The American Economic Meltdown caused by the fraudulent methods of traditional banks
By João Moreira
The Subprime Mortgage Crisis
The American financial crisis caused by subprime mortgages in 2007-2008 was an increase in the real estate bubble that expanded throughout the years and finally burst. In 2007, the financial market showed signs that the most significant reckoning of banks in American history was due to occur since banks lacked credit. However, many investors still did not believe in such a crisis, since banks profited as never before for many years.
A domino effect of BNP Paribas being unable to withdraw money from funds and the collapse of Bear Stearns funds finally led, on September 15th of 2008, to Lehman Brothers filing for bankruptcy. The announcement from one of the most traditional banks in the USA steered the stock market to plummet, caused several countries to announce plans to aid the economy, and gave rise to the worldwide recession.
“The 2008 Financial Crisis Did Not Prepare Us for the 2020 Coronavirus Crisis.” POLITICO,
Understanding the Roots
Investors in the US and abroad, in the year 2000, sought investments of high return and low risks, resulting in considerable investments in the housing market. The pursuit of higher returns from interest rates homeowners paid on mortgages, led to a massive boom in the real estate market.
Investors thrived for increasingly more mortgages, but were unwilling to deal personally with each mortgage payer. Instead, mortgage back-securities were bought at colossal rates. These were provided by large financial institutions (banks), which was the action of these institutions buying thousands of individual mortgages, bundling them together, and selling shares of these pools to the consumer (investor). These secured high rates of return to investors and therefore were attractive as a low-risk, high-return investment. As housing prices skyrocketed, in worst-case scenarios in which mortgage payers defaulted, investors would sell the house for higher prices.
Simultaneously, credit agencies called several mortgage back-securities "triple As" (AAA rating), which meant that this investment had close to no risk of not being paid back. These were rated from low to high risk as AAA, AA, A, BBB, BB, and B. These mortgages were only for borrowers with excellent credit, assuring the triple A rating. Nevertheless, the crisis focuses on triple As as the main issue.
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Investors chased additional securities, and lenders did their best to supply these demands. Lenders needed more mortgages to provide consumers with securities, loosening their boundaries and providing loans to people with low income and low credit. These were called "subprime mortgages". These are loans provided to individuals who may have difficulties repaying their loan, creating a high risk for those who invested in mortgages. During this operation, these individuals were defined as having FICO scores lower than 600, a measure of someone's creditworthiness, based on an analysis of credit reports.
Eventually, with massive demands, banks started using predatory lending practices. A practice based on giving out loans without verifying individual income and capability of affording such loans. Therefore, creating absurd adjustable mortgages that are initiated with low monthly or yearly costs raised tremendously throughout the years. This deceived individuals that needed shelter, as prices exploded beyond their means after a few years.
As the process was ongoing, and the bubble started to increase, credit agencies maintained their position, stating that these investments had low risks based on historical data. This concluded in consumers investing at enormous rates, driving housing prices even higher.
Early Stages of Concern
Bubbles in the economic sector tend to burst when enlarging due to rapid price increases and irrational decision-making. USA's housing bubble in 2006 was short to burst. However, the unlimited amount of assets and liabilities in balance sheets obfuscated the colossal problem banks faced. Consequently, banks and credit agencies continued to ensure that securities had tremendously low risks.
In 2006, according to "The Mortgage Reports", housing interest rates peaked at 6.41%, resulting in massive defaulting on the part of the borrowers, as they could not afford such expensive prices. This led to houses returning to the market for sale. Significant increases in housing prices led to few buyers, generating a decrease in demand in the market. Accordingly, supply was high and demand low, conducting the collapse of real estate prices.
Still, in 2006, borrowers faced mortgages above the value of their homes, creating hardship for American citizens. As a result of the adjustable-rate mortgages set by banks, costs were going up, and housing values were declining in immense numbers. This caused mortgage back-securities buyers to stop investing in the active, forcing banks to face loans that would not be paid.
The Leverage Strategy
The leverage method uses borrowed capital to improve return rates and profit. To invest and generate profit, individuals and institutions might ask banks for loans to invest and create more considerable return rates. For example, if an investment is predicted to have a 20% return and a business has $10, borrows $100 from a bank and invests $110, hypothetically, the company should get a return of $132. When returning the loan, the business is left with $32, a 320% return on its own capital invested. This method is tremendously helpful when applied correctly. Nevertheless, a vast issue arose from this method in the crisis.
Facing a vast decrease in housing prices, banks leveraged billions of dollars to try and maintain profit, as borrowers were not returning their loans to banks and investors were not buying mortgages back-securities. Therefore, these institutions borrowed capital from other banks, utilised it to cover their debts, and invested in mortgages, expecting greater returns on their money. However, with the consistent price decline of the sector, banks had negative returns and could not cover their own borrowed capital. As a contradicting example of the positive leveraging stated in the previous paragraph, if in the same case of an $110 investment, your investment does not pan out and you have a loss of 10%, you are left with $99 and a debt of $1 after returning the loans. This means your capital return was -10%. This was exactly what happened to banks, but instead of dealing with tens and hundreds of dollars, they dealt with billions.
Banks covered the debt of one leverage with another, leading to the never-ending cycle of leveraging and debts. Consequently, leveraging became not only one of the thousands of issues financial institutions had to solve, but it also became the leading cause of huge debt gaps in enormous banks.
In the late stages of the crisis in 2007, the US suffered from various banks and funds declaring bankruptcy, and investors started seeing no returns on their mortgage investments. However, it was not until September 15th, 2008, that the US entered the great recession. The announcement of Lehman Brothers filing for bankruptcy led to hundreds of other financial institutions doing the same, and finally, the stock market crashed.
The US government initiated the "TARP" program to seek the revival of some of these institutions via government loans. An investment of 700 billion dollars was made to proceed with the "bank bailout". However, the damage was already done, and several individuals lost their jobs, life savings, and homes.
Who is Michael Burry?
Michael Burry is the founder of the hedge fund Scion Capital and is known to be one of the few who predicted the subprime mortgage crisis. His story is depicted in the film "The Big Short", which tells how he envisioned the crisis and influenced two other funds to do the same. He swapped CDOs and Mortgage back securities and made a personal profit of $100 million and $700 million for his investors.
Betting against the economy did not only mean betting against banks and funds; it also meant betting against citizens' future lives. Burry could predict as he studied the real estate market intensely and calculated that the method used by banks would burst in the future. His action led other funds to make the same assumptions and investigate shelters and individuals. Although millions of dollars were made from this bet from Burry, the film that communicates this story leaves the audience with a philosophical question. Millions were made but at the expense of what?