The Financial Crisis 2008: How it all started?

The Financial Crisis 2008: How it all started?

Following a period of economic boom in 1990s, the financial bubble that is global in nature
is now burst. Stock markets have fallen around the world, large financial institutions have
collapsed or been bought out, and governments in even the wealthiest nations have had to
come up with rescue packages to bailout their financial systems. However, it is not simple to
answer the basic question; how it all started? Because this is actually a perfect storm which
has been brewing for years and now finally reached its breaking point.

This financial crisis is caused by many factors; major among them is the dramatic change in
the ability to create new lines of credit, that is why, may be, this crisis is also called “credit
crunch”. The world’s economy is based on credit, which is a great tool when used wisely but
can lead to a disaster when is unchecked and out of control. Infect, almost everything from
economic speculations, free economy theories, financial models, poor rankings by ranking
agencies, poor legislations, and most importantly the greed to earn easy money within days
have contributed in this great disaster of all times, affecting almost the whole world. This
problem could have been avoided if ideologues supporting the current economic and
financial models were not so vocal, influential and inconsiderate of others’ viewpoints and
concerns.

The crisis has its roots, at-least apparently, in real estate and the sub prime lending crisis.
Commercial and residential properties saw their values increase dramatically in the real
estate boom that began in 1990s and went on uninterrupted for nearly a decade. Increases in
housing prices coincided with government deregulation, in United States of America, that not
only allowed unqualified buyers to take out mortgages but also help blend new relationships
between traditional investment banks and mortgage lenders. Real estate loans were spread
throughout the financial system in the form of collateralized debt obligations (CDOs) and
other complex derivatives in order to disperse risk. However, when home values failed to rise
anymore and home owners failed to keep up with their payments, the banks and other lending
institutions were left with low cash flows and properties with almost no value, being forced
to raise capital or go bankrupt.

Written By: Muhammad Zia Aslam (University of Malaya) 1

 The Financial Crisis 2008: How it all started?

During 1930s great depression, the US government established Government Sponsored

Enterprises (GSEs), Fannie Mae and Freddie Mac are two leading mortgages institutions
charted to deal with mortgage problems. Fannie Mae operates in the US secondary mortgage
market and works with primary mortgage market players to help ensure they have funds to
lend to home buyers at affordable rates. Freddie Mac’s function is to provide stability and
ongoing assistance to the secondary market for residential mortgages by increasing the
liquidity of mortgages investments. In 1990s the US government urged GSCs, particularly
Fannie and Freddie, to acquire loans made to borrowers that were considered more risky. The
objective was to increase the home ownership in the US from 66% to 70%. From early
1990s, the US government had been emphasizing on the policy that “we are now an
Ownership Society”. This is the reason why the current crisis started actually, because, to
compete with GSCs, the commercial lending and mortgage industry lowered the standards
for making home loans. Thus the sub prime and Alt-A loan (undocumented loans also know
as the “Liar’s Loan”) came into being. Commercial lenders argued they had to charge more
and loan to riskier borrowers in order to compete with Fannie and Freddie. It was a win-win
deal in good times because the real estate prices were shooting up, in case a borrower could
not pay back, the lender had the property with its increased value, making riskier lending the
“darling” of all commercial lending institutions. Eventually making the loan was more
important than meeting the lending company’s fiduciary requirements.

Moreover, the ability of lending industry to package loans with Mortgage Backed Securities
(MBS), which were used to spread the risk and considered reliable last time with AAA
ratings, made the risky lending more riskier itself because now MBS were having a
significant percentage of sub prime and Alt-A loans. Hence, the plan to increase home
ownership in the US by lowering the standards for conforming loans turned into a
lending/borrowing extravaganza where seemingly all commercial lending standards were
thrown out. As the housing prices started going down because of the access supply, MBS
became toxic assets. It held as an asset, declined in value and in many instances could not be
valued since there was no market. Asset values of banks, investment banks, sovereign funds
etc started declining enormously and, as a result, the banking system is swaying on the verge
of collapse.

Written By: Muhammad Zia Aslam (University of Malaya) 2

 The Financial Crisis 2008: How it all started?

Looking from another viewpoint, the weaknesses in the global financial system have
surfaced clearly in this financial crisis. As, some financial products and instruments have
become so complex and twisted, that as things start to unravel, trust in the whole system
started to fail. The sub prime crisis came about in large part because of financial instruments
such as “securitization” where banks would pool their various loans into sellable assets, thus
off-loading risky loans onto others. For banks, millions can be made in money-earning
loans, but they are tied up for decades. So they were turned into securities. The security
buyer gets regular payments from all those mortgages; the banker off loads the risk. High
street banks got into a form of investment banking, buying, selling and trading risk.
Investment banks, not content with buying, selling and trading risk, got into home loans,
mortgages, etc without the right controls and management. When people did eventually start
to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while
and even now, there is a crisis of confidence. Some investment banks were sitting on the
riskiest loans that other investors did not want. Assets were plummeting in value so lenders
wanted to take their money back. But some investment banks had little in deposits, so some
collapsed quickly and dramatically. Banks suck money out of the economy as they try to
build their capital and are nervous about loaning. Meanwhile businesses and individuals that
rely on credit find it harder to get. A spiral of problems resulted.

Looking for ways to manage, or insure against, risk actually led to the rise of instruments that
accelerated problems. Derivatives, financial futures, credit default swaps, and related
instruments came out of the fear of risk taking. The finance industry flourished as more
people started looking into how to insure against the downsides when investing in something.
To find out how to price this insurance, economists came up with “options”, a derivative that
gives the right to buy something in the future at a price agreed now. Mathematical and
economic geniuses believed they had come up with a formula of how to price an option,
the Black-Scholes model. Once options could be priced, it became easier to trade. A whole
new market in risk was born. As people became successful quickly, they used derivatives
not to reduce their risk, but to take on more risk to make more money. Greed started to kick
in. Businesses started to go into areas that was not necessarily part of their underlying
business. In effect, people were making more bets, speculating, or in other words gambling.

Written By: Muhammad Zia Aslam (University of Malaya) 3

 The Financial Crisis 2008: How it all started?

In essence, what had happened was that banks, hedge funds and others had become over-
confident as they all thought they had figured out how to take on risk and make money more
effectively. As they initially made more money taking more risks, they reinforced their own
view that they had it figured out. They thought they had spread all their risks effectively and
yet when it really went wrong, it all went wrong. In an interview, Naseem Taleb, once an
options trader himself, argued, very rightly, that many hedge fund managers and bankers fool
themselves into thinking they are safe and on high ground. It was a result of a system heavily
grounded in bad theories, bad statistics, misunderstanding of probability and, ultimately,
greed, he said.

Written By: Muhammad Zia Aslam (University of Malaya) 4