The Starting Point
Although the financial system, financial instruments, parties involved during this period had many complexities, we will try to describe this complicated story in a simple way.
Most economists agree that the initial trigger of the crisis was the housing bubble, driven by low interest rates moving the housing prices higher, which peaked in early 2006 and starting to drop in 2006/2007, with the Case–Shiller home price index reporting its largest price drop in its history on Dec 30, 2008.
New Financial Instruments That Played a Major Role
The core financial instrument that played a huge role in this story is called MBS (Mortgage backed security), a bundle of mortgages banks sell to a third party, which then sells shares of this pool to investors.
This product attracted many investors both from US and globally. As they looked like low risk investments (a lot of these MBSs had AAA ratings) and provided high returns in relation to other so-called safe investments, investors went to pour more and more money into purchasing them. In turn, lenders were motivated to create more of these products, so they loosened their standards and granted more loans to people with poor credit and insufficient income. These new huge investments drove the housing prices even further.
In addition to this, large financial institutions, such as AIG started to sell another product called CDS (credit default swaps), considered an insurance product against MBSs.
So backed by this insurance (CDS), this AAA rated products were seen as a perfect investment with lowest risk and high returns. “There is no risk: the house prices are going higher and higher, so in the worst case scenario, we can sell the collateral in the secondary market and cover the losses” probably what the investors and banks thought.
This subprime lending practices were thought to work well for all the parties involved. However, things went terribly wrong.
The Panic Begins
Poor credit and low income borrowers started defaulting on their loans, so more houses moved back on market for sale. This resulted the house prices to drop, down to a point where the price of the house was lower than the mortgage. Borrowers stopped paying.
This massive increase in default rate of loans affected all the parties involved. The biggest financial institutions, such as Lehmann Brothers defaulted, an event that started a panic on Wall Street, with Dow Jones Industrial Average dropping more than 500 points, the largest decline since the September 11, 2001, attacks.
The financial system was thrown into a terrible state, which led to a recession affecting the whole world.
Who is to blame?
Although almost all the parties involved can be blamed for the crisis, the major cause of this collapse were:
- Government’s non-efficient regulation of financial system
- Central banks’ lowering of interest rates to stimulate the economy
- Rating agencies’ AAA ratings for risky instruments
- Lenders’ granting loans to customers with poor credit and low income
What Can Be Learned?
- Diversify within asset classes and individual instruments.
- Don’t rely much on Rating Agencies. Although Credit Agencies were hugely criticized for financial crisis and seem to have learned lessons from it, you can’t still rely solely on their ratings. Do your own research, make your own analysis. Some investors did that and noticed the problem with subprime mortgages in 2006 and were able to avoid risks and even earn profits from it.
- Don’t be driven by crowd opinion.
- Be careful with derivatives! When investing in derivatives, examine every related aspect of it, what can influence its price, how it is connected to other products, etc.
Although it’s extremely difficult to predict the timing of the bursting of bubble or anticipate the next financial crisis, still you can position yourself in a way to minimize the losses and even benefit when hard times hit.