The seeds of the current financial crisis, described as a “tsunami” by former Federal Reserve Chairman Alan Greenspan, were sown at the time the dotcom bubble burst and the US Federal Reserve lowered interest rates to restrict its impact on the economy.
The Federal Funds Target Rate dropped from over 6 per cent to 1 per cent in 2004. While a low interest rate regime made loans cheaper, it also spurred the demand for property and prices began to rise.
Low interest rates meant that banks started offering cheap mortgages, even to the not-so-deserving, or sub-prime, borrowers, at higher rates. Besides, unlike in India, where the size of the loan is linked to a person’s income, the US banks link loans to the value of the property.
Rising interesr rates and highly leveraged borrowers ensured that defaults started climbing from 2006. But this did not deter banks.
The housing boom also generated a tremendous interest in the market for mortgage-backed securities (MBS), collateralised debt obligations (CDO) and other complex derivatives. The market for these instruments grew from less than $100 trillion in 1998 to around $600 trillion by the end of 2007. As rates rose and defaults went up, derivatives products were also exposed to risks.
In June 2007, first signs of the crisis were seen in two hedge funds owned by Bear Stearns that had invested heavily in the sub-prime market. As time went by, banks realised that the securities that they had invested in were laced with toxic assets. In addition, the rising number of foreclosures helped speed up the fall in property prices and the number of defaults in prime mortgages started rising. By August 2008, mortgage delinquencies had touched 6 per cent and foreclosures around 3 per cent.
In 2007, three banks failed, the most in five years, and the Federal Deposit Insurance Corporation (FDIC) identified 13 problem institutions in the US. In 2008, the number of failed banks touched 27. The the count so far this year is 51. This is in addition to the 164 troubled institutions identified by the FDIC.
With losses mounting, the Fed averted a crisis and helped Bear Stearns avoid bankruptcy by taking over liabilities of $30 billion and pushing for its sale to JPMorgan Chase.
Soon, Fannie Mae and Federal Home Loan Mortgage Corporation (Freddie Mac), two entities created by the US government to develop the mortgage market and, later to spur the secondary market for mortgages, came under pressure as they had assumed around $5.4 trillion of MBS and debt outstanding. Due to fall in housing prices following the sub-prime crisis, there were question marks over servicing the guaranteed bonds and, on September 7, 2008, the US government took over the two institutions.
The business model of the Wall Street investment banks, which had large exposure to derivatives, came under pressure. They banked on short-term liabilities to fund their assets and were highly leveraged. As a result, they had lesser capital to service in case of a fall in asset values. As the crisis unfolded, banks suddenly found that others in the system had stopped lending to them. So, they could either sell assets or raise capital and both these options became difficult.
After talks over the weekend, the US government let Lehman collapse, while Merrill Lynch opted for a merger with Bank of America.
AIG, an insurance company that had turned itself into a financial services firm, suffered losses, including $5.6 billion in market valuation, on the credit default swap portfolio. The downgrading of the company led to additional demand for collateral, which AIG was unable to arrange. Finally, the US Fed provided a $85-billion lifeline, but took control of the institution.
