Even if you have an idea as to what actually happened during the 2008 financial crisis, you probably still have the big question unanswered: why did the financial crisis happen? What caused the domino effect to occur in the first place? The short answer, not just for the 2008 crisis, but for nearly every major economic event out there is that there were multiple moving parts working in congruity with one another.
The important thing to keep in mind going forward is that the 2008 financial crisis truly was a complex situation and that there’s only so much we can go through in a single article. As such, we’re going to explain 4 of the 7 main causes and cover the rest next week. So without further ado…
Subprime Lending
A subprime borrower is someone who has a high chance of defaulting and so lending them a mortgage is a risky move. Competition between mortgage lenders eventually dried up the supply of prime borrowers (people who are likely to pay off their loans). So in order to attain further market share, lenders had to lower their standards of who was eligible for a mortgage, hence expanding their customer base so to speak. And that’s exactly what they did, with subprime lending going through the roof:
What this did was desabilitize the ground from which the banking system and financial markets were built upon.
Housing Bubble
Any analysis of the financial crisis must include the United States housing bubble, as its burst set in motion the domino effect we spoke of in our previous article. In economics, a bubble is where prices are much higher than what it's “actually worth.” It sounds a bit weird, since you could argue that nothing has innate value and that it depends on person to person, but investors have ways of determining a justifiable price that’s based on the asset’s fundamentals. Say we have a company with a total of $50 in assets, but a single stock costs $30. Oh and there are around 2 million shares available to buy and sell. This would be an example of a company that’s massively overvalued.
That’s what happened with the American housing market. As shown below, home prices went soaring in the 2 decades prior to the financial crisis:
There were various factors behind this, including but not limited to:
The aforementioned rise in subprime lending resulting in larger demand for housing
Changes in housing tax policy which incentivize people to buy/invest in multiple homes and other real estate assets as opposed to stocks or bonds
After the NASDAQ dropped 70% in what would later be called the dot-com bubble burst, this also resulted in people shifting their investments from the stock market to real estate
The cultural push for homeownership, through media promotion as well as the widespread belief that housing was an infallible investment. A lot of people don’t realize that homes do indeed fall in value, but we just don’t see it. The reason is because they’re valued on a yearly basis unlike stocks, which are updated in real time, thus “smoothing out” how we see a home’s price volatility
There is also debate as to whether the government’s affordable housing programs played a role in fuelling the unsustainable housing boom. The Housing and Urban Development Act of 1992, for example, mandated that 30% of Fannie Mae and Freddie Mac’s (home mortgage companies created by Congress in order to either buy and hold onto mortgages from the secondary market or repackage and sell them as mortgage-backed securities) loan purchases be related to affordable housing. In 2005, the mandate was lifted 52%. Some argue that to fulfill these requirements, Fannie and Freddie had to not only loosen their criteria for which loans they would purchase, but also promote looser lending standards across the entire industry.
On the other hand, those who defend Fannie and Freddie are skeptical of these charges for a few reasons. Firstly, the US government’s market share of home mortgages was declining in the same time period as the housing bubble grew, so the correlations don’t follow. Secondly, the vast majority of subprime mortgages were in fact issued from private institutions which could also explain why loans held by the government generally performed better than those held by investment banks.
Low Interest Rates
Federal funds rate is the interest rate at which commercial banks, which are banks that accept deposits and provide loans, lend their excess reserves to each other overnight. It’s considered one of if not the most important metric in financial markets. As shown in the graph above, the Federal funds rate was dramatically lowered at the beginning of the century in order to counter the effects of the dot-com bubble burst and the 9/11 attacks. As we explain in our article on interest rates, central banks will often lower interest rates during an economic downturn in order to stimulate borrowing. Unlike what policymakers were hoping for, the borrowed money ended up fuelling housing instead of business investment.
The other culprit in this regard was the rising US current account deficit. Current account refers to the sum of the balance of trade (exports minus imports), net income and transfers from abroad. A current account deficit means the country is a net borrower from the world. Basically, if a country is running a trade deficit, they must also have a capital account surplus of the same amount, meaning the net flow of investments into the country (which is what capital account refers to) must essentially compensate for the account deficit. The reason for this is beyond the scope of this article, but what it meant was that American financial markets were met with a flood of money, further bidding up asset prices and lowering interest rates.
Financial Complexity
Ironically enough, this luckily isn’t difficult to understand. All it means is that Wall Street became more creative with investment opportunities. Securities such as adjustable-rate mortgages (home loans with variable interest rates that fluctuate in accordance with an underlying benchmark interest rate that changes overtime), collateralized debt obligations, and synthetic CDOs were the new, hotshot financial products.
All this ensued in 3 things:
Increased the number of investments connected to a given mortgage, allowing say, an original $500k mortgage to turn into a network of securities worth tens millions of dollars. This means that if the original mortgage fails, so does that entire network of investments
Increased distance between the investors and the underlying mortgages that they were buying and selling their derivatives on. Among other things, this ultimately leads to an obfuscation regarding the mortgages and whether or not they’re risky investments
Allowed some firms dealing in these securities to ignore regulations and thus engage in financially reckless behavior. This is often referred to as the “shadow banking system”, in which institutions that provide similar services to traditional banks but without the government oversight ran rampant
Econ IRL
A startup being able to receive adequate funding through investors is a crucial component in their success. Venture capitalists not only provide entrepreneurs with money but also (sometimes at least) guidance and mentorship. But are those all the benefits that come along with getting an investor on your side? This week’s paper explores the prospect of a third advantage: reputation. In other words, can simply being affiliated with a given investor result in measurable perks?
To answer this question, the researchers conducted a field experiment on AngelList Talent, an online search platform for startup jobs. Luckily, the AngelList platform is perfectly set up for this kind of research: they recently released a feature where startups that received funding from a reputable investor had a badge added to their name in search results. Additionally, users (potential employees) would, at random, have the visibility of these badges either enabled or disabled, thus creating groups of those who know of the startup being funded by the reputable investor and those who don’t.
The main finding is what most people would expect: being funded by a reputable investor makes that company more attractive for employees, with the top investor badge increasing the likelihood of a user clicking on the job posting by 30%. Since the platform has multiple stages with regards to applying for a job at a given company, the results were further broken down. Having the badge resulted in:
26% increase in the probability of a click for further information about a job
35% increase in the probability of a click to begin the application process
67% increase in the probability of submitting an application
‘Till next time,
SoBasically