I view derivatives as time bombs, both for the parties that deal in them and the economic system. –Warren Buffet
What really happened
The so-called “subprime mortgage crisis,” which had been taking shape over the years, began signaling “The Great Recession” in 2006. So, what is this “subprime mortgage crisis”?
The banks and other financial institutions of U.S. started granting loans to the general public keeping their homes as a Mortgage-Backed Security (MBS) which artificially inflated the prices of real estate and soon the public was being given loans in large amounts taking the artificial prices of MBS into consideration, at low-interest rates, without even checking the creditworthiness of individuals due to which a lot of debt piled upon the public and when these individuals weren’t able to repay the loans, the housing bubble finally burst and the whole economy collapsed. Banks and other financial corporations had invested in these in the form of derivatives, and when the Fed raised rates in 2006 and derivatives based on subprime mortgages lost value. Although these loans had no value of their own, they were bundled with other AAA-rated securities, which increased the rating of these loans as well, and the banks and financial institutions invested huge amounts in these so-called Collateralized Debt Obligations (CDOs), not realizing that their investments were worthless. Soon, all the big banks, including Lehman Brothers, declared bankruptcy. The Fed ignored declines in the inverted yield curve. Instead, they thought the strong money supply and low-interest rates would restrict any problems faced by the real estate industry. The banks felt safe because they also bought credit default swaps (CDS), which insured against the risk of defaults. But when the MBS market collapsed, insurers did not have the capital to cover the CDS holders. As a result, the insurance giant American International Group (AIG) almost went bankrupt before the federal government saved it.
Fannie Mae and Freddie Mac were given a government-sponsored monopoly in large part of the U.S. secondary mortgage market, which meant the government’s implicit guarantee to keep these firms afloat, which together contributed to the mortgage market’s collapse. They were regulated by the Department of Housing and Urban Development (HUD) and the Federal Housing Finance Agency (FHFA). They created a liquid secondary market for mortgages where the financial institutions could sell mortgages shortly after origination, which freed up funds for creating additional mortgages.
Wall Street began to make a liquid and expanding market in mortgage products tied to short-term interest rates like LIBOR. It sold these adjustable-rate mortgages to borrowers as loans that the borrower would refinance out of long before payments adjusted upward. They had attractive features like interest-only or even negative-amortization. Home loans often consisted of lax underwriting guidelines, leading to the growth of subprime mortgages.
Investors purchased these securities with a positive outlook. Fannie Mae and Freddie Mac saw their market shares drop. So they began to purchase and guarantee an increasing number of loans and securities with low credit quality. Soon the government seized them in 2008 as they began to realize large losses. Foreclosures and repossessions increased, which further decreased property values. And soon, a large number of financial institutions faced bankruptcy.
On September 29, 2008, the stock market crashed when the Dow Jones Industrial Average fell 777.68 points in intra-day trading because Congress rejected the bank bailout bill. But after that, on Oct 3, 2008, Congress established the Troubled Assets Relief Program (TARP)to allow the U.S. Treasury to bail out troubled banks. The Treasury Secretary lent $115 billion to banks by purchasing preferred stock.
To prevent bankruptcy, the Federal Deposit Insurance Corporation (FDIC) limit for bank deposits increased to $250,000 per account and allowed the FDIC to tap federal funds as needed through 2009.
On February 17, 2009: Congress passed the American Recovery and Reinvestment Act which introduced a $787 billion economic stimulus plan consisting of $282 billion tax cuts and $505 billion for new projects, like health care, education, infrastructure, etc.
March 9, 2009: the Dow dropped to a bottom of 6,547.05. That’s a total decline of 53.8% from its close of 14,164.53 on October 11, 2007.
February 18, 2009: Obama announced The Homeowner Stability Initiative, a $75 billion plan to help stop foreclosures by helping 9 million homeowners before they defaulted in their payments wherein they subsidized banks that restructured/refinanced mortgage. He launched the Homeowner Affordable Refinance Program (HARP) to stimulate the housing market by allowing up to 2 million credit-worthy homeowners to refinance and avail lower mortgage rates.
Banks could have, but didn’t, prevent foreclosures because it would further hurt their bottom line. Lending was down 15% from the nation’s 4 biggest banks: Bank of America, JPMorgan Chase, Citigroup, and Wells Fargo.
If you look at the 18 months of potential foreclosures in the pipeline, it looked like banks were hoarding cash to prepare for future write-offs.
If we had just let the banks go bankrupt, the worthless assets would be written off. Hence, other companies would purchase the good assets making the economy much stronger. But when they attempted the same with Lehman Brothers, the market panicked. Hence, the free market couldn’t solve the problem without government help. In fact, using the government funds assets allowed the banks to write down almost $1 trillion in losses. Moreover, no other banks had funds to save these banks. Even the banks that the government hoped would bail out the other banks—required a bailout to keep going.
The Dodd-Frank Wall Street Reform Act and new Federal Reserve regulations prevented another banking collapse by conserving capital to conform to regulations and write down bad debt. The bill stopped the bank credit panic. It allowed LIBOR interest rates to return to normal, and made it possible for everyone to get loans.
Without the bill, it would be impossible to get home mortgages and even car loans. The lack of capital due to high-interest rates would have led to a shutdown of small businesses. Even more, foreclosures would have occurred. The Great Recession would have become a depression.