How I understand the Financial Crisis in 2007/2008

Lending, complex financial products, and sociological behaviour are what I believed resulted in the Financial Crisis in 2007 and 2008 which happened just over 10 years ago. First, let’s dig into how we did end up in that situation. The objective is not to blame who caused the financial crisis but to discuss what caused it. I find it fascinating understanding the financial crisis and how it affected us all globally. My interest was curious at the event of occurrence and grew from discussing with friends and from watching films and documentaries illustrating the event occurred, to name a few: The Big Short, Margin Call, Too Big to Fail.

I think it’s important to explain the origins of the mortgage securitization that was developed in the 1970s by Lewis Ranieri. He was a bond trader and created the securitizations called mortgage-backed security (MBS). It allowed banks to package a large number of mortgages and split it into different tranches. These can be bundled with loans based on their maturity and their associated types of risks. The bonds were available in the open market to purchase domestically or internationally and that is a factor of why it affected us all as well as globalization. Pensioners and pension funds also bought into these bonds because they have a high return with presumably relatively low risks as it was seen low risk investing in the housing market that made regular payments to the investors.

The Rating Agencies

Rating agencies are important to the financial system and serve a critical role for investors. Responsibilities of the rating agencies were to assess the qualities and grade the financial securities on an alphabetical system, where an AAA-rated bond is a significantly safer investment than a C-rated bond. C-rated bonds are often known as junk bonds or high yield bonds because of the higher amount of risks.

What Made it Worst?

The fundamental changed after lending money to everyone that was able to afford a mortgage during the mid-2000s. In order for banks to maintain the generating revenue, they were required to find new customers. They next sought alternative customers known as sub-prime mortgages or NINJA loans — No Income, No Job, No Asset. These mortgages were issued in a great number to people who have low credit scores and very unlikely to service their debts. This drove house prices up quickly.

Insurance makes money from the premiums which should outweigh the claims. Investment banks have purchased insurance on their financial securities from AIG. To make matter worst, AIG also invested in some financial securities for what they thought was low risk, effectively they were investing in the same industry sector for which they provided insurance to the banks. There was a big risk and the consequences were amplified!

What went wrong at AIG by Kellog Insight

The Equation

When Sub-Prime Mortgages defaults, it drove the market to sell their properties and property prices fell, the value of the bonds went down and the insurance company received more claims. Businesses could not pay to their suppliers and it interfered with their cash flow, in result they could not pay their employees. This then led to more assets on the balance sheet of businesses go down and some companies around the world went into bankruptcy.

Lehman Brothers the fourth largest investment bank at the time went bust. AIG was bailed out because if the insurance company was not then it would have caused a catastrophic damage to the economy at large. AIG was deemed too huge and too interconnected to fail and its assets top $1 trillion at the time.

Why wouldn’t the Government wouldn’t let AIG Fail by Time

System Implemented after the Financial Crisis

An interesting one page factsheet by the Bank of England, explains the types of systems in place explaining how banks and financial systems are safer. Specifically, in the UK, banks have a larger capital reserve (they call it loss-absorbing capital), intrusive supervision of banks and stricter stress testing on loan applications.

The Financial Crisis 10 years on: What’s been done to make the system safer? by Bank of England

After the Financial Crisis

From my perspective, the interest rate in the UK has been relatively low and constant. I think the Bank of England (BoE) has done a ‘relatively’ good job as inflation has not risen to high. Low-interest rates also stimulate the economy, as it provides a great environment for companies to service their debt as it is cheaper borrowing. Consumer spending will be higher as it’s more attractive to spend money than to put it in the bank, which also stimulates the economy. Investors look towards alternatives assets instead of bonds as investments such as stocks and shares. I agree that economic cycles of booms and busts exist, but like everyone else, I do not know when the next bear markets will be and how the BoE will react if the interest rate is currently at 0.5% and it is not ideal to have a negative interest rate environment.

Definitions:

Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or a collection of mortgages. The mortgages are sold to a group of individuals (a government agency or investment bank) that securitize or packages, the loans together into a security that investors can buy.

Financial security holds some type of monetary value known as a stock or bond or options.

Securitization is the process of taking an illiquid asset or group of assets and repackages to investors known as financial engineering and transforms it into a Financial Security.

A Tranch is a slice and categorized from a large pool of investment