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The Credit Crisis of 2008

Many factors have contributed to the 2008 financial meltdown. The details behind the credit crisis can be summarized as follows:

The major impetus behind the entire crisis can be attributed to the low cost of borrowing. Since the United States’ economy was lagging severely back in 2001, its central bank initiated a policy of lowering interest rates, with the intention of reviving a stalled economy. The FED reduced the federal funds rate, which is rate of interest that banks charge one another, to its lowest point in 2003. With low rates abound, this helped fuel the real estate market, and speculation in the real estate market. The end result was that home values saw a dramatic increase.

Banks and mortgage companies saw this as a time to make money. They jumped into a frenzied real estate market with both feet, and began lending to unqualified borrowers. This was the beginning of what we call the subprime mortgage market. To hide these subprime mortgages as much as possible, these subprime mortgages were bundled with more credit-worthy loans, and as a package, were sold to the investment community.

Since these packaged loans masked its subprime components, they were able to get underwriters to purchase unregulated insurance policies against the bundles, known as credit default swaps. The CDS’s guaranteed to the investor that these subprime loans would be paid. Since these loan bundles were now insured, so to speak, credit-rating agencies were quick to rate them as AAA, the highest rating possible that can be given to a debt instrument.

The packaged loans, known as collaterized debt obligations (CDO’s) were then sold to the investment community. Although there was underlying insurance for these CDO’s, the CDS’s were not governed by the insurance industry, and did not require its insurers to carry necessary capital to pay off the insured, in case it was necessary to do so. CDS’s were purposely created outside the bounds of the insurance industry, so that they would not have to be governed by the rules and regulations of the insurance industry. These CDS’s were devised by mathematical “gurus”, hired by Wall Street, and became a $ 50 trillion industry.

As home prices began to decline, housing went into a free-fall. The FED reversed their course from several years prior, and began raising interest rates. This rise in rates, directly effected the adjustable-rate mortgage market, which in turn adversely effected many of the subprime mortgages that had been issued. For many homeowners who were not very qualified in the first place, the free-fall of their home price resulted in them having a mortgage that was greater than the price of their home. Thus, many foreclosures resulted.

With foreclosures on the rise, rating agencies that had falsely rated CDO’s as AAA, began to lower their subprime loans ratings to that of junk level. The investment banks, commercial banks, and pension funds that had been buying these CDO’s saw a large decline in their holdings. Many of these CDO’s wound up defaulting. The owners of these CDO’s could no longer peddle them in the open market, and this resulted in the debt market seizing up.

Since Wall Street accounting mechanisms require that their constituent companies “mark to market” the value of their investments, they were forced to write-down the value of their CDO holdings, since effectively they weren’t worth the paper they were printed on. Thus, the free-falling values of these intruments, created a free-falling value of the investment companies that held this debt.

These investment bank write-downs resulted in these companies becoming under-capitalized, as billions of dollars of worthless CDO’s were written-down. Many banks’ asset-to-capital ratio soared, as investment companies became more and more leveraged. Moreover, both Fannie Mae and Freddie Mac, which had a stake in over $ 5 trillion dollars of mortgages, became extremely over-extended, and were effectively taken over by the government.

At the same time of this mortgage meltdown, oil and other commodity prices began soaring around the world, due to the increased productivity and economies of Asia. At its peak, oil reached an unfathomable $ 148 per barrel.

As the crisis deepened, more bank failures and mergers occurred including IndyMac (failure), Countrywide (bought by Bank of America), and Bear Stearms (failure).

Lending continued to dissipate, as banks felt too much risk to lend to other banks, for fear of loan repayment inability, despite the efforts of government to encourage lending. Further, many investors started withdrawing funds from uninsured money market accounts in droves.

The government was unable to restore confidence in the financial markets. This was further exemplified by the failure of Lehman Brothers, the purchase of Merrill Lynch by Bank of America, and the government takeover of insurance-giant AIG.

Next, the government passed an $ 850 billion bank bailout, and injected some of that money directly into the ailing banking system. The purpose of this was to try and stimulate banks to once again resume lending, to help jumpstart the economy.

Home prices continue to plummet. Banks have lost $ 1 trillion to bad debt so far during this credit meltdown, and some feel that this number will double before everything is restored to normalcy. Until that time, lending will be tight, with borrowers being able to borrow less, and requirements to obtain a loan tightening up considerably. A deeper recession is likely as we move forward, with a chance that we will move to a deep depression, comparable to that of 1929.

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