Did somebody see it coming?

Did somebody see it coming?

The answer to the above question lies in the history when the bubble busted and to be precise, some of the greatest economists knew but nobody listened to them.

Yes, I am talking about one of the biggest financial crises. As we all know that when something is too good to be true, then it usually isn’t!

In the late 1990’s, the US economy was booming. This was a period of optimism. Tech companies were in trend and everybody was investing in tech companies. And since the stocks of these tech companies got highly overvalued and the bubble busted. People started withdrawing money from stock market and since the interest rates in banks were very low, the investors were looking for an alternative to invest in. So, guess what will be the next best alternative, yes you got that right! The housing market.

Now before going further I would like to ask you a question that if you want to buy a house and the banks are ready to grant you a loan without a down payment, without mortgage, on a very low rate of interest and without checking your eligibility to pay. Would you take it? Obviously, you will.

Continuing the story, so at the initial stage everything seemed great, people were buying houses by taking a loan from commercial banks, commercial banks sold these loans to the investment banks and investment banks put a bunch of these loans/mortgages in a box and named this box CDO (collateralized debt obligation). Investment banks get those CDO rated from the biggest rating agencies like S&P, Moody’s and Fitch. Then investment banks sold these CDO’s to investors. Now there is a general sense i.e. wherever there is a demand, there will be a supply. And there was a huge demand of investment opportunities in housing market. (Refer to the last sentence of paragraph 3). Because of huge demand and to meet this demand the investment bankers became greedy and asked for more loan/securities to buy from commercial banks. Now to increase the loans the commercial banks started lowering their standards and granted loans without a down payment, without mortgage, on a very low rate of interest and without checking eligibility to pay back. And people also took those loans by believing that if bank says that they are eligible then they are and after all they wanted to live the “American Dream”. So, this process kept on going. Now when the interest payments started getting defaulted by the real house owners than automatically the value of these CDO’s started declining and investors again started selling these CDO’s back to the investment banks, the investment banks opened that box of CDO’s, mixed these low rated loans/securities with some Good loans and got these loans highly rated (AAA rated) by giving bribe to the rating agencies. And gain the prices of these securities revived. Investors again started buying but then there came a time when huge defaults happened from the house owners and suddenly the value of the securities became worthless. Because of this incident Investment Banks, Insurance companies and failed people lost trust in the US financial sector.

Failure of investment banks and resolution – Several investment banks like Bear Sterns, Lehman Brothers along with the world’s biggest insurance company (AIG) failed because of this incident. But what about the Goldman Sachs which never failed? There came a time when Goldman Sachs realized the risk of poisonous securities or CDO and it decided to buy credit default swaps so that at the time of crisis it was able to save itself. Now what is credit default swap? Credit default swap is issued by insurance company which secures the CDO and compensate the investor if the CDO gets defaulted but with the help of derivatives, somebody who do not actually own security can also buy Credit Default Swaps bet against it and can get money in case of default by the real house owners. In simple language, with the help of Financial Derivatives, Investment banks can transfer their risk to insurance companies. Goldman bought enough Credit Default Swap and was able to save itself and guess which that insurance company was? Yes, it was world’s biggest insurance company AIG.

So to save the trust of the people of USA and resolve this issue, US government came up with a solution named TARP (Troubled Asset relief Plan). Under this plan US government decided to buy all these poisonous securities at a good price from the investment banks and this saved the banks and insurance companies and stabilized the situation.

FUN FACTS – Do you know that the Treasury Secretory at the time of the 2008 financial crisis was the former CEO and chairman of the biggest investment bank Goldman Sachs? And surprisingly he became the treasury Secretory of USA during just little before the Bubble burst from July 2006 to January 2009 and surprisingly Goldman Sachs survived the crisis. Does that ring a bell?

By Arpit Sharma