Vienna, Town Hall, opened 1883 (architect: Friedrich von Schmidt)
In the US the crisis broke first. It is important to look at the economic background and the warning signals. Between 1995 and 2005 sociologists identified the baby boomer generation peak earning years, a massive group of people, which drove excessive demand in the US. The internet bubble in 2000 broke exactly in the middle of their peak earning years. Furthermore internet trading enabled the access of many more people to the stock market by making trading cheaper and easier.
Structural changes in the world of the 1990s influenced the economy of the US, such as the collapse of the Soviet Union, the rise of China and south-east Asia, low oil prices – in 1999 a barrel cost $21-, the terror attacks of September 11, 2001 and the collapse of Enron. The US was already in recession. Uncertainty leads to panic and panic leads to reaction, not pro-action. Reactions tend to focus on today, not on the future. That was the situation when Alan Greenspan, the chairman of the FED in those years reacted with a specific monetary policy. It was based on three assumptions: First, markets are fragile, second, markets infer signs from Greenspan’s behaviour and third, he saw himself as the promoter of free markets. After September 11 US citizens did not go on holidays, did not fly, bought DIY stuff, renovated their homes and stayed at home; they reverted to “cocooning”. Greenspan’s drop of the FED Funds Rate after the burst of the internet bubble to 1% in 2004 should have stimulated the US economy.
This resulted in a refinancing boom of people who had a high credit rating. Mortgage rates fell from 6% to 4 ¾ %. When refinancing ended, subprime lending started, namely offering a mortgage to people with low credit rating. Speculators bought homes to make a profit, not to live in: second or investment homes. This made up approximately 40% of all purchases in 2005. The home price index was already inflated when the subprime loans came in, then this trend further boosted the mortgage markets. Retail sales increased due to home equity loans: People took appraisals of the prices at which houses in their neighbourhood were selling to their bank and they were offered a loan on the difference between the high market price of their house and the price at which they took out the mortgage loan. Then they went shopping with this new loan.
Another aspect causing the crisis was the dismantling of bank regulation in the US. Prior to 1999 the Glass Steagall Act of 1932 stipulated a clear separation between commercial banks, investment banks and the insurance industry to protect customers of each line of business. Regulation Q in the 1970s imposed a limit on interest rates banks could offer. Back then commercial banking was not a very competitive business. In 1978 competitive banking started, which brought down the regulatory wall bit by bit and commercial banking was turned into a risky business, which had been reserved for investment banks before. The 1992 Basel I world-wide agreement attempted a global banking regulation that should have limited risk. But in 1996 the floodgates opened, when commercial banks were allowed to do the business of investment banks. The Gramm-Leach-Bliley Act further tore down the regulatory barriers. Now insurance companies could even merge with investment banks. This happened in a totally ineffective regulatory environment as the regulators did not understand the fast changing system.
The technological innovations contributed to the bubble: First, the development of valuation models -models to value stock options- which made the value supposedly measurable mathematically, and second, the connectivity via the internet. This changed the way in which risk was managed, especially in financial institutions. A reliance on the numbers the valuation models produced offered a false sense of security. Within 10 years the validity of these valuation models was smashed.
Another new phenomenon drove the crisis, namely securitization:, which signifies the disconnection of the person who offers the loan and the one who bears the risk via repackaging of the loans. The rating agencies rated all these financial products wrongly and made a lot of money with the rating. The subprime loans were offered from in 2002 on and the adjustable mortgage rates of these loans usually started to rise after 24 months, so the first subprime-related foreclosures already took place in 2004. Speculative bubbles like the internet bubble or the mortgage bubble were driven by crowds according to Hyman Minsky’s theory on bubbles. The sheer number of baby boomers created a rise in bidding prices and fostered the crisis.
To sum up the causes, the roots of the crisis of 2008, one can start with careless lending by primary and secondary lenders, followed by securitization and vanishing responsibility for monitoring debtors. Furthermore the lack of oversight by regulators due to ideological blinders and political imperatives caused the crisis. The boom mentality of the time was promoted by lenders, borrowers, risk specialists, financiers and CEOs who were all walking with the crowd. It is always easier to be wrong with the crowd than to be right against the crowd. Those who spoke out against the system at the time were not listened to. A unique opportunity to gamble against society offered itself: “only stupid people have a savings account that earns them 2-3%, whereas clever investors get a return on their investment of 20% and more”. Excess borrowing worked like the children’s game “musical chairs”: You lend money to people who can’t pay it back, but you don’t care because you sell the debt. Who you sell it too doesn’t care either because he sells it again and so on. The one who holds the paper when the music stops, loses, all the others before made a lot of money. But everyone is sure that he will never be the one who holds the paper when the music stops because he is so clever!
The escalation of real estate -around 10% per year- contributed to this mentality. With the leverage effect one could make 25% by reselling a mortgage via securitization. The creation of various sorts of derivatives split papers into good, bad and toxic assets. Toxic assets were insured, so that then the derivatives with toxic assets could easily be sold because they were insured and they were also rated excellently by the rating agencies. What’s more, companies acted in the same way, e.g. buying back shares, keeping the debt and reducing the equity to increase the profit performance. Additionally, hedge funds were in this boom game as well. Hedge funds do anything but hedging. A typical hedge fund contract is a “2+20 contract”: They collect 2% of the investment immediately and if they make a profit they collect additionally 20% of the investment. In 2008 there were derivatives of a total of approximately 60,000 billion US dollars -for comparison the GDP of the US was 14,000 billion US dollars- and AIG insured 40% of these derivatives.
The events that triggered the crisis were March 16, 2008 when the US investment bank Bear Stearns collapsed and was saved by the government and JP Morgan, but Lehman Brothers was bankrupted later because it was the next in line and the government had to set an example. It had to make a point about the moral hazard of saving every bank. It would have affected any other bank that would have come next to go bankrupt. If a major bank collapses and if no one knows who can pay back what then no one lends anything to anyone. There was a real crisis in March 2008 with the threat of mayhem, social unrest and upheaval in the US. Another trigger were the so-called NINJA loans – no income, no job, no assets – you get a loan anyway- and OPTIONARM loans -you pay back what and how much you want – the remainder increases the principal, which further increases the interest, so the loan gets bigger and bigger and can’t be paid back in the end. These are just two examples of the products that were offered. Still no one knows what all of these papers are worth, so the banks stopped lending, the companies shut down production, the banks stopped lending further, the banks wrote down their assets, they made losses and had to sell assets. All in all, increasing ownership in the US was just an excuse for selling subprime mortgages, the main trigger of the crisis, because despite these risky mortgages there was just an increase in home ownership of 1 % between 2000 (67.4 %) and 2007 (68.1 %).
Literature: Duchac, Jonathan, The Perfect Storm: The Global Financial Crisis of 2008, Vienna 2008
Mesznik, Roger, The Financial & Economic Crisis. Are We on the Way out of It?, Vienna 2009
Robert J.Shiller, Irrational Exuberance, Princeton University Press 2005