You might have heard about the global financial crisis of 2008. It was one of the most severe crises in world history. The turmoil mostly impacted both stocks and the housing market.
We will discuss today the 2008 financial crisis; how did it happen and what are implication of it in India.
Dotcom boom was going on in the US in 1996. The prices of technology companies were running high at that time. But between 2000 to 2002, this dot com bubble burst & stock prices saw a sharp decline. Due to that, people started withdrawing their money. In 2001, the interest rates in the US had fallen to just 1%. At that time, the stock market was running low and people stopped investing in the stock market. People also don’t want to keep their money in the banks, since the interest rates were low.
So obviously people started looking for a good investment opportunity. At that time, the rates of real estate were rising. The government was also encouraging people to invest in real estate. Due to low-interest rates, people also keep on taking loans. As the demand and prices both are increasing, investors started paying attention to real estate in the US. Investors had thought that demand for housing will keep increasing and prices as well, and this way they can earn a lot of profit.
Now Investment Bank comes into the picture. They also wanted to gain out of this hike in real estate. There was saying that ‘Behti Ganga mai Hath Dhona!’.
What are Investment Banks?
We all have the basic idea about the bank, right! They provide Saving accounts, current accounts, FDs, loans, all of that. The investment bank work as a mediator or arbitrator. They help companies to raise or create capital. They help companies in mergers and acquisitions also. They sell derivative products and derivative trading. Morgan Stanley, Goldman Sachs, etc. are all investment banks.
Investment banks started purchasing loans from the banks. They combine lots of loans, make their bundles, and create a complex derivative product. They name the product as Collateral Debt Obligation (CDO). Then they got the credit ratings for these CDOs from credit rating agencies. They used to inspect the loans and then give CDOs a rating. Then the investment banks would sell these CDOs to the investors.
In a normal case, you might have faced or heard a lot that when banks give a housing loan to someone, the banks check the entire credit history of the borrower along with their income. Typically, the loan repayment duration for a housing loan is very long. In this case, banks were selling their loans to the investment banks. Here, the banks transferred the risk of the loan to the investment banks. A credit rating agency, to most of the CDOs, had given AAA rating, which was the highest rating and it means that the investment is very safe. Investors started buying CDOs in a large amount. Seeing the growing demands of the CDO, investment banks started demanding more loans from a bank. So, the bank was also started giving housing loans to the people for whom there was no guarantee of them repaying. Such loans are called sub-prime loans.
Countrywide Financial Corp. and Ameriquest Mortgage Company, both these companies gave subprime loans worth 177 billion dollars between the years 2000 to 2007.
AIG, the biggest insurance company in the world, started giving insurance on these CDOs. AIG thought AAA-rated CDOs’ failure chances are very low. It was called Credit Default Swap or CDS. So CDO investors were started buying CDS.
Most of the subprime loans by the banks were adjustable-rate loans. Most of the sub-prime borrowers did not have any idea. They initially had to pay very little interest. But after 3-4 years, in most cases, 2007, the interest increased very much. When the interest rates soared, those who had taken sub-prime loans, found it very difficult to pay such high-interest rates. Then the banks started selling their houses to recover their money. 50% of their borrowers had paid nothing from their own pockets. They had taken the entire money from the bank.
As the interest rates started rising, the number of loan defaulters also started rising. Banks came up with lots of house properties for auction. By the year 2007-2008, the interest rates had come to around 5%. The banks found it difficult to find the borrowers of the house. The value of the homes started decreasing much lower than the value of their house.
For example, if someone purchased Rs.50 lakhs worth of a house, with the help of a loan, and now if the value of that house is 30 Lakh. Then the borrower would feel, for a house, of Rs 30 Lakh, why would they pay a more loan which is way higher. hence almost all the borrowers were now defaulting on loan repayment. Due to this, banks started facing short of funds and their operations came to a halt. Because of this, the value of the CDOs became zero. The investors who purchased the CDO lost all their money.
The investors who knew the complete reality of the CDO knew that the CDOs could fail anytime. Hence, they purchased CDS in huge amounts. When the CDOs failed they received lots of profits. AIG which provided insurance on the CDOs, incurred losses worth $99 billion in value. AIG was a giant company, so to save that company. The US government bailed out the AIG company. The government itself put around $85 billion in AIG and rescued the company. Because of this, people stopped buying CDOs. The companies that had lots of CDOs, had to bear the losses from those CDOs. The top 5 investment banks in the US, were on their knees. Lehman Brothers went bankrupt and around 25000 employees lost their jobs.
In this crisis, bank and other financial institutions lost their recorded loss of $450 billion. A lot of businesses were closing down due to not getting the capital from the banks. Global trades started affecting the other nations. The financial crisis was so big, it affected almost the entire world.