What caused the financial crisis of 2007-2008? Could it happen again? We take an in-depth look at the history of the credit crunch.
August marks the 10th anniversary of the start of the 2007-2008 financial crisis. It seems like a lifetime ago that pundits were announcing ‘the end of capitalism’ and angry citizens were calling for bankers to be jailed.
Rapid coordinated responses by governments effectively contained the immediate major threat of the crisis: a meltdown of the global financial system. In the decade since, markets have rallied and banks have regained their appetite for risk. However, many consequences of the crisis are still with us. Rather than complacency, we need to be vigilant as global finance reverts to its old habits.
Let’s take a closer look at the causes of the crisis in order to understand how to navigate the future.
Bad debts that shook the world
The global financial crisis was triggered by a large number of American borrowers defaulting on their home loans. Specifically a large number of subprime mortgages were issued to prospective homeowners, culminating in mass defaults.
A subprime loan is a loan offered to borrowers who are less likely to be able to meet their repayments. A high default rate should therefore not have been surprising. Why were so many subprime mortgages issued? And how did defaults by lower-income Americans send financial shockwaves around the world and almost take down the global financial system?
The answer lies in the increased financialisation of advanced economies, and the accompanying increase in complexity and opaqueness of financial products. These conditions were made possible, and then aggravated, by the loosening of banking regulations.
Reacting to history
In the wake of the Great Depression, governments, particularly the US government, imposed much stricter financial regulations. Perhaps the most well-known such legislation are the Glass-Steagall laws that prevented commercial banks from engaging in investment banking.
A period of slow economic growth and high inflation in the 1970s and 80s licenced politicians to impose new policies aimed at recapturing some of the tremendous economic growth of the post-war years.
The consequence was an ongoing process of deregulation, which reached its apotheosis in the Reagan-Thatcher years. The emergence of ‘Reaganomics’, characterised by tax cuts and deregulation, marked a sharp shift from the Keynesian orthodoxy of the preceding decades.
By the time Bill Clinton became president, financial markets had realised a degree of autonomy unprecedented in modern times. And although Clinton famously was furious that his reelection depended on the whims of bond traders, Glass-Steagall was largely repealed under his administration.
Inflating the bubble
The succeeding period can be characterised as a boom time for the US economy. Although there were periods of turbulence (Federal Reserve Board chairman Alan Greenspan famously cautioned about “irrational exuberance” just prior to the dot.com collapse of the mid 90s) it was possible at the time to declare “The End of History” (political scientist Francis Fukuyama’s contention that free market liberal democracy was the only game in town) without embarrassment.
But the financialisation of the economy had many less public consequences, increasing the systemic risk of the global financial system in a number of ways.
Financial products became increasingly complex and opaque, making it hard even for experts to understand how risk was spread and leading to distortions in how securities were priced. Additionally, the increase in off-the-books accounting made it harder to measure market exposure. The mandated techniques for measuring risk were also inadequate.
These factors were aggravated by rating agencies, which effectively acted as clients of the banks. Rating agencies were incentivised to provide higher investment grade ratings to a bank’s products or risk losing business to a rival agency that would give the bank the ratings it desired.
Bankers themselves could secure high fees by selling clients any number of complex products, regardless of market performance. Similarly, bankers could earn themselves hefty bonuses by inflating returns through massive leveraging, an imprudent procedure by bankers who felt they had little to lose and everything to gain by taking huge risks with clients’ money.
That confidence was partly hubris, but also marked a belief in the role of complex financial products to hedge against risk.
In this system, an individual home loan becomes little more than a piece in a dizzyingly complex financial jigsaw puzzle (regardless of the consequences for the individual who took the loan in the first place).
Skin in the game
Let’s consider a traditional home loan. Prospective homeowners approach a bank or similar financial institution and request a loan to buy property. The bank will carefully consider the applicant’s likelihood of repaying the loan.
Given that the bank spreads its risk across a number of borrowers, it can tolerate a certain numbers of defaults. The repossession and sale of the borrower’s property, which is used as collateral in a home loan, can also mitigate losses. However, we can see that a traditional loan entails risk for the bank and that there is a strong incentive for banks to keep defaults at a manageable level.
Banks are willing to tolerate risk in return for profits in the form of interest paid by borrowers on top of their repayments. However, that risk is carefully calculated. We can say that whom banks choose to lend to, and at what interest rate, is rationally determined.
This is a simplified account; the reality in any advanced economy is always going to be a little more complex. But we can appreciate that on this model the likelihood of a mortgage bubble is significantly reduced, and that the fallout from mass defaults is more likely to be contained within the affected bank or banks.
Feeding the machine
On the traditional model, the bank has a strong interest in the ability of individual borrowers to repay their loans. They’re careful to keep defaults to an acceptable limit. The liability pertaining to any single borrower is reasonably clear. The bank’s risk in terms of overall loans to all its borrowers is also relatively transparent.
The securitisation of mortgages increased risk and made risk harder to evaluate. Securitisation is effectively the pooling various debts into a financial product that is sold onto investors. Securitisation in modern finance is exceptionally complex. Indeed, the full complexity is rarely grasped even by those involved in buying and selling securities.
Individual mortgages could now be pooled in mortgage backed securities, with profound effects. Mortgage issuers effectively became middle men who would sell on individual loans to institutional investors. With money pouring into the securitised mortgage market, lenders were incentivised to maximise the issuance of mortgages with little heed for the ability of borrowers to meet their repayments.
According to the logic of the system, while any given subprime mortgage is a risky debt, the risk could be mitigated by pooling the mortgages, with the resulting mortgage backed security safer than the sum of its parts.
Securitisation didn’t stop there. During this period, investors showed a tremendous appetite for collateralised debt obligations, securities which increasingly took the form of pooled collections of mortgage backed securities. Moreover, CDOs were commonly comprised of aggregations of the riskiest parts of of mortgage backed securities, i.e. a CDO would often consists of a collection of the riskiest mortgages within an already risky mortgage backed security. If that makes your head spin, it’s worth pausing to consider why these products were bought and sold with such confidence during the boom.
Contrast that logic to the way banks traditionally mitigate their lending risk. A bank could never entirely eliminate the risk of default, and applying too high a standard would too severely limit the pool of potential borrowers, affecting profits. Risk need to be managed by imposing a sufficiently high standard on each borrower, reducing the chances that an unacceptably large number of borrowers will default at a given time. Whereas, subprime securities were pyramids of junk debts, each loan similarly liable to fail in the event of the slightest economic hiccup.
Easy money produced a surge in demand for housing and rampant speculation in the housing market. The rise in demand and housing prices in turn fuelled investors demands for securities, fuelling mortgage supply and further increasing property prices. The resulting housing bubble could never be sustained indefinitely.
Trading in the shadows
Selling bad debts as stable investments needed the buy-in of the rating agencies. Banks had little trouble securing investment grade ratings on securities comprised of junk mortgages, or even comprised of collections of collections of the most junk parts of junk mortgages. The failure of rating agencies to properly grade securities was probably due to a mix of perverse incentives and an inability to grasp the complexity of a given product or the financial ecosystem as a whole.
Selling risky products marked as AAA grade investments is bad enough. The danger was considerably magnified by massive leveraging that occurred off the books, within the so-called shadow banking system, with very little scrutiny from investors or analysts.
Risk was therefore underestimated in two profounds ways: investments that were in reality highly risky were graded good quality by rating agencies; and the degree of exposure to these products was to a significant extent hidden from public view.
When the subprime mortgage industry collapsed, global investors found themselves holding massive quantities of securities that nobody wanted and no one knew how to price.
The consequences were felt across the financial system. For example, insurer AIG had insured large numbers of CDOs without setting aside sufficient reserves (after all, it was insuring AAA rated CDOs). The company only survived the crisis because of a government bailout.
The US government had to act quickly to restore confidence in the financial system. The Troubled Asset Relief Programme (TARP) was enacted: a bailout in the form of government purchases of toxic assets, such as by then worthless CDOs.
The bailout was extremely controversial, but few would suggest TARP did not at least have a stabilising effect. Financial institutions arguably should never have been permitted to become ‘too big to fail’, but it seems incontrovertible that simply allowing the financial sector to collapse would have had devastating consequences for the world economy.
However, we should continue to ask tough questions about the ongoing measures to stimulate the economy.
The Home Affordable Modification Program (HAMP), which was supposed to help homeowners, was by most accounts a dismal failure. Issuers of toxic assets received massive bailouts while regular borrowers lost their property.
Central bank efforts such as quantitative easing have produced sustained market rallies but have arguably not done much to improve the economic security of ordinary wage earners.
Meanwhile, Donald Trump has vowed to repeal the Dodd-Frank Act, the regulatory legislation passed in response to the financial crisis. As with any Trump promise, there is little connection between what the president says and what he achieves, but there is no doubt the current administration is committed to easing financial sector regulatory constraints.
The global view
Financialisation of advanced economies occurred alongside increased globalisation, characterised by free trade and the free movement of goods and capital across borders (just think of Asian and European investors snapping up securities comprised of mortgages issued to low-income borrowers in Florida).
Globalisation’s champions insist globalised free trade has lifted millions out of poverty. However globalisation has produced economic winners and losers. Poor people in poorer countries have seen substantial increases in wages in previous decades. In richer countries, the wealthiest became much wealthier.
However, poorer citizens of advanced economies have not flourished in a globalised world. In the US, poor and middle class communities experienced flat wages and job insecurity. Regional deindustrialisation profoundly affected communities in the so-called rust belt, which had previously depended on stable, well-paying manufacturing jobs.
The conjunction of a flat economy in which recovery is concentrated amongst economic elites, who seem not to have been penalised for their role in the crisis, and a global trade regime that benefits the 1% at the expense of the advanced economies’ poor and middle class, with growing inequality, precarity and regional dislocation, will invariably be politically destabilising. The ascent of anti-establishment politics in Europe and America cannot be entirely explained by these dynamics but they are certainly an important factor.
Finding the balance
The lessons of the crisis seem clear enough: we need a more transparent financial system with better oversight and more responsible stakeholders. The hard part is achieving it. There is no simple measurement that will tell us whether we need more or less regulation. Rather, we need the appropriate legislation, whatever that may look like, and effective enforcement.
In a complex interconnected world, political economy is everyone’s business. Decisions taken on Wall Street or in the White House can hurt or help workers from Michigan to Shenzhen. Policies written up in the Union Buildings will affect the size of your retirement savings whether you live in Cape Town or Polokwane.
For now, investors are regaining an appetite for risk and complex financial products. Many financial institutions remain too big to fail and deregulation in the US financial sector could be imminent. Staying informed about the state of global finance is no longer a niche concern, it is our duty as global citizens.