Understanding the 2008 Financial Crisis

Ever wondered if there was an easy way to understand how the world’s most powerful economy crashed in 2008? Read on to find out!

Drishti Singh

Management Student

Although the heart of the Lehman Brothers crisis or the sub-prime crisis was at the USA, it still certainly crippled the world economy too in 2008.

In order to understand how this happened, we have to understand what a balance sheet (simplest form) of a financial institution looks like-

Liabilities (in crores)Assets (in crores)
Equity60Other Loans410
Long term Borrowings100Mortgages800
Deposits from customers1500Cash-in-hand450

Mortgages (home loans) are an asset for a financial institution (since home loan is a resource which provides economic income in future).

What happened in 2006-07?

Let’s take the example of the same Financial Institution. Let’s call it Alpha Ltd.

Alpha Ltd. sold its mortgages to another institution, say Beta Ltd. Now, Beta Ltd. will receive all the EMI payments (interest and principal). Beta Ltd., now has assets and thus can issue securities on the same and the payment for these securities will be done via the EMIs received. This process is called securitization. Seems above board so far right? Well, here’s where the issue started.

These newly issued securities were not properly regulated because they were a new financial instrument then and thus had been given a good quality rating by credit rating agencies (S&P) which led to people believing that it was a great place to park their savings.

Now, as financial institutions like Alpha Ltd. became very aware of the fact that they could easily sell off their mortgages, they started giving more and more home loans, even to people whose credit worthiness was questionable and the amount of loan given sometimes even exceeded 100% of the house price (Some people even had more than 1 house loans availed.). Banks did this because they knew that if someone defaults, they could recover the damage by selling off the house on which loan was availed. But at the same time, due to a demand surplus, house prices started falling.

Since these securities started gaining popularity, more and more financial products started cropping up around them. One of them was called Credit Default Swap (CDS). Let’s say there was another company called Vega Ltd. who sold CDS. What CDS basically did, was to insure the security buyers against default. So, if someone paying mortgage to Beta Ltd. defaults on the payments, Vega Ltd. will cover it for them (Of course, Vega Ltd. would charge premium for its services to security buyers).

What happened in 2008?

Now, a major portion of loan takers started defaulting on their EMI payments (questionable credit worthiness) and as a result, the security buyers of Beta Ltd. did not receive their payments. Initially, they were paid off by Vega ltd. (CDS seller). As the defaults started increasing, financial institutions whose mortgages were not sold (Alpha Ltd), companies who bought mortgages from financial institutions (Beta Ltd), and CDS seller (Vega Ltd) all collapsed.

Security buyers also lost their savings parked in such instruments. Banks could not recover the loan amounts as well since the houses on which the loan was availed became almost worthless. As a result, the entire financial system collapsed. The fallout from this was not only limited to security buyers but the entire population of USA had to shed huge amounts of taxes to cope up with the losses. 55 lakh American jobs were lost. US lost a staggering $7.4 trillion of wealth in the capital markets.

After facing such a massive loss in the aftermath of the crises and identifying such obvious flaws in the system, the USA legislated and brought in many new laws and regulations. As a precautionary measure since then, no such securities have been allowed to be traded.

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