This blog post will discuss causes of the Global Financial Crisis, and break down and explain a scene from The Big Short.
THE BIG SHORT is finally here, I don’t know about you, but I sure as hell cannot wait to watch it.
For those of you who don’t know what the movie is or what it’s about don’t fret, I got the trailer right here (thanks YouTube), as well as the summary of the plot.
So, in short (see what I did there): it’s about a group of investment bankers that bet against the housing market. They knew it was going to collapse, and so a way to make money was to bet it’s collapse, with those who believed in the housing market, and were ignorant to listen to the warnings of the collapse.
These investment bankers were conscious of the causes of the collapse and not long ago I went to a crash course on the Global Financial Crisis taught by Dr Eagleton-Pierce at SOAS University, which gave me an insight into the causes of the global financial crash. Since, I’m in the feels for the movie, I thought I would post my notes, on what I’ve learned.
The Global financial crisis.
Firstly – the politics of finance: (just a quick background)
The financial sector rose in Power during the 1980’s, their drive was to expand and make profits. In order to do so, the government must authorise such expansion. In the world today we can see that the financial sector is remarkably larger then what it was before the 1980’s. An explanation for this was the idea of personal ties between the elite policy makers and financers, they are known to engage in personal activities together such as having dinner occasionally, together. This can be described as ‘revolving doors’. The implications are that these policy makers are influenced by the bankers’ drive for expansion. This results in a society that is run by those who are already wealthy, yet money hungry, people who are greedy.
An example of personal ties with the financial sector would be political parties who are supported and rely on the financial sector to fund their election campaign.
So what caused the financial crisis?
The following ideas were explored in the masterclass held at SOAS:
- Risky Lending practices
- Credit Rating agencies
Risky Lending Practices:
This idea explores the extent to which bankers are willing to expand their industry. Major banks took on dangerous levels of debt to become the dominating firm in the industry (monopoly). The riskiness became severe to the extent where banks were no longer able to provide people with deposits. Then the desired home ownership came about, where the US housing market – labelled as the ‘Wild West’, due to credit and mortgages made more readily available. Predatory lenders needed little or no evidence of borrower income, this means that people who couldn’t even afford a mortgage were still given mortgages even though they couldn’t pay it back. Homeowners couldn’t afford the debt, so the debt burden for the low income purchaser increased. However, this is good for the salesman as banks pay him more if he’s able to make more sales. Larger profits are therefore generated for the lenders.
Securitisation: A form of financial engineering, it’s where credit risky assets e.g. bad debt – mortgage is packaged with higher quality assets e.g. good debt – government bonds. This usually has great implications in general, e.g. for a financial sector it’s a good way of spreading the risk, however the risks are not completely eradicated, they are just accumulated in different areas. The metaphor Dr Eagleton-Pierce used to describe it was a bad piece of debt sandwiched by good piece of debt. Overall the good outweighs the bad, but this may not necessarily mean that it is a good thing, in the real world securitisation features products where hundreds of pieces of debt combined into one single package to sell. It becomes difficult to know which piece of debt belongs to who, came from where. It’s a ‘moral hazard’ in terms of where responsibility lies. Bankers just want to pass on the loan to buyers, but bad mortgages in the US triggered the financial crises, people couldn’t pay their monthly mortgages, so there was no money coming into the banks, and so hundreds of securities would need to be reassessed and so this caused utter confusion and complexities, contracts even stretched over the world and financers couldn’t work out all the connections. Bankers also didn’t tell the world they hid their problems. You can’t solve what you hide.
Credit rating agencies: They are distant from banks, and claim to be partial judgers on risks of different assets. Ratings are made on the financial health of many things e.g. products, banks and governments. It’s a marking system for ‘large-scale borrowers, whether companies or governments, and are an indication to buyers of debt’, it lets borrowers know the likelihood of getting paid back. The issue here was that, there was a situation of conflicts of interest, which have surfaced between credit rating agencies and their clients. An example was the famous Lehman Brothers collapse, yet their ratings were still AAA. Showing that ratings are unreliable.
HERE’s a clip from the Big Short explaining the collapse of the housing market – hopefully the notes helped with following Ryan Gosling’s quick explanation.
Ryan Gosling walks in with his jenga block, representing the housing market. The letters on them AAA’s to B’s, show the ratings of mortgages, from safest ratings – AAA to riskiest B’s. The one’s rated AAA, mean greater likelihood of being paid back – and the B’s are more risky as there is less likelihood the debt will be paid back, but if they do then more money could be made due to interest rates on the debt. The B loans are known as subprime, what Gosling delightfully describes as dog manure, as they got bundled up with mortgage loans rated AAA. These bundles were then sold off. Due to more and more loans being taken on by people who cannot afford them, as time went on, more and more of these bonds contained subprime mortgages and that is unlikely to be paid back. This is a result of having no “income verification”, meaning that there was no checks to see if the amount of these loans were capable of being paid back. Default rates are increasing, meaning that the amount of worthless bundles are increasing, and will fail at a certain point. Those who offered credit default swaps on insuring that the rates of return were good in the housing market suffered heavily, as we all know it collapsed, and those who offered insurance on the collapse, profited heavily. Short sellers are those who bet that the market will go bust. These are the people who profited in the global financial crisis.
Clip summary: If you are a visual learner, this video should summarise 😀
The question is, where were governments intervention when this happened?
Governments were part of this problem themselves, they wanted cheap money to keep up growth, keep up optimism, so reduced interest rates to below 1%, e.g. 0.5% to provide cheap access to money for the population to spend and increase their consumption to continue the circular flow of finance. This tempted banks to return and take on more debt, as more people wanted to spend so take out more loans in the banks. They became greedier.
The lecture ended with a seminar discussing the question ‘Is greed good?’
Let me know in the comments section below your opinion on this question, also if whether or not you found this useful at all.