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Jun 25, 2024
The Great Recession is considered the most significant global downturn since the Great Depression in the 1930’s. What began as a domestic slowdown swiftly turned into a global monstrosity. There are many lessons to draw from the great recession and a key one to note was how avoidable[1] the issue was. As with many economic collapses, factors stemmed from greed. In this addition of the Narwhal Blog, we will try to understand and rationalize the Great Recession, what led to it, what followed, and the lessons learned.
When looking back at remarks made by various figureheads in finance and the government, what is remarkable is the near consensus on the fact that most could have never predicted the collapse that was nearing the horizon. As Ben Bernanke, the chairman of the Federal Reserve Board since 2006 told the Commission itself that a “perfect storm” occurred that no regulator could have rightly seen or anticipated. Alan Greenspan who was President of the Federal Reserve the 20 years proceeding Bernanke’s tenure made similar comments noting that it was beyond the ability of regulators to ever predict such a share fall. “History tells us [regulators] cannot identify the timing of a crisis or anticipate exactly where it will be located or how large the losses and spillovers will be.”[2] The reality may have been different than what these distinguished men of finance may project. The warning signs leading to the Great Recession were plentiful, someone just had to look. Richard Breeden, the former chairman of the Securities and Exchanges Commission takes a different angle pointing that the warning signs were not hidden but rather out in the open, “I mean, it wasn’t hidden.... You cannot look at any of this and say that the regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or somewhere. It was right here.... You can’t make trillions of dollars’ worth of mortgages and not have people notice.[3]”
Regulation of Financial Mortgage Lending Industry Practices
One of the greatest failures of the Great Recession was the lack of oversight in the subprime mortgage lending business. Subprime loans were an expansion of the mortgage industry, designed to incorporate borrowers who would otherwise have had difficulty obtaining a mortgage. These mortgages were deemed “risky” investments by debt holders, but lenders began to package these subprime loans into pools to seek diversification which in theory would reduce the risk. If one mortgage fell, it would be okay, because what is the probability that all these mortgages default was the thinking behind subprime investments. As subprime loans were dished out to borrowers, oversight and credit quality of these borrowers fell significantly. The demand for mortgages resulted in a supply/demand imbalance in housing, resulting in elevated housing prices or a bubble[4]. Following the dotcom bubble and the attacks on 9/11, the US economy was hammered, and the Federal Reserve begin a policy of low interest rates to help stimulate what was a stalled economy. Combined with easing home buying restrictions and low rates, we saw a rise in home values. The rising home prices led to further speculation in home pricing allowing high-risk borrowers some initial relief; “When high-risk mortgage borrowers could not make loan payments, they either sold their homes at a gain and paid off their mortgages or borrowed more against higher market prices. Because such periods of rising home prices and expanded mortgage availability were relatively unprecedented, and new mortgage products’ longer-run sustainability was untested[5]”. This eventually reached a peak, and housing was no longer affordable, resulting in a large swath of defaults and home value crashes, leading to the global recession.
Complexities of Financial Securities
Among the factors that increased and turned the housing crisis into a Global Financial Crisis were the rise of complex financial securities such as Credit Default Swaps “CDS” and Collateralized Debt Obligations or "CDO". CDS products are financial derivatives that allow an investor to swap or offset their credit risk with another risk[6]. The lender essentially buys “insurance” from another investor who agrees to reimburse them if the borrower defaults. Like insurance, the buyer of a CDS would have to make ongoing premium payments and if the debt defaulted, they would receive a payout from the seller of the CDS. To simplify things, it is essentially insurance on a bond, but in this instance CDS were being sold to investors in mortgage-backed securities (large pools of mortgages packaged together for sale). CDS demand rose drastically in 2006 culminating in 2008 with a market cap above $33 trillion dollars. Collateralized Debt Obligations are bundles of debt packaged together and sold to investors., that often includes bundles of mortgages.
[1] The Financial Crisis Inquiry Report, FCIC, February 2011, Page xvii
[2] The Financial Crisis Inquiry Report, FCIC, February 2011, Page 3
[3] The Financial Crisis Inquiry Report, FCIC, February 2011, Page 4
[4] https://www.federalreservehist...
Collapse on Wall Street
Founded in 1923, Bear Stearns was a global investment bank with offices around the globe. Bear Stearns was a titan in global financial services throughout its history. Bear Stearns was involved in a mix of financial services including hedge funds. These hedge funds were incredibly leveraged in the CDO markets.
Bear Stearns had no choice but to bail out these funds internally totaling billions not including the billions in the asset write downs that would ensue. Bear Stearns’ financial securities began to be downgraded igniting the snowball. Bear Stearns was left with illiquid assets depreciating in value in a down market. After tapping into a Federal Reserve credit line, Bear was downgraded again, and a bank run followed. By March of the same year, Bear Stearns was officially broke. After Bear ran out of cash, it requested a $25 billion loan from the Federal Reserve Branch in New York, which was denied, leading to interest from Jamie Dimon and J.P. Morgan Chase. J.P. Morgan ended up purchasing the distressed bank for $10 a share, a steep discount from its $170 share price earlier in the same year.
Lehman Brothers filed for bankruptcy on September 15 of 2008. The photos of hundreds of business clad attire individuals leaving the historic building with cardboard boxes was a sobering reminder that nothing is permanent even in the world of finance. At the time, Lehman was the fourth largest investment bank with assets over $600 billion. Lehman’s collapse sent shutters throughout the global economy as the financial crisis began to hit big banks and their assets. Lehman was a central player in the CDO market.
In the early 2000’s, Lehman made a sizeable entry into the mortgage lending world while the housing bubble was beginning to take shape. Lehman acquired 5 mortgage lenders including BNC Mortgage and Aurora, which had a specialty in underwriting “Alt-A” loans which were essentially loans made to borrowers without full documentation[1]. The plan initially worked out for Lehman, with record profits being reported from 2005 through 2007. As the initial cracks began to show in early 2007, delinquency rates began to tick upwards (see chart 2).
As concerns were mounting around Lehman, the firm reported record revenues and profits for its first fiscal quarter. Lehman said the risks posed by rising home delinquencies were well contained and they noted they did not see this materially impacting earnings[1]. Lehman continued its MBS business, underwriting more than any other bank and when opportunities arose to unload some of its mortgage portfolio, it chose not to, eventually forming the recipe for its collapse. In June of 2008, Lehman announced a second quarter (2008) loss of $2.8 billion. Lehman made strides to reduce its exposure, noting that they reduced exposure to residential and commercial mortgages by 20% but this was too little and too late.
In the first week of September 2008, the stock fell 77% and a last-ditch effort of a capital injection by the Korea Development Bank fell through paving the final steps towards the proud financial institution’s demise. Barclays and Bank of America made one last effort to takeover Lehman, but that ultimately failed. On Monday, September 15, Lehman Brothers declared bankruptcy. Lehman’s collapse led to approximately 26,000 people unemployed, a massive credit freeze, and a severe global recession[2].
The Government Comes to the Rescue
As the global financial crisis carried onwards, the U.S. Treasury initiated the Trouble Asset Relief Program “TARP”. TARP was designed to stabilize the country’s financial markets and restore economic growth which was a different approach (stimulus) than we saw when compared to other country’s policies of austerity, (Greek Debt Crisis). As banks failed, credit markets tapered down dramatically. As the situation deteriorated, TARP was brought in to increase liquidity by purchasing mortgage-backed securities, to reduce the potential losses that banking institutions could potentially be subject to. As TARP progressed, it turned into am equity plan allowing liquidity to be injected into banks to prevent any banking runs.
The U.S. treasury under TARP purchased preferred shares in eight major banks; Bank of New York Mellon, Bank of America, Wells Fargo, State Street, Morgan Stanley, J.P. Morgan, Citigroup, and Goldman Sachs. The structure of the arrangement was relatively simple, the banks would give the government a 5% dividend which would increase to 13%. The high dividend yield incentivized the banks to buy back the stock in the 5 years leading up to the dividend yield adjustment. TARP not only played a role in stabilizing the banking industry, but also the U.S. auto industry ($80 billion), distressed insurer AIG ($70 billion), and foreclosure prevention programs ($46 billion)[3].
The Fallout and Lessons Learned
Although the global financial crisis was a disaster led by greed and speculation, efforts made to reduce the damage proved to be fruitful. Actions such as TARP and bailouts in general allowed the global financial crisis to peak as a recession and not a depression. TARP will and has been deliberated for years by academics and economists. The general population saw it as a bailout at the expense of the U.S. tax payer. TARP is credited to saving the U.S. auto industry and in doing so, saving approximately one million jobs in the process.
Following the years after the global financial crisis and great recession, lending regulations became much stricter creating sturdier guidelines for mortgage approval. Banking regulation oversight has since increased with an emphasis on liquidity and leveraging as well as capital ratios. As we reflect on the aftermath of the global financial crisis, it is imperative that we continue to prioritize robust regulatory frameworks and prudent financial practices to safeguard against future economic turmoil.
[1] https://money.cnn.com/2007/09/...
Account Executive
Moe started at Narwhal in the fall of 2022 as an investment intern and joined the Narwhal team in a full-time role in April of 2023 after graduating from the University of Georgia with a degree in Finance and an emphasis in Pricing and Valuation. Moe is tasked with servicing a portion of Narwhal’s client base and evaluating and doing research on investments as a member of the Investment Committee. In his free time, Moe enjoys going to Braves’ games, playing golf, hiking, and watching the Georgia Bulldogs win National Championships.
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