In all of the financial recessions throughout history, excesses -more specifically monetary excesses- has been the main cause of a boom and an inevitable bust. The 2007 crisis in the US sub prime market was no different or at least, partially. After briefly analyzing the causes of the recession, which were lax monetary policy, the securitization food chain, conflict of interest from the credit rating agencies, Fannie Mac and Freddie Mae and policymakers’ inertia, the blog post will then analyze how this crisis spread to the rest of the world.
1) Lax monetary policy
In 2001 the US economy had faced a relatively mild recession that was caused by end of the dotcom boom. Policy makers responded to the 2001 mini crisis by slashing interest rates to its lowest levels in almost 45 years. The rationale behind these rate cuts were that they were made in response to the large amounts of capital flows coming from Asia as well as the fear of deflation that would have catastrophic effects on the economy as was the case in Japan during the lost decade.
2) Securitization food chain and maturity mismatch
These low interest rates lead to a surge in housing prices as consumers and bankers alike rode the wave of cheap money. Housing prices within the US effectively doubled within 5 years. This lax monetary policy and consumers insatiable hunger for mortgages was coupled with banks implementing an “originate and distribute” banking model which usurped the traditional banking model. This originate and distribute model lead to what was termed the securitization food chain in which banks would sell the mortgages of their clients to investment banks. These investment banks would then pool mortgages, credit card debt and student loans and repackage them into what was called collateralized debt obligations (CDO’s). These CDO’s were then sold to investors all over the world based on their individual risk appetite. The sale of these assets were beneficial to the commercial banks due to the maturity mismatch between their assets which had long maturities relative to their liabilities. Therefore, the commercial banks were essentially offloading their risk to investors and decreased the liabilities on their balance sheet such that their balance sheets accorded to the Basle I capital requirements. Moreover investment banks where making enormous profits by selling these CDOs to investors all over the world. Some of these investors were commercial and investment banks themselves as well as hedge funds and pension funds. Completing the securitization food chain was the insurance companies who insured theses CDO’s through credit default swaps (CDS) which essentially insured the investor a lump sum payment should there be any defaults on the specific tranches that were bought in return for quarterly installments.
3) Conflict of interest from the credit rating agencies
Investor sentiment towards these CDO’s were really good given that these products were insured through CDS and that the three major credit rating agencies rated these products AAA. This rating implied that these securities were really low risk. This lead to a conflict of interest problem that stems from the fact that these mortgage backed securities would be in higher demand if they had better ratings. The result was that investment banks were incentivizing better ratings by paying credit rating agencies higher rates. The benefit to the rating agencies was that they would get repeat business and increased profitability. Moreover they could fall back on the fact that their ratings were just opinions should anything go wrong. Furthermore these credit rating agencies convinced government that there was no conflict of interest problem because there future profits depended on their reputation and that it was not in their best interest to give fallacious ratings.
4) Freddie Mac and Fannie Mae
Coupled with all of the above, government-sponsored agencies Freddie Mac and Fannie Mae were given a mandate to to help foster home ownership in order to help mitigate the high levels of inequality within the US. These agencies were making significant amounts of money by borrowing money at a low interest rate and then buying mortgages with higher interest rates. This profitability however, was subject to the size of the market as well as the level of regulation within the market. Policies encouraged these agencies to accept lower quality mortgages and backed them which triggered credit extension to subprime borrowers.
5) Policymakers inertia
A final point to make on the causes of the recession was their inertia with regards to what was unfolding. There was no regulation regarding the lowering of lending standards or regulation of the derivatives market which included the CDO’s and CDS. Furthermore, regulators had allowed the banks to increase the levels of leverage that they were allowed to have on their books. This increased leverage lead to banks taking on excessive risks through the issuing of more subprime mortgages that were not carefully approved or monitored. Thereafter more CDO’s were created in order to make higher profits from the higher interest rates that could be obtained through these subprime mortgage backed securities. This resulted in increased profitability throughout the securitization food chain as well as for Freddie Mac and Fannie Mae. This higher profitability and the whole chain was however very susceptible to higher delinquency rates as well as falling housing prices due to the high levels of leverage.
How did the recession propagate to the rest of the world?
The short-term interest rates lead to a lot of banks financing their day-to-day activities through short-term money market funds. After Lehman Brothers filed for bankruptcy, banks became more reluctant to lend to one another through the overnight lending channel due to the increased probability of insolvency and counter party risk. This led to a decrease in banks ability to finance themselves, which lead to banks engaging in fire sales. These fire sales were amplified by the large amounts of leverage taken on by banks. Moreover, CDO’s had been sold to investors in countries all over the world and when housing prices and delinquency rates started to rise, people started to see that the assets were essentially worthless and left a lot of people who were exposed to the assets, bankrupt. This financial contagion affected not only people within the US but also Europe and emerging markets. As the banks battled insolvency and a decline of their assets on their balance sheets, the impact moved on to borrowers, households and firms. This then affected production and employment, which decreased the demand for investments and goods within the US, which spread across the world through finance and trade linkages where the US is a major component. Therefore countries exports declined dramatically and this affected their growth that lead to the worldwide recession.