Securitization and 2008 Financial Crisis

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The 2008 financial crisis were the worst financial disaster since The Great Depression of 1929-30. The problem, which began in 2007 when sky high home prices in the United States, started falling spreading panic first within U.S. financial sector and then to financial sector outside the U.S… The causalities were the few of the biggest name with financial sectors like:

  1. The Lehman Brothers
  2. The AIG insurance (Once considered too be to big to fall)
  3. Two enterprises supported by the government to facilitate mortgage lending (fannie mae and freddie mac)
  4. Several large commercial mortgage lenders

The problem which started within financial sector did not just limit to financial sector but it spread to other sectors like Auto Industry which was bailed out by federal government.  One of the main reasons for 2008 crisis is considered to be “Securitization”.

Securitization:  Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming it (or them) into a security.  Basically, securitization is a process by which a bank or a financial institution clubs different financial assets or debts to form a consolidated financial instrument which is issued to the investors and in return investors get share of the interest on underlying mortgage or loan portfolio. Like in 2008, several banks clubbed together home loan portfolios, get it rated from credit rating agencies and sold it to investors in lieu sharing interest income.

It all started with Gramm-Rudman act, which allowed banks to engage in trading profitable derivatives that they sold to investors. These mortgage-backed securities needed home loans as collateral. The derivatives created an insatiable demand for more and more mortgages.

Why Securitization resulted into one of the biggest Financial Crisis?  The initial signs of financial crisis were seen in 2006, when housing sector prices started falling. Most of the realtors applauded it thinking over heated housing sector is correcting to more sustainable prices. But, realtors did not realize this correction was due to too many home owners with questionable credit history were given loans. The greed to making more money resulted into banks giving loans with value of almost 100 percent or even more than the value of the new home. Banks started mixing subprime loans with prime loans which helped to make more money as interest charged to subprime customers was higher than prime customers.

Securitization, which initially started with the purpose of sustain funding resulted into a source of income for banks thus created an insatiable demand for more and more subprime mortgages.

To cover the credit risk of subprime loans banks started buying insurance cover from companies like AIG. For insurance companies, it came as an opportunity to make money as in return of insurance cover of subprime loans; insurance companies started charging higher premium.

Big Banks, Insurance Companies were making money but panic started when they realize they have to absorb huge losses due to nonpayment from subprime customers. Suddenly supply of houses was high and demand was less which resulted into fall of house price index.

Moreover, banks stopped lending money to other banks in return of loan portfolios. Banks did not want other banks giving them worthless mortgages as collateral. No one wanted to get stuck holding the bag.  As a result, interbank borrowing costs, known as Libor, rose. This mistrust within the banking community was the primary cause of the 2008 financial crisis.

Many of us would have seen famous Hollywood movie “The Big Short” in which one the character Jared Vennett (Ryan Gosling) explains the securitization also known as CDO(Collateralized Debt Obligation). He uses a “Jenga” tower with AAA, BBB, and CCC pieces. The CCC pieces are the equity tranches and the BBB are the mezzanine tranches. The AAA (senior tranches) are the safest part of the tower but as he explains (in the movie) if the base (CCC) starts to default the BBB will follow and finally the AAA will collapse.

Cost of 2008 Financial Crisis: In 2007, the Federal Reserve began pumping liquidity into the banking system via the Term Auction Facility. In March 2008, investors went after investment bank Bear Stearns. Rumors circulated that it had too many of the toxic assets. Bear approached JP Morgan Chase to bail it out. The Fed had to sweeten the deal with a $30 billion guarantee. Wall Street thought the panic was over.

Instead, the situation deteriorated throughout the summer of 2008. The U.S. Congress authorized the Treasury Department to bail out mortgage companies Fannie Mae and Freddie Mac. The Fed used $85 billion to bail out AIG. In October, this rose to $150 billion.

The U.S. federal bank in September 2008, submitted to Congress a $700 billion bailout package. Their fast response convinced businesses to keep their money in the money market accounts.

 


 

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