What Caused The 2008 Financial Crisis?

This section of the site relating to bear markets could hardly be complete without a look at the 2008 financial crisis. Though the situation had been building for months (and years) over the course of around six weeks in October 2008, many of the largest financial institutions in the world either came close to collapse, needed some form of rescue from the Wall Street bailout or did actually go under. We look at some of the causes here.

There have been a number of books published about the credit crisis and it's causes so far. In their individual ways, each looks at parts of the problem as if it were the whole. Unfortunately, it appears that each may be right in evaluating the problems in an area, but these problems still have to fit in with the all the others. The interconnected, global scale of the problem makes accurate analysis difficult - if not impossible - and also makes workable long-term solutions hard to find.

Everyone on earth must by now know of the problems in the United States with homeloans, mortgages and shaky lending standards. For a time, NINJA loans (No Income, No Job or Assets) that carried too much financial incentive to the seller and the re-packager were the problem. However, it appears that these were simply the froth on the top of the beer, the real problems lay way below.

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Despite the risk that each low standard mortgage was adding to the system, it was in the financial interests of the brokers to sell more. As with investment bankers, the long-term health of the financial system was being undermined by a short-term bonus culture in which each individual was acting rationally.

Unfortunately, the ratings provided on these "sliced and diced" investment products proved to be very optimistic and the debt was repackaged and sold around the world to be added to investment and pension funds (ie, you and me) which is what turned the September 2008 financial crisis into one that impacted the entire global financial system.

This expansion of the problems to a global scale meant that it was very difficult for anyone (central bankers, governments, financiers and even the media such as CNN, CNBC and the Wall Street Journal) to be able to predict what or who would be forced into trouble next. This added to the drama and panic of the 2008 global financial crisis. 

An excellent book on the subject is called Fool's Gold by Gillian Tett. Ms Tett writes the 'Lex' column for the Financial Times and so it can be presumed that she has access to knowledge and people that the rest of us simply do not. She used this access to look into the birth and early years of the derivatives that were to prove so harmful to the world economy. What she found was a team of mathematics geniuses that had found a way - via derivatives - to reduce risks on the balance sheet of a major US investment bank. The careful use and analysis of these products enabled the bank to find other companies, funds and organisations that wanted to take higher risks with their money and were willing to take increased risks to do so.

So far, so much financial common sense.

The problems started to arrive when other banks realised that they could earn millions of dollars in commission for repackaging these risks and selling them on. Before long a business model ballooned as major funds looked to take on low risk (much of this was AAA rated) assets that offered a slightly higher return. Much of this was based around the cash flow of groups of homeloans and mortgages in the USA.

As Tett tells it, there was a tranche of risk - the safest part - of these products that many firms decided was so safe that they would take it themselves. This is called super senior. While it was the safest part, it seems that many firms believed it to be risk free which is actually rather different to lowest risk tranche! Over time, these companies managed to build up tens of billions of dollars (!!!) of super senior on their balance sheets. I think that with hindsight, everyone can now agree that even if an asset is incredibly low risk, if you have tens of billions of dollars worth of it, you are still holding significant risks...

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The unregulated nature of the derivatives market (it seems to be that there were less than 100 people on earth that truly understood these products!) meant that there was no liquid market for super senior. As credit markets started to stick and no bank seemed to be willing to lend to anyone else, it was impossible to value these super senior products. As their values fell, banks looked increasingly sick and prone to immediate bankruptcy.

As we now know, governments viewed some of these mega-banks as being 'too big to fail' and so we 'the people' have stepped in to prop up their balance sheets with a US$700 billion bailout to somehow keep the world financial system alive - even if only on life support.

Some companies were considered to be worth saving, AIG (the world's largest insurance company) being the main example, while others such as Lehman Brothers were left to collapse. Bear Stearns, the oldest investment bank on Wall Street was bought for a nominal sum (including liabilities which were anything but nominal) by JP Morgan Chase.

One of the worries was that AIG's liabilities were so large that if it failed both the insurance and derivatives markets would go into instant meltdown. They would likely take everything else with them. Thus, with a limited pot of money to save the system, some financial institutions were saved while others had to be let go.

Considering the panic that was visible on stock markets around the world and the dramatic plunges in prices day after day, it is amazing that so few banks were forced to close their doors (and yet, worldwide there were hundreds of banks that did).

There can be little doubt that this borrowing by government is causing another financial shock at some later unknown time. But before that time comes, world stock market's plunged and every major economy on earth fell into recession. Some notable experts, 2008 Nobel Prize winning economist Paul Krugman among them, suggests that this is the 'mother of all recessions' and possibly The Great Depression 2. Not nice.

We recognise that this is a very simplistic overview of the 2008 financial crisis and credit crunch, but it will hopefully lead you to read Fool's Gold by Gillian Tett, which does seem to explain the situation incredibly well.

Further developments

As time has passed since the financial crisis, it has become ever more clear that within some investment banks the level of rapacious greed was overwhelming and blinded their judgement. One such example of this is coming to a conclusion (in mid 2013). It relates to Goldman Sachs and their former trader Fabrice Tourre.

The case is relatively complicated, but the essence is that Mr Tourre was constructing sub-prime mortgage investments that he knew were going to fail. On one level, it can be argued that if a party bought either side of the trade, then both thought they would make money (and they both cannot be right). However, it has also been argued that a greater duty of care was required.

To make matters worse, there have been some internal emails released which make Fabrice Tourre look and sound arrogant and guilty, which considering the collapse that came, and the image of Wall Street throughout America, is not very helpful. Even less helpful, the emails also suggest that these exotic products were so complex and highly leveraged that even he did not fully understand what could go wrong.

To read more about bull and bear markets, please use the following links:

Understanding Bull And Bear Market Situations

Bear Market Definition

What Is A Bear Market?

Bear Market Investing Strategies

What Is Short Selling?

Secular And Cyclical Bear Markets

The Great Crash 1929 by J.K.Galbraith

What Caused The 2008 US Stock Market Crash?