Over 10 years ago, on 15th September 2008, the world read about the most significant bankruptcy in history. Lehman Brothers, the fourth largest investment bank in the US, collapsed. The result was the loss of 25,000 jobs and, more importantly, the start of a chain reaction across global markets that led to arguably the worst financial crisis in history. Connection’s Oliver Ronald provides a bit of perspective…
1. EARLY WARNING
The first warning of the danger of mortgage-backed securities and other derivatives came on February 21st, 2003. That’s when Warren Buffett wrote to his shareholders, ‘In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’.
2. THE BELIEF IN BRICKS AND MORTAR
Before the crisis, real estate made up almost 10% of the US economy. The US Government was happy that the property market would continue to prosper. The US Federal Reserve decided to significantly lower the Federal Funds Rate, which meant that more people could get their mortgages approved even if their credit rating was questionable (subprime mortgages). Believing that property was as safe as houses AND interest rates would stay low, both borrowers and lenders believed they were on to a winner – even when things started to go wrong. The Federal Reserve attempted to slow down the housing market with over a dozen interest rates hikes between 2004-2006 – but it didn’t stop. What happened next was key: House prices began to fall, federal interest rates went up and those on interest rate only mortgages where often lured with lower rates for the first two years. The banks were keen to reduce their risk.
3. COLLATERALISED DEBT OBLIGATION
After the lenders (not just banks) approved the loan, they were sold to an investment bank. The investment bank would then ‘bundle’ these mortgages to other parties (pensions, derivatives) to invest in Collateralised Debt Obligation (CDO). The collateral part of the name comes from the promised repayment of the loans. The CDO is a derivative and has long been used by the stock market, as the name implies it ‘derives’ its value from the core asset. But why did the banks take this route?
1. It moved any risk from their books to someone else’s.
2. It gave them more money to get back on the mortgage lending trail.
3. It gave the banks more products to sell, boosting share prices and of course bonuses.
So, were the banks cautious when they saw things going wrong with the housing market? No, they carried on and were less disciplined in adhering to strict lending standards, knowing they could offload the risk.
4. ANTHONY BOURDAIN
For the best, and most entertaining, insight into how the financial crisis of 2007-2008 was triggered by the United States housing bubble, watch The Big Short. It also contains a cameo from the world’s coolest celebrity chef, now sadly deceased – Anthony Bourdain. He likens the banker’s repackaging of bad loans to resell to his management of ageing stock in the kitchen…’Being the crafty and morally onerous chef that I am, whatever crappy levels of the bond I don’t sell, I throw into a seafood stew. See, it’s not old fish. It’s a whole new thing!’
5. WHY WAS THIS SO BAD?
Whilst the Federal Reserve believed they were trying to slow the speeding market down by increasing the interest rates, they undoubtedly led to a less than safe landing – in fact, a crash.
At that time, most economists thought that, as long as the Federal Reserve dropped interest rates by summer, the housing decline would reverse itself. It was not fully appreciated, in the murky world of credit swaps and securitisation, just how big the subprime mortgage market was.
6. HAVE WE LEARNED?
The good news is that subprime mortgages don’t exist – actually the do, but in a different name, the cleverly disguised ‘non-prime loans’, to borrowers struggling with their credit. Whilst most of the complex securitisation and credit-default swap and other such tools have gone, there is a growth in collateralised loan obligations. A friend of the CDO, these are used for ‘companies’ with low credit ratings.
Whilst the banks have tightened their standards (as many businesses will have witnessed post-2008, when the horse had bolted) some non-bank lenders have not. In the US, those non-bank lenders who typically lend to those with lower credit scores account for half the mortgages issues.
7. AND THE EFFECT ON US NOW?
What caused two of the biggest political upsets in recent times?
From 2008, earlier in some cases, most of the world endured a period of austerity. Crucially, however, that austerity affected people in different ways, often depending on where you lived and worked. What is clear is that it was felt most by those least able to afford it. The American dream was to have greater wealth than your parents. The financial crisis changed all that. So whilst all those with the financial clout made clever knockdown price cash investments during the recession, many with negative equity and a less than rosy future were feeling less positive. Up popped Messrs Trump, Farage and Johnson (Boris), with a promise to lead us to the Promised
Land. Whilst other factors have led to the rise of the deep community and family divides in the UK and the US there is little doubt that the financial crisis of 2008 played a significant part in our current state of the nation.
And jail time for those masters of the universe that helped cause millions of households to lose jobs, their savings and their homes? No. In fact. With the single exception of Kareem Serageldin of Credit Suisse.