On September 15, 2008, the United States investment banking giant Lehman Brothers Holdings Inc filed for bankruptcy. The crisis and panic it triggered not only resulted in loss of thousands of jobs but also resulted in a global financial crisis with many parts of the world plunged into recession. The single biggest reason for the failure of Lehman Brothers was their excessive involvement in subprime lending and securitisation of subprime mortgages. But what does that mean? How could it result in such a massive global crisis? And how much did it affect India?
What caused the 2008 financial crisis
The seeds of 2008 subprime mortgage crisis, or simply known as housing crisis, were sown way back in the 1980s. Subprime loans are loans offered to people who are less likely to repay. Since they involve greater risks, they involve high interest rates and are mostly adjustable. The idea of taking home loans gained popularity in the US when to beat the crisis resulting from The Great Depression of 1930s, newly elected President Franklin D Roosvelt offered a 'New Deal'.
A major component of the 'New Deal' was to help the people own a house and, to do that more effectively, encourage lenders providing property loans to people. This gave birth to Savings and Loan associations, cooperative financial institutions which took deposits and lent to home buyers.
In his book The Ascent of Money, British historian Niall Ferguson tells the story of how these Savings and Loan associations paved way from subprime mortgage-backed securities. Ferguson writes that to facilitate these Savings and Loan associations and to reassure the depositors, Roosevelt Administration introduced federal deposit insurance.
Later the Federal Housing Administration was established to provide insurance to mortgage lenders, which facilitated long-term low-interest loans to home buyers. However, the policy to cap lending rates for while keeping return rates offered to depositors high, ensured that the Savings and Loan associations face a tough time.
The final blow came in 1970s when, in order to check inflation, the US central bank increased interest rates sharply. Consequently, S&L associations were deregulated, which meant they had a choice to invest wherever they want and provide whatever interest rate they like. But this resulted in another crisis as reckless investments by S&Ls followed, creating a wide gap between their assets and liabilities.
Finally, the Federal Savings and Loan Insurance Corporation shut down most of these institutions in late 1980s and early 1990s. However, the going down of S&Ls gave someone a new idea in bond trading.
American author and journalist Michael Lewis explains in his book Liar's Poker how Lewis Ranieri at Salomon Brothers, an investment back where the former also worked, came up with the idea of bundling together mortgages of S&Ls and sell them as securities - i.e. convert mortgages into bonds.
Coming back to successive US governments' efforts to make the 'American Dream of home ownership a reality', which, needless to say, encouraged a large amount of subprime lending to those who could not otherwise avail loans to buy houses.