You probably know a catchphrase or two about what happened, when and who to. But do you really know why the world economy collapsed? In this article I aim to explain in the simplest terms possible how and why the world economy collapsed, so that you may better understand the warning signs the next time around. Also, why there inevitably will be a next time.
The collapse of the American housing market is widely accepted as the catalyst for the collapse of the world economy. So firstly we must consider the causes of the collapse of the American housing market. The crisis has been described as a perfect storm of microeconomic failures such – competitive deregulation of the financial markets due to heavy lobbying of congress, fundamental flaws in the rating agencies business models and more than anything else, overwhelming amounts of greed in the finance industry.
It all started in early the 2000’s when investors, looking for a high yield low risk investment scheme started throwing money at the housing market. Their belief was that they could get a better rate of return for their money from the interest rates on mortgages than if they invested in low risk stocks/shares or US treasury bonds. They didn’t want to buy individual mortgages so instead they bought Mortgage backed securities, or MBS, which are created when large financial institutions securitize mortgages, so bundling them together in a big group. They would sell shares of that pool to investors who were attracted to them because they believed them to be low risk high yield.
Then came the Community reinvestment Act – A US law passed to help low income Americans get mortgages. In exchange for allowing low income families mortgages the banks would have their applications for new bank branches and mergers and acquisitions approved. Also, due to the high demand for more MBS mortgage lenders began to lend money to people who were less likely to be able to pay back their loans – called sub prime mortgages (Sub prime here means high risk). This caused housing prices in the US to soar due to a large increase of potential buyers.
This was perfect for investors as it allowed them to invest much more money into mortgage backed securities as there were millions more mortgages to securitize and sell on. The investors thought that their investments were safe due to a belief that if people defaulted on their mortgage they could simply sell the house on for more money -as housing prices had gone up – or lose a little but long term see excellent returns on their investment.
Some lenders even went as far as using predatory lending practices – pay day loans are an example of this practice – where the lender would not verify the income of the debtor and just hand out loans to pretty much anyone with payments people could easily afford at first but later on spiked to absurd rates – as high as 500% so that they could sell the debts on for more money.
At the same time credit ratings agencies – who’s job it is to independently and fairly rate a debtors, or mortgage owner’s ability to pay back a debt – began to give these Mortgage backed securities AAA ratings, which means the ratings agencies believed they were very unlikely to default. Since the crash ratings agencies have claimed that since sub prime loans were new they relied on historical data in order to rate the loans. It probably didn’t help that the credit agencies would likely give the big banks the ratings they wanted because otherwise the big banks would just go to another ratings agency.
This kind of relationship between regulator and the regulated made it impossible for the credit agencies to be impartial or to offer correct ratings. It defies all logic in terms of regulation and begs the question; if the banks run the regulators thus the regulators are not impartial, why do the rating agencies exist? simply, because they legitimize the banks selfish investment decisions. It wasn’t investment bankers who ended up homeless as a result of all this.
Investors trusted the ratings agencies and continued to pour in money. Traders then started to sell an even riskier financial instrument called the CDO – or Collateralized debt obligation – which were also rated AAA by the ratings agencies even though most of them were made up entirely of unbelievably risky loans and mortgages. All the while housing prices continued to climb which convinced investors that MBS/CDO were solid safe investments.
In the second quarter of 2007 the interest rates on sub prime mortgages began to spike. Borrowers started defaulting which put more houses back on the market for sale, but there were no buyers. This flip of supply and demand sent housing prices crashing though the floor. Hundreds of thousands of American home owners suddenly had a mortgage for nearly double what their house was actually worth, which they simply could not pay – so they didn’t. This led to more people defaulting on mortgage payments, more foreclosures and housing prices dropping further.
Lenders could no longer sell their sub prime loans they had given out to the big banks, so one by one they started declaring bankruptcy. By 2007 some of the biggest lenders began to drop, either declaring bankruptcy, being bought out or forced into mergers or having to be bailed out by the government. The biggest of which was ABN AMRO – valued at the time at $70 billion, shortly followed by Northern Rock in the UK in February 2008. The virus then spread to the big investors who had poured money into MBS and CDO – they now started to hemorrhage money, culminating in Lehman brothers – at the time the fourth largest investment bank in the united states – declaring bankruptcy.
The icing on this cake comes in the form of one last financial instrument called the credit default swap. Essentially, this is insurance for an MBS or a CDO. The banks and investors who had heavily invested in these sub prime loans had balanced their books by selling credit default swaps – as it was believed at the time that the housing market would never fail, so they would never need to pay out on these credit default swaps.
But the mortgages did default, the housing prices did drop and they most certainly did need to pay out on those credit default swaps. AIG is the best example to illustrate the damage of credit default swaps; they sold over $10 billion worth of these insurance policies without money to back them up. That was how sure the financial industry was that the housing market would not go down. That is the level to which the banks trusted the regulators. That is how badly the lack of financial regulation in America affected just one company. Not to mention the rest of the world.
Inevitably the stock market collapsed, plunging the US into a recession. The US government then decided intervention was necessary. They offered loans to banks they regarded as “fundamentally sound” in order to stabilise markets. They then activated what they called TARP – Troubled asset relief program – which spent nearly $250 billion of taxpayer money bailing out the banks – just in America. In the UK £137 billion was spent bailing out the biggest banks.
Since the crash, you would imagine that in order to prevent history repeating itself America would have to place many extra stringent rules on its financial institutions, regulators and credit agencies. You would imagine that the people responsible would be hung, drawn and quartered (or at least slapped on the wrist). You would imagine that something would have changed. I imaged so, at least until I read about “bespoke tranche opportunities”, which are the post financial crash CDO equivalent, according to Dominika Wawrzyniak of the Market Mogul website.
Its even more worrying when you consider that, due to lobbying, there really isn’t any more financial regulation than before the crash, and the ratings agencies are caught between the same rock and hard place. Housing prices are constantly on the rise in the UK – often leaping tens of thousands of pounds every year – meaning mortgages are becoming increasingly unobtainable , especially for people working for the government who have face pay caps of 1% year on year – pretty low considering the price of a house increases between 1.9% and 7.5% year on year. So where does this road we’re on lead?
One of three things is going to happen (at least in the UK); If house prices continue to skyrocket year on year, fewer people can afford homes – leading to mass renting, thus further financial instability for more people in the UK (greater wealth inequality) . If the bubble bursts – supply outweighs demand – prices houses plummet and people are once again left with mortgages worth much more than their property is worth. If house prices continue the stay exactly where they are it would be years before most families could afford to buy thus people are increasingly reliant on social housing (which in England is less than reliable) or renting, in which prices are also going through the roof.
It’s predicted that within twenty years half of all households will be renting privately in the UK. Buy to let landlords are now so swiftly building and buying property that as people age their chance of owning a house the following year is actually worse. It seems now that two paths have been put in front of us; A second financial crash caused by the collapse of the UK or US housing market, or the gap of wealth inequality gets even bigger. Something about out of the frying pan.
So how exactly are we going to prevent another housing crash? Anyone?
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