The world was economically crippling especially when the USA’s housing sector collapsed was considered to never fall in value. The crisis was so bad that the Lehman Brothers declared bankruptcy. Lehman Brothers were America’s fourth-largest investment bank before it filed bankruptcy in the year of 2008. Not just the USA, but the entire world was in a credit crisis. In February 2008, the troubled British mortgage company Northern Rock was nationalized, causing a run on the country for the first time in 140 years. The following month, US investment bank Bear Stearns was acquired by J.P. Morgan Chase was acquired in a transaction mediated by the US Treasury and the Federal Reserve. So what happened? Let’s review the timeline.
How did it start?
Growth in the housing sector was rapid from 2000-2006. It can be observed from the total percentage of subprime loans that were given out for mortgage purposes during the same timeline.
This growth was given to the low-interest rate scenario during the same time which further led to a substantial increase in housing prices. Low rates of interest also led to investors including institutional investors looking for yield-enhancing investment options. This yield was found in these subprime mortgages. So what are subprime mortgages?
What are subprime mortgages?
Subprime mortgages are a type of home loan that is extended to poor individuals with incomplete or non-existential credit histories. Since these loans possess higher risks for the lending parties, the borrowers are charged higher than normal interest rates.
Subprime Mortgages and Teaser Rates during the 2000s
Many of the subprime mortgages that were lent were charged at teaser rates. Teaser rates are the interest rates that are extremely low for the first few years of the scheme and then followed by, much higher rates once the teaser period ends. Many of these mortgages for interest-only for a few years meaning no principal payment will be required for the teaser period. To exit the higher payments after the teaser period ended, the people just had to either refinance into a similar mortgage loan or declare default on the loan.
The Complexity of CDOs and MBSs
The loans and credits were sold by the banks to institutional investors who looked for opportunities for yielding interest rates. This was done via complex financial instruments called Collateralized Debt Obligations (CDOs) and Mortgage-Backed Securities (MBSs).
Due to these securities, the loss from subprime mortgages was actually borne by these investors and not the Banks. To appeal to the investors, banks often created a waterfall structure. Here, they would often have a mix of highest-rated and lowest-rated bonds together. From their theory, this sounded apt because they felt that losses from lowest graded loans would be covered by returns from safer loans.
However, this was just in theory. This can be attributed to the ingenuity and frauds committed in the credit rating agencies of the country that were privatized and had to supply the highest ratings for loans if they did not want their client to go to another business. The banks also breached their regulatory capital limits by lending loans more than their limits and securitizing them to such investors.
Consequences of the problems
Until the middle of 2007, the counterparty risk was not priced by the market. Personal Loans, especially subprime ones, have the highest counterparty risk. So you can understand the gravity of the situation. Due to the constant defaults of these subprime loans, the MBSs started losing their value. This led to a rapid downgrading of the credit quality of various SIVs.Simultaneously the demand for sub-prime mortgage loan-related securities disappeared. Further leading to a liquidity crunch for these securities.
Starting from June 2007, the investors started worrying about the value of these securities and which led to the exploded OIS-Swap spreads. It remained high throughout the crisis, even when Lehman Brother Failed. It failed to come back to pre-crisis levels.
At the same time, the credit spreads on all the credit assets increased which led to lowered market prices the same. This led to a systematic increase in haircuts from zero pre-crisis to 45%+ in 2008 when Lehman Brothers failed.
Between the fall of 2007 and the end of 2008, the federal Bank created a series of facilities as backstops for a majority of asset classes that experienced the stress during a crisis. The actions included:
- Creation of Long-Term lending facilities against high-quality collaterals
- A discount window was opened for investment banks and securities firms
- Relief funds were provided to the market so as to increase liquidity via money market funds
- Funds were provided to high-quality illiquid assets backed securities
- Funds were provided to finance the purchase of unsecured CP and ABCP
Assets of Fannie May and Freddi mac were purchased
Impact and Learnings from the Crisis
- To consider the counterparty risk while investing
- Carefully analyzing any portfolio invested in
- Credit Rating Agencies are not always correct
- Not to trust and sector to never fall in value