When the Wall Street evangelists started preaching "no bailout
for you" before the collapse of British bank Northern Rock, they hardly
knew that history would ultimately have the last laugh. With the onset
of the global credit crunch
and the fall of Northern Rock, August 2007 turned out to be just the
starting point for big financial landslides. Since then, we have seen
many big names rise, fall, and fall even more. In this article, we'll
recap how the financial crisis of 2007-08 unfolded. (For further reading, see Who Is To Blame For The Subprime Crisis?, The Bright Side Of The Credit Crisis and How Will The Subprime Mess Impact You?)
Before the Beginning
Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during unusual times. In 2001, the U.S. economy experienced a mild, short-lived recession. Although the economy nicely withstood terrorist attacks, the bust of the dotcom bubble, and accounting scandals, the fear of recession really preoccupied everybody's minds. (Keep learning about bubbles in Why Housing Market Bubbles Pop and Economic Meltdowns: Let Them Burn Or Stamp Them Out?)
To keep recession away, the Federal Reserve lowered the Federal funds rate 11 times - from 6.5% in May 2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money,
once out of the bottle, always looks to be taken for a ride. It found
easy prey in restless bankers - and even more restless borrowers who had
no income, no job and no assets. These subprime borrowers
wanted to realize their life's dream of acquiring a home. For them,
holding the hands of a willing banker was a new ray of hope. More home
loans, more home buyers, more appreciation in home prices. It wasn't
long before things started to move just as the cheap money wanted them
to.
This environment of easy credit and the upward spiral of home
prices made investments in higher yielding subprime mortgages look like a
new rush for gold. The Fed continued slashing interest rates,
emboldened, perhaps, by continued low inflation despite lower interest
rates. In June 2003, the Fed lowered interest rates to 1%, the lowest
rate in 45 years. The whole financial market started resembling a candy shop where everything was selling at a huge discount and without any down payment. "Lick your candy now and pay for it later" - the entire subprime mortgage market seemed to encourage those with a sweet tooth for have-it-now
investments. Unfortunately, no one was there to warn about the tummy
aches that would follow.
But the bankers thought that it just wasn't enough to lend the
candies lying on their shelves. They decided to repackage candy loans
into collateralized debt obligations (CDOs) and pass on the debt to another candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans developed. To make things merrier, in October 2004, the Securities Exchange Commission (SEC) relaxed the net capital requirement for five investment banks - Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MS) - which freed them to leverage
up to 30-times or even 40-times their initial investment. Everybody was
on a sugar high, feeling as if the cavities were never going to come.
