What drove the GFC?
The GFC was the worst global financial crisis since the Great
Depression. It saw the freezing up of lending between banks, multiple financial
institutions needing to be rescued, 50% plus share market falls and the worst
post-war global economic contraction. At the core of the GFC was something very
basic. In an environment of low interest rates (with often initially low
“teaser” rates) too many loans were made to US homebuyers that set off a
housing boom that went bust when interest rates rose and supply surged. So no
big deal – it happens all the time! But it was what went on around it that
ultimately saw it turn into a global crisis.
A massive proportion of the loans (40% or so) went to people
who had no ability to service them – sub-prime and low doc borrowers. Remember
NINJA loans – loans to people who had no income, no job and no assets! And many
were non-recourse loans – so borrowers could just hand over the house if its
value fell below the debt owed on it and that was the end of their liability.
Recall – jingle mail!
This was encouraged by public policy aimed at boosting home
ownership and ending discrimination in lending.
It was made possible by a massive easing in lending
standards facilitated by financial innovation that packaged up the sub-prime
loans into securities, which were then given AAA ratings on the basis that
while a small proportion of loans may default the risk will be offset by the
broad exposure. These securities were then leveraged up and sold all over the
world with fancy names like Collateralised Debt Obligations (CDOs) that found
willing buyers looking for decent low risk (remember AAA rated!) yield at a
time of low interest rates. Hedge funds investing in such products even got
awards like “yield manager of the year”. But the trouble was that with the
sub-prime loans moved out of the banks, there was no “bank manager” looking
after them.
This all came as banks globally were sourcing an increasing
amount of the money they were lending from global money markets – which had
freed them up from relying on expensive bank deposits via bricks and mortar
branches.
The music stopped in 2006 when poor affordability, an
oversupply of homes and 17 interest rates hikes from the Fed over two years saw
US house prices peak and then start to slide. This made it harder for sub-prime
borrowers to refinance their loans at their initial “teaser” rates. As a
result, more and more borrowers defaulted causing investors in the fancy
products that invested in sub-prime loans (like CDOs) to start suffering
losses. The problem really caught the attention of global investors in August
2007 after BNP froze redemptions from three of its funds because it couldn’t
value the CDOs within them, which in turn set in train a credit crunch with
sharp rises in the cost of funding for banks and a reduction in its
availability triggering sharp falls in share markets. Shares rebounded but only
to peak in late October/November 2007 before commencing roughly 55% falls as
the credit crunch worsened, the global economy fell into recession, mortgage
defaults escalated and multiple banks failed.
The crisis went global as: losses mounted; these were
magnified by gearing, which forced investment banks and hedge funds to
liquidate sound positions to meet redemptions thereby spreading the crisis to
other assets; the distribution of securities investing in US sub-prime debt
globally led to a wide range of exposed investors and hence greater worries
about who was at risk; this all led to a freezing up of lending between banks.
All of which affected confidence and economic activity.
Fault lay with home borrowers, the US Government, lenders,
ratings agencies, regulators, and investors and financial organisations for
taking on too much risk.
It came to an end in 2009 after significant monetary easing
and fiscal stimulus helped restore the normal operation of money markets,
confidence and growth. That said, aftershocks continued with sub-par global
growth and very low inflation.
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