The 2008 Financial Crisis: What Caused the Financial Crisis & Recession?

The 2008 Financial Crisis: What Caused the Financial Crisis & Recession?

A decade ago, the 2008 financial crisis wreaked havoc on global markets as well as the world. The financial crisis has sunk some banks and paralyzed markets, resulting in staggering losses for many people out there. It is also considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

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How did it all happen? 

After 10 years, the causes and repercussions remain tricky to comprehend. What exactly set it into motion involves a whole series of complex questions with a number of interlocking answers.

Here is a quick infographic attempting to detail what caused the 2008 Financial Crisis:

2008 Financial Crisis Infographic by InvestingNote
2008 Financial Crisis Infographic by InvestingNote

 It all began with the use of securitization. Securitization simply means the pooling of debt and then issuing assets based upon that debt.

When someone wants to buy a house, he/she will make a huge amount of loan from a bank. The bank will receive a piece of paper in return– called a mortgage.

The homeowners (borrowers) are required to pay back a portion of the principle plus interest to whomever holds that piece of mortgage paper every month. When homeowners are unable to pay or cease to make their payment, we call this a default.

The bank (the original lender) often pass the mortgage paper to another third party, which means borrowers do not necessarily pay its interest to the original lender but rather to whoever holds the mortgage paper. There are times where 3 different banks have had the same mortgage paper.

Back in the old days, it is not easy to obtain a mortgage if a borrower had a bad credit or didn’t have a steady job. This is because lenders wouldn’t want to risk that borrowers might default on their loans, but things start to change in the 2000s.

In the 2000s, investors in US and abroad were looking for investments that give them low risk and high return – that is when they see opportunity in the U.S housing market. They think that by investing in US housing market, they could get a better return from the interest rates when the home owners paid on their mortgages compared to safe investments like US government bonds or treasury bonds.

However, global investors or big investors didn’t want to just buy up the mortgages alone as it is too much of a hassle to deal with. Instead, they bought investments called mortgage backed-securities (MBS). So, the original lender which is the bank, packaged all the mortgages nicely into little box and sell it to the investment banks or government agencies. Every month, they will receive payments from the homeowners of all the mortgages in the box.

Mortgage-backed security (MBS) is a bond that represents an investment in a group of house loans. It is formed when banks bundle their mortgages into pools and sell them to the government agencies or investment banks.

But that’s not it.

The MBS was further sliced and packaged into other financial innovation to enable large wagers to be made. Investment banks and hedge funds came up with new derivatives such as credit default swaps, collateralized debt obligations (CDOs) and synthetic CDOs.

For one, house prices were soaring – this made lenders think that in the event of default, lenders can just sell the house to cover the losses and make more money. Meanwhile, credit ratings agencies were telling investors that these mortgage-backed securities were safe investments. These MBSs were backed with triple A ratings.

Little did they know, more and more loans were made to people with low income and poor credit. This is when sub-prime mortgage comes in. Sub-prime mortgages are mortgages issued by a lender to borrowers with low credit ratings.

It is very obvious that these investments have become less safe, but investors still continue to pour in their money for more because they trusted the ratings. Many investors believe that if house owners default on their mortgage, they would still be able to have all the houses at a higher value. But no.

In this case, the supply was more than the demand, and home prices started to collapse. As prices fell, some borrowers realized they had a mortgage that is way more than their house was currently worth. This has led to more defaults and hence prices are being pushed down further.

The Contagion Effect

The high delinquency rates led to a rapid devaluation of financial instruments including both MBS, CDOs and other derivatives. Banks who were heavily invested in these financial assets began to experience liquidity crisis.

This event has led financial institution like Lehman Brothers filed for bankruptcy. Other banks that are affected during the financial crisis are such as AIG, HBOS, Royal Bank of Scotland, Bradford & Bingley, Fortis, Merrill Lynch and etc.

How Does It Affect Singapore?

Singapore slid into recession during the 2008 financial crises as Singapore’s economy is heavily dependent on exports to the developed world. The fall in consumer demand from the US and Europe has hammered its manufacturing exports.

Here are some data and statistics for Singapore market during the 2008 financial crisis:

Unemployment:

We can see that the number of unemployed workers were slowly dwindling from the chart. Employment growth slowed significantly in the 4Q of 2008, as the condition of the economy worsened. The slowdown affected across many industries, the manufacturing industry was affected the most in this event.

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Interest Rates:

Domestic interbank interest rates edged lower over the first half of 2008. As you can see, the 3-month US Dollar SIBOR declined resulting from the aggressive monetary policy easing by the US Federal Reserve.

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Economy outlook:

The composite leading index is an indicator that provides early signals of turning points in business cycles showing fluctuation of the economic activity around its long term potential level. In this event, the aforementioned indicator fell further in the 4Q of 2008.

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Singapore’s GDP growth prospects appear weak in 2009 on account of the pessimistic global economic outlook. After taking into account of all the factors, the Ministry of Trade and Industry forecasted that the Singapore economy will contract by 2.0% to 5.0% in 2009.

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Also, during the recession, the Monetary Authority of Singapore moved to a neutral policy of 0 percent appreciation in exchange rate. This has caused the local dollar to slide and drag down the currencies across Asia-Pacific.

Asia relies on the West for trade, so when the US and UK economies “sneeze”, Asia will eventually catch a cold and growth will be hit.

As you can see from the chart below, the market plunged around 9th June 2008 and only started to pick up around 9th March 2009.

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Normal candlesticks: STI index

Blue line: Dow Jones Industrial Average Index

Purple line: FTSE 100 Index

Green line: Nasdaq Composite Index

We hope that this article has given you a better understanding of the 2008 financial crisis and how it affects other economy.

Previously, we’ve also written an article about the different segments in the oil and gas industry. Check it out here.

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Sources:
https://www.scmp.com/business/global-economy/article/1936027/singapore-adopts-2008-crisis-policy-growth-grinds-halthttps://www.theguardian.com/business/2008/oct/10/creditcrunch-marketturmoil1
https://www.mti.gov.sg/ResearchRoom/Documents/app.mti.gov.sg/data/article/17562/doc/AES_2008_Full_Report.pdf
https://www.benzinga.com/general/hedge-funds/11/07/1220803/a-brief-history-of-the-08-financial-crisis-infographic 

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