Understanding the 2008 Crash, p1.

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The 2008 financial crisis, and subsequent collapse of the property market, was a watershed moment in modern history. The shockwaves of the crisis were felt worldwide, leading to a global recession and significant financial hardships for many businesses and individuals, myself included.

It’s something I often mention on the podcast and in this blog, but I’ve never really taken a deep dive on the causes and the fallout.

Over the next few weeks I’m going to take a look at the history, how it all played out, and the lessons we’ve learned from it. This week, I’ll take a look at subprime mortgages, the housing bubble, and the collapse of Lehman Brothers.

The rise of subprime mortgages

The 2008 property crisis was a culmination of various factors that had been bubbling underneath the surface for a while. The US housing market had been witnessing a boom, and this in turn led to excessive lending practices, particularly in subprime mortgages.

Financial institutions had started to relax their lending standards, and give mortgages to borrowers with poor credit histories. This allowed a significant number of people to access mortgage financing, where previously they’d not have been able to do so.

Mortgage-backed securities

These subprime mortgages, which came with higher interest rates, and increased credit risk, were then bundled together with other mortgages and sold to investors as mortgage-backed securities (MBS).

MBS are a type of investment that is created by packaging together a group of individual mortgages, and allowed investors to buy a stake in a pool of mortgage loans: in the 00s their perceived benefit was primarily centred around their potential for generating attractive returns.

MBS were often marketed as offering higher yields compared to traditional fixed-income instruments such as government bonds. The underlying mortgages were seen as generating a steady stream of income through borrower payments, which attracted investors seeking higher returns.

It was believed that by spreading risk across various investors and tranches, the impact of default would be minimised.

Housing bubble

Because it was now easier for borrowers with poor credit histories to get mortgages, combined with low interest rates at the time, there was a surge in demand for housing. As the demand increased, so did the prices of homes.

This meant speculation became rampant. Many believed that the housing market was a surefire way to make substantial profits and there was a prevailing mentality of “buy now, sell later at a higher price”.

However, the foundation of the housing bubble was built on unsustainable factors, so the rapid increase in home prices wasn’t supported by fundamental economic factors such as income growth or housing supply and demand dynamics. Instead, it was largely driven by the expectation that prices would continue to rise indefinitely.

Bursting the bubble

Eventually, the bubble reached a point where home prices became significantly overvalued compared to their intrinsic worth. This overvaluation created an unsustainable gap between the actual value of properties and their inflated prices and the bubble burst.

House prices dropped far and fast, leaving many homeowners with properties worth less than their outstanding mortgage balances and in serious financial trouble. They found themselves unable to meet their repayments, which led to an increase in delinquencies and foreclosures. As a result, the value of the MBS plummeted. The losses incurred by banks and other investors exposed their vulnerabilities and led to a crisis of confidence in the financial sector.

When the bubble burst, it led to a wave of foreclosures that depressed property prices. This, in turn, led to a loss in confidence in the US housing market, spreading to other real estate markets as well. It also affected the stock market, which saw significant losses, with banks and financial services companies being some of the worst hit.

When the US sneezes, the world catches a cold

Because many of financial institutions had taken on too much risk, either on their own balance sheets or through the investments they had made, they were unable to continue operating when liquidity dried up. Many of these institutions were unable to continue operating, while those that did were required to be bailed out by their respective governments.

Lehman Brothers, the renowned investment bank, had grown its operations aggressively, fuelled by the risky MBS and other complex financial instruments. As the value of MBS and other risky assets started declining, their balance sheet weakened significantly, leaving the bank with with substantial losses and a reduced ability to raise capital or borrow money to support its operations.

This severe liquidity crunch meant that there wasn’t enough cash to meet short-term obligations: other financial institutions became reluctant to lend to Lehman due to concerns about its exposure to risky assets and deteriorating financial health.

Unlike previous financial institutions that faced trouble, such as Bear Stearns (which was bailed out by the Federal Reserve in partnership with JPMorgan Chase), Lehman Brothers couldn’t find a buyer or secure a government-backed rescue. Potential buyers were concerned about the magnitude of Lehman’s losses and the uncertainty surrounding the broader financial system.

Faced with mounting losses, lack of liquidity, and with no lifeline in sight, Lehman Brothers filed for bankruptcy on September 15, 2008. This marked the largest bankruptcy filing in U.S. history. The once-powerful institution, which had stood for over 150 years, crumbled within a matter of days.

The failure of Lehman Brothers shattered confidence in the financial system and raised concerns about the financial health and stability of other banks and investment firms. The uncertainty surrounding the exposure of these institutions to Lehman’s toxic assets created a widespread loss of trust and increased the perceived risk of doing business with them, which in turn led to a freeze in lending and a breakdown in trust between banks, intensifying the credit crunch and hampering the functioning of the financial system

Next week we’ll take a look at the direct aftermath of the Lehman Bros collapse, how it all played out and the lessons we’ve learned since – see you then!