In her column this week, Jenny Floki looks at the stock market during the 2008 Financial Crash. How it contributed to a housing bubble and how that bubble’s popping brought down the global economy.
The Housing Market Crisis
Do you remember back in 2008 when one day, out of nowhere, our news was filled with pictures of American employees leaving a large building, carrying boxes with their personal belongings because they had just lost their jobs? It was a day like any other except that each TV channel or online news agency around the world kept announcing that something bad had happened in the US stock market. As a result a few big US financial institutions went bankrupt or in danger of becoming so. Their names might have been familiar to our ears perhaps (such as Lehman Brothers and Standard & Poor’s) but their exact activities were extremely obscure to us. It was in 2008 that the US housing market collapsed. This event was to deliver the biggest economic crisis since the Great depression and wreak havoc on the global economy.
What led to this?
There is a common consensus that people in higher level jobs know better than us. We tend not to truly understand the financial activities of the stock markets and what Wall Street is all about, but surely all these people working high up within finance know their stuff. We assume too, that the government is aware of their activities as well and that there are rules for them just like for any other professional activity. Apparently, the 2008 stock market crisis refutes this consensus alongside that which assumes the free market’s ability to self-regulate. Admittedly, no mainstream economists, golden boys or even the US government could see the crisis coming. Actually, even at the onset of the crisis there were still economists unable to give answers to the public regarding what happened.
In this article we will explain what triggered this economic crisis, which is affectionately known also as the Great Recession. To do so, let’s build some perspective on stock market operations.
In my last article, â€œTalking Stockâ€, we looked at what shareholding means and its role in economic expansion. The stock market however is so much more than just the exchange of shares between businesses and investors.
The stock market as a shopping centre
Think of the stock market as a shopping centre for people with multiple zero’s on their bank account. This market does not trade T-shirts and shoes that we all need and we can afford to buy but rather it trades financial products, such as shares, bonds, MBSs (Mortgage backed securities), CDOs(collateral debt obligations) and so on. These represent ownership of a percentage of companies, mortgages or other debt obligations which generate revenue and can be bought and sold for profit. We all know how an ordinary shopping centre looks and functions but let’s now look at how this â€œstock market shopping centreâ€ functions. We can’t really see the stock market operating so it can be helpful to put it into a more familiar outfit to grasp what it’s really doing.
Initially the shoppers have to pass through a credit check to be allowed to enter the building because the products for sale have prices ranging from the thousands to the billions. The first floor is called the primary market and this is the place where financial products are being issued and sold by banks and businesses. These products are being sold in bulk and the only shoppers on this floor are big financial institutions such as investment banks. The second floor represents the secondary market which is where those first floor shoppers go to sell what they bought downstairs. Anyone with enough money can come here and buy and sell these pre-owned financial products.
After a big purchase on the first floor, the buyers then move to the secondary market on the second floor to sell their â€œgoodsâ€ on. The big investment banks have to price these products with the help of rating agencies who, as their name suggests, rate their goods according to their risk for default (what we call it when the debt obligations go unpaid). To illustrate this kind of rating, think of the financial products as jackets. One for example, might be a GUCCI and another could be a non-branded jacket. GUCCI is considered a successful brand with quality products in high demand. As a result the jacket might be priced highly at £1000 according to the company’s reputation. On the other hand, the non-branded jacket is made by a company that has a reputation of making lower quality products whose demand is unstable and therefore it might be priced at £20. This judgement is more or less what is used by rating agencies whebign it comes to valuing stocks and other financial products. They are not given exact price values but rather ratings. These ratings commonly use the following system: ranging from AAA which is the highest to AA+, AA-, A, BBB, BB and so on until the lowest, which is D. Based on these ratings, the shoppers/investors decide which products better suit their interests. The better the product’s rating, the lower the risk it incurs and thus, the higher the value of the product. The first floor is regulated by laws while on the contrary; the activities on second floor are left largely, if not completely unregulated. Everyone is allowed to trade their financial products with anyone else, set their own prices and even gamble on the success or default of the products on circulation. So with this system in mind, let’s see how it is that it created a growing financial bubble which eventually burst, with devastating effects for the global economy.
The housing market bubble
In the early 2000s, investment activity was low because the stocks and bonds on circulation were either too risky or their potential profits weren’t that high. Apparently, there was a need for a new investment portfolio with high returns and low risk that would motivate investors to bring the desired liquidity (the availability of funds for businesses) into the economy. The housing market was the solution to this problem. Investment in mortgages or mortgage backed securities (MBS) was considered a very safe and profitable investment. It was profitable because houses were in constant demand and there was an on-going supply of people willing to become indebted in exchange for security for themselves and their families. Furthermore, it was a safe investment because the probability of homeowners defaulting on their monthly debt obligations was low due to the threat of homelessness. At the same time, even in the event of a mortgage default, the owner of this debt obligation would still own the house and hence would be able to sell it. It seemed like a win-win investment. Note however, that investors would not get into the hassle of actually buying individual mortgages but rather lump packages that contained many of them, which is what we call an MBS. These packages were created by investment banks such as Lehman Brothers to sell on to everyday investors. The investors buying these MBSs would go on to make great profits trading them and happily continued to buy more. Naturally, the banks, also making huge profits by selling these mortgages in the first place, were more than willing to meet the increasing demand. It transpired however, that there were only a finite number of people financially credible enough to give mortgages to, so the banks began giving out loans far less discriminately to lenders with much lower credibility. These loans were named NINJA loans (No Income, No Job, No Asset) which meant that people who under normal circumstances would not be eligible to get a loan, could now get one. These practices added significant risk to the wider financial system. No one seemed to care however, about the debtor’s ability to pay back in the long run simply because in the short-run the stock market participants could generate huge amounts of profits millions or even billions of dollars. This process triggered the creation of what is called the housing market bubble.
The banks could create many high risk mortgages, and then quickly get rid of them like hot potatoes by selling them in the stock market where the same hot potato could change hands multiple times for profit. The market was now flooded with sub-prime loans (high risk NINJA loans) that were hidden inside MBSs and sold away to highly motivated investors. You would expect that the MBSs consisting of NINJA loans would be given a lower rating in order to signal the buyers for the product’s potential default, right?
Well this was not the case for the American housing market in the early 2000s. Cynically, the investment banks were actually hiring these rating agencies to price their products, so predictably they would rate all the mortgages highly, no matter what. As a result, MBSs with AAA ratings were being circulated in vast amounts at high speeds in the stock market, while traders completely underestimated the growing infestation of high risk loans packed inside them. This of course, not being enough, the financial institutions decided to create new financial products named CDOs (Collateral Debt Obligation) which consisted of various debts including corporate bonds, mortgage bonds, bank loans, car loans, credit card loans and so on. These were also put in circulation. The system was filled with increasingly complicated and risky products and at the time, the significant danger posed by this, was unknown to those trading them. There were several other forms of product introduced to the market that added to system’s fragility, all of which I won’t go into. The most important one was the Credit Default Swap (CDS) (made famous in the film, The Big Short). Where a normal investment in a product can be thought of as a bet in favour of its success, a CDS is the opposite where the investor can pay the seller of the CDS under the agreement that if the company/product defaults, the buyer will be due money. It is essentially a bet against the success of the company/product. For the seller of the CDS (like big insurance companies AIG), this meant free money as long as the market did not collapse. CDS issuance alone generated a debt of $62 trillion. The members issuing the CDSs (Investment banks and Insurance companies) simply did not have the money to cover them. They either foolishly trusted that the system could never fail or they knew that in case of emergency the government would step in to save them. To clarify, investors initially only had access to the toxic subprime mortgage bonds for as many mortgages existed. With the creation of CDOs and CDSs among some other invented products however, exposure to these assets increased, and investors didn’t realize the underlying assets were much riskier than they thought.
These activities greatly increased the fragility and expansion of the financial bubble and it follows that the bigger the bubble, the bigger the burst.
When the bubble burst
In October 2007, 3% of houses in the US were in foreclosure process and 7% were a month past the due date of their payments. People unable to afford the increase in interest rates were defaulting on their mortgages. More MBSs were turning into real estate and the market was flooded with more houses than the original estimates, and of course the more supply there is relative to demand, the lower the price. A fall in house prices led to losses for investors who, now despite their inability to receive mortgage payments, could not even profit from selling houses. Another side effect that triggered more loan bankruptcy was the fact that the remaining homeowners were left with huge debt obligations for properties whose current value was much lower than the original. Hence, the proliferation of the defaults left more investors holding these financial hot potatoes in their hands and having no one to pass them on to. This cost them billions. The massive debt generated by the frenetic activities in the stock market, could not be paid off and some of the biggest financial institutions were threatened with bankruptcy. Lehman Brothers, the biggest US investment bank, was bankrupt on September 15th 2008, leaving 25,000 employees jobless and of course their debt obligations were never to be met. In four months, two million people lost their jobs.
This disastrous financial activity led to the collapse of the housing market, huge losses in the stock market, spiking homelessness and a trickledown effect that quickly spread worldwide leading to the so called Great Recession.
When the problem became political
Are you still struggling to see how the housing market collapse that took place inside the stock market could have come to affect you? Well here is where the problem gets political. The US government chose to bail out the bankers rather than putting them in jail for their disastrous activities and the burden they put on the real economy. The same policy was adopted by the majority of the European governments including the UK. The US Federal Reserve had, by March 2009, committed $7.77 trillion to rescuing the financial system alongside the initial $700 billion Troubled Asset Relief Program (TARP) signed into law on October 2008. Similarly, a bank rescue package totalling some £500 billion was announced by the British government on 8 October 2008, as a response to the on-going global financial crisis. This pool of fresh money would be used to clear the banks’ balance sheets and an extra £50 billion of taxpayer investment would go to the banks themselves.
In other countries whose governments could not print new money to save the banks, making people shoulder the burden of bank recapitalisation was the only option. Hence, heavy austerity was implemented in countries like Greece, Italy and Spain in order for the necessary liquidity to be met. They also saw higher taxation, massive spending cuts which led to underperforming welfare systems and deregulation of the labour market as a method to attract foreign direct investments (FDI) into their countries. To put it simply, if a country offers cheap labour and low corporate taxes, big corporations are more likely to invest in these countries. The new measures aiming to save the economy from complete collapse would cost increased unemployment, lower wages and homelessness but thankfully the banks were saved!
So nowâ€¦ do you feel the same anger as I do when reading that we, the ordinary people had to save the banks for a problem they created? If the answer is yes, then it is time to turn this anger into a productive force. It is time to increase our sensitivity in social matters that might not affect us individually but can hurt us collectively, as workers, as households and as citizens. Take that anger and make it your motivation to argue for a better welfare system and a better government that cares for the people and not for the banks. Think critically and act!