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The Economic Crisis of 2008

Finance, Maketing

A Simplified Analysis of its Causes, Mechanism and Lessons Learnt (Part One)

By: Tariq Ali Asghar

There is a plethora of literature written on the economic crisis 2008-2009. The information overload on this topic tends to be confusing at times. In this article, divided into three parts, I have made an attempt to summarize the causes and mechanism of this crisis in a simplified and coherent way. This was not just one crisis but a combination of three crisis which moved in a sequence initially and later operated in parallel. The three crisis that went in sequence during 2008 were housing, financial and economic crisis. From 2009 onward these three crisis moved in parallel with strong economic ramifications spread out not only in USA but also globally. It is important to note that all the three crisis were very strongly correlated to each other with complex linkages. In part one of this article, I have highlighted and explained the key factors which had cropped up during the decade preceding the economic crisis of 2008. These factors paved the way for occurrence of this mammoth economic event in 2008. In part two of this article, I will take these factors and build an analysis of the exact mechanism which underpinned these three crisis.

 

The US Housing Market

The epicentre of 2008 crisis was in the housing bubble which was created in a very low interest environment during the period 2000-2007. When the housing bubble burst, the median household suffered 40% contraction in their wealth (factoring in housing as well as stock based investing).

 

What is a “bubble”?

A bubble is an artificial and of course temporary escalation in the price of an asset due to an artificially created demand which is not built around actual market realities. The key driver behind any bubble is the speculation that the prices will keep rising forever. The law of gravity holds both in the physical and the financial world. Put simply, no asset can keep moving north and ultimately it has to undergo correction and reversal of upward movement.

Statistics point out clearly that the housing market in the decade preceding the crisis had grown into one of the largest bubbles in the modern economic history. It is interesting to note that the housing prices at the peak in 2006 were nearly twice the long term average from 1890 to 1997. Some prescient economists had already warned of the unsustainability of the housing prices but unfortunately this information was not supported by Mr. Alan Greenspan (Chairman of the Fed) and others as explained in the later part of this article.

 

Behaviour Economics behind the Bubbles

The critical question is understanding of behaviours and psychological factors behind this great bubble. The first one of course is Herd Mentality which entails that humans have been programmed to follow the majority and the majority is not always right. In fact some contrarian investors like Warren Buffett, Jim Rogers and David Dreman believed that the majority is wrong in most cases. This tendency is further reinforced by a bias known as representativeness heuristic, whereby humans focus on recent events in a myopic way and assume that the current trends would continue unabated.

The second important factor is of Bounded Rationality which is a counter-argument to one expounded by some economic theorists that humans act as rational decision makers. Bounded Rationality entails that rationality is often an elusive concept because it is constrained by the available information at a certain point of time. This leads to another important concept studied in economics and sociology called as Reflexivity. It becomes sometimes difficult to understand and separate the causes and effects because the human perception is relative, constrained and limited by many factors in time and space.

The third factor, combined with the above psychological factors, was the Efficient Market Hypothesis (EMH). This hypothesis states that the Markets are self-correcting and efficient because these are dominated by humans who make rational decisions. Again the fallacy with this argument is that the humans are rational to the extent that they can assimilate and process the information at a given point of time in a dispassionate way. But as explained above, this does not happen always. Therefore there is a substantial evidence to support the hypothesis that the markets are not always efficient. Actually the breakdown of the housing bubble is a clear evidence that the markets can be inefficient. Unfortunately Mr. Alan Greenspan who presided four terms as Chairman of the Fed was a strong believer in the doctrine of efficient market hypothesis and admitted to the Congressional Committee that he was simply shocked by what happened during the financial crisis of 2008.

 

The fourth factor which is a derivative of the EMH stated above was a strong mandate of the public sector to minimize interventions on the Wall Street and push for complete deregulation of the financial system. The Fed and the treasury strongly believed that the ubiquitous prevalence of the EMH will ensure that markets are efficient and that the self-correcting market mechanism will mitigate possibilities of any bubble occurring at a massive scale. This of course meant maximization of deregulation and not controlling the over $70 trillion derivatives markets which could unleash many of these cascading bubbles and destabilizing headwinds in a big way.

 

Finally the fifth factor toward the escalation of bubbles is the Moral Hazard problem. Big Banks in an era of complete financial deregulation during 2008-2009 thought that they are too big to fail. There was a sense of euphoria that Big Banks lead the future of the financial markets and that any negative ramifications of their risk taking strategies will be rescued by the Fed and the US Government. Moral Hazard is a typical problem when Big Banks play risky games in the hope that any fall out will be ultimately rescued by the government.

The Credit Markets Boom and the Escalation of Bubble

The credit markets boom in the financial sector, in combination with the above psychological factors, gave the real impetus to the escalation of the housing bubble. Historically the credit has been the prime catalyst in the generation and subsequent busting of the bubbles. During the period preceding the financial crisis, many factors had led to the burgeoning of the credit in the US housing market. Here is the summary of different factors which gave birth to the biggest credit boom in the history of the housing market.

 

(a)-Low interest environment in the aftermath of the dot.com bubble as well as September 11 attacks. The prime trend at that point of time was to strengthen the stock markets, housing markets and the security of the American nation. The Bush-Greenspan strategy was focused on low tax and low interest rate environment for igniting the economy.

 

(b)-In economics, low interest environment is directly linked to a greater supply of money and credit. Keeping the interest rates low for a longer period of time would led to escalation of credit which in turn would transform onto creation of bubbles.

 

(c)-The third factor leading the enormous size of the housing bubble was even more pernicious and destabilizing. It was embedded in the deregulation of the financial markets (mapping it back to the conviction of Alan Greenspan that the markets are perfectly efficient), immense greed of the unregulated Wall Street, innovations in the financial engineering and consequent upsurge of the esoteric products and finally the quest of investors to find alternatives to low interest paying bonds.

 

(d)-The fourth factor is the deregulation of the Wall Street and the belief that the operation of the efficient market hypothesis would suffice. This led to a series of reforms in the US financial history. Starting with the delinking of gold and dollar during the Nixon Administration, these deregulatory reforms culminated in the milestone amendment of the Glass-Steagall Act in 1999. This amendment reversed separation of the commercial banking and the investment banking. The result was merger of big banks on the Wall Street and creation of giants like AIG, Lehman Brothers and Bank of America. The repeal of the substantive portion of the Act also gave impetus to the doctrine of too big to fail and subsequent Moral Hazard problems associated with it.

 

(e)-Concomitantly, the inaction on part of government to regulate the multi-trillion dollar derivatives industry led to a highly risky environment of over-leveraging by the financial institutions. The exponential growth of derivatives (instruments which deploy leverage for magnified returns) in tandem with the innovation in the financial engineering led to the development of esoteric products like MBS (Mortgage backed securities) and CDO (Collateralized Debt Obligations), which proved to be the weapons of mass destruction in worsening of the financial crisis. Put simply these esoteric instruments helped banks and speculators to package mortgages onto highly leveraged vehicles like MBS and CDO-CMOs. The banks in turn passed on the risks to the consumers of these products. What attracted consumers to these products was of course a better alternative to bonds and other alternatives offering subdued returns in a low interest rate environment.

 

The Mortgage Securitization Process

The process of creating the esoteric products like the MBS (Mortgage backed Securities) and CDOs (Collateralized Debt Obligations) is called as the Securitization Process. See diagram 2 below which explains the mortgage securitization process. The starting point of this securitization process is the pooling of the mortgages which are bundled in a way to generate the desired cash flows. The banks would then securitize these instruments and sell to the investors.

 

 

by charging hefty fee. In this process, the banks passed on the risks to the investors while holding on to the profits (fee). These securities were popular with the investors because these ostensibly paid better returns than bonds in a very low interest rate environment. During the period 2003-2008, the banks across the globe (and mostly in USA) made over $2 trillion fees on these securities.

 

Banks assumed that there is a little risk in the securitization process because of the following factors: (a)-Banks could never assume that the housing prices would collapse at a larger scale; (b)-During the securitization process, they underwrote the securities in a way that the risk was transformed to the investors; (c)-On top of this, the MBS, CDO-CMO and other such securities were insured using Credit Default Swaps (issued by AIG and Lehman Brothers); (d)-More important, the credit rating agencies assigned inflated positive ratings to these esoteric products issued by the large financial institutions; (e)-The mortgage pools were packaged in different tranches covering a vast spectrum of risk profiles. Banks charged extra fee for offering tranches with less risk of default.

 

The sale of these esoteric products increased from $30 billion in 2003 to $225 billion in 2006 making a strong case for increase in subprime mortgages. Investors lived in a false delusion that the MBS and CDO-CMO are risk free from default. Unfortunately this was not the case as the time bomb of spurious mortgages was ticking off quite fast. This is the classical example of Bounded Rationality doctrine that human decisions are constrained by the limited knowledge, time and information. Worst of all, CDS (Credit Default Swaps) and the exaggerated ratings by the Credit Agencies accelerated the bubble creation. Diagram 3 explains this process.

 

 

The sub-prime mortgages were the fuel for the securitization process explained above. These were the mortgages offered to people who would generally not qualify for the conventional bank mortgages. These folks had low incomes, broken credit and were more vulnerable to economic risks. These mortgages were offered in the hope that the housing prices would keep going north indefinitely.

 

The banks used extensive leveraging to build the MBS and CDO-CMOs with the aim of earning grater fee and passing on the risks to the investors. In this whole game, there was only one key assumption: the housing prices were going nowhere but north. This assumption was predicated on greed, bounded rationality, representativeness heuristic and EMH (Efficient Market Hypothesis) as explained in the article earlier. In part two of the article coming next, I will delve in more detail about how these assumptions, which were orchestrated by the majority of people and even experts, fell apart and unleashed the biggest financial and economic crisis during 2008-2009.

 

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