The long trail of US financial crisis  

September 15, 2018 marked the 10th anniversary of the financial crisis that almost killed the American economy. The enormity of the crisis baffled economists who thought they finally had a handle on why financial crisis occured, but their sophisticated macroeconomic models could not forecast the crisis of such a magnitude. The financial crisis left debris in the aftermath of the crisis and is still unraveling in some countries.  Just in one month alone, December 2008, 524,000 people lost their jobs in the USA. The unemployment rate soared from 5 per cent in January of 2007 to 9.8 per cent in January of 2010.  The total job losses in the USA in 2008 alone were 2.6 million. The aftershocks were also felt very strongly in European countries, reverberating through the financial capitals with torrential speed, particularly in the so-called southern counties of Europe.

The crisis was in the making for many years. Risk exposure of banks increased because of the change in their business model in the early eighties. Banks started relying more on wholesale banking than traditional retail banking. Instead of traditional deposits, banks started sourcing their funds from large, short term loans from other banks and money market mutual funds. These kinds of funds are not covered by deposit insurance and make banks highly leveraged. While these funds helped generate better bottom lines for banks, they also increased banks' exposure to risks.

Home buying got a shot of adrenaline in the first decade of 21st century because of a combination of several factors:  1) very low interest rate caused by saving glut, 2) approval of mortgages requiring no or little down payments and no documentation, 3) appearance of bank-like institutions on the scene, and more importantly 4) securitisation of loan - mortgages are bundled together, packaged, repackaged and sold as securities to individual investors. Financial industry was working overdrive, developing so-called synthetic derivatives out of mortgage-backed securities, and ordinary investors had no idea where they were investing.

The securitisation process is an important innovation which changed the financial landscape and to some extent, is responsible for the unfolding of the financial crisis. Initially, Freddie Mac and Fannie Mae, the two government sponsored institutions were involved with the securitisation process. They keep mortgage market liquid by buying mortgages from banks (so that bank loan is not tied up for many years), and selling mortgage-based securities (MBS) based on cash flows from interest and principal payments from a pool of mortgages. The innovation was carried one step forward when MBSs were pooled together to create a new class of securities called CDOs (Collateralised debt obligations) which were divided into three different risk classes or trances.  Investors in the highest trances, rated AAA, were to be paid first from the mortgage payments, even though the underlying assets on which those securities were based were highly default-prone. The lowest trances were even riskier as investors in those securities would be paid after the highest and middle trances were paid.

The complex securitisation and the mysterious trancing of securities hoodwinked people by making them think they were investing in safe securities. With the help of quantitative nerds and through complex financial engineering, investment banks such as Goldman Sachs, Morgan Stanley and Lehman Brothers bundled together bad mortgages and sold them as highly rated securities. However, the edifice of that security industry was built on a shaky foundation. When house prices started falling in 2006 and mortgage holders could not make regular payments because of rising interests, prices of securities built on those mortgages started falling. Consequently, investment banks who were holding those securities fell behind in making payments to their investors and the entire industry fell like a house of cards.

Fed (Federal Reserve Bank) in the USA immediately jumped to action, by flooding the economy with high doses of liquidity both through conventional and unconventional channels. Overnight Fed became like any other bank. Fed cut the interest rate to zero in December, 2008.  It loaned to an insurance company (AIG) and auto industries and bought so-called toxic securities worth billions of dollars - securities based on mortgages and were of questionable market value.

What seemed to be a local crisis in the USA morphed soon into a global crisis of gigantic proportions, thanks to increasing interconnectedness between transatlantic financial institutions as part of enhanced financial globalisation. European banks were doing lots of business in the USA and were engaged in the so-called currency mismatches. On August 2007, French bank BNP paribus announced that it was freezing three of its investment funds due to problems with mortgage-backed securities in the USA. The same day European Central Bank (ECB) injected $131billion of liquidity into Europe's banking system. Northern Rock Bank, a big bank of the United Kingdom filed for bankruptcy in February of 2008. Through currency mismatches, banks borrowed in US dollars in exchange for their own currencies to swap them back at a later date. The currency mismatch enabled non-US banks to have access to wholesale markets for funds in dollars to be able to do business in US dollars. These banks used some of these funds to buy mortgage-backed securities. Thus the contagion also spread through international investment in mortgage-backed securities which originated in real estate market in the United States. European banks held about 30 per cent of US mortgage-backed securities. A sudden sale of these securities would create further panic in the market and create a run on dollar-denominated funds and dollar itself, the Fed feared. Thus Fed emerged as the banker of the world lending to foreign banks.

The financial crisis affected the economic landscape in the USA and other developed countries in many other ways. The already-skewed income distribution in US became skewer in the aftermath of the crisis. According to the 'Washington Center for Equitable Growth', average income of the top 1 per cent household increased from $999,000 in 2009 to $1.3 million in 2015 and the remaining 99 per cent from 45,300 to $48,800.  According to times analysis of the Federal Reserve data, the net worth of top 10 per cent of households in the USA increased by 30 per cent, while that of the remaining households fell by 27 per cent. Millions of families lost their houses due to foreclosure, which Adam Tooze, in a recently published article in the Foreign Affairs, called "the largest forced population movement in the United States since the Dust Bowl." ("The Forgotten History of Financial Crisis - What the World Should have Learned  in 2008", the Foreign Affairs, September/October, 2018)

Internationally, Greece is yet to recover from the crisis. The structural differences between the economies of the North and the South were exposed by the crisis. The Brexit might well be one of the casualties of the financial crisis. The 2007/08 crisis will be remembered as spawning the Great Recession of our times.  Timely intervention may have saved the world economy, however, public in the west lost confidence in the ability of macroeconomic models to forecast a financial crisis.

Syed Mushtaque Ahmed Ph.D. is a Lawton Independent Agents Chair and Professor of Economics and Director of Bill Burgess Jr. Business Research Center at Cameron University, Lawton, Oklahoma, USA. [email protected]