The recession of 2008 was one of the worst economic disasters since the Great Depression of 1929. Originating in America, the adverse effects of this crisis spread throughout the world like a virus. Some European economies, like that of Greece, were completely crushed and have still not been able to recover properly. This is because the banks in the USA got a huge government bailout from the US Federal Reserves but countries like Greece did not receive the economic assistance which was promised to them by the Eurozone. This was also a huge setback for the US-espoused capitalist ideology as throughout the cold war, it had presented capitalism as an entity that would always lead to prosperity. But what exactly happened? A lot has been written about this crisis. It is a well-known fact the corrupt bankers and the credit rating agencies were largely responsible. This article will attempt to analyze their role and give a simple explanation as to how a housing bubble spiraled into a catastrophe.
So, let’s start with the basics. In the USA, if you want a house, the bank gives you a loan after verifying whether you have the income and the job to repay it. As proof of this lending, the bank keeps a legal document known as a mortgage. When the debtor pays off the entire loan with interest, the mortgage becomes void. Or in other words, he pays off his mortgage. Now, the banks have a lot of mortgages as they give out house loans to many people. So, what the banks started doing in the early 2000s was that they started bundling thousands of these mortgages together to make a housing bond. Technically, it was called a Mortgage-Backed Security (MBS). They put these bonds up for sale. The investors rushed in to buy these bonds because they were not risky and there was a high probability of good returns. Why? Since the bond was made up of so many mortgages, its value would go down only if thousands of Americans defaulted on their payments. But since the banks verified their ability to repay before passing a loan, defaults were rare. Even if a debtor defaulted, the banks could always re-sale his house and cover up the losses. So, buying housing bonds was considered a stable, risk-free investment.
The process of selling a bond was simple enough. The banks compiled mortgages together and took them down to a credit rating agency. The credit rating agency inspected the mortgages in the bond and assigned a rating to it. The rating was meant to indicate how safe it was to invest in that bond. So, the most stable bond, with fewer chances of defaults, got a 90 to 95 percent AAA rating. After this, they were put up for sale. When an investor bought them, the bank charged a two percent commission fee for preparing the bond and facilitating its sale. So, the sale of these bonds was a great source of income for the banks. The housing business also received a huge boost and house prices kept increasing.
But, soon enough, the banks ran into a problem. There were only so many mortgages to put in the bonds. So, more mortgages were needed if the sale of the bonds was to be continued. To counter this problem, the banks started to give out loans without verifying whether the debtors could repay it. They did not care to check important parameters like income or employment status before passing loans. The bonds were stuffed up with bad loans with very little probability of getting repaid. So the question arises, why did the investors continue to buy bonds filled with risky loans? The answer is shocking. They didn’t even know that the bonds were this bad. How? That is where the corrupt credit rating agencies come in. For examining and assigning a rating to a bond, the rating agencies charged a fee. Now, the banks were very selective about choosing a rating agency. They were only willing to approach those agencies which gave their bonds a good rating. After all, even the rating agencies competed with one another. So shockingly, the rating agencies gave a 90 percent AAA rating even to bonds filled with subprime bad loans. They did it out of fear of losing banks as their customers. Such levels of fraud were completely unprecedented. But, this could not go on forever.
By the time 2008 kicked in, the defaults skyrocketed. Thousands of people had been given unverified loans and they failed to repay them. The banks’ hypothesis of covering the losses due to defaults by selling the houses did not work as so many people defaulted on their payments at the same time. Hence, thousands of houses were emptied and put up for sale by the banks. In other words, the supply of houses rose dramatically while their demand fell. Because of this, the prices of houses throughout America plummeted to a record low. Even people who could afford to pay mortgages stopped doing so out of frustration at the loss of value of their house. For instance, if a person availed a loan of $600,000 to buy a house whose value then reduced to $100,000, he is bound to feel angry at having to repay the loan for such a low-value house. Bottom line is, the banks couldn’t cover the losses borne out of defaults because no one bought the houses. In the process, the banks lost billions of dollars. Prestigious banks such as Lehman Brothers declared bankruptcy. The credit rating agencies had to shut down as well. As a direct result of this, thousands of people who worked at the banks lost their jobs. Now, Banks are the financial institutions that sustain the economy by giving out credit. Because the banks failed, every sector of the economy which depended on them was also deeply affected. Hence, a housing bubble turned into a nationwide disaster affecting the technology and manufacturing markets as well. All of this happened only because the bankers and credit rating agencies were too consumed by greed to consider the adverse implications of their actions. To get the economy back on track, the US government sought to pay the liabilities off the banks through the US Federal Reserve. Soon enough, the banks were back in business. But, what about the people who lost homes, jobs, and savings? As always, they bore the brunt of the corrupt deeds of gluttonous capitalists who thought it was convenient to exploit the common man as he has no influence on the government. Simply put, no one cared for them.
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The one word that defines him is curiosity. Always looking for new things to explore and learn. Apart from this, he is an avid debator which largely stems from his habit of reading voraciously. Currently pursuing Political Science (Hons.) at Ramjas College, Manraj is a movie buff and a huge football fan.