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By Maulika Desai (Senior Columnist)
If a financial institution is too big to fail, it is too big to exist. The Great Recession of 2008 stands as testimony to this. One might ask, what leads to a financial crisis? When the functioning of a financial system is hampered by panic or the prospect of panic, it causes people to lose confidence in their ability to transform long-lived assets into substitutes for money. A financial crisis is the result of this panic. It leads to systemic risk, wherein all components of the financial system lose faith in one another.
In the early 2000s, investors in the U.S. and abroad seeking a low-risk, high-return investment started placing their money in the American housing market. They expected greater returns from interest rates that homeowners paid on mortgages as compared to U.S. treasury bonds. Instead of buying individual mortgages, large institutions bought mortgage-backed securities (MBSs). These securities were thousands of mortgages bundled together, whose shares were sold to investors to gain high returns. These seemed to be extremely safe bets, for home prices were on the rise. Lenders thought they could sell houses for more money in case someone defaulted on their mortgage.
Credit rating agencies were also hinting to people that MBSs were safe investments by giving them AAA ratings. Investors wished to buy more securities, and lenders did their best to create more of them by granting subprime mortgages – loans given to people with low incomes. Traders also started offering a riskier product called Collateralized Debt Obligations (CDOs), and they, too, were given the highest credit ratings. Investors, traders, and bankers were putting tons of money into the US housing market. The new lax lending requirements and low-interest rates made housing prices skyrocket, which only made MBSs and CDOs seem like an even better investment.
This “too good to be true” housing bubble eventually burst, and people could not pay for their incredibly expensive houses or mortgages. Supply went up while demand went down for homes, so their prices began to plummet. Big financial institutions stopped buying subprime mortgages, and lenders were stuck with bad loans. Early indications came when Bear Stearns was forced to be bought by J.P. Morgan for a dollar. The Lehman Brothers' collapse followed suit, leading to an overall mistrust among financial institutions.
Simultaneously, unregulated over-the-counter derivatives called Credit Default Swaps (CDSs) were sold as insurance against MBSs. The company AIG sold tens of billions of dollars' worth of CDSs without money to back them up in case of a crisis. All this led to an extremely complicated web of assets, liabilities, and risks. Stock markets crashed globally, and the U.S. economy found itself in an unprecedented recession.
Piled-up inactions and severe oversights led to the vulnerability and inevitable downfall of the world’s largest economy. The inability to limit risks that were building up in money market funds was a key reason for the downfall. Congress should have to set limits on capital and leverage on funding. Margin requirements in derivatives should have been in place. Down payment requirements should have been raised, or limits should have been put on people who were borrowing to finance the purchase of a house. The biggest mistake, in some sense, was a failure in imagination. The Americans failed to contemplate the possibility that they could face a classic panic and run like the Great Depression. They thought it was unforeseeable, so they did not build the system to be strong enough to reduce the risk. The takeaway from this catastrophic Credit Crisis is that prevention is far better than cure.
Reference: Metrick A. and Geithner T., The Global Financial Crisis [online course], Coursera, https://www.coursera.org/learn/global-financial-crisis?
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