The 2007-2008 Financial Crisis for Dummies

Shomit Sengupta

Shomit Sengupta

“The 2007-2008 Financial Crisis for Dummies” is a short & simple summary of the key events that led to the great Financial crisis of 2008, tailor-made just for you 🙂 To read more such articles, please visit our library.

The Financial Crisis of 2007-2009 was the greatest economic disaster since the great depression of 1930. It cost the US economy more than $20 trillion and resulted in the loss of roughly 7.5 million jobs between 2007 and 2009. Moreover, in 2018, the Federal Reserve Bank of San Francisco estimated that the crisis resulted in the loss of roughly $70,000 in lifetime income for every American. Notwithstanding these jaw-dropping figures, very little is understood of the unfortunate chain of events that led to the financial crisis. In this article, we attempt to get a bird’s eye view of the crisis without getting too much into the nitty-gritties.

financial crisis

Real estate prices in the US sky-rocketed between 2000 and 2006, with the average sales price of new homes increasing by as much as 75% in just six years Simultaneously, a new kind of financial product was born, known as collateralized debt obligations (CDOs). How did a CDO work? – Banks would shell out loans to various borrowers, and then bundle together many such loans in a pretty little basket and call it a CDO. The banks would then sell these CDOs to investors such that the investors (who buy the CDO) would now be entitled to receive the loan repayments that the banks would otherwise have received.

THE CDO CYCLE

Basically, a CDO is a bunch of debt obligations (loans given to people) which are backed by collateral (something belonging to a borrower that a bank holds on to, till the borrower repays the loan. If the borrower fails, the bank sells the belonging and makes money), hence the name. One more interesting aspect about a CDO is that a bunch of highly risky loans could be made to made to look really appealing to investors. This is because, the riskier a loan (for ex. a loan given to someone with a low monthly income or probably, a history of default), the higher is the interest rate that the bank charges the borrower. And this is where Banks succumbed to poor judgement.

You see, banks thought that if they give a lot of loans to high-risk borrowers, they would be able to lure investors with the prospect of receiving higher repayment amounts (due to higher interest rates). Investors got so fascinated by this proposal that they readily purchased these CDOs from banks, until they realized that it was all a delicate house of cards. In 2007, real estate prices crashed; the main trigger for a sequence of unfortunate events that were about to unfold in the days to come. However, before we explore the chain of events that followed, let us take a step back and understand why real estate prices crashed, and why they had surged in the first place.

In 1999, the US Government decided to roll out a policy that was aimed at helping everyone attain the American dream of home ownership, even those that were not financially well off. Hence a bunch of mortgage lenders (companies that give home loans to people) started shelling out loans to anyone who came knocking at their doors. Because so many people suddenly started buying houses, the demand for houses went up and hence real estate prices surged. The surge became even more pronounced as Banks tried everything possible to maintain this uptrend, so that they could profit from selling more CDOs. However, the prices rose to such an extent that the high-risk borrowers (people who were not financially well off) were no longer able to repay these very costly loans. And that’s when real estate prices began their sharp decline.

Since real estate prices crashed, the high-risk borrowers starting defaulting (not repaying their loans) one by one as they didn’t see the point in repaying a loan that is several times the value of the house(imagine that you take a loan to buy a house that’s worth 2 crores and later find that the market price of the house has dropped to 1 crore, but the bank still asks you to repay the 2 crores and an additional amount); nor were they financially capable of doing so. 

After the 1st bunch of high-risk borrowers defaulted on their loan payments, investors got the hint and decided to stay away from CDOs. However, by then banks had already given loans to thousands of high-risk borrowers with the hope that they would be able to sell these loans (in the form of CDOs) to profit-hungry investors and thus make a neat profit. They were forced to hold on to CDOs that no investor wanted to buy, and no borrower could repay, and thus had to bear losses worth millions of dollars. Nonetheless, banks had one final ray of hope before they lay on the floor belly-up. But before we can get into what this ray of hope was, we need to understand how a certain financial product works – the credit default swaps (CDS).

THE CDS CYCLE

CDS is like an insurance contract that banks can buy to protect themselves from the risk of borrowers defaulting (not being able to repay the loan). In order to secure this contract, banks need to make periodic “premium” payments to the seller of a CDS (Insurance companies), such that when the borrower does default on the loan, the CDS seller would pay the bank the amount it lost.

Now that we have understood what a CDS is, let us continue from where we left off. So, banks had one final ray of hope in the form of CDSs. They turned to their insurers for reimbursements. However, many banks turned to relatively few insurers and they all demanded reimbursement at the same time. The insurers obviously could not pay everyone at once, and so they collapsed, dragging with them banks that had so fervently trusted them.

 

Moral of the story for Banks – Balance is the name of the game! After all, it is not the usage of CDOs but their misuse (overuse) that caused the financial crisis. If only banks had sold CDOs backed by credit-worthy borrowers, instead of chasing unrealistically high returns (by giving loans to high-risk borrowers). Tsk Tsk.

Moral of the story for Investors – Never buy financial products that you do not completely understand. (The opaque nature of CDOs made it difficult for investors to analyze and estimate their worth. Investors had no way of knowing that CDOs promised such high returns only because they were backed by risky loans)

Moral of the story for Governments – Always implement checks and measures to ensure that financial institutions don’t go overboard with their innovative products ( The objective of checks and balances should be to regulate a product, and not to ban it). Prudent and timely measures could very well have prevented the great financial crisis.

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