Assessing and Evaluating the Main Causes of the 2008 Financial Crisis

September 15th 2008; one of America’s leading banks, Lehman Brothers, files for bankruptcy leaving
the entire US - and by default, the world’s economy on the brink of total failure. The company
eventually defaulted with $619bn debt1 which was the largest at the time in history, however
bizarrely this same company had been making record profits in the three years leading up to its
collapse. By the end of the crisis the US unemployment rate was over 10% (Bureau of Labour
Statistics 2012), 2.6m jobs were lost (US Labour Department) and $19.2 trillion was lost in household
wealth (Department of the Treasury 2012). Many different parties have many different theories of
how something that started out as a near risk free business practice by the major investment banks
in America, lead to the greatest economic downturn since the great depression. However, in this
report I will do my best to look at it from all angles to form my own opinion on who really was to
blame for what could arguably be called the defining moment of the 21st century so far.

Mortgage Bonds and CDO’s

A good place to start this investigation would be with what could arguably be the catalyst to the
disaster – the Collateralized Debt Obligation, or ‘CDO’ for short. Back in the late 1970s banking
wasn’t seen how it is today, it was traditionally run by boring old men talking numbers without the
huge salaries and bonus’ there are today. It took a man called Lewis Ranieri who was a bond trader
at Solomon Brothers to change all this. In 1977 savings banks were feeling the financial strain of
balancing the funding of short term high interest loans with long term low interest loans, such as
your average mortgage. Unwillingness from the banks to deal with average mortgage applications
from consumers lead to a suppression of the housing market and this was until Ranieri developed an
instrument to bring extreme profitability to this market through his invention of a mortgage backed
security (MBS). An average mortgage lasted 30 years to pay off and only yielded a small amount in
interest to the bank but were extremely low risk as back then default on a mortgage was almost
unheard of, with a foreclosure rate of a mere 0.4% for mortgages in 1977 (US census). An MBS was
essentially hundreds or in some cases thousands of mortgage payments wrapped up into a bond in
which the risk was still minimal but the yield was thousands of times greater, which was lucrative
enough for major banks to invest billions in. Banks which focused more on consumer loans were the
ones who packaged up these bonds and then sold them onto the bigger investment banks such as
Deutche Bank in return for a lump sum. The seller benefits from the extra liquidity gained from
selling as well as passing on the albeit minimum risk to the buyer, who benefits from the long-term
profit brought in by the mortgage payments in the bond. A win win so it seemed.

1
https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp
A CDO could typically be composed of any type of loan, from mortgages and credit card loans, to car
and aircraft leases. At first through the 80s the mortgage bond sector concerned itself with the more
solvent half of America, meaning pretty much all these investments were safe and given a triple A
rating by the agencies, such as Moodys, the highest guarantee that the investor will see a return on
his investment. Inside one of the mortgage CDO’s were thousands of individual home mortgages but
at the time this was an issue as homeowners has the right to choose when they wanted to pay off
their debt, typically done when interest rates were at their lowest which is no use to the banks
looking to reinvest. Funnily enough an investors worst fear back then was not the risk of non-
payment but in fact their investment being returned to quick. To combat this the bond holder
divided the CDO into tranches which could be sold as separate investments. Think of it as the owner
of a three storey home in a flood. The ground floor represents the first tranche so gets hit with the
first wave of prepayments, and as this wasn’t what the investor wanted they received the highest
interest rate. The second tranche is the one to receive the second wave of repayment and so
receives the second highest interest rate and so on.2

All this buying and selling of tranches was working well until the banks began to run out of
mortgages to fit into the CDO’s and so went to the mortgage lender to ask for more. However at this
point almost everyone who qualified for a mortgage and wanted a home, had one, so the banks had
to extend finance into riskier areas, such as sub-prime. Sub-prime lending is the process of extending
finance to those who may have difficulty repaying, due to circumstances such as lack of income or
lack of credit. In a conventional loan the borrower was required to show documents such as proof of
income and proof of assets, as well as a deposit of usually between 10%-20%. Whereas with sub-
prime loans the borrower didn’t have to show any of these, also known as a NINJA loan (No income
no job no assets). Although the banks had to charge higher interest rates to compensate for the risk,
they didn’t necessarily disclose this or explain it to the borrower well enough. Sneakily the banks
attached teaser rates to the loans which would have a low rate to start with which was appealing to
the borrower, who would typically either have poor English skills or be employed in a low skilled job,
thus having minimal knowledge of how finance or loans worked. Over time the interest rates
ballooned into payments the sub-prime borrowers simply couldn’t afford, causing them to default
on their homes.

In the event of a default whoever owns the right to that mortgage now owns the home, which for
the holder of the CDO was no problem as house prices were typically on the rise so they could
simply just re-list the house to regain their investment. However during the crisis the mortgage

2
The Big Short page 26
delinquency rate (the percentage of loans that have defaulted) for single-family residential
mortgages rose from 1.42% to 11.53% between the years of 2005 and 2010.3 This meant that the
banks had a lot more empty houses on their books and as per simply supply and demand laws, when
the supply increases as large as that, the average price will fall, and it did. Using the US National
Home Price Index which has Jan 2000 as the base year, the index value in June 2006 was 184.4, this
fell to 146.5 within two years. 4

Who’s to blame then?

Obviously all this crisis centres around the American investment banks who created the toxic CDO’s
which were packaged up and valued at billions when in reality they were worth next to nothing,
however you can trace it back further towards the bankers that extended finance to those
unworthy. These will be referenced throughout the other groups I look at throughout this section.

Rating Agencies

The role of a rating agency is to give investors a better idea of how likely a chance your bet will be
repaid. They are in effect a marking system which are designed to benefit both the buyer and the
seller as selling firms will strive to ensure they have the best possible rating, which is usually AAA.
The scale then goes AA, A, BBB and so on until the lowest single D rating. Triple A of course means
that the investor will have almost no chance of not being repaid and D means the investment is
highly risky and chance on non-repayment is very high. Historically a triple A rating loosely meant
there was just a 1 in 10,000 chance of default5. These ratings are given to large scale borrowers
which include both companies and governments, so for example the UK had a credit rating of triple
A, compare this to the US’s AA+ and investors can see that it is believed the UK economy is more
stable than the US’s meaning they will be more likely to see a full return on their investment.

Nowadays the rating agencies market is dominated by the ‘big three’ of S&P, Moody’s and Fitch
Rating, and this was the case back in 2008 too. In short the rating agencies misrepresented the risks
associated with mortgaged backed securities, leading investors to believe that these bonds were a
safe bet when in fact they would have been better described as a timebomb. To give scale to how far
off the agencies were in their predictions after house prices began to fall in 2007 Moody’s
downgraded 83% of the $869bn in mortgage backed securities they rated at the highest AAA. 6

3
https://fred.stlouisfed.org/series/DRSFRMACBS
4
https://fred.stlouisfed.org/series/CSUSHPINSA
5
The Big Short page 51
6
https://www.fin24.com/Economy/moodys-slammed-with-massive-864m-penalty-20170116
The reason most give when blaming the rating agencies for their role in the crisis is the clear conflict
of interest involved in the rating of securities. The same investment banks that packaged and sold
these mortgages were the same ones that actually paid the rating agencies to grade them. So for
example if JP Morgan were to approach Moody’s and ask for a rating on a CDO they were planning
on selling, Moody’s knew that if they didn’t rate it how JP Morgan found favourable then they would
take their business elsewhere to one of the other ‘big three’, causing Moody’s to lose out on
potential income. Investment banks were desperate to get a hold of the very top AAA ratings as they
knew without that many investors would steer clear of it, and due to the complexity of the security
nobody really knew what was inside the bonds – even the agencies according to some.

Michael Lewis is a well-respected financial analyst turned author and he believed that the agencies
were actually just outright stupid rather than bent. His take on the situation was that the individual
workers who actually placed the rating on securities didn’t even know what them as the only tool
was inside they had to use was a rating model and a computer. That simply did all the work and they
trusted it. The scariest part is that the investment banks knew how these models worked so could
package a CDO with the right amount of solid mortgages to give the whole bond a strong AAA rating,
even if a great proportion of it was underwritten by weak teaser rate loans which were highly likely
to go bad once the interest rate rose. He also stated that it wasn’t just the agencies who were the
stupid ones in the whole crisis as it turned out the very same invest banks that were duping the
rating agencies with their garbage securities, were the same ones who actually invested in buying
more of them from other banks. It was JP Morgan who managed to lose $50bn on sub-prime
securities7 as even though they were betting against them, they decided to fund these bets by
purchasing the same kind of securities – which really summed up the madness of the whole market.

Government and Federal Reserve

Another group that people like to pin the blame on is the government and central banks, but more
specifically the deregulation of the banks. To get to the bottom of this you first have to trace it back
to the years after the great depression – another crisis blamed on the fact banks had overstepped
their mark and begun making riskier and riskier loans in order to maximise their profits. In 1933 the
Glass-Steagall Act was passed with the intent to create a wall between commercial banks and
investment banks, but more importantly between the types of loans and bets the two made.8 This
was put in place to limit the risk in which the general population and therefore the economy as a

7
https://www.forbes.com/sites/robertlenzner/2012/06/02/the-2008-meltdown-and-where-the-blame-falls/
8
https://www.investopedia.com/articles/03/071603.asp
whole were exposed to. One more feature of this law is it guaranteed consumer savings of up to
$250,000 by 2008 as long as these savings were held in a commercial bank.

The act was a success for 50 or so years but after the British banks began to deregulate in 19869, the
American banks felt the need to use legal loopholes to access the investment banking centre as this
was a lot more lucrative than standard lending to manufacture, trade and service industries. By 1996
the US Federal Reserve – the central bank of the United States, began to ‘reinterpret’ the rules
regarding the Glass-Steagall Act, allowing banks access to the capital market, one bank to benefit
from this was JP Morgan, the same JP Morgan Greenspan had worked for prior to chairing the
Federal Reserve. By 1996 a law was passed allowing commercial banks to invest in the capital market
to 25% of their capital10, this was the biggest step towards the official 1999 repeal of the Glass-
Steagall act, allowing commercial and investment banks to completely merge as one. From this
banks now had access to commodities, stock, bonds and most importantly for the crisis –
securitization including sub-prime loans. Without regulation banks were able to keep pumping these
loans out, growing the bubble more and more.

Then in 2000, Greenspan, the former and current treasury secretaries passed a bill that would
deregulate the use of derivatives such as mortgage backed bonds and credit default swaps – the
same two tools at the centre of all this.11 Bonds such as CDOs were allowed to grow into a monster
that would one day cripple the largest economy in the world. The issue was inflated even more by
Greenspan again between 2002-05 when he lowered the interest rate to 1%, 12allowing a greater
amount of mortgages to be issued, raising the average price of houses even more.

Some economists and politicians have defended the move to lower interest rates and deregulate
the banks, saying it was vital to ensure the US economy didn’t stagnate in the late 90s to 00s like the
Japanese and European economies did during that time period. 13The US has always felt obliged to
use riskier forms of stimulus to counter act stagnation, in particular they replaced public deficits with
private deficits and asset price inflation – the rise in average price of an asset such as real estate or
stock market without a rise in the price of goods and services.14 It was this asset price inflation that
allowed the internet bubble to grow and grow until it burst in 2001, causing the Federal Reserve to
reduce interest rates to around one percent to encourage consumer spending to counter act a

9
https://www.twn.my/title2/resurgence/2009/231-232/view01.htm
10
https://www.twn.my/title2/resurgence/2009/231-232/view01.htm
11
https://www.forbes.com/sites/robertlenzner/2012/06/02/the-2008-meltdown-and-where-the-blame-falls/
12
https://www.rollingstone.com/politics/news/how-alan-greenspan-helped-wreck-the-economy-20110616
13
https://www.twn.my/title2/resurgence/2009/231-232/view01.htm
14
https://www.investopedia.com/ask/answers/032715/what-difference-between-assetprice-inflation-and-
economic-growth.asp
potential recession. What they didn’t realise is that it was this low interest rate that allowed the
housing bubble to grow to an even greater size than the internet one that had just burst years
before. Simply housing credit was easier to obtain so more people bought houses, leading to
average house prices rising.

Consumers

When doing a report this size you have to look at it from all angles, and there is one party involved
who everyone paints as the victim of this whole crisis, however it can be said the average consumer
was at fault for the collapse of the financial system as we know it. Ultimately many homeowners
took out home loans they either didn’t understand well enough to be ensure they would be able to
repay, or took out loans they knew they had no logical method of being able to totally repay.

This situation is maybe best summed up in Cleveland, which was known as the ‘sub-prime capital of
America’. It’s a poor, neglected, working class city which was hit hard by the downturn in
manufacturing jobs in the US. As was often the case lenders would target those who already owned
their home and encouraged them to refinance, but tried to hide the terms of the floating rate loans
which often at least doubled what their initial teaser rate was after two years. the majority of these
loans were made around 2005, so two years later in late 2007 one in ten homes in the Cleveland
area was left repossessed. Deutche bank which is a German investment bank became the largest
property owner in the city as a result.15

Another case of this was discovered in the small remote town of Bellingham, Washington and a
lending giant called Household Finance Corporation. The height of their shady business occurred
around the year 2002, the same time many of their rivals were suffering from the internet bubble
burst, Household were making loans at a faster rate than ever. Like in Cleveland a big proportion of
the growth had come from what they called a ‘second mortgage’. However their contracts were
even more confusing than a standard teaser rate loan. What they chose to do was market the loan
as a 15 year fixed rate mortgage, however the loan actually took the stream of payments the
homeowner would make over fifteen years and spread it hypothetically over thirty years, allowing
them to calculate an ‘effective’ interest rate which was low so they could entice more customers.
The borrower was told they had an ‘effective’ rate of around 7% when they were being charged
closer to 12%.16 It was the sort of dishonest and manipulative sales pitch that was rife across the
country at the time.

15
http://news.bbc.co.uk/1/hi/business/7073131.stm
16
The Big Short page 17
These are just two examples of billions of dollars’ worth of shady sub prime loans and if I wasn’t
clear enough I don’t believe that you can hold the vast majority of sub-prime borrowers accountable
for the consequences of them taking out these loans. Ignoring the manipulation of the lenders,
when people are desperate for income in deprived areas they could do a lot worse than apply for a
second mortgage they know they probably wouldn’t be able to pay off. For them it may be a case of
refinancing or living on the streets, anyone in their position would have done the same. Then you
move on to the lenders. These are the people in power who know the contracts and loans inside out.
They knew they were ripping off vulnerable people and whereas there’s no laws to prosecute them
against this, morally someone should have stepped in. However they didn’t. As was the attitude at
Wall Street at the time all they were interested in was making the loan, selling on the mortgage and
therefore passing on the risk to the next person, then that person would do the exact same if they
could. In simple terms it was one big game of hot potato, with the potato being the entire United
States economy.

Those who Actually Won

Eventually the system collapsed, as few predicted it would right from the very start. The vast
majority of the population lost out. Banks lost billions and as a result had to make cutbacks which
resulted in job losses. Consumers lost homes and found it harder than ever to access finance,
everyone lost out – except those who saw it coming and were brave enough to bet on it.

The vast majority of what I will talk about in this section will come from Michael Lewis’ The Big
Short, a book released 2015 which had recently been adapted into movie. The feeling on Wall Street
has historically been profits first and consumer second, this was standard procedure yet some
realised the ongoing abuse of consumers through the use of sub-prime mortgages and CDO’s was
too much for the economy to handle. One man called Steve Eisman was one of the first to realise
this.

Eisman was a weirdly cynical financial analyst turned investment banker for a leading sub-prime
trading firm called Oppenheimer Co. Ever since a family tragedy regarding the death of his very
young son Eisman, know a investment manager at FrontPoint Partners, was known for telling it how
it was on Wall Street, even if that wasn’t what his bosses or rivals wanted to hear. As much as he
liked to knock down weaker companies he did see the positive in subprime lending as it allowed
those at the bottom to access the basic human rights such as a stable home over their head. This all
changed as he noticed the loans and mortgages were getting more and more dubious. He admitted
he’d never properly understood mortgage backed securites or CDO’s so hired one of his lead
analysts to examine the thousands of individual loans that held up the entire bond. Six months later
the results shocked them. First they noticed that there was high prepayments – the settlement of
debt before its due date 17 , under a heading called ‘manufactured housing’ a shady term Wall Street
use to call Mobile Homes so it doesn’t look as bad. The reason for these prepayments was that they
were all classed as ‘involuntary payments’ another fancy term for default. It was clear these loans
were going to go bad but there was no current tool available to bet against them. One idea was to
short the stock of companies likely to go encounter trouble in the event of a housing crisis however
this was risky as there was no guarantee the system would blow up anytime soon so the payments
needed to short the stock may outweigh the value of the short. To short a stock the investor sells
shares of borrowed stock on the market with the expectation the price will decrease, over time if the
value decreases they will buy back the stock for a lesser price than they received before and return
the stock to where it was borrowed from, keeping the profits18

As this was deemed too risky what Eisman did was realise that if the mortgages in the bonds hit an
8% default rate then the whole bond proves to be worthless. To do this trade they had to invest in a
tool called a credit default swap, or CDS for short. A credit default swap is a tool that is designed to
transfer the credit exposure between two or more parties. The buyer of the swap agrees to make
payments to the seller up until the contract ends. If within this time the debt issuer defaults on their
payments then the seller will pay the buyer the securities premium as well as any interest paid
before. Eisman and Frontpoint invested with a man called Greg Lippman who was short $10bn in
these credit default swaps, costing him $100m a year in premiums alone.

March 14th 2008. As predicted the market collapses in spectacular fashion with the beginning of the
demise of Bear Stearns, two days later they are bought out for just $2 per share – down from the
$159 a share it was valued at just a year before.19 Eisman reluctantly sold for a healthy sum, worried
that if he was to profit off of this crisis he would be just as bad as the bankers and crooks who he
believed caused this. Banks began to fall like dominoes with billions being lost in equity.

Aftermath

When all was said and done, 5 trillion dollars in pension money, real estate value, savings and bonds
had been completely wiped out. 20 Eight million jobs were lost and six million lost their homes in
America alone. You would have thought the US government would have made it a number one
priority to bring justice to however they believed was responsible for this. They didn’t. instead they

17
https://www.investopedia.com/terms/p/prepayment.asp
18
https://www.investopedia.com/terms/s/short.asp
19
http://www.phoenixrealestateguy.com/bear-stearns-collapse-159share-to-2-in-365-days/
20
The Big Short Movie (2015)
chose to bail out the banks with over $426.4bn in taxpayers money 21through the Troubled Asset
Relief Programme – TARP for short. This money wasn’t exactly handed to the banks but instead
‘invested’ in their stock and used to buy the worthless sub-prime mortgage bonds. As sickening as it
may sound to give that much money to crooks it was actually absolutely necessary to protect the life
savings of millions of Americans. Without the bailout many more banks would have collapsed,
resulting in the complete loss of the average consumers savings, had this happened it would have
lead to outright riots. The government also claimed this bailout protected the car industry and saved
over one million jobs.

In 2013 the government announced it had actually made a profit on the money invested through
TARP, the investment had returned $444.1bn from the $426.4bn invested, a tidy $17.7bn in ‘profit’,
although I don’t believe they’ll want to use that method of investment again anytime soon. This
money was only bale to be regained due to the clause in the contracts made when the Government
purchased these shares. The banks were required to pay a dividend of 5% which increased to 9% in
2013 unless they bought the shares back, so the vast majority did that to avoid wasting money in
large dividends. 22

So thanks to the government the banks themselves suffered minimally, except some smaller one and
the biggest casualty which was Lehman Brothers after amassing $619bn in debt in comparison to the
$639bn in assets. At the time of collapse it was the fourth largest investment bank worldwide,
employing over 25,000 people. Lehman tried many methods of saving the dying company through
stock issues and cutting 2,500 mortgage related jobs however this wasn’t enough as the firm
continued to make mass losses until the first week of September 2008 when their stock price
managed to fall by 77%. Eventually Lehman collapsed with just $1bn left in cash, many were shocked
at the governments decision to let them fail compared with how they saved Bear Stearns – later to
be acquired by JP Morgan.

Conclusion

I feel I have looked at the crisis from every angle possible and to be honest their isn’t a definitive
answer to the question of who was to blame for the crisis. The bankers played a massive part by
abusing their position of power by extending credit to those who had no realistic chance of being
able to repay them. The bankers issuing these loans knew that but their bonus’ often depended on
the amount of mortgages they could produce to fuel the out of control CDO machine in America.

21
https://www.investopedia.com/terms/t/troubled-asset-relief-program-tarp.asp
22
https://www.investopedia.com/terms/t/troubled-asset-relief-program-tarp.asp
So then you look at the bankers bosses who were pushing their employees to make these crazy
investments. They were certainly at fault as they became so greedy they ignored all the logical rules
they should have followed when gibing out loans. However, they only did this due to how easy it was
made for them to make money off the CDO’s as they could pile them full of garbage and the rating
agencies would still rate the bonds as AAA rating.

These AAA ratings were given as the rating agencies were too scared to lose business if they didn’t
give the investment banks what they wanted. The greed from this hurt other investment banks who
trusted the agencies judgement when looking to invest in different stock or bonds. These false
ratings caused the bonds to be bought in mass amounts, so the sellers just had to produce more and
more to cope with the demand.

You take it further up and you know that the government’s role should have been to regulate the
rating agencies to ensure there was no conflict of interest in the business. They should also have
kept up with the market and noticed the amount of sub-prime loans being created was
unsustainable. I understand the American attitude is usually that of allowing the free market to do
its job however when something is ballooning as big as the housing bubble the government should
have known and stepped in. This would have saved millions of jobs and billions in equity.

In short the private market became greedy and the government were asleep at the wheel, yet it was
the average consumer who was left to bail them out and suffer the most through the oncoming
recession. Totally unfair yet that was the only viable solution to avoid a complete meltdown of the
US economy.