beginning of the housing slump. Housing is going to collapse, and when it does it's going to take the rest of the economy with it”.[8]
Although it seemed unlikely at the time, Schiff was right, and the United States was devastated.Millions of jobs have been lost[9] and consumer spending dropped significantly.[10] The recession has even spread to other countries.Moody’s Analytics recently reported that there weremore than 15countries in a recession, and at least 22 countries that were in the process of recovering, including Canada and the United Kingdom.[11]
The many different factors that led to the destruction of the economy made it hard to predict, but also challengingto place blame on any specific individual or organization.The long chain of events that occurred gave many different impressions as to who was responsible, but by the time the economic recession had devastated the world it was clear who was at fault. As a result of financial institutionsignoring common-sense lending practices, creating complex and repackaged investments, and utilizing adjustable rate mortgages in combination with discounted interest rates, the American financial institutions were directly responsible for causing the economic crisis.
It is argued that there are a number of parties who all hold some responsibilityfor causing the economic recession; ranging from the Government, to the consumers, to the financial institutions.
One party that is always quick to be blamed is the Government.This case is no exception. In response to the recession that began in 2000(caused by the bursting of the technology bubble)George Soros argues:
...the Fed continued to lower rates-all the way down to 1 percent...Cheap money engendered a housing bubble...When money is free, the rational lender will keep on lending until there is no one else to lend to.[12]
After the Government lowered interest rates to stimulate the economy, credit became easily available. Soros explains that financial institutions (lenders) were just doing what any organization would do under the circumstances.
Although it is easy to point blame at the Government and financial institutions, often times it is a lack of common sense that is at fault. Most people know that one should not buy things one cannot afford. A decrease in interest rates should have led to lower payments, rather than purchasing larger and more expensive homes.Paul Krugman, a Nobel Prize winner in Economics blames the consumer for this situation:
Low interest rates should have changed the mortgage payments associated with a given amount of borrowing, but not much else. What actually happened, however, was a complete abandonment of traditional principles...this was driven by the irrational exuberance of individual families who saw house prices rising ever higher and decided that they should jump into the market, and not worry about how to make the payments.[13]
Others however, contend that financial institutions are to blame for thecrisis of 2008. In their article “The Ratings Charade”, Bloomberg writers Richard Tomlinson and David Evans assess the validity of financial investment instruments such as Collateralized Debt Obligations (CDOs)[14]. They say that “it's nearly impossible to find out exactly what's in a CDO, and CDOs aren't regulated”.[15] It is also noted that “U.S. banks have invested as much as 10 percent of their assets in CDOs”.[16]The conclusion that can be drawn from this is that banks (and other financial institutions) were putting a significant amount of their money into investments that were very risky.
USA Today writer Adrienne Lewis also lays blame on financial institutions. She observesthat having realized their mistake, banks have returned to more traditional types of loans. “Gone are loans for people who have trouble paying their bills on time. Gone are mortgages for 100% of the home price. Gone are loans requiring no proof of income or assets.”[17]
The willingness of American financial institutions to loan their money to anyone who wanted it caused a string of events that was a direct cause of the economic crisis.After thousands of consumer mortgage defaults, other people were scared of losing their houses and stopped spending money. Many retailers went bankrupt and laid off their employees. There became less money to spend and more businesses failed.
Beginning in 1991, housing prices in the United States began to increase steadily.[18] From 1997 onward, Robert Shiller - creator of the Case-Shiller home price indices - found that housing prices in the US were increasing significantly faster than household incomes, population growth, or building costs (refer to figure 1).[19]It quickly became clear that housing prices would continue to increase and financial institutions began to take advantage of the situation. They realized that they could afford to begin taking risks on clients because if a loan was not repaid, the bank could seize the client’s house and sell it at a profit.Risk-Management expertsRobertDon Tapscott explain, “Banks and brokers were lending against a greater estimated ‘future market value’ that never materialized”.[20] Though it was a risk on the part of the financial institution it ended up affecting consumers as well.
On the other side of the spectrum, consumers needed additional funds to afford more expensive homes. The average price of a house in the US rose from approximately $200,000 in 2000 to $275,000 in 2005.[21]There were many Americans who were unable to afford a house, and because they had a low credit rating they were unable to get a traditional mortgage.Instead, consumers got what was known as a subprime mortgage.
Subprime mortgages are useful because many people who could not get into the housing market were given a chance to do so.The risk however, is that there is a larger chance of the borrower not paying back the loan in full.
Subprime mortgages have proven to be extremely dangerous. Initially they were not used except in rare cases; however in the early 90’s subprime mortgages became more common.[22] Then, in 2004, the use of subprime mortgages skyrocketed.[23] Subprime mortgages accounted for 20% of all mortgages in 2005 and 2006.[24]Although it seemed very risky to have one-fifth of all mortgages as subprime mortgages, the banks looked at it as a money making opportunity. After all, they could just repossess the higher-valued home.
Banks were not considering what might happen if house prices decreased. As mentioned earlier, the average price of a house in the US rose by $75,000 in just five years. If that trend continued, banks would gain from repossessing a house.However, the true dangers of subprime mortgages were revealed when housing prices began to decline. In the first quarter of 2008, only 12% of mortgages given in the US were a type of subprime mortgage, yet they accounted for approximately 50% of home foreclosures.[25]
In addition to using subprime mortgages, banks began to advocate re-financing.Many families who were well on their way to paying off their mortgage opted to re-finance because they wanted a new car or a boat. Author and Economist George Soros notes the ability of banks to convince clients to refinance:
From 1997-2006, consumers drew more than 9 trillion dollars in cash out of their home equity and home equity withdrawals were financing 3% of all personal consumption.[26]
The particularly disturbing part is that re-financing was used for personal expenditures. Often consumers re-finance out of necessity, to pay their bills.Re-financing a home proved to be extremely dangerous later on as house prices began to drop.
Banks were lending as much as they could to anyone who wanted their money. Soros states, “Towards the end of the bubble houses could be bought with no money down, no questions asked”.[27] Soros notes that banks began to give out mortgages equal to the full cost of the house.This was a major cause of the recessions as it led to defaults on homes that were worth less than the price of the mortgage, causing a substantial loss for the loan giver.
For example, an individual wants to purchase a house for $100,000. The financial institutions chose to loan the individual the full $100,000, regardless of whether or not there was a good chance of being repaid. If the price of the house went up, the bank either got paid by the individual, or the individual defaulted on their mortgage and allowed the bank to take over their higher-valued house. However, if the price of the house went down and the individual defaulted on the loan, the bank would lose thousands of dollars. It wasn’t uncommon for loans to have a value greater than that of the house.With a higher supply of homes on the market, prices went down. To put it simply, initially subprime loans were not an issue, but as they became more widespread they caused a huge problem for financial institutions.
Some will argue that the government is at fault because they failed to enforce strict regulations.While this argument appears valid, it is important to note that three highly influential positions in the US Federal Governmentwere held by former Goldman-Sachs (a major US financial institution) employees.[28]It is logical that decisions of the Government would be heavily swayed in favour of banks when they were influenced by former bank employees.In addition, the fact that regulations were loosened did not forcefinancial institutions to give out these kinds of loans.Common-sense should have been used to understand that if a large number of people have subprime mortgages, there will be a larger number of people defaulting, thus increasing supply and decreasing price.
Others argue that by lowering interest rates the Government created the problem. It was easier for financial institutions to give out big loans with a small interest rate.The low interest rateargument can be proven false by comparing the Canadian and American economies. At its lowest point, interest rates in the United States were only 1% less than that of Canada.[29] Canada’s economy however, fared much better than the United States’. Even well into 2008, housing prices in Canada continued to rise,[30] suggesting a demand for houses. The true cause of this problem was the number of subprime mortgages given. James MacGee, a researcher at the Federal Reserve Bank of Cleveland writes:
While subprime mortgages accounted for less than 5 percent of mortgage originations in the U.S. in 1994, a fifth of all mortgages originated between 2004–2006 were subprime…But while subprime lending also increased in Canada, the subprime market remains much smaller than in the U.S. The most cited estimate is that subprime lenders had a market share of roughly 5 percent in 2006.[31]
This difference of over 15% was caused by financial institutionsthat were greedy and attempted to give out overvalued subprime mortgages.
The banks made a fatal error in assuming that housing prices would continue to rise. They took advantage of rising house prices to lend out as much money possible and in the end it backfired. Even though the government did not intervene by tightening regulations, the blame still lies on the financial institutions for their use of subprime mortgages.
The second reason that financial institutions are to blame for the economic crisis is because they manipulated bond investment ratings in such a way that they depicted an inaccurate rating of the bond’s risk. These inaccurate ratings led to poor judgement when investing and caused many unnecessary financial losses.
Before this argument can be made clearly, it is necessary to definea Collateralized Debt Obligation (CDO). To quote the BBC’s Business Editor, Robert Peston, CDOs are, “bonds created out of other bonds”.[32] Much like bonds, CDOs are given ratings based on the amount of risk they hold. These ratings can range from AAA (the safest investments) all the way to B.[33]Often times a CDO is made up of several different loans or mortgages put together.[34]
The problem with CDOs is that the risk they hold is unknown.Many times they are created from thousands of subprime mortgages.[35]As outlined above, subprime mortgages are very risky and ended up creating a huge problem for banks.
The banks were able to repackage these risky loans to appear as if they were more secure investments by grouping large numbers of loans together. They would then sell the rights to this package of loans to different investors based on a hierarchy of the likelihood of default. The first mortgages to default would be considered lower rated investments, while the higher rated investments would be those that defaulted only after all the other loans had failed. The problem behind this theory is that it was believed that the likelihood of the majority of the loans in a pool defaulting at the same time was low. However, when the majority of the loans pooled together were high risk, it did not prevent them from defaulting.
One would think that the rating system would help separate the good investments from the bad ones but this proved to be false. Millions of dollars were being spent on investments that were unrated. It was found that:
...the California Public Employees’ Retirement System, the nation’s largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches[36] to Calpers.[37]
In just 5 years, over $500 million has been spent on equity tranches (unrated CDOs) by pension funds.[38]Why would banks sell unrated CDOs worth over $500 million, to a pension fund, something that can not afford risk?
It is true that credit rating agencies such as Standard & Poor’s, Fitch, and Moody’s, are responsible in creating many of these false ratings, but they hold less of the blame than the banks.The credit rating agencies recognize themselves as a guide to help investors, rather than as a decision making tool. “What we're saying is that many people have the tendency to rely on it, and we want to make sure that they don't,” says the senior managing director at Moody’s, Noel Kirnon.[39]Due to the complex nature of CDOs, it is extremely hard to be accurate when classifying them and rating agencies do their best to act as a guide.Financial institutions however, are responsible for creating the CDOs,[40] as well as selling them.
When assigning ratings for CDOs, it must be understood that the first mistake was not made by the rating agencies. As an example, assume that a CDO is made up of 1000 subprime mortgages. It is true that some of those mortgages are safer than others, but ultimately, they are all subprime, meaning they are all dangerous.The complexity of these investments made it hard to assess what was actually being purchased.Robert and Don Tapscott note: