What made Banks too big to fail to collapse? (Financial crisis of 2008)
September 15, 2008, Lehman Brothers, one of the largest investment banks in the United States filed for bankruptcy. What was behind the collapse of a bank that was believed too big to fail? Was it the victim of the vicious circle of the market or the market itself was responsible for it?
Before explaining it, let us go back to 2001 when the fed rate in the USA was 1.75%. In 2002, the federal reserve system of USA again lowered fed fund rate as much as 1.24 %. At that time market started trading heavily derivative products such as mortgage loans, adjustable rate mortgage, credit default SWAP, and subprime mortgages.
Before that, till 1984, only investment banks were allowed to trade derivative instruments as they are considered high risk. However, the enactment of deregulation that repelled the Glass Stegall Act 1933 allowed banks to engage in trading of derivative instruments too. Banks mainly engaged in the trading of mortgage and credit default SWAP.
Things went well until 2001 when the fed rate was below 1.75 %. At this lower rate, people who were not capable of taking a loan at normal situation find themselves in a convenient position. They were able to take a loan (specifically interest only loan as interest rate was related to the fed rate) to buy homes. This availability of easy loan leads to the booming of the real estate sector too. People found it easy to get a loan to buy homes. So many were buying homes to sell again. This easy loan also led to an increase in the demand for homes thereby its prices. On the other hand, banks started lending enormously to those who even were unqualified for getting loans under mortgage security.
So what made banks to provide loans unethically? It is the profit (fee) they made from these derivatives. First of all, they issued a subprime mortgage and collected money from it. Then they will resell those mortgages to govt. Chartered organizations such as Fannie Mac and Freddie Mac. These organizations again resold these mortgages to hedge funds and investment Bankers. Investment bankers combined these mortgages with other similar types of mortgages and resold them dividing into smaller parts perhaps 1000 parts to investors as safe securities.
What was the problem with it? The process of purchasing and selling derivatives, the derivative itself or anything else? Derivatives that derive its value from the value of it is it is underlying security explain that the problem was at the core. The mortgage holders who were unqualified were at high risk of being defaulted. As an example, you build a luxury home with everything beautiful except the base. What will happen if any natural disaster attacks? Inevitably it will fall no matter how good it looks outside.
As long as, the house prices kept going on, everyone got benefited. People were paying loans from the increased equity of the house. Remember, that most of the mortgage holders were fixed income earners. There the terms of the majority mortgages were increasing interest rate after two years even penalty for prepayment. Didn’t the bank think how these people will pay when the rate goes on after two years?
At that time, some predicated foreseen crisis shortly including Alan Greenspan, chairman of Federal Reserve System and FBI. Warren Buffet, CEO of Berkshire Hathaway, warned derivatives as a product of mass destruction. However, the Fannie Mac and Freddie mac rated the derivative products as a safe investment.
Moreover, negative gross domestic product growth and the US budget deficit emerged as a warning sign for the US economy. To handle the market, the Fed started increasing the fed rate. In 2005, it became 4.25% that reached 5.25% in 2006. Very few anticipated that fed rate would rise after two or three years. Now questions are, how it led to the crisis?
The mortgage holders who took interest only loans or adjusted rate mortgage found it impossible to pay the loans of their homes due to the increasing rate. It led to the default of significant numbers of mortgage holders. Banks no longer could get back the loan. So they started selling homes that they kept as collateral of mortgages. It led to the oversupply of the houses thereby decreasing its prices. So House prices fall sharply known as the bubble burst.
Banks and other financial organization who invested heavily in mortgage-backed securities found themselves making huge losses. Following the chain of the process discussed earlier, all parties related to the derivatives faced losses. The situation got worse when trading of derivatives in the secondary market stopped as the market could not determine the real value of derivatives after the burst. Banks denied taking homes as collateral anymore. It created chaos in the market. Financial institutions stopped trusting each other. Banks stopped providing credit to all including an organization which daily operations were heavily dependent on the credit of banks.
The first victim of this crisis was a countrywide financial corporation, the largest American mortgage lender. It was saved by Bank of America which agreed to purchase it for $4 billion on January 2008. Next victim was Bear Sterns which was rescued by JP Morgan. Until that market makers could not predicate how critical it can be. Fannie Mac and Freddie Mac were the next victims online. These two organizations which enjoyed a slight edge in the marketplace by virtue of their Congressional charted faced huge losses. The Fed seized control over them to rescue them from bankruptcy.
The market's falling did not stop there — the market bid down share prices of Merrill Lynch and Lehman brothers after the disposed of Bear Sterns. Merrill Lynch facing losses due to its exposure to mortgage-backed securities agreed to sell itself to Bank of America under pressure from the treasury. However, Lehman Brothers could not find a buyer which forced it to be bankrupt.
On the other hand, the insurance company (American International Group) became the next victim due to its involvement in credit default SWAP. It failed to secure credit through normal channel due to massive losses on its credit default swaps. However, it was saved by the Fed with & treasury with a total of $123 billion.
However, after the bailout of Lehman Brothers, it created chaos in the market. The burning question was Who will be the next? Only two big independent investment banks left – Goldman Sachs & Morgan Stanley. These two investment banks converted themselves into ordinary bank holding companies rather than proving their innocence to bankruptcy court.
It did not impact only US market but spread all over the world. In the UK, the govt. provided $88 billion to buy banks completely and guaranteed another $438 billion worth of bank loans. The Netherlands nationalized the bank’s Dutch holdings. The German government, Angela Markel approved $10.9 billion recapitalizations of Commerzbank and rescued a series of state-owned banks. Perhaps Iceland was the worst victim ever. There three banks collapsed under their weight. The govt. was at the edge of declaring national bankruptcy. Spain, France, Dubai & Greece were the victims too of this global financial crisis. There, the economy of China and India did not get affected such negatively, but its export-oriented industry got destroyed.
Now the big question is, what caused this crisis. The majority believe it is the derivative instruments and deregulation. However, it is the lack of proper control of the authority and greed, corruption and misuse of derivatives instruments that created the chaos and could be stopped. Banks were providing loans to those who were an unqualified and high probability of default. They knew if they default it will lead to the loss of the whole system. Despite they kept providing more and more mortgage loans to make profits.
Moreover, the investment bankers were the primary culprits. Matthew Tannin and Ralph R. Cioffi, former managers of hedge funds of Bear Sterns are two responsible for the loss of subprime mortgages of Bear Sterns. An investigation report revealed that they knew earlier their fund was melting down and the subprime loss would be much worse ever people have seen before the crisis, but still, they continued convincing people to add more money. CEO of Goldman Sachs, Lloyd Blankfein batted against his customers in the market for the complicated derivative products. If you intentionally keep selling default cars and later blame the drivers for the accident then what to say?