A few years ago, Wall Street thought that it had found an ingenious way to minimize risk in the financial system. In fact, the period came to be known as the Great Moderation Era. However, the whole system was sitting on a ticking time bomb, and a small trigger in the form of the subprime mortgage crisis was all that was needed to bring the financial system to its knees.
How it all began?
In the early part of this decade, the U.S. economy was on the verge of a slowdown, following the dotcom bubble bust. Alan Greenspan, who was the Federal Reserve Chairman back then, decided to lower the interest rates to boost the slowing U.S. economy. Many believe that this was really the start of the housing bubble. However, the lower interest rates cannot entirely be blamed for the housing bubble. The housing market was also boosted by the growth in the Securitization market. Securitization markets have existed for the past three decades. However, it was the phenomenal growth of securitization in the early part of this decade that made its contribution to the bubble so significant.
So what exactly was the problem?
For this we need to first understand how the securitization market works. The idea behind securitization is that you can convert any asset that has future cash flows into debt securities, which can then be sold to investors. This allows the holder of an asset to free up capital. In the early 80s, Wall Street firms found that this could be applied to the mortgage markets. In a bank’s balance sheet, a mortgage would appear as an asset. So the idea was that banks would sell the mortgages on their balance sheet to investment banks, which would then convert them into debt securities, with the interest payments acting as coupon, and sell them to investors. The result, the bank would now be able to free up capital on its balance sheet and in turn lend more. A perfect system that should not have failed, but it did. Here is why.
Are You a NINJA?
In the early part of this decade, as the securitization market grew, banks were now confident that they could sell mortgages on their balance sheet easily. Since they were no longer carrying any risk on their balance sheets, they could afford to lower their lending standards. In fact at the peak of the crisis, you had banks issuing loans called NINJA, which were mortgages given to people with No Income, Jobs and Assets, hence the name NINJA. However, if banks lowered their lending standards, why did Wall Street firms continued to buy them? There were two reasons for this. The first of course was the housing bubble. The second reason was the creation of financial products such as CDOs (Collateralized debt obligations). With these, Wall Street firms could now package mortgages of different quality into tranches and get an AAA rating.
The Summer of 2007
By 2007, Wall Street firms were convinced that they had finally managed to build a robust financial system. However, their system was built on many assumptions that were fundamentally wrong, first of which was that house prices will never fall. In the summer of 2007, as the number of defaults in the subprime mortgage market increased, house prices did fall and so did the financial system. As banks ran to cover loses, it triggered a contagion that further enhanced their losses. By March 2008, the first casuality came in the form of Bear Sterns, one of the oldest Wall Street firms. In September that year, Lehman Brothers collapsed. What followed was the worst economic environment since the Great Depression of 1929.
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