The Story Behind the 2008 Crisis: Is it coming back?
Created on 27 Mar 2023
Wraps up in 8 Min
Read by 1.6k people
Updated on 30 Mar 2023
With Repo Rate (aka Repurchasing Option) reaching the hike of 6.5%, home loan eligibility has decreased by 20% since February. This hike by the RBI will help avoid borrowers from causing default due to high-interest rates. After all, nobody wants a repeat of the 2007-08 financial crisis anytime soon.
With the reminder of the financial crisis, let’s discuss what led to one of the biggest economic disasters in the Stock Market history.
The morning of September 15th, 2008, jot down to be the worst day in Wall Street history, side by side with the 1987 “Black Monday” financial crisis. The absolute chaos of the 2008 crisis by which the whole world was affected, actually has an interesting storyline. There are many reactants along with a few catalysts, completing the process and causing the 2008 financial crisis.
The stock market might have tanked in 2008, but the path leading to this dark route began a few years earlier with the new millennium. To simplify, the event spread from 2000-2008, let’s describe it in the form of a chain reaction. If you think about it, it's a good reference because people’s dreams, interests, and finances tumbled away, just as it happens in a wonderful chain reaction.
Read along to see how the greed of so many people ended up blasting the US economy into bits and pieces.
The 2008 Financial Crisis Explained
The first tumble that led to the chain reaction, the beginning of the 2008 financial crisis, was the plan of “home sweet home” for all. The United States of America has always been high on the whole ek ghar ho apna idea for its citizens. Agendas were planned around this ideology as a large population of the country didn’t own a home at that time. Plus, the shocking incident of the September 11 attacks by Al-Qaeda led to unrest among people and the country’s economy.
So the Federal Reserve came forward to improve the condition by decreasing the Federal Funds rate from 6.5% in 2000 to 1.75% in September 2001, the lowest in 45 years. This reduction brought opportunities for both consumers and businesses to rise & shine in different sectors. People who were dreaming of getting a house were finally able to do so with such low mortgage rates.
Loans were being sanctioned to many, including subprime borrowers. Usually, a CIBIL Score of 750 is required to be eligible for a home loan. But the conditions and eligibility criteria for these subprime borrowers were almost non-existent, as people with no job, asset, or even income were being welcomed with phoolmalas by the lenders. In short, everyone was happy-happy, which should have been a sign for the upcoming financial toofan in the country.
Why, you ask? Because an excess of anything is bad, and my personal experience says that just as there is light after darkness, there are bad days after a few happy hours. (If you have happy days instead of hours, unlike me, then I salute you!!)
Subprime Mortgage-Backed Securities
The second tumble in the happy-happy train of the low mortgage rates in the USA was the side deal between lenders and investors.
People of all statures took the advantage of the decline in mortgage rates, leading to a booming uproar in the real estate industry. Prices of houses were inflating, around 46.35% between 2003-06, which attracted the attention of investors and investment banks alike. Even government-backed banks like Frannie & Freddie dipped their fingers in the pie.
These subprime loans were then collected in bundles and sold to large-scale investors in the form of mortgage-backed securities. Subprime refers to the interest rate being higher than the prime value. Here, the borrowers with a low credit rating are referred to as subprime because they had a much higher probability of defaulting than other borrowers.
Let me simplify the whole phenomenon for you. Mortgage-Backed Securities are similar to the exam papers gathered by teachers. Collected exam papers include assessments of different students with good, bad, or average grades. Similarly, the bundles in the mortgage-backed securities included all kinds of loans, borrowers capable of paying loans, and vice-versa.
But, because the mortgage rate was as low as 1%, maximum borrowers had low credit scores. Thus, there was a high probability of default, making the securities too risky to invest in. This point, however, was omitted or, should I say, overlooked by the lenders.
Bursting of the Real Estate Bubble
Everything was sailing smoothly or tumbling smoothly in our chain reaction. The real estate industry was booming, investors and lenders were earning good returns and borrowers had finally found a place to call home. So then, what went wrong in La La Land?
Here’s how the downfall began for the economic standing of the country.
The US government started to raise the interest rates again after seeing improvements in the economy. Federal Reserves increased rates up to 5.25% by 2004, which proved to be chaotic for both borrowers and lenders. With the rise in interest rates, maximum of the borrowers, who were subprime, started defaulting.
As borrowers were finding it impossible to pay such high mortgage amounts, lenders started foreclosing houses. Thus the real estate market saw a horde of houses on sale. But, the sudden supply of houses available for sale in the market did not lead to an equal increase in demand. As businesses were being closed due to the great recession, people were not in the condition to purchase houses. This led to home prices going down.
Borrowers were in the worst state as they couldn’t sell their houses without paying off their large mortgages. And the ones selling were getting the short end of the stick because of the reduced home prices. This led to the toppling of the US economy as the eventuality of houses being foreclosed became a daily occurrence.
Not only borrowers but even investors suffered, as many applied for bankruptcy. Big names like the Swiss bank UBS were the first ones to announce losses of around $3.4 billion by getting involved in subprime investments. The numbers sure are astounding as, according to the reports, 8 million US citizens lost their jobs, 4 million homes foreclosed each year, and 2.5 million businesses shut down by the beginning of 2008.
Freddie & Fannie Dilemma
Along with the common man in America, even big names with the ashirwad of the government felt their pedestals shaking. Fannie Mae & Freddie Mac are the two names often spoken along with the 2008 subprime mortgage crisis.
Government Sponsored Enterprises (GSEs), Fannie Mae, short for Federal National Mortgage Association, and Federal Home Loan Mortgage Corporation, aka Freddie Mac, were the catalysts of the chain reaction named the 2008 crisis. These enterprises bought loans from banks and gave money in return for more lending. Thus, they worked as kerosene to the fire in the ongoing financial crisis.
Freddie & Fannie guaranteed 40% of the mortgaged loans that ended with them suffering a loss of $8.7 billion by 2007. They took high risks by issuing a large number of subprime loans without cross-checking the borrower's ability to repay. The reason behind such leniency was the greed for high returns on such loans. By 2008, both Fannie & Freddie were looking for a lifeboat from the drowning debt. Hence enters the hero of the story, aka the US government, with a cape.
Saved by the Government
Big corporations such as Lehman Brothers, reputed for being the fourth largest investment bank in the country, had to put their shutters down on 15th September 2008. The tsunami that was the subprime mortgage rates took them under, leading to the worst day in the economic downturn of American history.
At this point, it was clear that the nation required help from higher authorities, so the US government came for backup. National Economic Stabilization Act of 2008 by then-in-charge Treasury Secretary Henry Paulson & Federal Reserve chairman Ben Bernanke was enacted. Funding of $700 Billion was raised as part of the Troubled Asset Relief Program (TARP) to purchase toxic assets from investment banks to drag the economy back from the downward spiral. All the actions were taken in quick motion to avoid any further loss to individuals as well as the corporations involved.
The US government definitely pulled a doobti naiyya ko paar lagana in this scenario. Henry & Ben put on their supercool hero capes and brought forward solution after solution to solve the crisis. Although these solutions proved to be a heavyweight in the already overwhelming national debt of America, estimated to be $31 trillion at present.
How was India Affected by the 2008 Financial Crisis?
What if I tell you that India was one of the few nations to recover fastest during the great recession? Unbelievable? Sure, but absolutely true! India maintained its position of being the second fastest-growing economy in the world during 2008-09 with a GDP count of $1.2 Million. In 2023, India sits in the fifth country with a GDP count of $3.4 Trillion.
Although foreign investors took out a large number of investments, around $12 billion, from the stocks, India still managed to sustain its economy. The reason behind this was the low integration of Indian sectors, especially banking ones, in global trade.
But, the Indian markets did get hit hard during the second phase of the recession. By the end of the year 2008, many countries, including India, suffered a massive decline in the stock market. Sensex faced a vast decline from 20,465 points to a staggering 9716 points. This decline affected different sectors such as export, and commodity prices tanked by more than 2% in the last 3-4 months of 2008. So, it is safe to say that India left 2008-09 FY with a few scratches to show for the global war.
The Bottom Line
One of the best investors in present times, Warren Buffett, expressed in an interview that there wasn’t one perpetrator responsible for the 2008 recession. Where everyone went wrong was believing that the booming real estate bubble would go on forever.
If subprime lenders and investors had taken a breather with the free distribution of loans to low CIBIL score borrowers, then things would not have gone this far south. Similarly, if the investors had taken into consideration the risky nature of the mortgage-backed securities, then the US economy might not have collapsed. Or maybe I am just blabbering, and the crisis was bound to happen one way or another.
No matter what, history tends to repeat itself. And after seeing the ongoing fall of investment banks like Silicon Valley Bank and Signature Bank, the possibility of another crisis taking place is not farfetched. Regardless of many crises or drops in the market, the 2008 subprime mortgage crisis would always be Pandora's box filled with devastation and misery for billions.
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