May 5, 2016    4 minute read

The Financial Crisis: Who’s the real culprit?

   May 5, 2016    4 minute read

The Financial Crisis: Who’s the real culprit?

The global financial crisis began in early 2007 with the bursting of the US housing bubble, and then continued throughout 2008 and 2009, spreading to the rest of the world. We will explain the causes and discuss which of the institutions is the most likely to be considered the real guilty party.

Except for two-quarters in 2001-2002, the US experienced a great GDP growth rate for the 2000s, with a peak of 7% in the early 2004 and an average of 3.4% from 2000 to 2006. This growth went along with a positive inflation rate, which attested at an average of 2.3% through the early 2000s, a threshold that right now is probably one of the wildest dreams of Mario Draghi and Janet Yellen. A number of factors caused the great credit expansion: banks were very likely to lend money to private individuals, that, especially after the Bush campaign “A house for every US citizen” really hoped to own their own home. This mechanism made house prices surge, translating into a real bubble.

ushouseprices

What was happening in reality? Banks were so  full of liquidity that they started giving out mortgage loans to whoever asked for them, asking for collateral in the forms of the houses of the people they were financing. At the same time they were reselling the mortgages to investment banks that, exploiting the lack of regulations, created CDOs (Collateralised Debt Obligations), a financial instrument that pools cash-flow generating assets and slices them into different tranches, and each tranche was given a different level of seniority in terms of claims of the underlying pool. The tranches were usually broken into three parts:

  1. AAA-rated tranche: payments are very likely to be done in full
  2. BBB-rated tranche: likely to be repaid almost at full value
  3. Risky and Non-rated tranches

On average, the returns for the first tranche were at 3%, for the second at 6-7% and for the third over 10%. Considering a risk-free rate remaining at around 1%, CDOs represented a great deal for investors. The rating agencies didn’t even bother finding out the real value of CDOs; they assumed them to be safe and ended up assigning AAA ratings to mortgages given to families with jobless parents and four children. Was the situation known? Of course, it was, but as Charles O. Prince III (Citigroup CEO) stated at the start of the crisis,

“As long as the music is playing, you’ve got to get up and dance. We’re still dancing”

In 2007, when the bubble burst, more and more people began defaulting on their mortgages, leaving the banks with thousands of unprofitable houses (the collateral of mortgages). House prices dropped, causing more and more people deliberately default on their mortgage, given that they could now buy a house at a much lower price. Credit froze, the TED spread, the difference between the interbank lending rate (LIBOR rate) and the risk-free rate, went up significantly, meaning that banks didn’t trust each other and didn’t want to lend each other, reducing the quantity of money in circulation, and if we sum even the huge drop in consumer confidence given by the government’s misunderstanding of the situation that led to the crisis, we are in a huge recession from 1929. If we were to find a culprit, we would have had been spoilt for choice. Commercial banks, hedge/mutual funds and investment banks were doing their job: profiting as much as possible. Everything changes when rating agencies are considered: their favourable ratings on CDOs coming from subprime residential mortgages and other debt obligations were crucial for the sale of these bonds to all the institutional investors. We just have to think that in 2007, as housing prices began to decrease, Moody’s downgraded 83% of the $869 billion in mortgage securities it had rated at the AAA level in 2006.

Therefore, of course, we have to condemn the whole system behind the crisis: an unwise government, lack of regulations and the selfish investment and commercial banks, but in my opinion, the rating agencies were the ones who played the biggest role, as they were supposed to find out the real value of the underlying assets of CDOs, and they clearly didn’t. Furthermore, the rating agencies were paid by the same entities whose bonds the agencies were rating, creating one of the most controversial conflicts of interest in the recent financial world. Therefore, it is fair enough to state that “the greatest shareholders” of the 2007-08 financial crisis were the rating agencies themselves, which weren’t able to identify the real models to objectively evaluate the risk associated with some financial instruments and inflated the bubble over and over.

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