The 2007-08 Financial Crisis

In Review
By Manoj Singh
When the Wall Street evangelists started preaching "no bailout for you" before the
collapse of British bank Northern Rock, they hardly knew that history would
ultimately have the last laugh. With the onset of the global credit crunch and the
fall of Northern Rock, August 2007 turned out to be just the starting point for big
financial landslides. Since then, we have seen many big names rise, fall, and fall
even more. In this article, we'll recap how the financial crisis of 2007-08 unfolded.
Before the Beginning
Like all previous cycles of booms and busts, the seeds of the subprime
meltdown were sown during unusual times. In 2001, the U.S. economy
experienced a mild, short-lived recession. Although the economy nicely withstood
terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the fear
of recession really preoccupied everybody's minds.
To keep recession away, the Federal Reserve lowered the Federal funds rate 11
times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood
of liquidity in the economy. Cheap money, once out of the bottle, always looks to
be taken for a ride. It found easy prey in restless bankers - and even more
restless borrowers who had no income, no job and no assets. These subprime
borrowers wanted to realize their life's dream of acquiring a home. For them,
holding the hands of a willing banker was a new ray of hope. More home loans,
more home buyers, more appreciation in home prices. It wasn't long before things
started to move just as the cheap money wanted them to.
This environment of easy credit and the upward spiral of home prices made
investments in higher yielding subprime mortgages look like a new rush for gold.
The Fed continued slashing interest rates, emboldened, perhaps, by continued
low inflation despite lower interest rates. In June 2003, the Fed lowered interest

rates to 1%, the lowest rate in 45 years. The whole financial market started
resembling a candy shop where everything was selling at a huge discount and
without any down payment. "Lick your candy now and pay for it later" - the entire
subprime mortgage market seemed to encourage those with a sweet tooth for
have-it-now investments. Unfortunately, no one was there to warn about the
tummy aches that would follow.
But the bankers thought that it just wasn't enough to lend the candies lying on
their shelves. They decided to repackage candy loans into collateralized debt
obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a
big secondary market for originating and distributing subprime loans developed.
To make things merrier, in October 2004, theSecurities Exchange
Commission (SEC) relaxed the net capital requirement for five investment banks Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), Lehman Brothers, Bear
Stearns and Morgan Stanley (NYSE:MS) - which freed them to leverage up to 30times or even 40-times their initial investment. Everybody was on a sugar high,
feeling as if the cavities were never going to come.
The Beginning of the End
But, every good item has a bad side, and several of these factors started to
emerge alongside one another. The trouble started when the interest rates
started rising and home ownership reached a saturation point. From June 30,
2004, onward, the Fed started raising rates so much that by June 2006, the
Federal funds rate had reached 5.25% (which remained unchanged until August
2007).
Declines Begin
There were early signs of distress: by 2004, U.S. homeownership had peaked at
70%; no one was interested in buying or eating more candy. Then, during the last
quarter of 2005, home prices started to fall, which led to a 40% decline in the
U.S. Home Construction Index during 2006. Not only were new homes being
affected, but many subprime borrowers now could not withstand the higher
interest rates and they started defaulting on their loans.

This caused 2007 to start with bad news from multiple sources. Every month, one
subprime lender or another was filing for bankruptcy. During February and March
2007, more than 25 subprime lenders filed for bankruptcy, which was enough to
start the tide. In April, well-known New Century Financial also filed for
bankruptcy.
Investments and the Public
Problems in the subprime market began hitting the news, raising more people's
curiosity. Horror stories started to leak out.
According to 2007 news reports, financial firms and hedge funds owned more
than $1 trillion in securities backed by these now-failing subprime mortgages enough to start a global financial tsunami if more subprime borrowers started
defaulting. By June, Bear Stearns stopped redemptions in two of its hedge funds
and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge
funds. But even this large move was only a small affair in comparison to what
was to happen in the months ahead.
August 2007: The Landslide Begins
It became apparent in August 2007 that the financial market could not solve the
subprime crisis on its own and the problems spread beyond the United State's
borders. The interbank market froze completely, largely due to prevailing fear of
the unknown amidst banks. Northern Rock, a British bank, had to approach
the Bank of England for emergency funding due to a liquidity problem. By that
time, central banks and governments around the world had started coming
together to prevent further financial catastrophe.
Multidimensional Problems
The subprime crisis's unique issues called for both conventional and
unconventional methods, which were employed by governments worldwide. In a
unanimous move, central banks of several countries resorted to coordinated
action to provide liquidity support to financial institutions. The idea was to put the
interbank market back on its feet.
The Fed started slashing the discount rate as well as the funds rate, but bad
news continued to pour in from all sides. Lehman Brothers filed for bankruptcy,

Indymac bank collapsed, Bear Stearns was acquired by JP Morgan Chase

(NYSE:JPM), Merrill Lynch was sold to Bank of America, and Fannie Mae and
Freddie Mac were put under the control of the U.S. federal government.
By October 2008, the Federal funds rate and the discount rate were reduced to
1% and 1.75%, respectively. Central banks in England, China, Canada, Sweden,
Switzerland and the European Central Bank (ECB) also resorted to rate cuts to
aid the world economy. But rate cuts and liquidity support in itself were not
enough to stop such a widespread financial meltdown.
The U.S. government then came out with National Economic Stabilization Act of
2008, which created a corpus of $700 billion to purchase distressed assets,
especially mortgage-backed securities. Different governments came out with their
own versions of bailout packages, government guarantees and outright
nationalization.
Crisis of Confidence After All
The financial crisis of 2007-08 has taught us that the confidence of the financial
market, once shattered, can't be quickly restored. In an interconnected world, a
seeming liquidity crisis can very quickly turn into a solvency crisis for financial
institutions, a balance of payment crisis for sovereign countries and a full-blown
crisis of confidence for the entire world. But the silver lining is that, after every
crisis in the past, markets have come out strong to forge new beginnings.
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Who Is To Blame For The

Subprime Crisis?
By Eric Petroff

Anytime something bad happens, it doesn't take long before blame starts to be
assigned. In the instance of subprime mortgage woes, there is no single entity or
individual to point the finger at. Instead, this mess is a collective creation of the
world's central banks, homeowners, lenders, credit rating agencies and
underwriters, and investors. Let's investigate.
The Mess
The economy was at risk of a deep recession after the dotcom bubble burst in
early 2000; this situation was compounded by the September 11 terrorist attacks
that followed in 2001. In response, central banks around the world tried to
stimulate the economy. They created capital liquidity through a reduction in
interest rates. In turn, investors sought higher returns through riskier investments.
Lenders took on greater risks too, and approved subprime mortgage loans to
borrowers with poor credit. Consumer demand drove the housing bubble to alltime highs in the summer of 2005, which ultimately collapsed in August of 2006.
The end result of these key events was increased foreclosure activity, large
lenders and hedge funds declaring bankruptcy, and fears regarding further
decreases in economic growth and consumer spending. So who's to blame?
Let's take a look at the key players.
Biggest Culprit: The Lenders
Most of the blame should be pointed at the mortgage originators (lenders) for
creating these problems. It was the lenders who ultimately lent funds to people
with poor credit and a high risk of default.
When the central banks flooded the markets with capital liquidity, it not only
lowered interest rates, it also broadly depressed risk premiums as investors
sought riskier opportunities to bolster their investment returns. At the same time,
lenders found themselves with ample capital to lend and, like investors, an
increased willingness to undertake additional risk to increase their investment
returns.
In defense of the lenders, there was an increased demand for mortgages, and
housing prices were increasing because interest rates had dropped substantially.

At the time, lenders probably saw subprime mortgages as less of a risk than they
really were: rates were low, the economy was healthy and people were making
their payments.
As you can see in Figure 1, subprime mortgage originations grew from $173
billion in 2001 to a record level of $665 billion in 2005, which represented an
increase of nearly 300%. There is a clear relationship between the liquidity
following September 11, 2001, and subprime loan originations; lenders were
clearly willing and able to provide borrowers with the necessary funds to
purchase a home.

Figure 1
Note: The data presented herein are believed
to be reliable but have not been independently
verified. Any such information may be
incomplete or condensed.

Partner In Crime: Homebuyers

While we're on the topic of lenders, we should also mention the home buyers.
Many were playing an extremely risky game by buying houses they could barely
afford. They were able to make these purchases with non-traditional mortgages
(such as 2/28 and interest-only mortgages) that offered low introductory rates and
minimal initial costs such as "no down payment". Their hope lay in price
appreciation, which would have allowed them to refinance at lower rates and take

the equity out of the home for use in other spending. However, instead of
continued appreciation, the housing bubble burst, and prices dropped rapidly.
As a result, when their mortgages reset, many homeowners were unable
to refinance their mortgages to lower rates, as there was no equity being created
as housing prices fell. They were, therefore, forced to reset their mortgage at
higher rates, which many could not afford. Many homeowners were simply forced
to default on their mortgages. Foreclosures continued to increase through 2006
and 2007.
In their exuberance to hook more subprime borrowers, some lenders or mortgage
brokers may have given the impression that there was no risk to these mortgages
and that the costs weren't that high; however, at the end of the day, many
borrowers simply assumed mortgages they couldn't reasonably afford. Had they
not made such an aggressive purchase and assumed a less risky mortgage, the
overall effects might have been manageable.
Exacerbating the situation, lenders and investors of securities backed by these
defaulting mortgages suffered. Lenders lost money on defaulted mortgages as
they were increasingly left with property that was worth less than the amount
originally loaned. In many cases, the losses were large enough to result in
bankruptcy.
Investment Banks Worsen the Situation
The increased use of the secondary mortgage market by lenders added to the
number of subprime loans lenders could originate. Instead of holding the
originated mortgages on their books, lenders were able to simply sell off the
mortgages in the secondary market and collect the originating fees. This freed up
more capital for even more lending, which increased liquidity even more. The
snowball began to build momentum.
A lot of the demand for these mortgages came from the creation of assets that
pooled mortgages together into a security, such as a collateralized debt
obligation (CDO). In this process, investment banks would buy the mortgages

from lenders and securitize these mortgages into bonds, which were sold to
investors through CDOs.
The chart below demonstrates the incredible increase in global CDOs issues in
2006.

Image courtesy Hammond Associates. The

data presented herein are believed to be
reliable but have not been independently
verified. Any such information may be
incomplete or condensed.

Figure 2

Rating Agencies: Possible Conflict of Interest

A lot of criticism has been directed at the rating agencies and underwriters of the
CDOs and other mortgage-backed securities that included subprime loans in
their mortgage pools. Some argue that the rating agencies should have foreseen
the high default rates for subprime borrowers, and they should have given these
CDOs much lower ratings than the 'AAA' rating given to the higher
quality tranches. If the ratings had been more accurate, fewer investors would
have bought into these securities, and the losses may not have been as bad.

Moreover, some have pointed to the conflict of interest between rating agencies,
which receive fees from a security's creator, and their ability to give an unbiased
assessment of risk. The argument is that rating agencies were enticed to give
better ratings in order to continue receiving service fees, or they run the risk of
the underwriter going to a different rating agency (or the security not getting rated
at all). However, on the flip side, it's hard to sell a security if it is not rated.
Regardless of the criticism surrounding the relationship between underwriters
and rating agencies, the fact of the matter is that they were simply bringing bonds
to market based on market demand.
Fuel to the Fire: Investor Behavior
Just as the homeowners are to blame for their purchases gone wrong, much of
the blame also must be placed on those who invested in CDOs. Investors were
the ones willing to purchase these CDOs at ridiculously low premiums
over Treasury bonds. These enticingly low rates are what ultimately led to such
huge demand for subprime loans.
Much of the blame here lies with investors because it is up to individuals to
perform due diligence on their investments and make appropriate expectations.
Investors failed in this by taking the 'AAA' CDO ratings at face value.
Final Culprit: Hedge Funds
Another party that added to the mess was the hedge fund industry. It aggravated
the problem not only by pushing rates lower, but also by fueling the
market volatility that caused investor losses. The failures of a few investment
managers also contributed to the problem.
To illustrate, there is a type of hedge fund strategy that can be best described as
"credit arbitrage". It involves purchasing subprime bonds on credit and hedging
these positions with credit default swaps. This amplified demand for CDOs; by
using leverage, a fund could purchase a lot more CDOs and bonds than it could
with existing capital alone, pushing subprime interest rates lower and further
fueling the problem. Moreover, because leverage was involved, this set the stage

for a spike in volatility, which is exactly what happened as soon as investors

realized the true, lesser quality of subprime CDOs.
Because hedge funds use a significant amount of leverage, losses were
amplified and many hedge funds shut down operations as they ran out of money
in the face of margin calls.
Plenty of Blame to Go Around
Overall, it was a mix of factors and participants that precipitated the current
subprime mess. Ultimately, though, human behavior and greed drove the
demand, supply and the investor appetite for these types of loans. Hindsight is
always 20/20, and it is now obvious that there was a lack of wisdom on the part of
many. However, there are countless examples of markets lacking wisdom, most
recently the dotcom bubble and ensuing "irrational exuberance" on the part of
investors.
It seems to be a fact of life that investors will always extrapolate current
conditions too far into the future - good, bad or ugly.
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