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The financial crisis of 2007/2008 was the largest and most severe financial event since the Great Depression and reshaped the world of finance and investment banking. The effects are still being felt today, yet many people do not actually understand the causes or what took place. Below is a brief summary of the causes and events that redefined the industry and the world in 2007 and 2008.

The History

The underlying cause of the financial crisis was a combination of debt and mortgage-backed assets. Since the end of WW2, house prices in the United States have been steadily rising. There have been a few fluctuations but the trend has been upward.

In the 1980s financial institutions and traders realized that US mortgages were a previously untapped asset. Traders at Salomon Brothers and Drexel Burnham Lambert were looking to expand the bond market and they discovered that the steady stream of payments from US mortgages could be restructured into bonds and then sold off to investors. Prior to this, investors had no access to the US mortgage market other than by buying real estate or investing in construction companies, which was suboptimal and did not necessarily give the correct exposure to house prices.

The Causes

In the late 1990s and early 2000s, there was an explosion in the issuance of bonds backed by mortgages, also known as mortgage-backed securities (MBSs). The reason for this was the use of securitization. In brief, securitization is the pooling of debt and then issuing assets based upon that debt.

Investment banks were buying mortgages from mortgage issuers, repackaging them and then selling off specific tranches of the debt to investors. As time went on, there were less and less new mortgages to securitize so the structured products groups at banks started repacking MBS's (i.e. taking the unsellable tranches of lots of MBS's, repackaging them and then selling the new product - called collateralized debt obligations or CDOs).

Theoretically, the pooling of different mortgages reduced risk and therefore these assets were quite safe, but in reality the majority of the mortgages being securitized were of poor quality (also called sub-prime). The ratings agencies who rated the MBSs and CDOs did not fully appreciate the low quality mortgages backing the assets they were rating, or they overestimated the benefits of diversification in the housing market and as a result, many of the MBSs and CDOs were rated AAA (the very top rating).

The top senior tranche of the MBSs and CDOs were rated AAA and paid a low rate of interest whilst the bottom tranches were often rated as junk but paid a very high rate of interest. Many investors did not want the expensive senior tranches which gave a low return and in order to keep the securitization and CDO machine rolling, many investment banks took to keeping these tranches on their own balance sheet.

From the viewpoint of the banks it was a fantastic move. These assets were AAA rated (i.e. as safe as US treasury bonds at the time), required little capital to borrow against and essentially provided them with a free return. Even though the return on the senior tranches was low, the interest rate in the money markets was even lower so the banks were making an easy spread (borrowing short term in the money markets to buy long term AAA tranches of CDOs and MBSs) as well as taking the fees for creating the CDOs.

The US and global banks went on a massive spending spree, borrowing vast amounts of money at low rates in the short term to fund their investments. Investment banks had leverage ratios (debt to equity ratio) of 30x or even higher. Some of the top investment banks such as Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Stearns were almost entirely funded by short term borrowing.

The Run Up

In the mid 2000s there were hundreds of billions of dollars worth of mortgages given to individuals with poor credit ratings on adjustable rates. These mortgages typically required low interest payments (sub 8%) for the first 2 years, then increased to 15% per year for the next 28. There was no way that these sub-prime borrowers would be able to afford the higher repayment rates. As house prices stopped rising and started to fall, homeowners could no longer refinance and remortgage their houses for cash and started to default.

The peak years for issuing these mortgages was in 2005/2006, so by 2007/2008 the default rates on the subprime mortgages suddenly spiked. This meant that some of the bottom tranches on the CDOs and MBSs were being wiped out. Suddenly, investors started to lose confidence in the top AAA tranches and in the banks which held large amounts of them or had exposure to such assets.

The first signs of the crisis were in June 2007 when the 5th largest investment bank in the US, Bear Stearns, announced large losses in 2 of its hedge funds with exposure to subprime assets. Clients were prevented from withdrawing money and the funds were eventually shut down at a $3 billion dollar loss.

Problems with short-term debt funding and mortgages were not restricted to the United States. In September 2007 the UK mortgage lender and bank Northern Rock was declared insolvent and had to be bought by the UK government. The problem was that Northern Rock had a very small deposit base and was almost entirely funded through the short term repo markets. After the events at Bear Stearns, the credit markets started to dry up and Northern Rock could not meet its obligations and had to be bailed out.

In October 2007 two of the largest banks in the world both lost their CEOs. Stan O'Neal of Merrill Lynch and Charles Prince of Citigroup both resigned due to losses on their exposure to subprime debt. They were replaced by John Thain and Vikram Pandit respectively.

Over the next couple of months there was general unease about the global mortgage and credit markets with many banks and mortgage institutions announcing losses on their subprime exposure. It was in March 2008 however that things really started to get bad.

Bear Stearns had a bad run and lost a lot more money following its losses on the mortgage hedge funds it essentially ran out of money in March. JPMorgan had to buy out Bear Stearns with the US government guaranteeing up to $30 billion worth of the most toxic assets owned by Bear. The company was originally agreed to be sold for $2 a share but eventually went through at $10 a share; still valuing the company at less than the market price of it's head office in New York.

Lehman Brothers

Bear Stearns was the 5th largest investment bank in the US and after it failed, the 4th biggest bank (Lehman Brothers) was under intense pressure. Over the summer of 2008 the share price of Lehman went on a rollercoaster ride, often gaining or losing 40% or more in a single trading day. All the while, Lehman was hemorrhaging money and needed capital desperately. There was a lot of communication between bank CEO's, Henry Paulson (US Treasury Secretary) and the Federal Reserve in order to try and prevent a crisis.

Lehman tried many different things; a capital raise of $4 billion, a deal with Morgan Stanley, a deal with Bank of America, a merger with Barclays but none of it worked. Everything came to a head in September 2008. Lehman Brothers was intending to do a deal with Bank of America for the entire company, but the US government refused to provide any kind of support following the public outcry after the Bear Stearns bailout.

All the banks were suffering at this point but the worst affected after Lehman was the 3rd biggest bank, Merrill Lynch. Although Merrill was not widely publicized in the media as being in trouble, it too was losing money and if Lehman failed, Merrill would be next. During September 2008 the US Treasury orchestrated meetings between all the CEOs of the large banks at the Federal Reserve in order to try and save Lehman Brothers. During these meetings, the government reiterated its position of not providing any form of assistance and insisting that there had to be a market solution similar to that of Long Term Capital Management in the 1990s.

The two banks interested in Lehman at this point were Bank of America and Barclays, with Bank of America being preferred. Barclays, despite not being the preferred bank, was definitely interested in the deal and was about to buy the bank when the UK government and regulators blocked the deal on the grounds that it would make the UK bank less stable.

After performing due diligence of Lehman Brothers, none of the other banks were interested without government support except for Bank of America. However, John Thain of Merrill Lynch jumped the gun and on September 14th 2011, Merrill Lynch was sold to Bank of America for a 70% premium over the previous days trading price.

Lehman Brothers was now out of options and the US government was still refusing to bail them out or to provide any kind of funding for a deal. On Monday 15th September 2008 Lehman Brothers filed for Chapter 11 bankruptcy.

The Fallout

All throughout the summer and autumn of 2008 financial institutions had been under immense pressure and the next domino to fall was the insurance giant AIG. Although it was not an investment bank, AIG had a group called AIG Financial Products which had been participating the in traditionally stomping ground of investment banks by issuing derivatives called Credit Default Swaps (CDSs).

Credit Default Swaps are a kind of insurance on bonds. For more information on them, please read the following page:

AIG had been issuing tens of billions of dollars worth of CDSs on mortgage-backed securities and CDOs and because of the turmoil in the financial markets, it was facing the possibility of needing well over $40 billion in cash within a matter of days. AIG had been working closely with JPMorgan to attempt to fill the hole via a capital raise, government loans using some of its insurance assets as collateral and more but none of it was working.

Following the bankruptcy of Lehman Brothers, AIG's credit rating was downgraded on September 16th, which meant it had to post tens of billions of dollars worth of extra collateral to its creditors. The US government and Federal Reserve deemed that AIG had too much counterparty exposure and was too entwined in the global financing system and was 'too big to fail' and less than 48 hours after letting Lehman Brothers fail, they bought equity stakes in AIG for over $80 billion, effectively bailing them out.

Now that 2 large investment banks and the largest insurance firm in the world had either collapsed, been taken over or bailed out in the space of 3 days the financial markets entered a meltdown. The Dow Jones Industrial Average fell by nearly 30% in the next 2-3 weeks.

Many other financial firms were now facing imminent bankruptcy including Morgan Stanley, Goldman Sachs, Citigroup, Wachovia and more. Many different combinations of deals and mergers were suggested, but the crisis advanced. Morgan Stanley eventually sold a 21% equity stake to Mitsubishi UFJ for $9 billion, which was paid as the largest check ever written.

Throughout September 2008 the US government and Federal Reserve had been searching for a way to stabilize the financial markets. The plan they devised was to buy troubled assets from the banks in order to reduce uncertainty in the markets. This plan was called the Troubled Asset Relief Program (TARP). TARP was tweaked slightly in October to allow the TARP program to buy equity stakes in the banks as well as buying the assets.

The US government had to ask Congress for $700 billion and was signed into law on October 3rd 2008. Many of the firms which took money from the TARP program have paid it back and until summer 2011 the financial markets stabilized and grew.

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