Principles of Finance I WEEK 2: Discussion Prompt #2 - The financial crisis was

Question

Principles of Finance I WEEK 2: Discussion Prompt #2 - The financial crisis was caused by several factors related to investments in real estate. This week, we have discussed a variety of reasons why the financial crisis occurred. For this discussion, choose one of these reasons and discuss why you believe this reason was at the root of 2008 financial crisis and recession. In addition, discuss what legislation has been enacted to prevent this event from taking place in the future and causing another financial crisis.

Explanation / Answer

Throughout financial history, investors have been attracted to the boom and eventually the bubble in one sector of the economy or other. Examples would include the Dutch tulip bubble of the 17th century, the 'Railway Mania' of the 1840s, the roaring twenties stock market bubble, the dot com bubble of the late 20th century and finally the US real estate investment bubble in the run up to the 2008 meltdown.

However, what sets apart the 2008 sub-prime crisis is the fact that a new financial engineering technique popularly known as 'securitization' led to ills of the real estate bubble spilling over into the world financial markets and balance sheets of globally renowned financiers (Banks, mortgage institutions, non-banking lenders,etc).

'Securitization' spurred reckless and huge investments in Mortgage backed securities (MBS) and/or collateralized debt obligations (CBOs) by all and sundry in the investment market and this fact - the 'imprudent lending by financiers to home buyers and investments in MBS/CBO' was the root cause of the widespread meltdown. Central bankers along with the aforementioned regulators are also to be blamed for the crisis as they turned a blind eye to these ever increasing risky investments.

The process leading upto the crisis was triggered by the 'savings glut' in China and other major emerging markets in the early 2000. This led to capital flowing into 'safe' American Government Bonds and other similar securities which in turn led to upsurge in Bond Prices and consequently decline in yields (and interest rates). This drove financial investors such as banks, hedge funds and mutual funds to look for riskier higher yield assets. Simultaneously, the US real estate market was witnessing a boom with banks doling out home purchase mortgages to 'subprime' borrowers with poor credit histories who would eventually struggle to repay these mortgages.These large number of mortgages were turned over to financial engineers who pooled them and converted them into low-risk (apparently) MBS/CBOs. The financial engineers believed that since property prices cannot collapse simultaneously across the entire nation, these securities offered less risk and higher returns in a world plagues by lower interest rates.Further, these collateralized securities were spliced into tranches as per their propensity of default. Ratings agencies conferred the relatively safer tranches with triple A ratings as they too believed that housing prices were uncorrelated across the country. Investors buoyed by the credible ratings started investing in these securities in large amounts.

When the housing market turned, MBS/CDOs slumped in value overnight despite the seal of approval from credible rating agencies. Selling these seurities became impossible at any price point and these could no longer be used as collateral to fund short term securities. Additionally, 'fire sale' of these assets led to instant and large scale collapse of confidence in the viability of these securities. The problem was compunded by the practice of 'marked to market' accounting which forced banks to report these fire sale losses in current market prices thereby further spooking the broader market. The practice of reckless lending and imprudent fnancial engineering reached it nadir when large number of credit default swaps (insurance against lending defaults taken out by lenders) started destabilising large insurance houses such as AIG. Consequently, the collapse in the real estate market spilled over onto the money market, the capital markets, the insurance market and finally the overall economy.

Two major regulatory responses to this crisis were the 'Volcker Rule' (which infact was a slew of reform bills) and the Basel III banking regulations that among other things regulated the shadow banking industry, restricted humungous executive payouts, legislated provisions for consumer protection, gave Federal Reserve expanded mandate to follow regulated quantitative easing, raised minimum capital requirements for banks, restricted the classification of bank capital, limited corporate leverage, enhanced counter-party risk protection and implemented stringent liquidity requirements.

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