Understanding The Housing Bubble

In the wake of the 2008 sub-prime mortgage crisis, financial markets across the globe have become subject to close scrutiny by banks, government bodies and investors alike. Although crises in the financial world are usually restricted to a small domain, the effects of some such as the 2008 recession have been felt down to the household level.

According to a paper by Hurd and Rohwedder titled “Effects of the Financial Crisis and Great Recession on American Households”, the extensive surveys carried out by them revealed that “between November 2008 and April 2010 about 39 percent of households had either been unemployed, had negative equity in their house or had been in arrears in their house payments”.  Their research further went on to reveal that the S&P500 had declined 37 per cent by October 2008 and the unemployment rate in the country had escalated to 7.4 per cent by December 2008. It may have been off to a slow start, but observers have often been cited as saying that the recession of 2008 has given tough competition to the Great Depression of 1930.

A visual representation of the number of bank failures in the two instances has been displayed below to bring out this comparison.

US banks failures
Source: FDIC

Global Dimension

In fact this is one of the few recessions to have taken on a global dimension. Most ‘first world’ economies which have direct and high volume investments in the US bond and stock markets felt the greatest blow when the sub-prime mortgage crisis struck. The effects have been experienced by businesses which have had to reconsider their investment portfolios and undertake massive layoffs. A few GDP indicators compiled by the World Bank have been represented below:

gdp growth

The plunge in GDP growth rates has been observed in other economies around the globe which have ties with the developed world and its markets. As opposed to the record growth documented in the last decade, the global economy grew a measly 1.9 per cent in 2008 and declined by 2.2 per cent in 2009.  Thus as is evident, the global recession of 2008 has made quite a disastrous impact on the world. But that leads us to the unavoidable question of how it all began. Through this article, I have attempted to explain a few of the phenomena that culminated in the all (in)famous global recession of 2008.

The Boom – Creation of the Bubble

The beginning of any narrative detailing the history of the sub-prime mortgage crisis is at the real estate boom of 2004-07. The American banks were facing saturated markets when attempting to sell loans. This (along with a little help from the government as we will see later) prompted the discovery of a new segment of the population which had not seemed attractive in the past – the sub-prime section. These borrowers did not have the required credit worthiness or bank balance to secure loans. However, since real estate rates, especially residential housing, were high at the time, the banks went ahead and provided mortgages to sub-prime borrowers, keeping the new houses as collateral. This secured their loans against defaults. The loans were provided at floating rates which were initially low due to the surplus supply of loans, but would escalate to their real values within two years. Hence, individuals who could not afford them earlier now owned multiple houses!

Banks were further encouraged by government sponsored bodies like Freddie Mac, Fannie Mae and Ginnie Mae, which would buy these loans and provide government backing against defaults. The government played an active role in creating the foundation for the sub-prime mortgage crisis. Since this new category of loans now seemed so attractive, investment banks bought them from the issuing banks and then packaged them into securities. These asset backed securities (ABSs), or more specifically, mortgage backed securities (MBSs) were sold to both, institutional and retail investors. Securitisation was further extended to create an instrument known as collateralised debt obligations (CDOs). These are defined as “a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans”.  These tranches received payments in waves. Hence, the owner of the highest tranch would receive the first wave of payments, the second highest received the second wave and so on. The interest rates of these tranches were also adjusted according to the high risk-high return system. Thus although the owner of the lowest tranch would have to bear the consequences first in case of a default, he would also enjoy the highest interest rate on his investment. Furthermore, due to the mixed bag of securities, each pegged with a different credit rating, the risk of default was minimalised.

Another financial innovation that promoted securitisation were credit default swaps or CDSs. CDSs offered on MBSs and CDOs functioned as an insurance against default on these securities. The trade in these instruments had risen to such exorbitant levels that an investor was not required to hold any MBSs or CDOs in order to purchase CDSs on them. They were provided mainly by insurance giant American International Group (AIG).  Another major player in the markets who influenced trade in these securities was the credit rating agencies. Standard & Poor, Moody’s and Fitch Ratings were the main enterprises responsible for assigning credit ratings to the instruments. They are believed to have assigned faulty investment-grade ratings to MBSs which ultimately defaulted in a big way. These ratings misled investors and fuelled the boom in the financial markets.

The Bust – The Bubble bursts

As the two-year period of the floating rate mortgages came to a close in late 2007, home owners be defaulting on their interest payments. Since there was no servicing of debt, the flow of payments to the various securities backed by these mortgages started drying up. Foreclosures on the houses which had served as collateral escalated across the country, creating an excess supply of houses for sale and bringing real estate prices crashing down. The highly traded securities were reduced to junk-bond status and insurance claims on them could not be serviced. The crash in financial markets ultimately led to an economic depression in the country, which then spread its way into other parts of the world as well.

The extent of the damage caused by the sub-prime mortgage crisis can be easily summed up by the fact that it was transformed into a global scale recession and even instigated debate likening it to the Great Depression. The US Federal Reserve had to come up with multiple bail-outs which have been disbursed through the umbrella programme known as the Troubled Asset Relief Programme or TARP. About $245 billion have been despatched to US and foreign banks under this programme. It has been a long and arduous rough patch that the financial world has had to endure, although in all fairness they are the prime party to be shouldering the blame for such a turn of events. There have been many lessons that have come out of this ordeal and the recession of 2008 will surely remain an example of how bad things can get, for a long time to come.