Mortgaging Money: 2008'S Financial Crisis And Its Profiteers

The 2008 financial crisis was triggered by the collapse of the US housing market and the subsequent inability of homeowners to service their mortgages. The crisis was catalysed by an influx of money from the private sector, the participation of banks in the mortgage bond market, government policies aimed at expanding homeownership, speculation by homebuyers, and predatory lending practices. The crisis was characterised by a decline in US housing prices, with many borrowers finding themselves in a situation of negative equity, where their homes were worth less than their mortgages. This resulted in a wave of mortgage defaults, which caused financial giants like Lehman Brothers to face mounting losses and liquidity crises. The collapse of these financial institutions led to a widespread economic downturn and eroded investor confidence globally.

Subprime mortgages and high-risk borrowers

The subprime mortgage crisis of 2008 was caused by a combination of factors, including the actions of lenders, borrowers, and investors.

Lenders played a significant role in the crisis by offering mortgages to high-risk borrowers, often with poor or no credit history, and at prices that were beyond their ability to repay. These subprime mortgages were often bundled into mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which were then sold to investors. The ratings of these securities as "triple-A" by agencies like Moody's gave them a false sense of security, attracting global investors.

The influx of money from the private sector and the banks' entry into the mortgage bond market also contributed to the crisis. Easy credit and the belief that house prices would continue to rise encouraged many subprime borrowers to obtain adjustable-rate mortgages. When house prices peaked and began to decline in mid-2006, selling homes or refinancing mortgages became less viable for borrowers to settle their debts. As a result, mortgage loss rates began to rise for lenders and investors.

High-risk borrowers themselves were also a contributing factor. With stagnant wages, many borrowers took on mortgage debt that was well beyond their means. When interest rates rose, they were unable to keep up with their mortgage repayments, leading to mass delinquencies and foreclosures.

Additionally, investors played a part in the crisis. A 2017 NBER study argued that real estate investors were more to blame than subprime borrowers, as the rise in mortgage defaults was mostly attributable to investors taking on more leverage by misreporting their intentions to occupy the property. This contributed to higher rates of default when house prices declined.

The combination of these factors led to a full-blown recession in the US by the winter of 2008, with significant disruptions to the flow of credit and a negative impact on businesses and consumers.

Housing price bubble and declining home values

The 2008 financial crisis was caused by a combination of factors, including a housing price bubble and declining home values. This was fuelled by historically low interest rates and loose lending standards, which made it easier for people to borrow money and buy homes. Even those with poor or no credit history could get mortgages, often for prices they could not afford in the long term. This was further compounded by the fact that, as demand for housing increased, so did home prices.

The availability of credit, combined with low-interest rates, led to an increase in speculative buying. Investors purchased homes with the expectation of selling them for a profit, which contributed to the rapid rise in home prices. This was further exacerbated by the creation of mortgage-backed securities (MBS) and credit default swaps (CDS), which spread the risks of the housing market throughout the global financial system.

As a result, when the housing market began to collapse in 2006, there was a widespread credit freeze as banks and financial institutions faced significant losses. This led to a decline in housing prices, which fell by over 20% from their mid-2006 peak by September 2008. This decline in housing prices had severe consequences for homeowners, many of whom found themselves with homes worth less than their mortgages, leading to widespread defaults and foreclosures.

The impact of the housing price bubble and declining home values was felt not just in the US but also globally, with countries like Iceland, Ireland, and Spain suffering severe economic consequences. The crisis led to significant regulatory changes and greater scrutiny of the housing market to prevent a similar crisis in the future.

Credit default swaps and financial derivatives

Credit default swaps (CDS) are financial instruments used as a hedge and protection for debtholders, specifically MBS investors, from the risk of default. They can also be used by speculators to profit from default. CDSs are the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate bonds.

The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from $33 to $47 trillion. CDSs played a key role in the 2008 financial crisis, specifically in the subprime mortgage market. American International Group (AIG), Bear Stearns, and Lehman Brothers issued CDSs to investors to protect against losses if the mortgages that were securitized into mortgage-backed securities (MBS) defaulted.

Mortgage-backed securities are mortgages bundled into packages and then offered as shares. The CDSs were insurance against mortgage defaults, so investors believed they had completely reduced the risk of loss. This was not the case, as the net worth of banks and other financial institutions deteriorated due to losses related to subprime mortgages, increasing the likelihood that those providing protection would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.

The derivatives market involves more than just put and call options. It also includes contracts involving swapping fixed-interest-rate payment streams for adjustable or floating interest rate payment streams. Businesses involved in speculation in the derivatives market is like gambling. The financial crisis of 2008 could be blamed on the businesses that were heavily involved in gambling rather than the instruments themselves.

Mortgage-backed securities and private-label issuers

The 2008 Financial Crisis was triggered by the collapse of the subprime mortgage market and the complex web of mortgage-backed securities (MBS) and related derivatives. MBS are asset-backed securities formed by pooling together mortgages. The investor who buys an MBS is essentially lending money to homebuyers. MBS can be issued by government-sponsored enterprises like Fannie Mae or Freddie Mac, or they can be "private-label", issued by investment banks or other private financial institutions.

Private-label MBS, also known as non-agency MBS, are not guaranteed by the government and carry higher risk and potentially higher yields. They are grouped by seniority and sold to investors with different appetites for risk. MBS loaded with subprime loans played a central role in the 2008 financial crisis, wiping out trillions of dollars in wealth.

The issuers of private-label MBS used structured finance to create securities. This involved slicing the pooled mortgages into "tranches", each having a different priority in the monthly or quarterly principal and interest stream. The more senior tranches were filled first, and only once they were overflowing did they start to fill the tranches below. This gave the top tranches considerable creditworthiness, in theory, earning them the highest "triple-A" credit ratings. This made them sellable to money market and pension funds that would not otherwise deal with subprime mortgage securities.

Many observers have criticised security ratings agencies for improperly rating MBS in the run-up to the 2008 Financial Crisis. Critics claim that too many securities, especially subprime, were rated AAA. However, others argue that the performance of those securities was not as bad as assumed and that the agencies were unfairly villainised.

Government policies and lending practices

The 2008 financial crisis was caused by a combination of factors, including government policies aimed at expanding homeownership and the predatory lending practices of mortgage lenders.

In response to the bursting of the dot-com bubble, a series of corporate accounting scandals, and the September 11 terrorist attacks, the Federal Reserve lowered the federal funds rate from 6.5% in May 2000 to 1% in June 2003. The goal was to stimulate the economy by making money more accessible to businesses and consumers at lower rates. This resulted in an increase in home prices as borrowers took advantage of low mortgage rates to purchase homes. Even subprime borrowers with poor or no credit history were able to obtain mortgages, often at prices that exceeded their repayment capabilities.

The government policies and lending practices that contributed to the crisis included:

• Historically low-interest rates: The Federal Reserve lowered interest rates to boost the economy, making borrowing more affordable and accessible.
• Loose lending standards: Banks and lenders offered risky home loans to individuals who may not have qualified under traditional standards, often with little to no proof of income or documentation of ability to repay.
• Predatory lending practices: Some mortgage lenders engaged in predatory practices, such as adjustable-rate mortgages and indirect lending via mortgage brokers, taking advantage of vulnerable borrowers.
• Development of mortgage-backed securities: Lenders created complex financial products by bundling mortgages into securities, which were then sold to investors. These securities were often rated as triple-A despite the underlying risk, creating a false sense of security for investors.
• Inadequate risk assessment: The volume of credit default swaps (CDS), which are used to hedge against the risk of default, increased significantly in the years leading up to the crisis. However, as more borrowers began defaulting on their loans, the interconnectedness of the financial system meant that the risk of default spread across multiple institutions, creating uncertainty and instability.

The combination of these factors led to a housing bubble and, ultimately, a financial crisis when the bubble burst. The crisis had far-reaching consequences, including a decline in housing prices, an increase in foreclosures, and a recession in the US and global economies.

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