Here goes, I have set out some important links for anyone that like me is trying to understand the financial crisis for the first time
Start of with youtube videos - (This will help you get the basics)
Here are my notes on the financial crisis - They mostly deal with what caused the financial crisis and who is to blame
Introduction:
It was the collapse of the Lehman Brothers, a sprawling global bank, in September 28 that almost brought down the world’s financial system.
Massive monetary and fiscal stimulus prevented a buddy can you spare a dime depression. With a nearly a decade’s hindsight, it is clear the crisis had multiple causes.
· The most obvious is the financiers themselves (Bankers (who are speculators)
· Central Bankers (FED RESERVE) and other regulators also bear blame
· The Macro economic backdrop was important – The Great Modernization years of low inflation and stable growth fostered complacency and risk taking.
· A saving glut in Asia pushing down global interest rates
All of these factors came together to foster a surge of debt in what seemed to have become a less risky word.
Now let’s take a look at each aspect:
Bankers (speculators/financiers)
The year before the crisis saw a flood of irresponsible mortgage lending. Loans were doled out to subprime borrowers with poor credit histories who struggled to repay them. (BIG MISTAKE – SUB PRIME MORTGAGES – FACTOR)
These risky mortgages were passed on to the bankers at the big banks, who turned them into supposedly low risk securities by putting large numbers of them together in pools
However, pooling only works when the risks of each loan are uncorrelated, the bankers argued that the property markets in different American cities would rise and fall independently, thus they are uncorrelated. This proved wrong.
Fast forward 2006; America is suffering a nationwide house price slump.
The pooled mortgages were used to back securities known as CDO, (Collateralized Debt Obligations) which were sliced into trances by degree of exposure to default.
Investors bought the safer tranches because they trusted the triple A credit assigned by agencies Moody’s and Standard & Poor’s. (THIS WAS ANOTHER MISTAKE – FAILURE OF AGENCIES)
The agencies were paid by the banks that created the CDOs. The agencies were far too generous in their assessment of them.
Investors sought out these securitized products because they appeared to be safe (AAA rating) whilst providing high returns in a world of low interest rates.
(Low interest rate is another story – some blame the FED for keeping short term interest too low, some blame the saving’s glut in Asia – the surfeit (surplus) of saving over investment in emerging economies especially in China. THAT capital then flooded into safe American government bonds, driving down interest rates.)
Back to the story:
The low interest rates created an incentive for banks, hedge funds and other investors to hunt for riskier assets that offered higher returns.
They also made it profitable for such outfits to borrow and use the extra cash to amplify their investments; the low volatility of the Great Modernization increased the temptation to leverage in this word.
The interest rates appeared stable; investors took the risk of borrowing in the money markets to buy longer dated higher yielding securities (mortgages).
Houses to money markets:
America’s housing market plummeted, pooling and other clever financial engineering bankers had done did not provide investors with the promised protection.
Mortgage backed securities slumped in value, CDOs turned out to be worthless despite the rating agencies seal of approval
It became difficult for banks to sell suspect assets at almost any price, or to use them as collateral for the short term funding many banks had relied on.
This dented banks capital thanks to deviating away from ‘mark to market accounting rules, which would have required the banks to revalue their assets at the current prices, and thereby acknowledge losses on paper that might never actually be incurred.
Financial instruments such as CREDIT SWAP DEFAULTS (in which the seller agrees to compensate the buyer if a third party defaults on a loan), that were meant to spread risk turned out to concentrate it)
AIG, American insurance giant, who had provided thousands of these swap defaults, buckled within days of Lehman bankruptcy
The whole system was revealed to have been built on flimsy foundations – Banks had allowed their balance sheets to bloat, but set aside too little (actual) capital to absorb losses. In effect they had bet on themselves with borrowed money, a gamble that paid off in good times, but proved catastrophic in these times.
Regulator’s fault: (Regulators asleep at the wheel)-
There is no doubt that failures in finance were at the heart of the crash. But bankers were not the only people to blame.
Central bankers (FED Reserve) and other regulators bear responsibility too, for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions.
The regulator’s most dramatic error was to let Lehman Brothers go bankrupt, because this multiplied panic in markets and suddenly no body trusted anybody, so nobody would lend.
Non financial companies, unable to rely on being able to borrow to pay suppliers or workers, froze spending in order to hoard cash, causing a seizure in the real economy.
Ironically, the decision to stand back and allow LB to collapse resulted in more government intervention and not less. To stem the consequent panic, regulators had to rescue scores of other companies.
But the regulators made mistakes long before the Lehman bankruptcy, most notably by tolerating global current-account imbalances and the housing bubbles that they helped to inflate
Central banks could have done more to address all this. The Fed made no attempt to stem the housing bubble.
Central bankers insist that it would have been difficult to temper the housing and credit boom through higher interest rates. Perhaps so, but they had other regulatory tools at their disposal, such as lowering maximum loan-to-value ratios for mortgages, or demanding that banks should set aside more capital.
Lax capital ratios:
Lax capital ratios proved the biggest shortcoming. Since 1988 a committee of central bankers and supervisors meeting in Basel has negotiated international rules for the minimum amount of capital banks must hold relative to their assets. But these rules did not define capital strictly enough, which let banks smuggle in forms of debt that did not have the same loss-absorbing capacity as equity.
Under pressure from shareholders to increase returns, banks operated with minimal equity, leaving them vulnerable if things went wrong.
And from the mid-1990s they were allowed more and more to use their own internal models to assess risk—in effect setting their own capital requirements. Predictably, they judged their assets to be ever safer, allowing balance-sheets to balloon without a commensurate rise in capital
The Basel committee also did not make any rules regarding the share of a bank’s assets that should be liquid. And it failed to set up a mechanism to allow a big international bank to go bust without causing the rest of the system to seize up.
All in together:
Regulators and bankers were not alone in making misjudgments, when economies are doing well; there are powerful political pressures not to rock the boat.
The long period of economic and price stability over which they presided encouraged risk-taking. And as so often in the history of financial crashes, humble consumers also joined in the collective delusion that lasting prosperity could be built on ever-bigger piles of debt.
