A simplified Analysis of the 2008 Financial crisis: Case study of AIG and the Lehman Brothers
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The 2008 financial crisis is said to be one of the greatest financial events to have taken place after the great depression of the 1930s. It is however surprising that most experts didn’t foresee it coming. The unfortunate event had adverse effects on income, inequality, wealth, and politics of individuals and nations around the world and there’s a lot to learn from it. That is why I have decided to write about it in a way that would be understandable to everyone and not just the finance gurus.
The Whole Story
During the 1990s, America was getting huge inflows of funds from Russia and other Asian countries that had financial crises at that time. And as you know, idle money yields no interest, American banks as you would expect didn’t want that money lying around doing anything.
As such, they made it easier for the American dream to come true for many Americans who ordinarily aren’t qualified for mortgage loans, they created Adjustable-rate Mortgages.
An adjustable-rate mortgage, or ARM, is a home loan that starts with a low fixed-interest “teaser” rate for three to 10 years, followed by periodic rate adjustments.
Banks bundled these mortgages into single bonds or debt instruments known as Collateralised Debt Obligations (CDOs) with the intention of selling to other parties which include investment banks, pension funds, etc.
Meanwhile, Insurance companies, banks, and pension funds wouldn’t want to buy these instruments because of their high riskiness. So what can be done? This is where AIG (America Insurance Group) comes into the picture.
AIG was the largest insurance company in America and the world at that time and it had a very strong credit rating (Ability to fulfill financial commitments). They created an insurance policy protecting the CDOs with poor credit ratings against default risk on behalf of the banks, asset managers, and funds that invested in them. To put this into context, they swapped the poor credit rating of the CDOs with their strong credit rating, This process is called Credit default swap (CDS).
AIG was raking in cool money within the period and went on to insure CDOs worth more than their Assets. Normally, insurance companies should only insure amounts that their assets should be able to cater for. AIG relied heavily on statistical probability thereby concluding that the market won’t fail. They began accepting and granting protections to CDOs with low credit scores (Higher risk of defaulting). Unfortunately, as time progressed, the interest rates started rising and customers started defaulting on their loans.
When the CDOs began defaulting AIG began to pay claims until they ran out of money in September 2008 and on that same day, the Lehman brothers were forced into bankruptcy.
Who are the Lehman Brothers?
In 2003 & 2004 during the US housing bubbles, Lehman Brothers Acquired 5 mortgage lenders which specialise in risky loans. Around that period, Lehman Brothers was the 4th largest investment bank in the US with over 25,000 employees.
Lehman securitised mortgages worth $145b in 2006 and in 2007 Lehman underwrote more mortgages than any other firm, accumulating over 4 times its shareholder equity. But by the first quarter of 2007, cracks in the US housing market were becoming apparent, and defaults on subprime mortgages rose to a 7-year high.
A subprime mortgage is a type of home loan extended to individuals with poor, incomplete, or nonexistent credit histories. Because the borrowers, in that case, present a higher risk for lenders, subprime mortgages typically charge higher interest rates than standard (prime) mortgages
Lehman didn’t have money of its own but borrowed from other banks to fund its mortgage services. When subprime mortgages began to default, banks began to collapse because they had stakes in these Mortgage loans. When banks became vulnerable, they stopped lending to each other. Thus, faith was lost in the system; with no faith, comes no credit and with no credit, there will be no Lehman.
What Happened After:
The US Congress rejected a bill to bailout banks and financial institutions that are victims of this financial turmoil, however, AIG was deemed “Too big to Fail” Because it is the largest insurance company in the US and many financial institutions within the US and around the world had policies and stakes with it. If AIG collapses, it will result in serious trouble not just for businesses in America but around the world.
The US government went ahead to bail AIG out with over $85 billion dollars and took an 80% stake in the company. AIG then paid over $165m to staff as an incentive not because they did well but because they needed to clean out the mess. In total AIG received a bailout of over $182b as of March 2009, and also reported the single largest corporate loss in history. In 2012, the Federal Reserve Bank sold the shares of AIG to make a $22b profit.
Lehman Brothers filed for bankruptcy on September 15, 2008. Hundreds of employees, mostly dressed in business suits, left the bank’s offices one by one with boxes in their hands. It was a somber reminder that nothing is forever even in the richness of the financial and investment world.
Important Lessons from the story:
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Do not be in a hurry to invest in a sudden boom or flourishing company or market. It could be a bubble, take your time to study why it is so, and even when you are convinced enough to invest, don’t invest an amount that can wreck you when you lose it.
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Beware of too-good-to-be-true offers, from the perspective of those who collected the mortgage loan, they should have taken their time to understand the implications of this seemingly amazing offer (Interest rate)., The investment firms buying the CDOs or MBS should have taken more caution, they should have prioritized sustainability over profitability.
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Know your limit, Do not take risks blindly. AIG and the Lehman brothers were minting millions from their trades, playing deaf ears to the very rule of finance. They took on risks they could not contain which later resulted in their downfall.
References
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https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp
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https://corporatefinanceinstitute.com/resources/knowledge/finance/lehman-brothers/