Web Exclusive
Financial crisis explained: How greedy US banks crippled world economy

Representative Image. Illustration by ajay mahanty
It has been 10 years since the Lehman Brothers shut shop. People who faced the global recession at that time say it was not their fault and still had to leave their homes. The housing market in the USA crashed and the whole world's economy went for a toss. Three million people in the US lost their jobs and five million lost their homes. But, how did it all happen? What was the root cause of it? Here is an explainer on the global financial crisis.

Good people with good jobs wanted houses to live. They followed the simple, tried and tested method. They went to a bank and asked for a loan. The bank obliged. Many people who were capable of repaying the loans bought houses. They paid their installments on time and everything looked fine. This was the time when the real estate market was on a boom. Also, the general notion about the real estate market is that it never goes down. 

Now, the investment banks wanted to make some money. They bought these loans from the banks and bundled them together and sold them in the market in the form of Collateralised Debt Obligation (CDO). In the early phase, loans that were held by people who were capable of repaying it made the major chunk of a CDO. An investment bank would go to a credit rating agency and get these CDOs a good rating before putting them up for sale in the market. So here is the picture. Some capable people took loans from banks to buy houses. Banks sold these good loans to investment banks for a good fee. Investment banks bundled few hundreds of these loans and asked the credit rating agency for a good rating and got it. Now there is a product called CDO ready to be sold in the market. Since a CDO had the stamp of rating agencies, investors bought them with the hope that they would get a good yield out of the investment. 

The demand for CDO was rising in the market as these CDO were nothing but a bundle of home loans, and it was assumed, everyone pays their home loan. So the risk was low. Seeing the rise in demand for CDOs, the investment banks went to the banks and asked for more loans they could buy. The banks got greedy and started giving loans to people without verifying their income or credit history. Now, this came to be known as sub-prime loans. And these loans had adjustable rates. Meaning that in the initial years, the interest rates would remain low. but later the rates would spike. But the home buyers had no idea about it. They were happy that they were getting homes to live. After giving loans to people with questionable credit history, the banks sold these loans to the investment banks. The same process of bundling and selling it in the form of CDO was repeated. Everyone was making money. 


The insurance company too wanted a piece of this housing market boom. So there comes a company that says it would sell insurance on CDO. Simply put, an investor invests in CDO but thinks it might not give good returns. That investor can go to an insurance company selling insurance on that CDO. So the investor will pay a monthly premium to the insurance company and in case the CDO fails, the insurance company would pay the investor his money. This was known as credit default swap. So insurance companies, too, began making money.

Now, in the second quarter of FY07, the adjustable rates on sub-prime loans, or the risky loans, started to kick-in. The people who had questionable income history were unable to repay the loans and hence the defaults started. The houses on which the loans were not paid went to the bank. The bank auctioned it to get its money back. This would have worked had it only happened with only a handful of houses. Since the banks had given out sub-prime loans to a lot of people, there was just far too many houses to auction and not many willing buyers for them. 

With an abundance of such houses and not many buyers, the real estate prices started coming down. This led to another unfortunate situation. A good person with a home loan became unwilling to pay his loan back because they value of his house had gone down but he was still paying more as he had a loan. As the loans started defaulting, the values of CDO, which is nothing but a bundle of home loans, also went down. As the value of CDO came down, investors lost their money. The investment banks had far too many worthless CDOs to sell but no buyers for it. The banks had too many bad loans to sell to the investment banks, but no takers. And yes, seeing the value of CDOs going down, the investors who had insurance against it, sought returns. The insurance companies had to pay the money to those investors. 

The banks had no money, the investment banks were clueless about what to do with CDOs, and the insurance companies were paying the price of their greed in the form of returns. Moreover, people lost jobs and their homes. The entire financial system came to a standstill as the bank had no money to function or give to others. The stock of banks went to zero on the exchange. They filed for bankruptcy and shut their door. A behemoth like Lehman Brothers was reduced to nothing. Merill Lynch was sold to Bank of America, AIG was bailed out by Federal Reserve. The shock waves crippled the stock markets across the globe. And all this began with some banks getting greedy.


Outbrain