The What, How and Why of the 2008 Recession

Today, the 15th of September, marks fifteen years since Lehman Brothers declared bankruptcy, sending cataclysmic shockwaves across the world, eventually cracking open the global economy. It wasn’t the first financial institution to bite the dust that year, nor was it the last, but it was the one that forced everyone (even the ostriches in suits that roam political corridors) to finally admit that something was irreparably broken in the system.

We may never know the full extent of the jobs lost, homelessness caused and lives changed irretrievably by the Global Financial Crisis of 2008. 8.8 million (88 lakh) jobs lost in the United States of America, 1.3 million (13 lakh) pink slips handed out in the United Kingdom and half a million (5 lakh) job cuts in India in just three months at the end of 2008 (that number only grew in 2009 and 2010). All this misery and very few people seemed interested in understanding what caused it all. I'm aware that statistics make eyes glaze over. That part is understandable because statistics are, indeed, rather dull. However, this disinterest extends to the issue at large. Why is that?

Is it because it didn't affect them directly? I'm not sure that's the whole story, because I've known people who lost their jobs as a result of the 2008 Recession and still haven't bothered to understand what happened. Maybe, it's the desire to distance ourselves from bad news. Most likely, the boring and somewhat intimidating financial jargon associated with it kept most of us at arm's length.

Either way, we played straight into the hands of head honchos at big finance firms who paid themselves billion-dollar bonuses even as this humongous fraud was still unfolding, lobbyists who get paid millions to get laws tailored to suit their clients at the aforementioned firms and politicians who accepted the riches and 'favours' that came their way as a reward for abandoning the interests of the folks who voted them into power.

Let me state, right at the get go, that I didn't lose my job during the 2008-09 Recession. I did, however, watch many colleagues being fired in the middle of the work day and being escorted off the premises. It was humiliating to even watch. What made it worse was knowing that the people sacked were paying for crimes committed halfway across the globe by people who would be bailed out by the tax dollars of the very people they had defrauded. I was thoroughly confused by all of it. So, over the years, I read articles, watched documentaries like Inside Job and The Untouchables and films like The Big Short to understand what really happened and how it came to affect us all.

The best way I can explain what caused the 2008 Recession given the limits of both my knowledge and your patience, is to say that it was a consequence of good old-fashioned greed, an erosion of common-sense checks and balances and a system where a lack of integrity paves the path to prosperity. Spoiler alert! Fifteen years later, that system remains mostly unchanged.

LOANS GALORE

The crisis, like charity, began at home or more accurately, with home mortgages, which is another term for loans where the purchased property serves as collateral. These are also referred to as secured loans. In other words, if you failed to make your mortgage payments, the bank that loaned you the money would gain ownership of the house. This house would then be sold to someone else to recover the loan.

This, however, is not Plan A for the bank. Bankers’ dreams are made up of giving loans to individuals who will pay them back, with interest and on time. And since, bankers can't figure out a person's credit-worthiness just by looking at them, they are supposed to conduct checks into an applicant’s ability to pay back the loan before handing it out. Makes sense, right? Well, that's not what happened.

THE HOUSING BUBBLE

In the early 2000s, interest rates on loans in the United States were low and housing prices started to rise. This made buying a house a great investment opportunity. Banks started disbursing loans to just about anyone who wanted to buy a house in the booming housing market. Take the case of a woman who worked as an exotic dancer, presumably making all her money in cash. She held mortgages on five houses. Yes, you read it right. Five houses! And no, she didn't make that much, just in case you are considering a change of profession!

The sober reality is that the bank's due diligence into her ability to pay back those loans was as good as absent. She wasn't the exception either, thanks to one of the protagonists of this story, sub-prime mortgages.

SUB-PRIME MORTGAGES

A sub-prime mortgage is a type of loan granted to people with poor credit scores, who, as a result of their bad credit histories, don't qualify for conventional mortgages. These loans typically cover 100% of the cost of the house, have higher interest rates and are available without too much pesky paperwork.

The relaxing of credit lending standards by banks led to the bloating of sub-prime mortgages from less than 10% of all loans until 2004 to almost 20% in 2006. Let that sink in. Imagine if instead of there being the occasional rotten egg in a dozen, you were running the risk of finding two in every dozen. You’d change the store you were buying from, wouldn’t you? Not these guys.

It wasn't as if sub-prime loans just became less risky out of the blue. Wall Street just accepted this higher risk because it gave them with an opportunity to cash in on the housing boom. To be fair, at this point, nobody was complaining. These sub-prime loans allowed customers with bad credit histories to participate in a booming housing sector, bankers to be rewarded for bringing their banks more business and for investment bankers to get rich selling financial instruments that bet on these loans. It was Christmas all year round. For a while.

WHAT ARE MORTGAGE-BACKED SECURITIES?

All this lending led to millions upon millions of sub-prime loans being accumulated by banks. This raises the question - why were these banks not concerned about the potential losses, incurred by these sub-prime loans, affecting their bottom-line? The reason for their apathy was that they had already sold this debt to other financial institutions like investment banks and hedge funds. So, it wasn’t their problem any longer.

The buyers of this debt, the investment banks, clubbed thousands of these loans into something called mortgage-backed securities (MBS). These securities would then be sold to corporate investors and the general public. Till 2007-8, housing MBS were considered safe investments because conventional wisdom dictated that people always pay their mortgages. Except in this case, conventional wisdom turned out to be more conventional and less wisdom.

POP GOES THE HOUSING BUBBLE

The difference this time around was that the real estate market was booming and people were buying houses not just to live in, but as investments. When the housing bubble burst in 2006 and housing prices began their downward slide, the houses that were supposed to make their buyers a quick buck, were fast turning into a losing proposition.

Picture this. You buy a house for 80 lakh (with the bank lending you 100% of the amount required) and around the time that you've paid off only a small portion of the loan (say, about 10 lakh), the price of the house falls to 60 lakh. What would you do? Would you stop paying back the loan to cut your losses? Of course, you would lose the ten lakh you'd already paid, but at least you wouldn't be stuck with a rapidly depreciating asset that you never intended living in anyway. And of course, there was also the danger of prices plummeting even lower.

While I don’t know what you, my reader would have done, data shows that thousands and thousands of people did renege on their mortgage payments. Consequently, the default rate on mortgage loans surged and led to the failure of mortgage-backed securities. Remember, the viability of mortgage-backed securities depended on people paying back their loans as planned. The unsinkable Titanic had struck an iceberg.

THE ROLE OF THE RATING AGENCIES

Now, let's focus on why everyone was sold on these mortgage-backed securities. One reason, of course, was the popular belief that people always pay their mortgages, which made betting on them seem like a no-brainer. And this belief was not some folksy truism. It was backed by the world's top rating agencies. All MBS were graded by rating agencies like Moody's, Standard & Poor's and Fitch. The ratings go from AAA, which is the best, through AA, A, BBB, BB all the way down to B. The highest-rated securities (AAA) are considered the safest investments because they are a collection of mortgages that are most likely to be paid back.

There were, however, many tranches of debt that were rated too low to be attractive to investors. Not that that posed much of a hurdle for the high priests at Morgan Stanley, Bank of America and their ilk. They simply bundled even larger numbers of these 'too bad to sell' sub-prime mortgages into new financial instruments called Collateralized Debt Obligation (CDOs), declared them "diversified" and sold those instead. Who says there is no imagination in banking? These guys were making stuff up as they went along!

Of course, how these sparkly new CDOs, brimming with bottom-rated, high-risk mortgages, obtained favourable ratings this time around is a question for the venerable folks at the rating agencies. Though I must say that it's just fascinating to note how benevolent these agencies are to the financial entities that write them fat cheques!

Common sense, if it walked the streets of the financial districts of New York and London, would have spotted a blatant conflict of interest in the incestuous nature of this arrangement. Unfortunately, that didn't happen (still hasn't) and so the gravy train rolled on, heading straight for a catastrophic derailment.

THE FRAGILITY OF INSURANCE AGAINST DEFAULT

As the rave reviews for these MBS and CDOs poured in, even famously stodgy organisations were tempted into investing their employee pension funds into them. Part of what assured them to take the risk was a financial tool called Credit Default Swaps (CDS).

Credit Default Swaps protect bondholders and lenders against the risk of the borrower defaulting. The lender's insurance partner takes on this risk in return for payments, which are similar to insurance premiums.

American Insurance Group (AIG) was one such lending partner. Understandably, these staid institutions felt as reassured as you do while driving your car around town, having paid the insurance premium, safe in the knowledge that you're covered even if you get into an accident. After all, nobody ever expects the insurer to run out of money.

THE FALL OF LEHMAN BROTHERS

As the number of home-owners defaulting on their mortgages swelled to unimaginable levels, the inherent hollowness of all these concepts was exposed.

One of the biggest casualties of the 2008 carnage was Lehman Brothers, an investment bank which owed more than $600 billion in debt, of which $400 billion was covered by Credit Default Swaps. However, even before they could heave a sigh of relief for having had the good sense to insure their debt, they found that the bank’s insurer, AIG, lacked sufficient funds to cover their losses. So much for insurance!

Lehman Brothers was far from an isolated case. The collapse was wide-spread and every large financial institution was affected in one way or another. This was a classic example of a short-sighted idea built on a bubble, floating on a seemingly solid but intrinsically-flawed concept.

The logic of insurance in the form of CDS only holds water if one or two securities fail. In that case, the insuring parties would've had enough money to cover the losses of the insured. One can only assume that having to withstand the tsunami caused by the bursting of the housing bubble, compounded by the sub-prime crisis resulting in the 2008 Recession was not something anyone had even imagined. Quite like the time when there weren't enough lifeboats on the Titanic. I suppose it had been unfathomable to the builders and owners of the ship that lifeboats might be needed someday.

Anyway, since the markets don't confine themselves to the limits of human imagination, housing prices fell more than 30%. This was a steeper price plunge than what was witnessed during the Great Depression. Panic selling was at its peak. The unsinkable Titanic had hit an iceberg, split into half and the only way to go now, was down.

TAX DOLLARS TO THE RESCUE

Eventually, the Federal Reserve of the United States intervened. The Treasury disbursed $439 billion to the Troubled Asset Relief Program (TARP). The TARP funds helped a few key areas - banks, auto companies, credit markets and modifying mortgages.

The Fed's bailout of AIG alone cost $182 billion. Across the world, billions had to be spent in the form of stimulus packages to restart national economies. All this, from the taxes paid by the average Joe to bail out firms who pride themselves on hiring only "the best and the brightest".

JUST DESSERTS FOR ONE, PLEASE!

While we could point fingers till the cows come home, the question that asks itself is – how many individuals found themselves charged with aiding and abetting this global meltdown? How many fat cat mortgage bankers (who handed out sub-prime loans like candy on Halloween and then made tidy little profits by selling the debt to investment bankers), CEOs of gargantuan investment banks (who injected this garbage into the economy while they enjoyed the rarefied air reserved for the top 1%) or bosses of credit rating agencies (which labelled absolute scrap as the crème de la crème of investments for a cushy payday) saw the inside of a jail cell? One. Yup, that's right.

The esteemed law enforcement agencies of the United States managed to zero in on this one guy as the perpetrator of this multi-trillion-dollar scam. Who is this super-villain, you ask?

Kareem Serageldin, an executive at Credit Suisse, whose crime was approving the concealment of hundreds of millions in losses in Credit Suisse's MBS portfolio. I agree, it sounds bad. It was wrong. He was complicit in some serious wrongdoing and deserved to pay the price. He did. Thirty months in jail.

ARE THE RICH AND CONNECTED IMMUNE TO THE LAW?

Now, let's zoom out a wee bit and look at the bigger picture. This guy, Serageldin, was not even part of the second tier at a second-tier financial institution. Talk about small potatoes!

And he was the only person prosecuted for a scam that spanned across major financial institutions like Merrill Lynch, Citigroup, Goldman Sachs, AIG and Lehman Brothers to name a few. Nope, no guilty parties there, sir. It’s anyone’s guess whether they were all innocent or happened to have friends in high places. Why wouldn't they?

Many top Wall Street executives have served in various US administrations before and after their time at Wall Street. I'm not sure if there is honour among thieves but there certainly seems to be loyalty. And maybe, the fact that many of the wealthiest 1% contribute as generously as they do to the election campaigns of both Democratic and Republican candidates might have something to do with this stroke of luck.

I doubt if there is a more apt explanation for the lack of legal action against the worst offenders in the Global Financial Crisis of 2008 than that offered by economist Nouriel Roubini, in the documentary Inside Job. When asked why there have been no real investigations into the matter, Roubini replied,

Add to this what, the then Senate's second-highest ranking Democrat, Dick Durbin was honest enough to admit about the US Congress. He said that the banks

THE SWILL ABOUT POLITICAL WILL

January 2009 was a time of audacious hope. President Obama had just stepped into the White House and there was much talk about how the full force of the law would be made to bear down on Wall Street and its corrupt practices. The likes of Attorney General Eric Holder and the head of the Criminal Division at the Department of Justice, Lanny Breuer were tasked with the job.

Months and then years passed, and nothing of note happened. Except, of course, the prosecution of the one and only, Kareem Serageldin. Why didn't they prosecute the bigger players in this unprecedented financial crisis?

The PBS Frontline documentary, The Untouchables places part of the responsibility on Eric Holder for being overly concerned with

The consequence of his excessive caution was that the administration ended up pushing for cash settlements over proper criminal procedure.

Breuer, on the other hand, was clearly jousting with some deep legal issues like believing that the actions of Wall Street were not criminal. How someone who holds a law degree and works for the Department of Justice doesn't believe fraud to be a criminal act is frankly beyond ridiculous!

This is the same Lanny Breuer on whose watch, a few years down the line, another banking goliath, HSBC faced no criminal prosecution for laundering funds for designated terrorist groups and drug networks. His logic, in that instance, was that prosecuting or taking away HSBC's banking license would cost too many jobs. Maybe he thought terrorist acts and drug trafficking don’t incur any damage. What a beacon of empathy and legal luminescence Mr Breuer is!

THE PENALTY THAT NEVER WAS

In the end, it all came down to a friendly slap on the wrists of the financial giants that caused and survived the debacle of '08. Till 2015, 49 financial institutions had paid various government entities and private plaintiffs nearly $190 billion in fines and settlements, according to an analysis by the investment bank Keefe, Bruyette & Woods.

Are fines of less than $200 billion fair reparation for losses that ran into trillions? And even that pale shadow of a penalty came from the pockets of shareholders, not the bankers themselves because the settlements were levied on corporations, not specific employees, and hence, paid out as corporate expenses. In some cases, these amounts were even deductible from taxes. Just like payments made to charity!

And in case you thought that the whole exercise had taught the swindlers of Wall Street a little something about corporate accountability and responsibility, well, I applaud your optimism. What happened instead was that, in early 2014, just weeks after Jamie Dimon, the CEO of JPMorgan Chase, settled out of court with the Justice Department, the bank’s board of directors gave him a 74% raise, bringing his total compensation to $20 million. What can I say? Life can be so unfair!

RECESSION 2008 : IN CONCLUSION

So, that's the way things panned out. It boiled down to the sad fact that individuals and institutions seldom do the right thing if doing the wrong thing brings them a lot more money or power, with little or no risk of retribution. I doubt if any lessons have been learnt at the level of financial institutions and governments. I, however, did learn a few lessons from the 2008 Global Financial Crisis and the recession that followed. Though that's a post for another day.