Updated: Aug 1, 2020
The Financial Crisis of 2008, referred to as the “Great Recession” is the 2nd worst economic crisis worldwide preceded by the “Great Depression”. It originated in the US, but soon spread like wild fire in other parts of the world as well. But what is the reason behind this crisis and what lead to it? What was the role of the private sector ? Let’s try and understand with the help of the following points:-
BASIC TIMELINE OF THE CRISIS
Faulty Loans by Private sector banks: One of the main reasons behind this crisis in my opinion, was the excessive lending to subprime lenders by the banks. On the investment front, as we all know, post 9/11 many investors had lost their confidence in the Us stock markets and wanted to venture into the real estate markets.
The investment banks understood the investor sentiment and started utilizing this opportunity. They bought the real estate loans from the banks and converted it into complex derivatives known as CDOs (Collateralized Debt Obligation). Banks happily started passing on the risk of these loans to the investment banks. The banks were paid a decent commission on these loans by the investment banks.
Gradually as the demand for CDO increased amongst the investors, the banks started lending to more borrowers. However, after a certain point of time banks had already given loans to all those borrowers who were eligible and had the ability to repay the loans.
This was the turning point which is the root cause of the crisis.
We all know that usually when a bank grants a housing loan several documents and parameters are checked upon and only those who fulfil all conditions are granted the loans.
However due to increasing demand for CDO’s banks eventually started lending loans to those lenders also who did not have the capacity to repay. Such loans are referred to as subprime loans. These subprime borrowers were those who defaulted on their payments. This led to a decline in the demand for CDO’s in the market which was followed by declaration of Bankruptcy by several big names in the market
False Credit Rating:
Another important reason behind the crisis is the false credit rating given by credit rating agencies. The Investment banks got the CDO’s rated from credit rating agencies . It was extremely surprising to see that most of CDO’s which comprised of subprime loans got AAA rating from the agencies due to which investors were not worried regarding their investments. It enhanced their confidence and hence many of them could not anticipate what was coming.
So who were these credit rating agencies and why did they do such a thing?
A sovereign credit rating agency reduces the information asymmetry between borrowers and lenders. They are critical to the financial system in deciding the quality of the financial products and give the investors an insight into the level of risk associated in investing in these.
The reason being to retain clients. As the Oscar-nominated movie The Big Short shows Melissa Leo as an employee of Standard & Poor explaining a hedge fund manager (Steve Carell) why S&P continues to give AAA rating to junk loans: “They will just go to Moody’s.”
Insurance without Hedging:
Some investors played cleverly and got their CDO’s insured from agencies like AIG. Thus, a chain was established in the market. The banks passed on their risk to the investment banks who passed on the risk to the investors and the investors passed on the risk to the insurance companies by taking an instrument called CDS (credit default swap).
As we all know when the market crashed some of these agencies also suffered huge losses. According to experts AIG (finance and insurance company) suffered primarily because it sold CDS without hedging the same. The US government bailed out AIG for $ 180 billion.
Hence, we can see that some of the mistakes committed by private sector bodies did play an instrumental role in the crisis. However, in my opinion, private sector alone is not to be blamed. There were certain mistakes committed by the other sectors of the economy as well as some external factors all of which collectively lead to one of the worst economic disasters of the world.