How Did It Happen?
Ephraim Eshel - Director of Recruiting
Despite the facts, the analysis, and the headlines it is still difficult to comprehend: How did the whole world veer off course financially and economically? Here is the explanation, step-by-step, mistake after mistake.
There are moments in time when we are witnessing an event that will be inscribed in the history books: hard moments like the beginning of a war, assassination of a leader, attack on skyscrapers or happy moments like a declaration of independence in a new country, peace accord signing ceremony, or the fall of a wall… This is one of those moments.
The moment that Lehman Brothers investment bank declared bankruptcy, or the moment that the big UK banks were nationalized did not appear as historical moments and perhaps they did not register in anyone’s memory as such. Even the moment that the LIBOR interest rate doubled is not memorial-album material, however these moments and the incredible processes that led to them – and unfortunately continue to happen – will get a prominent place in the history books.
The biggest financial crisis since the “great depression” of the 1930’s and perhaps even bigger than that, started at an elusive point in time. It began as an innocent process where several causes joined together and created a positive pressure in the American residential real estate market and in other world markets.
In 2001 the Federal Reserve Bank was busy for several months to counter the recession that started due to the collapse of the dot.com and technology bubble. September 11, 2001 and the terror events that landed at the heart of Wall Street were like an Al Qaeda-guided dagger into the core of the American Empire. This cocktail of events accelerated the Feds’ decision to invigorate the economy by reducing the Prime interest rate until it reached 1% in June 2003, a 45-year low.
Low interest rates allow people to borrow easily but it also reduces the propensity to save. According to the average consumer, when the “cost of money” is low, it makes more sense to spend rather than to save. Low interest rates also encourage companies to make capital investments, expand and increase spending, and reduce the accumulation of cash in unattractive low return accounts. The American public responded happily to the consumer heaven. Within a couple of years savings levels went from 3% to negative levels. The spending and borrowing culture had reached its peak.
During that time in the US economy, a spectacular wave of growth started in Asia, South America and Eastern Europe. The huge flow of investments to these markets caused an increase in their currencies’ exchange rates and government bonds. A price increase of government bonds means a decrease in interest rates, so not only US interest rates went down, but also all major economies experienced the same drop. Credit became more appealing than cash, at least for those who were using it.
The Fed’s interest rate remained at the 1% level for more than a year. In June 2004 the Federal Reserve started a slow increase in interest rates. In this long period of low interest the American mortgage market expanded, especially at the lower end. The Chairman of the Federal Reserve had an idealistic vision whereby low-income persons and also people with low credit scores would be able to purchase homes.
The available credit and the greed of the Subprime [click here for glossary of terms] banks that took a 1% loan and sold it at 1,000% profit pushed the envelope even further and allowed people to purchase inflated-value properties at relatively low interest rates. The demand pushed real estate prices even higher. When real estate prices go up lenders are confident in the borrower’s ability to pay back the loans – due to the increase in value of the property, which the lender holds as collateral.
The action attracted the attention of Wall Street investment banks. A product (mortgage) that has a constant return (interest that is paid by the borrowers) can be used to create Securities . A complete mortgage bank portfolio can be combined to create securities, i.e., mortgage-backed securities [click here for glossary of terms] based on the assumption of those interest payments creating a return on investment (ROI) for the buyers. The investment houses bought portfolios, mixed them, split them, valued risk and created very complex securities that would have enabled them as well as the investors to realize huge returns.
As long as real estate prices continued to climb, the ROI on these Bonds also climbed, and so did the demand for them. Investment houses put pressure on the market to produce more and more mortgages. With that pressure and the hope for high ROI, caution was thrown to the wind. Mortgages were given to people with neither enough collateral nor ability to repay, and investment houses created more and more exotic bonds. These derivative bonds, called CDO (Collateralized Debt Obligation), were very popular by banks all over the world and created by default another derivative instrument by the insurance companies, called CDS (Credit Default Swap). Insurance companies insured the bonds for possible default at an agreed risk rate. More investors were brought into the chase of these “golden eggs” and traded the CDS and not the actual collaterals.
As demand continued, the mortgage companies — especially the Subprime ones — loaned money to people that were referred to as “Ninja’s “(No Income No Job or Assets).
The Bubble kept on growing until about May 2005 when the Chairman of the Federal Reserve Bank, Mr. Alan Greenspan, said that the escalating prices in the real estate market have no basis.
At the beginning of 2006, the Fed’s interest rate climbed to 4.5% and prices of residential real estate started dropping. 2006 was also the year of record-setting profits in derivatives trading. One of the only investment banks that noticed this excess was Goldman Sachs, which in one year eliminated all of its CDO portfolio to the surprise of competitors who continued to amass huge profits.
From the beginning of 2006 real estate prices went down and with it profits from derivatives. During the middle of 2007 several trust funds from Bear Stearns that were heavily invested in them lost so much value that the bank had to shut them down at heavy losses and reduction in their reserves. Since that time many banks exposed the fact that they lost billions in their investment portfolios in the subprime market.
Between mid 2007 and September 2008, losses in the market were not so evident. Government investment funds from China, Korea, Dubai and other nations bought stocks of American and European banks that needed infusion of cash, however the losses in the mortgage and derivatives markets continued to grow.
When banks lose money their capital is reduced. The investments lose value and their obligations such as loans from other banks and certificates of deposit reach maturity and need to be paid. Banks like that may find themselves unable to meet obligations and, even worse in this case found their capital-to-loans ratio decrease to a point of inability to meet the Federal Reserve requirements for liquidity and become insolvent. Bear Stearns was the first to collapse and was sold to JP Morgan-Chase with the federal government’s help.
The crucial day that the crisis went to the next level and became an historic event was September 14th, 2008 when Lehman Brothers declared bankruptcy after failing to secure US government assistance. That was the moment that the world lost confidence in the stability of the financial markets. In what was a unified act, almost all of the private banks and financial institutions in the world kept their cash in house to not loan to others. If an old and established bank like Lehman Brothers can fail you can’t trust anyone.
Credit Strangulation developed slowly between the Bear Stearns and Lehman Brothers incidents. However the day Lehman fell the process became lightening fast. The inter-bank rate doubled in one day, the result being a total freeze of money flow in Asia, Europe and America.
The major corporations bonds value dropped and the stock markets reached historical low points. Currencies all over the world lost value against the US dollar. Scared investors redeemed holdings in markets that were perceived as dangerous. Since then the only financial instrument people want to invest in are US Government Bonds, which are known to be the safest investment in the world.
The credit strangulation is choking the world economy. Despite the trillions of dollars flowing from central banks to commercial banks at low interest rates, and despite government’s declarations to guarantee banks’ obligations and public deposits, trust has not returned to the market.
All major corporations are gearing for recession by reducing expenses and lay off personnel. Thirteen countries are in danger of bankruptcy due to shaky economies with no loans available for their bail out.
Alan Greenspan, the person who prompted the lowering of interest rates seven years ago said a few weeks ago that unless the real estate market stops falling, credit strangulation will not stop.
We are in the middle of a financial crisis and it is hard to say when will it end. The key indicators for recovery will be the US real estate market, the inter-banks interest rate and the stock markets. Perhaps next year with strong leadership from the White House we may see the beginning of the end of this crisis.








