Lessons From The 2008 Financial Crises - Part 1

On September 15, 2008, millions of Americans woke up to startling news.

Lehman Brothers, an institution whose very name seemed synonymous with the financial industry, had filed for Chapter 11 bankruptcy protection, marking the largest bankruptcy filing in US history at the time (nearly $613 billion).

The bankruptcy had far-reaching effects on the global financial markets and directly contributed to the 2008 financial crisis.

It was the kind of news people had to verify because it sounded as far-fetched as a bill passing Congress unanimously.

How could something that felt as old as America itself fail?

Lehman Brothers helped build America.

It was founded in Montgomery, Alabama in 1850 by three brothers: Henry, Emanual, and Mayer. The company began as a small general store before shifting its focus to the cotton trading business.

Things started to take off when the brothers moved the company to New York in 1858, where they found access to resources to aid their transition into an investment banking firm.

They experienced considerable growth and profitability as they invested in railways, utilities, tobacco, and infrastructure development, even underwriting loans for the construction of the Panama Canal.

The firm was family run for over 100 years, with the last family member, Robert Lehman, serving as a senior partner until his death in 1969.

Before its bankruptcy, Lehman Brothers held around 4% of the US investment banking market share, putting their market capitalization at somewhere around $60 billion. But like many at the time, they invested heavily in mortgage-backed securities, which played a significant role in their downfall.

As people learned the news it sent shockwaves throughout the industry, leading to the collapse of other financial institutions, tightened credit markets, plunging stock markets, widespread unemployment, and a government bailout to stop a complete collapse of the financial industry.

Even with those interventions, we entered a painful recession.

Finance professors found themselves working at grocery stores, restaurants, and call centers.

Engineers and architects struggled to support their families as delivery drivers or handymen.

Panic and fear spread across the country like a contagious virus, and on September 29th the stock market had its biggest point decline in history (at that time).

Nearly 15 years later, most of us are familiar with what caused that crisis.

Banks had borrowed large amounts of money to invest in securities. This made them vulnerable to losses and left them with insufficient capital to cover their losses when the value of those securities declined.

The proliferation of subprime mortgages and the securitization of these risky loans into mortgage-backed securities (MBS) drove up mortgage prices to a level that caused widespread default.

Simply put, too many debts were secured by too many other debts, and when people stopped paying their mortgages the entire chain snapped, and over $8 trillion dollars disappeared overnight.

How did that happen?

Poor regulations and predatory loan practices ensured millions of Americans purchased homes at prices that many of them simply could not afford.

When homeowners started to default, this led to a sharp drop in the value of MBS held by banks and investors.

This created panic and financial institutions became reluctant to lend to one another, ultimately resulting in the collapse of some of those institutions, like Lehman Brothers.

This should all be a review but here is the shocking part — there was a major warning every year for 8 years leading up to the crash.

1. In 2001, economist and Nobel laureate Joseph Stiglitz warned that the deregulation of the financial industry could lead to a financial crisis.
2. In 2002, billionaire investor Warren Buffett warned about the dangers of derivatives and the risks they posed to the financial system.
3. In 2003, economist Robert Shiller warned that the housing market was overvalued and could experience a sharp decline.
4. In 2004, the FBI warned of an “epidemic” of mortgage fraud and predicted that this could lead to a financial crisis.
5. In 2005, economist Nouriel Roubini warned that the US housing market was a bubble that was about to burst and that this would lead to a severe recession.
6. In 2006, Alan Barber published a paper warning of an impending housing market collapse, predicting that it would cause a recession.
7. In 2007, the International Monetary Fund (IMF) published a report warning of the risks posed by the US housing market, predicting that this could lead to a global financial crisis.
8. In early 2008, financial analyst Meredith Whitney warned of major losses at major banks, predicting that the crisis would lead to a deep recession.

Derivatives are “financial weapons of mass destruction.” — Warren Buffet (2002)

But did most of us listen?

Of course not.

Most of us collectively agreed to skip the tedious years of discipline and strategy it takes to become financially independent and put it all on black instead.

Suppose you are as uninformed as I was. In that case, you probably think that after the big bailouts — President Bush’s $700 billion TARP Act, and President Obama’s $787 billion stimulus package — the government was done using taxpayers’ money to prop up financial institutions.

However, the bailouts were not nearly enough to plug the leaking dam. The economy was in tatters and no one was willing to loan to anyone, there was no ability to borrow and there were fears the economy would stop dead.

To combat this, they turned to Quantitative Easing or QE.

During a period of QE, the central bank essentially creates new money and uses it to buy securities (such as government bonds or mortgage-backed securities), which increases the demand for these securities and drives down interest rates.

Lower interest rates make it cheaper for businesses and individuals to borrow money, which can stimulate spending and investment.

The amount of QE the government has been cooking up created the lowest interest rates on record.

Although effective in the short term, it is a controversial policy, as some economists argue that QE can lead to inflation and other economic problems if not implemented carefully.

In addition to buying all of these junk assets and artificially stimulating the economy, the FED started loaning to banks at near 0% as an “extreme measure”.

That extreme measure became standard policy, and banks have enjoyed near 0% interest loans for over a decade.

The FED hoped (key word here) that banks would reinvest the loans to consumers and stimulate the economy. The FED also hoped that Congress would create laws since the FED lacked the ability to regulate how the banks spent the money.

Long story short, Congress did what it does best — got caught up in bipartisan initiatives and enacted no real regulations.

And banks did what they do best, used the money they were loaned to buy government bonds and securities, knowing that those investments would go up.

And they did, artificially inflating the stock market. And now that interest rates are being raised… no one is quite sure what will happen next.

Come back for part 2, and let's take a guess.

This story was originally published on Medium.