Module 4, Section 4: The Financial Crisis

Overview of Module 4, Section 4: The Financial Crisis, which summarizes the four phases of the 2008 Financial Crisis, which ultimately resulted in a near collapse of the global financial system.

Four Phases of The Financial Crisis:

Phase 1: The Bursting of the Housing Bubble

• The crisis originated with a significant housing bubble. Home prices peaked nationally in July 2006 and subsequently dropped by 9% in less than two years, with some major cities experiencing declines of over 20%.

Phase 2: ARM Credit Crunch

1. The increase in mortgage debt, particularly in the subprime market since 2000, was fueled by Adjustable Rate Mortgages (ARMs) and Interest-Only Mortgages. These were manageable during the bubble due to the ability to refinance with low rates as debt-to-equity ratios decreased with rising home prices.
2. However, when the housing bubble burst, debt-to-equity ratios sharply increased, preventing borrowers from refinancing. As ARM terms ended, borrowers faced higher monthly payments they couldn't afford, leading to a surge in delinquencies and foreclosures. As borrowers faced higher monthly payments as ARM terms ended and were unable to refinance, delinquencies and foreclosures more than doubled.

Phase 3: The Collapse of the Asset-Backed Securities (ABS) Market

1. The mortgages that underpinned Asset-Backed Securities (ABS) lost value due to rising non-payment and foreclosure rates. Consequently, the prices of these ABS sharply declined. Any ABS rated below AAA became almost worthless. And even AAA ABS financial products experienced a 60% reduction in value.
2. Banks held significant amounts of these ABS on their balance sheets, often financed with short-term funding. As the value of these assets plummeted, it created a severe credit crunch. Given the prevalence of these products on balance sheets financed with short-term funding, all major bank risks coalesced in rapid sequence.
3. The rush to sell ABS securities (i.e. a fire sale) was exacerbated due to the lack of due diligence in underwriting standards, by credit agencies, and by those purchasing the Asset Backed Securities. There was not a clear understanding of what risk exposure existed within ABS products, even those rated AAA.
4. Even ABS with low-risk profiles became worthless on the secondary market, hindering banks' liquidity despite the underlying mortgages still generating reasonable returns.

Phase 4: The Spread of Contagion and Bank Failure

1. Freddie Mac's warning and New Century Financial's failure (2007) Freddie Mac indicated the higher-than-perceived risk of subprime ABS, and New Century Financial, a leading subprime lender, filed for bankruptcy. This caused a panic in the ABS market.
2. Northern Rock's failure (February 2008):The failure of a major UK bank highlighted the global nature of the crisis and continued stress in the financial sector.
3. Bear Stearns' acquisition (March 2008) JPMorgan Chase acquired Bear Stearns, indicating escalating stress and the potential for further contagion, though this intervention provided some control.
4. IndyMac's failure (July 2008) The failure of IndyMac, a $30 billion thrift, due in part to a bank run, illustrated the accelerating speed at which contagion was occurring.
5. Fannie Mae and Freddie Mac conservatorship (September 2008) The government placed these organizations into conservatorship, further devaluing mortgage-backed assets due to the strong negative signal this represented.
6. Lehman Brothers' bankruptcy (September 2008) Lehman's sudden failure, heavily exposed to A