• EconAfterHours

A Beginner’s Guide to the 2008 Financial Crisis

Updated: Mar 11, 2020

By Ananya Iyengar

To quote former Governor of the Bank of England Lord Mervyn King-

“If the economy had grown after the crisis at the same rate as the number of books written about it, then we would have been at full employment some while ago.” [i]

Having said that, this article aims at introducing to beginners the long and tumultuous story of the greatest economic crisis in modern history. The period of economic history before the crisis was characterised by growth and a promise of stability. This phase suddenly and very quickly collapsed into the worst banking crisis the industrial world has ever witnessed. A lot of people were quick to lay blame on failed institutions and their heads for the crisis but the underlying cause for this breakdown lay in the flawed structure of money and banking, something King calls “alchemy”.[ii]

The events preceding the crisis can be understood under 4 heads (although it must be kept in mind that they all occurred together):

  1. Excess savings in developing countries

  2. Banking Glut

  3. Derivatives contracts

  4. The US subprime market

After the fall of the Berlin Wall, many developing countries started working on pushing up their exports for economic growth. They did this by devaluing their currency with respect to the US dollar. China is a classic example of such a growth strategy.  The success of this policy led to more people in developing countries saving more than what was being invested. Economists have called this the “savings glut”. While developing economies (especially Asian countries) were saving more, the advanced countries were spending more. However, the level of savings went up on a global level. An increase in savings meant that people were more willing to save than to spend, as a result of which interest rates fell. The fall in interest rates increased people’s appetite for risky investments, demand for housing swelled and real estate prices soared.

The second cause, as explained by Princeton professor HS Shin, has its roots in Europe. European banks drew wholesale funding from the United States and then lent it back to US residents. Although European banks’ presence in the domestic US commercial banking sector was small, their impact on overall credit conditions loomed much larger through the shadow banking system (credit intermediation involving entities outside the regular banking system) in the United States that relies on capital market-based financial intermediaries who intermediate funds through securitization of claims. In simpler terms, banks in Europe, incentivised by rising housing prices, borrowed funds from US money markets at low interest rates and used it to purchase mortgage backed securities (mortgage loans made to people demanding houses were pooled together and sold as securities by shadow banks like mortgage and investment companies). Securitization created a moral hazard – banks making the loan no longer had to worry if the mortgage was paid off – giving them incentive to process mortgage transactions but not to ensure their credit quality. This was termed as the banking glut which eventually led to subprime lending.

The third aspect of this crisis is derivative contracts. Derivatives are lucrative debt contracts based on underlying assets as a collateral. They are combinations of various types of debt like bonds- “derived” from them. Some examples of derivatives are futures and options. Derivatives are risky instruments and banks were relying heavily on them in the period before the crisis. Banks were, as aforementioned, borrowing huge amounts of money, thus more dependent on their borrowings rather than the funds of the shareholders i.e. Equity capital (This ratio of borrowings to shareholders’ funds is called Leverage. Leverage levels were as high as 50 before the crisis. Higher the leverage, higher the risk.)

Source: Modkraft

Banks had made large bets on the subprime market in the form of these derivatives. The subprime housing market refers to loans given for housing to those people who required housing but did not have the credit standing to pay back these loans. Banks thought that all these borrowers would not default at the same time. They did. When people did not pay back these loans, banks suddenly found themselves in urgent need of money.

Large bank balance sheets and disequilibrium in savings had led to a state of instability, like a pile of Jenga blocks ready to tumble down! When banks were unable to get back money, people lost trust in banks and started withdrawing their deposits. Banks found themselves in a solvency crisis. The collapse of banks like Lehman Brothers[iii] and The Royal Bank of Scotland, which were considered to be “too big to fail” created a state of panic. This panic quickly spread all over the world, with the possible exception of North Korea. Banks had to rely on Central Banks to act as “lender of last resort” and bail them out. As lender of last resort, central banks provide financial aid to ailing banks. A 2012 CNBC report values the total amount paid as bailout by the Federal Reserve to be $29 trillion.

A Lehman employee walks out of the bank with his belongings ;   Source: The Telegraph, UK

The 15th of September this year marks 10 years of Lehman Brothers filing for bankruptcy. Ten years down the line, the world economy is still healing its wounds. According to forecasts by the Organisation for Economic Cooperation and Development (OECD), the world economy grew at 3.3 percent in 2017- an improvement but not as high as 4 percent in the time before the crisis.[iv] While crises teach us important lessons, no one can predict what the uncertain future holds. Economics does not provide generic solutions to problems. What worked during the Great Depression did not work for the 2008 crisis and what worked for the 2008 crisis will not necessarily work in the future. Crises will always be a characteristic of the economy. We can only hope that the world has learnt from the mistakes made in the past.

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[i] (King, 2016) – The End of Alchemy

[ii] Banks borrow money in the form of deposits from households and firms in the short run and lend this money to borrowers for the long term. They charge a higher rate of interest on the loans they advance than on the deposits they receive, thus gaining. This phenomenon of borrowing short and lending long is what King calls “alchemy”. He argues that when banks make loans and borrowers are unable to pay back these loans, it creates a situation of panic. Depositors start withdrawing their deposits- a “run” on the bank. Banks depend on the trust of the depositors and when they lose this trust, they end up with a lack of funds- a liquidity crisis.

[iii] Marcus McCrea, who works for the government’s veteran’s administration said as he passed the Lehman HQ- “Bye-bye Lehman. It was nice knowing you.”

[iv] A Financial Times article dated 7th June, 2017

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