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How did the 2008 Financial Crisis happen?

What caused the 2008 financial crisis? It is a long story to explain everything as this was something orchestrated way before 2007. It was back in about 2003, after the dot-com bubble, FED cut interest rate down to only 1%. The figure below (Macrotrends, 2020) shows the interest rate change from 1990 to 2010 and recession within the timeframe (the gray area). As you can see history pattern repeats itself, interest rate is cut during a recession as companies’ expectation from central bank to mitigate the market turbulent.

A low interest rate means central bank encourages people to borrow more and hence can spend more, this contributes to the economy recover, because everybody have money to spend, as shown in figure below (Dvorak, 2019) is the S&P500 chart (blue) versus the FED rate (red). If you have watched the movie “The Big Short” (I recommend watching it if you haven’t), everybody in these periods, even a stripper could own many houses and condos. Of course, everything is just credit, people are encouraged to buy house though a so-called ‘Subprime Mortgage’ scheme. A subprime Mortgage allows people with low credit scores to borrow a loan for mortgage (Akin, 2019) which simply means you don’t really have to prove the income to get a mortgage. As a result, everybody buy a house without hesitation which drove up the housing market significantly, figure below (Macrotrends, 2020) shows the housing price within the stated period.

Credit is like a drug, when I say it’s like a drug, I’m not exaggerating, people were blind with the assets they were having and didn’t pay attention to the rising interest rate from 2005. More importantly, most of the debts were adjustable debts which intentionally led to a credit bubble.

Banks at the time came up with bunch of confusing concepts such as: Mortgage-Back Security (MBS), Collateralized Debt Obligation (CDO).

Remember when I said people buying houses with credit, that mortgage was issued by a Commercial Bank, Commercial Bank then usually sells these mortgages to Investment Banks. Investment Banks then issue bonds which are backed by these mortgages called MBS and then sell these to Institutional Investors. Here is where things getting complicated, because for certain investors like Pension Funds they are only allowed to invest in low-risk securities. Securities are rated into different ‘Tranches” by a third-party agency based on risk of itself. For example: Bond issued by a creditable company can be rated as AAA, the riskier ones could be BB BBB etc. However, there were many agencies (e.g. Moody, S&P, Fitch), if an agency doesn’t give the bank’s subprime-mortgage bond which is referring to the low-credit borrower’s mortgage AAA, they will just go to the other competitor agency, so the agencies only cared about the bottom line and rated everything triple A (Ritholtz, 2011). A CDO had existed way back in 2000s, it was usually made up by combining credit of mortgage and other assets such as cars, now the bank put random mortgages from different tranches regardless risk level and called it CDO and sold it to investors, they made a ton of fortune by buying and reselling these. When the borrowers pay back the mortgage instalments, they go straight to CDO buyer’s pockets.

What happened was because the money was moving so quickly between entities, Commercial Banks kept lending out money to get more mortgages, so the loosened the policy, no more income verification for a mortgage. When it came to the point people didn’t buy house anymore or they couldn’t pay off the mortgage due to the rise in interest rate (most was adjustable rate), that mortgage default, the bank took the house and sold it on the market. When there were too many people couldn’t afford the mortgage, the bank had to dump a big bag of houses on the market along with a weak purchase power from demand created a crash in housing market. Investment Banks at the time were holding a big risk doing this, as they didn’t sell all the MBS right away after buying the mortgages, which evaluation was bubbling and allowing them to leverage the capital to an extreme level that with just a small decrease in value can cause a loss greater than the capitalization of the entire company.

So, the one was safe was the first one to get out before everybody recognized the over-evaluated security, and when everybody are well aware of through words of mouth, that caused a panic sell-off, things got worse from the bankruptcy of Lehman Brother bank, because if one thing goes down, it will drag down many other things due to the fear and uncertainty of the market. The crisis wiped out 5 trillion dollars from pension funds, real estate market, saving bonds, etc. People also say, it’s a ‘public loss and private gain’ as some insiders of these banks know what’s happening and started to bet against their own company (placing a short position).

Finally, to clarify, FED (the US’s central bank) and the US’s Government is two independent entities, FED was made up by many different private banks. For every dollar printed from FED, they take back one dollar worth of Government Bond from the bank who borrows the money, so this basically means for every dollar printed, the Government owes it $1 dollar, and this is national debt which income is from tax? Which is from the citizen? This is why people call out bankers crashing the economy.

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