Transcript | 3. lecture: From the U.S. Bubble to the Global Financial Crisis - Why and How? - University for modern Slovakia

In the previous lecture we explained the reasons why and how the U.S. mortgage bubble burst. The question to which we will seek an answer in today's lecture is - how and why the U.S. mortgage bubble had become a global financial crisis.

The situation is well illustrated by the fact that the first large bank that collapsed in connection with the U.S. mortgage crisis (bailed out by nationalizing by the British government) was the British mortgage bank Northern Rock in 2007. It was followed by other German and French banks, and of course U.S. banks as well. The infection obviously spread around the world. How did that happen?

Over the last fifteen years, there has been a huge expansion of financial globalization. New products have been developed that did had not existed before and that had further inflated the bubble and helped it to spill over to the world and created an illusion of a low risk. Such main products were special mortgage bonds (mortgage backed securities, MBS) and products insuring against loan default risk (credit default swaps, CDS).

The process by which this was done is called securitization and is actually a transformation of traditional loan to a security in order to increase mobility of the loan. Specifically and simply put, originally there was a simple relationship between a bank and the client. The bank provided a mortgage to the client (if it considered the client to be solvent enough) and then the client paid the bank instalments, interests and principals.

In recent years, however, this has changed fundamentally. The first step is still the same; the client takes a mortgage from the bank. It does not end here however, it is just the beginning. The bank afterwards sells the claim on the secondary market, for example to Fannie Mae. FM then bundles the bought mortgages into large mortgage bundles and sell it further as MBS. It was assumed that these large packages were by their nature more immune against losses, because even if some mortgages are not repaid, the majority is which compensates for the unpaid, which is the basic principle of insurance.

It was also addressed by the risk of temporary regional downturn in prices. If they are contained in a real estate package from many U.S. regions, temporary fall in prices or solvency in some regions is backed up by a better development in the other regions. In addition, there was a general belief in long-term growth in real estate prices. This illusion of low risk then led in high ratings of MBS from rating agencies and investors who bought them were convinced of their low risk. The risk was further reduced by the expansion of CDS, which is actually the insurance of securities, including MBS, against bad loans.

The expected low risk validated by high ratings resulted in relatively low prices of CDS, which have been widely used and which has widely expanded. CDS were developed in the early nineties, but they became huge thanks to the real estate bubble after 2003. Thus, through the securitization of financial globalization, the high-risk U.S. mortgages (but also from other countries, such as Spain) spread around the world. And it was not only about special mortgage bonds. There has been a huge expansion of, what Paul Krugman called, shadow banking or non-banking financial sector called by others.

For a variety of other structured investment instruments, let us mention for example securities with periodically set interest (auction-rate securities, ARS). They invented it in the investment bank Lehman Brothers in 1984; however its massive use occurred during the economic boom before the crisis. In 2008, when the system was at its peak, the volume of ARS reached nearly 400 billion of dollars, and then it collapsed during the financial crisis.

What happened? ARS is created when a financial institution receives deposits of long-term commitment. Then regularly, at short intervals (e.g. every 30 days), there are auctions, in which new investors can redeem those who want to quit their long-term binding investment. The price of quitting is determined on the auction. Basically, the point is that this system produces a higher return for investors (depositors) compared with bank deposits and lower costs for issuers compared to the cost of long-term money. However, the point is that compared to traditional banking products, it was preferable simply because traditional commercial banks bear the costs of deposit insurance, minimal reserve and the like. ARS did not have these safeguards and operated only while the market grew. During 2008, ARS collapsed completely, because the demand for auctions greatly decreased.

Another pump that inflated the bubble was leveraging. Simply said it is loan investment. Upon deposit, financial institutions will provide a loan for investment in a high ratio, usually 1:100, 1:200. If the market is growing, you may earn a significant amount of money even if you do not have a lot of money. The problem arises when markets fall; the problem is then transferred to financial institutions. And that is exactly what happened.

So, two years after the growth in real estate prices stopped, it fully erupted in the U.S. Banks began to fall and after the U.S. government let Lehman Brothers to fall on 15.09.2008, the panic spread to the fullest. The financial world is intertwined, in which banks and financial institutions keep constantly lending to each other, and since they did not know whose turn is next and could not check the books of others, they did not know which partners and competitors have how much toxic assets, which resulted in freezing of financial flows and in a sudden loss of money.

The extent of this problem is well illustrated by the story of the largest American insurance company AIG, which was the largest provider of CDS. During the boom, AIG earned billions of dollars and even in its worst-case scenarios it only calculated a potential loss in the amount of 2.4 billions of dollars. The reality, however, was ten times worse, and if the government did not bailout AIG, the situation would be even worse. The problem spilled over from the financial world to the real economy, financial flows froze up not only between financial institutions but also between nonfinancial corporations and organizations. Panic and fear took its toll resulting in lower demand for products and services and many other problems in the real economy.