What happened in 2008 was not just a Stock Market Crash but rather an economic collapse of catastrophic magnitude that is often called “The Great Financial Crisis.”
In 1929 the stock market crash led to an economic depression, but in 2008 something much more complex happened. It took investors and economists alike years to figure out what exactly transpired in 2008.
What happened in the Crash of 2008? – Great Financial Crisis
The seeds of what was to happen in 2008 were sowed in 1977 when Mortgage Back Securities were first introduced by Lewis Ranieri.
“ You might not know who he(Lewis) is but he changed your life more than Micheal Jordan, the i-Pod and YouTube put together!”– The Big Short (2015)
A Mortgage-Backed Security is like a bond inside of which a bunch of home mortgages is bundled together. Just the way you receive coupon payments on a bond, you receive interest payments(which is rent) in an MBS.
Bundling many home loans together meant that the yield went up, but the risk did not because people aren’t likely to default on their house payments.
Banks sold these MBS hand over fist, and rating agencies graded all these MBS as AAA. AAA are instruments of the highest quality comparable to Government Bonds. But then the demand for housing could only go so high. The banks and rating agencies found out that they were running out of securities.
The demand for housing was limited – so… they created a Collateralized Debt Obligating (CDO).
The Difference between an MBS and a CDO?
While an MBS was backed by a mortgage, a CDO has a much broader scope. A CDO comprises … well, everything. A CDO has a mortgage, a corporate loan, a credit card loan, and honestly .. any form of payment ranging from royalty to credit cards.
A CDO was a mixture of genius and greed, but what followed was pure stupidity coupled with greed.
The Dean of Valuation, Aswath Damodaran in 2011, wrote, “our faith in both bankers and regulators has been shaken, perhaps to a point of no return. We can no longer assume that having regulatory rules on risk-taking will result in sensible risk-taking at individual banks.”
The Traitors: Bankers, Regulators and Rating Agencies
A mortgage or a credit card payment is secure only until the borrower has the ability to pay.
The bankers again got greedy and did something incredibly foolish. They slept on their job. Bankers get a fat commission if they can get customers to apply for specific policies or take certain loans.
While a loan application typically takes some time to complete, this was a bubble in the making. The loan applications were getting accepted even if the applicant were an immigrant who could barely speak English and had no steady income source.
The regulators were making so much money doing it, and they did not bother to check. The rating agencies were making so much money; they did not bother to check. The bankers were getting paid so much; they couldn’t care less about the loan defaults.
At this point, any application was getting cleared. If stories are to be believed, you could write your dog’s name instead of yours, leave the income section blank, and your loan would still be accepted.
People kept buying houses and condos because loans were readily available, and if the payments went too high, they could refinance them.
The problem came when they couldn’t refinance it.
Lehman – The bank that went under.
What do you call a situation when most of a country’s population has taken loans they can’t pay on properties they can’t remember?
When the payments prices became costlier than the properties they were on, people stopped paying their mortgage, and the default rates skyrocketed.
Remember we talked about rating agencies? They suddenly woke up. The CDOs rated AAA, i.e., of the highest quality, were now re-rated to CCC or even lower. Suddenly, people noticed what was happening and panicked.
The Lehman Brothers, the fourth-largest investment bank in The United States, a bank started in 1847 – a bank that claimed to have $639 Billion in assets filed for bankruptcy.
A bank “too big to fail”- failed. This led to the stock market crash.
The S&P 500 corrected by over 20% in a single day!
Followed by more corrections.
In India, the Nifty fell by about 40% while the Small-Cap or Mid-Cap index fell by about 80%! These weren’t exactly “crashes”, in fact, they were gradual corrections over months that wiped out billions of dollars.
Remember the banks that were making a lot of money, so they gave out loans to anyone? They bit on more than they could chew.
None of the major banks could pull through the losses they suffered because of the loan defaults until the government helped them. Morgan Stanley did a special deal with Warren Buffett and somehow managed to survive.
It’s a popular saying that when America sneezes, the world catches a cold – The recession in America in 2008 led to a global recession.
Summing up the Great Financial Crisis
“Rising prices are a narcotic”– Warren Buffett.
For the 2008 Housing Crisis, he said, “The entire American public was caught up in the belief that housing prices could not fall dramatically. “When your next-door neighbor is making money very easily by buying a second home, you start thinking ‘maybe I should do that too.’”
To sum all of it up. Investment banks got greedy; they took a perfectly decent product(MBS) and turned it into something riskier(CDO) for more profit. The rating agencies got greedy and did not grade the CDO. The bankers got greedy with the commissions and gave loans to everybody. People got greedy, so they bought more houses than they could pay for.
The bull run from 2003 to 2007 is called “The Mother of all Bull runs” in India. The bull run is only remembered because of the Stock Market Crash of 2008 which scarred an entire generation of investors. I guess that alone is enough to tell you about its impact.