spikegifted - Global Financial Crisis 2008 - one year on...
|ABS, MBS, CDOs, etc...|
|Credit rating agencies|
|Risk management (or the lack of)|
|Wall Street vs. Main Street|
|'Politicalization' of Finance|
|The future of banker’s pay, “tax on the rich”, risk management and financial regulations|
|The “true” causes of the financial crisis|
|Are banks “too big to fail” and are bankers too powerful?|
|How do we make sure another crisis will not occur?|
Early in September 2008, Lehman Brothers, one of the most famous Wall Street investment banks, filed for bankruptcy. It was the largest bankruptcy the world has ever seen. The loss of confidence in the global financial system in the immediate aftermath of Lehman's collapse nearly brought the whole system down. It was only saved after coordinated efforts by governments and central banks around the world pumping cash and providing guarantees to the banks.
How such an established name in finance met its end? Why was the global financial system so affected? What was the consequence of the crisis? I hope to give my own view of the events from my 'ring side seat' as a credit risk professional in an investment bank. It was a very scary time as all the previous assumptions of how the system worked were thrown out and no-one knew what rules to follow and where was it leading all us to, both within our industry and the wider world outside finance.
The root of the whole financial crisis can be traced back to mortgages, specifically US sub-prime mortgages. Mortgages are a very simple and common financial product. Almost everyone will have one at some point in his/her life. It is effectively a form of collateralized lending. A buyer finds a property to buy and approaches a bank to lend him a pile of money to complete the purchase. Of course, the bank would not lend the money without some form of protection. This comes from the right to claim ownership of the property if the borrower files to service the loan. In the banking circle, the size of the loan compared to the value of the property is called loan-to-value ratio (LTV). The higher the LTV, the more risk the bank is exposed to. This is because if the borrower fails to service the loan, the lender has to seize the property in order to sell it and recoup the money lent. The higher the LTV, the lender is more sensitive to falls in property prices.
In the old days banks seldom lent more than 70% of the value of the property. LTVs of 80% were very unusual. However, since the mid 90s, a new type of mortgage came to the market which allows the borrower borrow up to 95% (and sometimes even higher) of the property value. This development allowed a whole new set of people to enter the property market. As demand for properties outstrip supply in certain areas, typically city centers, this fed a property boom. So, by lowering the initial capital requirement (the deposit), banks created a boom. This had a feedback effect on the mortgage market - you lend 95% of the value of the property, which allowed more people with less capital to become home owners, which created more demand and pushed prices, which in turn lowered the LTVs of existing loans, so the loans looked less risky. So as long as property prices went up, and people keep servicing the loans, banks can keep lending.
Of course, while house price increases were one of the major factors that contributed to the continued increase in mortgage lending, the other major component was people's continued ability to service the loans. In a low interest rate environment and high employment in a growing economy, that should be relatively easy. To assess the borrowers' abilities to repay, the lenders were required to undertake a vigorous series of checks. Things like credit histories and employment records allow the lenders to form reasonable assumptions on the borrowers' continual abilities to repay. However, in a low interest rate environment, with strong competition, this spread was compressed and hence created a need to lend more to make the same amount of money.
Banks, by nature, are good at attracting deposits and then lending the
pooled cash out to needy borrowers. In doing so, they earn the
difference between they pay their depositors and the interest they earn
from their borrowers - the interest rate spread. Therefore, the more
mortgages they underwrite, the more money they earn.
So we have a financial product, the mortgage, which has been used as a money making tool for the lenders, the brokers and even borrower - as long as house prices continued to increase and borrowers continued to service their loans. This is a feedback loop. The problem is: if one part of the loop fail, the rest will fall away very quickly.
Next - ABS, MBS, CDOs, etc...
Back to top
|September 2009: First version.|