On September 15 2008, the US investment bank Lehman Brothers filed for bankruptcy, having racked up huge losses on its investments and speculation on the US mortgage market. Although it wasn’t the first casualty of the financial crisis, the collapse of Lehman Brothers was arguably the watershed moment that spurred governments into drastic action and caused financial markets to go into freefall.
Now, 7 years later, we’re still living in the aftermath of the financial crisis – retiresavvy looks at what caused it and some of the effects it may have had on your pension.
What caused the financial crisis?
One of the biggest causes of the financial crisis was a huge and – as it turned out – unsustainable mortgage boom in the US. In the early-to-mid 2000s, US banks and mortgage providers offered mortgages to people on lower or irregular incomes who were a poor credit risk – so called ‘sub prime’ mortgages.
Many of these sub prime loans were turned into financial products to be sold to other banks and insurers, in a process called securitisation. This meant that lots of mortgages were bundled up together as securities or bonds – essentially an IOU – called Mortgage Backed Securities (MBS).
Securitisation is a perfectly normal activity for many banks and building societies and is often used to generate more money to lend out for future mortgages and loans, but the problem in this case was that so much securitisation had been done on inherently very risky sub prime mortgages - by some estimates, banks had loaned at least $1.3 trillion in sub prime mortgages by March 2007 (Source: NBC News).
Although this is a lot of money, it is dwarfed by what is known as the derivative market, or financial products based on those original investments. Banks bought derivative products called Credit Default Swaps (CDS) – a kind of insurance to protect the value of the initial MBS product – and what’s known as ‘synthetic Collateralised Debt Obligations’ (‘synthetic CDOs’), which were products designed to give the same or similar returns as the original MBS, but built entirely from CDSes, often without any physical asset underpinning it.
If this sounds complex, it’s because it is. Some bank bosses have admitted that they didn’t fully understand what their banks had created or invested in, but trusted the financial whizz-kids to know what they were doing (Source: The Guardian).
A house of cards, falling
To recap: there were mortgages, there were financial products based on these mortgages, then products insuring the products based on the mortgages and then products based on the products insuring the products based on the mortgages. Like a house of cards, once one part started to wobble the whole edifice started to collapse.
A lot of sub prime mortgages had low starter rates, meaning payments were affordable for the initial few years, before rocketing up. As a result of rising mortgage costs and the slowdown in the US economy, many people were unable to pay and defaulted, creating a ripple-effect up the layers of products, and a lot of banks and other investors were unprepared for the ensuing losses.
Defaulting wasn’t just confined to sub prime mortgages, although these were the worst affected. Between Q3 07 and Q2 08, a total of $1.9 trillion of MBS were written off by banks and other investors.
There were other issues, too. These products were being created so thick and fast and were so complex that the credit ratings agencies, which were supposed to assess how risky the investments were, had neither the time, expertise nor resources to keep up. And thanks to the way the markets were regulated, these products could be kept ‘off the books’, disguising just how much had been invested in them.
Not too big to fail
Bear Stearns, a big US investment bank, saw two of its hedge funds that had invested in sub prime mortgages become all but worthless in July 2007, thanks to the collapsing US housing market. It was bailed out by the US Federal Reserve in March 2008 and sold to JPMorgan Chase, another US investment bank, for a fraction of its former value.
By September, US authorities chose not to bail out Lehman Brothers and allowed it to collapse into bankruptcy, hoping that by doing so, it would draw a line in the sand and demonstrate that banks were not ‘too big to fail’. The US Government was concerned about ‘moral hazard’ – the idea that banks would make ever more risky investments knowing that the Government would pick up the bill should things turn out badly.
But in letting Lehman Brothers fail, the US Government exacerbated the global financial panic - the UK FTSE 100 stock index plunged almost 1500 points in the space of four weeks, while the main US stock index, the Dow Jones dropped almost 3000 points over the same period.
In the UK, the Government was forced to support the already-beleaguered Royal Bank of Scotland Group, Lloyds TSB and HBOS, effectively nationalising them, while the Bank of England slashed interest rates and introduced people to the strange world of Quantitative Easing.
We’ll look at what this did to your pension next time.
Want to know more?
If you’d like to know more about the inside story of the financial crisis, I’d recommend watching the film Margin Call and reading Too Big to Fail by New York Times journalist Andrew Ross Sorkin.
Margin Call takes place over a fraught 24 hours in the offices of a fictional (but very much based on real-life) US investment bank on the verge of bankruptcy, having realised that the amount of money it will have to pay to prop up now-almost worthless investments will bankrupt the firm. It has a great cast that includes Kevin Spacey, Zachery Quinto, Jeremy Irons and Demi Moore.
Too Big to Fail is probably the definitive account – so far – of what happened in the US banking sector in the run-up to Lehman Brothers’ collapse and the policy actions taken afterwards. Drawing on candid interviews with hundreds of people from Wall St and the US Government and beyond, Sorkin takes the reader behind-the-scenes tour of the greed, egos and chaos of the investment banking and regulatory world during the crisis. It reads like a tense and griping corporate thriller in the mould of John Grisham, except the events were real.
This article has been commissioned by retiresavvy and any opinions voiced are the author's own.