What caused 2008 financial crisis?

An in-depth insight into housing loans in the United States

This article is mainly about housing loans in United States and how they work. A small part of the article will be about how financial crisis is related to housing loans.

What is a financial crisis?

In 2008, the news was all about an economic crisis affecting people all around the world.

As a developing country with less participation in economic activities in the globe, Sri Lankan people were not impacted as much as the people in developed countries did. Usually, these crisis situations bring high unemployment rate. Less products and services are produced by corporations resulting in low profits or heavy losses. And also high inflation or deflation come along with them. This results in decreased government revenue. So government becomes less capable in providing welfare for the citizens.

In overall economic crisis situations result in suffering, political instability and social unrest. A government’s job is to make sure such situations never occur or at least minimized.

United States is the largest economy in the world. There is no question about it. Comparing GDP values of large economies can easily prove it. USA has the largest financial system in the world. It is very sophisticated, complex and large beyond comparison with Sri Lankan financial system.

When the economic situation of USA goes down, it is natural for the world economy to go down with it. USA economy policies have been capitalist oriented for a very long time and it will continue to do so. Capitalism has brought economies around the world a long way and resulted in better lives compared to strictly socialist economies. Along with the fast growth it provides, there is an inherent problem with capitalism. Economic crisis in 2008 is an example. USA has failed to avoid economic downturns from occurring every decade. What is called ‘business cycles’ in economics books is an inherent problem with capitalist economies. That is why the modern world is trying to adopt a mixed economy.

2008 economic downturn occurred after 2000 economic downturn, which is also known as “dot com bubble”. This occurred due to the development of internet. People over-estimated the growth of the economy from the emergence of internet. It is a separate topic to learn about.

Similarly, an economic downturn occurs every decade. In 2020 an we are experiencing another downturn amplified by the Corona Virus. Given below is an interesting video about predicting financial crisis situations before they occur.

What are these housing loans and how can they create a huge crisis like this?

In Sri Lanka housing loans are common. People often take 20–30 year loans from banks and proceed to pay these loans over their lifetimes. Sometimes the interest payments can be a huge burden on the monthly income of a person. Inability to pay the loan in time can result in the house being seized by the bank.

In the USA, situation is similar. These loans are called Residential Mortgage loans. In Sri Lanka also, people take loans as mortgage loans.

This is how USA system becomes far more complex than our country. Let’s say 1000 mortgage loans are issued by a bank to general public. The bank has invested a large amount of money and expecting to receive them in 20 years or more. Now the bank’s balance sheet shows a long term loan receivable in 20 years (Asset — A pool of mortgages). What the bank does is selling these Assets to another large bank. What the large bank does is using this asset as collateral to loan cash from public by selling securities.

So this is a loan backed by a loan. These are called Residential Mortgage Backed Securities (RMBS). In other words, these are securities backed by Residential Mortgages.

When the house owners pay the principle payments and interest payments for the mortgage loan to the bank, the money can be used to pay the RMBS security holders created by the bank.

Subprime mortgages are the mortgages that are high risk. If the borrower is unable to pay the debt, bank can take hold of the house. There is a risk of house’s value being lower than the debt, hence there is a possibility of bank losing out.

Existence of RMBS securities seems crazy, when you hear it. Why on earth people issue loans on expected payments from another loan. There are people crazy enough to (not actually crazy-they are actually strategic about where they invest) bear this risk. Actually they want this type of risk exposure in their financial asset portfolio ( A persons list of financial asset investments). In fact RMBS are tradable, they have their own prices and interest rates that denote the risk level.

Is that all with mortgages? You wish :)

Issuing loans from loans does not stop here. In fact RMBSs are also collected as pools. Then another type of securities are issued from them. These securities are called, Collateralized Mortgage Obligations (CMO). This is a loan backed by a loan backed by a loan. Sounds crazy right? They exist! RMBS was not enough for some people. There was a problem with it called prepayment risk. People wanted to structure these RMBS into separate classes. This allowed people to expose themselves to very specific risk exposure level. This the world of Asset Backed Securities (ABS).

This seems to be a delicate system and works well to create an efficient financial system by allowing people to expose themselves to their expected risk levels. Why people want to expose themselves to risk is a different topic. Mostly they want to offset downside risks in their business activities with upside risks.

In an economic downturns this can turn very bad. By 2005–2006, housing prices of the USA rose very fast.

When prices rise too fast, it can get uncontrollable. Prices rise because of the hype. Increasing prices mean people want to buy fast and sell a little time later to earn a profit, when there is no actual value. This is a housing price bubble. These types of bubbles are bound to burst because there is no real basis behind these values.

For the purchase of these houses people obtained mortgage loans from banks. More loans the banks issue the better. Banks went on with the hype. Some financial institutions went on issuing loans without taking into consideration the creditworthiness of the person. Along with the housing price bubble, was a bubble of loans from individuals to large financial institutions. Suddenly the prices of houses fell down, resulting in the borrowers unable to pay them back. When banks went on to seize their houses, loan value was much higher than the house itself. A large amount of loans became bad debt. Suddenly everyone became bankrupt.

As described earlier, some of the loans are collateralized by loans, which are again collateralized by loans. One can imaging how these fail as a chain when, simple housing mortgage loans fail.

What I have described is just a small part of the economic crisis of 2008. One can get a general idea about the crisis from the description above.

Financial world is huge. It consists of financial systems that foster different financial markets around the world. It is a world that moves very fast. To get an idea about the sizes of these markets, as of December 31, 2019, the total market capitalization of all stocks worldwide was approximately US$70.75 trillion, which is known as Equity market. Equity (stocks) market is the most known type of markets. A good understanding about this fast moving world can be taken by watching Bloomberg channel.

https://www.bloomberg.com/live/us

In Sri Lanka financial literacy of people is very low and news channels can easily cover our eyes from the truth.

There is a much larger market called fixed income market, which is said to have a total size of more than US$100 trillion. Mortgage securities and mortgages are also fixed income securities. Bonds are the most significant type of fixed income securities in the world. In the financial world, Sri Lanka is a small fish in the sea. Central Bank of Sri Lanka(CBSL) issues foreign currency denominated bonds to obtain funds (This makes a part of the foreign debt owed by Sri Lanka).

Sri Lanka, does not look like a country in the financial world. CBSL is just a small entity trying obtain funds ( CCC rated) among thousand other financial entities. The recent downgrade of the Sri Lankan bonds rating to CCC means that bonds issued by CBSL will be known as ‘emerging market junk bonds’. Very few investors will want to buy Sri Lankan bonds and it will be at very high interest rates. Right now, Sri Lanka is severely experiencing an economic downturn as part of the worldwide economic downturn. Import restrictions imposed by the government is just one of the adverse effects occurred by the downturn.