Given the recent controversy surrounding 1MDB and Jho Low, which brought to the foreground the sheer terror that can be caused by a manipulation of the international financial system, I found it appropriate that I address what happened the last time a scandal of this magnitude graced the pages of human history. The financial crisis of 2008. Firstly, it is important to understand the somewhat daunting and complex machinery that constituted the system responsible for the financial crisis in 2008. The traditional operational structure of banks used to be that they loan money out to home buyers (mortgages) at a specific rate of interest and thus earn profit in the long run after the mortgage is terminated and interest rate payments form the basis of the banks profit. However, this meant that banks and credit institutions had to keep mortgages on their books for a long time before any profit could be realized and a lot of time had to be spent underwriting (process of approving mortgage applications) so as to secure against borrower default. Pursuant to the 1968 Charter Act, President Lyndon Johnson allowed said banks to sell of their mortgages as a means to increase home ownership for lower income families and reduce the exposure banks have on mortgages. This led to an overhaul of the financial system, which really only manifested in the early 2000’s.
Collateralized Debt Obligations and Synthetic CDO’s
This new system allowed investment banks and government linked companies like Freddie Mae to buy up pools of mortgages from various mortgage lenders and credit institutions, repackage them into a financial product using a Special Purpose Entity (SPE) (essentially these investment banks would create a subsidiary company and put all their mortgages under the ownership of the subsidiary company, also known as an SPE), and then the SPE would issue shares known as mortgage backed securities to investors. These investors would then receive the interest and principal payments made by the original homeowner.
This new financial structure led to increased competition in the mortgage backed security space due to the growing value of the real estate market. This growth in the real estate market in the early 2000’s can largely be perceived as a slowly developing market bubble (where asset prices surge beyond their fundamental value) as credit institutions and mortgage lenders started reducing regulatory and underwriting standards to extend more mortgages so that they could make more money by selling more mortgages to investment banks. A good example of this is the establishment of ‘No Income, No Job, No Assets’ (NINJA) loans. This allowed banks to cope with competitive pressures and gain a competitive advantage, however it also allowed a large subprime (loans extended to high-risk homeowners, i.e. people with low credit scores and no jobs) market to develop, which increased the risk of default.
The introduction of subprime mortgages increased the pool of homebuyers, which drove housing prices up, encouraging more subprime lending and the creation of financial products like the collateralized debt obligation (CDO), which is a mortgage backed security pool based on risk assessment, as shown below.
Investment banks created even more financial products such as the credit default swap (CDS), which essentially was insurance on the CDO in case homeowners defaulted and investors couldn’t recoup their investment, a CDS would reimburse investors. This in turn led to the creation of the synthetic CDO, which bundled together premium payments from the CDS and sold it to investors. There are many more financial products that investment banks utilized at this time, but their complexity and their volume make them unsuitable for a blog post. If you’re feeling slightly overwhelmed by all of this don’t worry. All you need to know is that the investment banks’ creation of these financial products inflated the value of the secondary market (mortgage backed security market) by more than 10 fold relative to the actual housing market, exacerbating the housing bubble. This is the principal reason for why the entire financial system nearly collapsed. It had little to do with the fact that lax regulations allowed subprime mortgages to be extended, (although this was one of the reasons underlying the crisis) and more to do with the exploitation of this system by the investment banks.
To use an allegorical analogy; subprime mortgages may represent an unstable foundation of land, ready to sink at any moment, but the financial products created by the investment banks represent the building of a tall skyscraper atop the unstable foundation. Left alone the unstable foundation would have sank with the only need being to replace the foundation, but because the investment banks built a skyscraper on top of the land, the entire thing will fall down when the land inevitably sinks, presupposing a replacement of the entire skyscraper, which is harder to do than simply replace the foundation.
This complex new system was working well for everyone because everyone would benefit as long as house prices kept on rising. The high risk nature and rising delinquency rates of sub prime mortgages were not reflected in the CDO’s as credit rating agencies like ‘Moors’ and ‘Standard and Poors’ inflated their value, giving BBB rated CDO’s (CDO’s with a high default rate) AAA ratings (CDO’s with low risk) so as to encourage investors to buy them and compete more effectively. Therefore, as investors started to lose money due to rising default rates, the value of CDO’s curiously went up. This pattern inevitably culminated in the market for housing, CDO’s, CDS’, synthetic CDO’s, and all other external markets crashing suddenly as investment banks offloaded their now toxic assets before correctly revaluing them at a significantly lower price. This led to a market freeze, Lehman Brothers going bankrupt, various Federal Bailout packages, and Bank of America taking over Merrill Lynch, as well as JP Morgan taking over Bear Sterns.
The crisis displayed the extent to which the financial system was corrupt. Banks like Goldman Sachs offloaded their CDO’s, which they knew were worthless to buyers so as to prevent a liquidity crisis, but despite this the federal government actually helped these banks by buying up their toxic CDO’s in lieu of prosecuting them. The financial infrastructure made the banks “too big to fail” and hence no action (barely no action) was taken against these banks. Although the market for CDO’s crashed and froze, similar financial products like collateralized mortgage obligations (CMO’s) and other asset backed securities still exist to this day. The key takeaway from this crisis would probably be the danger inherent in deregulation and the governments urgent need to amend legislation quicker in response to changing market conditions.