By Yash Shetty
The “American Dream” of every average person nationwide, owning their very own home was a sensational statement thrown around left, right and center in the late 90s and early 2000s. This period which could also be termed as the “Boom Period,” saw the creation of the real estate bubble. How did it happen?
With interest rates low and the demands for houses skyrocketing, local banks started issuing mortgage loans to borrowers with poor credit rating with a high probability that they would default on their loans. And what made the banks callous enough to stop performing due diligence before issuing mortgages to them? Mortgage Backed Securities(MBS) and complex financial instruments called Collateralized Debt Obligations (CDOs), a pool of various different types of loans which were repackaged and sold to investors as a “Big Bang for the Buck!” investment opportunity. But when the sheer volume of subprime borrowers, who by 2006 comprised the CDOs almost entirely, began defaulting on their mortgage payments, that’s when the sweet old “American Dream” started to taste not so sweet after all.
Billions of dollars’ worth of CDOs became worthless junk and with that they took the share prices of the gargantuan investment banks, literally, to the drain. The greed at wall street would bring the entire global financial system down to its knees.
The creation of a real estate bubble, through the market manipulation that took place during Alan Greenspan’s tenure as federal reserve chairman, was one of the major causes of the crisis. During the boom years, real estate turned its status from a consumer good to a financial asset. What made that happen? You guessed it, Political agenda was at the forefront of causing another crisis yet again! Banks were under pressure from the Congress to issue more and more home mortgages as a part of their “American Dream” campaign. It was some coincidence then that Greenspan decided to combat the economic slowdown, in the aftermath of the dot com bubble bust and the 9/11 attacks, with monetary stimulus in the form of lowering interest rates. For instance, the Federal Funds rate dropped to 2.5% from 6.5% by November 2001 and up to 1.75% by December of the same year. Greenspan justified all the cheap credit by pointing to a “boost in economic activity”. However the “boost in economic activity was just a euphemism for trying to encourage to borrow more. Meanwhile banks were handing out home mortgages like flyers to a Bieber concert-from anyone to everyone and the lower interest rates just amplified the demand for home mortgages. Subprime mortgages to borrowers with little credit-worthiness were the brain-child of the politicians’ affordable-housing ideology as they tried to increase home ownership at any price.
And how could we forget the game played by the Wall Street banks. Securities fraud, accounting fraud, honest services violation, you name it, they had it all covered! And blind-sighting investors to invest in their bad debt was not the only thing on agenda. Add bribery and perjury to the list of crimes and with that, they had managed lobby government and credit ratings agencies into setting up a system that made them millions of dollars in personal wealth off the panorama of ruins they were surrounded by, despite most of their firms being in a state of insolvency. When you have one of your own with the likes of Robert Rubin, former CEO of Goldman Sachs, as the secretary of the Federal Reserve, you could run the financial sector to your own tune. In 1999, at the urging of Rubin, Congress passed the “Gramm-Leach-Bliley Act” which repealed The Glass-Steagall Act, in place to prevent banks with consumer deposits to engage engage in risky investment banking activities. With the Act gone, Citi Corp and Travelers Group merged to form Citi Group, the largest financial services firm in the world, leading the way for other American banks to follow suite and put the common man’s savings in further jeopardy. Surprise, Surprise, the orchestrator of the merger, Robert Rubin, would later go on to become Vice- Chairman of Citi Group and make 126 million dollars in that capacity. That’s when the lobbying starts to look like collusion.
However, the stench of criminality wouldn’t end just yet. Chairman of the Federal Reserve, Alan Greenspan’s policy of unregulated, free markets, played right into the hands of the investment banks, with them selling Over the Counter(OTC) derivatives such as Credit Default Swaps on subprime mortgages bonds without setting aside a single penny to cover the failure of the CDOs. Moreover, an investor could purchase a CDS without even owning the insured security himself. Furthermore, in 2006 the SEC was lobbied by Fed Reserve Chairman Henry Paulson, coincidentally the CEO of Goldman Sachs from 1999 through 2006, to relax the capital requirements for investment banks by taking the leverage limits from the previously set 12:1 (1977 Net Capitalization Rule) to as high 40:1[forbes article] meaning the banks’ assets could now, almost entirely, be debt funded. The Credit Rating Agencies joined in on the act. Top ratings institutions like Standard & Poor gave even the Investment Banks’ high risk subprime residential mortgage backed securities and CDOs the triple AAA rating, the highest investment quality grade, ignoring all evidence of their high default risk nature. After all, rating your paymasters’ assets lowly ratings is really bad business!
The fallout from all that organized crime was catastrophic to put it euphemistically. The U.S. government undertook a massive scheme of corporate bailouts, special lending facilities, unemployment benefits, the economic stimulus package and other support across the financial sector, administered through some 50 different programs, amounting to a staggering 23.7 trillion dollars of taxpayers’ money which is equivalent to 157% of US GDP in 2011. Between October 2007 and March 2009 the stock market fell upwards of 50% equating to another 11 trillion of wealth vanished into thin air or about 73% of U.S. GDP in 2011. At least 3.6 million lost their homes to foreclosures with some statistics claiming the number to be 5 million! The no. of families under the poverty line rose from 12.5% in 2007 to 15.1% by 2012 accounting for over 46 million people deemed poor in the U.S. alone.
India is a prime example of a developing economy which was affected by the crisis despite having a financial and banking system that had barely any investments in structured financial instruments. That was mostly because of the withdrawal of Foreign Institutional Investments to the tune of 5.5 billion dollars, while inflow foreign direct investment doubled from 7.5 billion in 2007-08 which consequently funneled down to 2,500,000 million rupees being wiped from the Indian Share market on a single day, October 10 2007. The Indian IT sector was hit hard too with 61% of their revenue coming from crisis ridden US investment banks on the cusp of bankruptcy. The export Industry also took a hit with exports falling 9.9% in November 2008, in the immediate aftermath of the crisis, due to decreasing consumer demand in the fragile western economies, especially the USA, as it accounted for 15% of total Indian exports, and trade deficits reached 10 billion dollars.
Eight years on from the crisis, with Feds determined to keep interest rates low, the clamor for the return of the demons of the financial meltdown-the CDOs-is gathering momentum from investors looking for big, short-term returns, yet again. This research paper will analyze the causes of the 2008 crisis, scrutinize the measures taken to avert it to check for any loopholes, and will forecast if another gut-wrenching crisis is on the horizon. It will also provide a list of schemes, inspired by but not limited to how the Indian banks avoided major losses despite a panorama of capitalization around them, that could be adopted as preventive measures to another economic downturn while still letting the CDOs be in business and perform its highly beneficiary role of risk-diversification, creating another “boom” that will hopefully, be here to stay!
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About the Author
Yash Shetty is currently a freshman at Northeastern University working towards a combined major in Mathematics and Economics, and a minor in Finance. Hailing from Mumbai, India, he graduated from Oberoi International School in Mumbai, where he pursued the International Baccalaureate Diploma Programme. “I love the complexities of the financial world. Investment Banking, playing with numbers to bring about unprecedented economic prosperity to the world, that’s what I wanna be doing!” Yash is already furthering his interests in investing on campus and recently secured a position on the Northeastern Student Value Fund, a select group of students whom the university entrusts with $175,000 worth of their endowment to play around with, in the real stock market. He is also part of the Finance and Investment Club, famous for having alumnus that accepted positions upon graduation at major firms like Goldman Sachs, JP Morgan, Credit Suisse (amongst others). Actively involved in community service and philanthropy at high school in Mumbai, Yash co-founded organizations that addressed pressing issues in his city. One undertook monthly street clean-ups and the other visited slums, providing financial literacy and other financial services to the underprivileged. Befitting his socially and environmentally responsible character, Yash has joined the Beta Theta Pi fraternity’s men of principle, at Northeastern. An avid soccer lover and an immensely talented player at that, Yash has represented professional soccer teams in Mumbai, Colorado and Lisbon. He also possesses masterful skills in playing the guitar and piano. “I guess I am an all-rounder,” the 18-year old added candidly.