Financial Crisis 101

 

Well this article is pretty long and full of information so hold on to your seat and let’s dive in the reasons why three major financial crisis in history happened !

According to Wikipedia :

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value.

So basically, when financial assets — which can be bonds, stocks, bank deposits and so on — suddenly drop in value, it creates a large panic or bank run where investors all start selling off their assets or withdrawing their money from savings accounts at the same time.

Why do they do that ? Simply because they fear that the value of their assets will drop if they remain at the financial institution they’re at.

What leads to a financial asset’s value suddenly plummeting ?

Well first, it is normal for the economy to go through phases of booms and busts — here is a video I linked in a previous article on the inner workings of our economy.

Let’s look at three major crisis that have happened in history.

1637 : Tulip Mania

tulips-2544_1280Let’s go to Holland in the 17th century during the Dutch Golden Age when the country was the most powerful amongst Europe.

You have probably heard of the Netherlands being famously known for their flower industry. Well, at that time with a booming economy and the recent introduction of tulips in Europe, these flowers quickly became a luxury item.

Indeed, tulips were brought to Europe from Asia on Dutch trading vessels. So they were considered to be an exotic flower. Moreover, they were quite difficult to grow and a virus outbreak made this process even more complicated.

However, the flowers that managed to bloom developed beautiful colors creating a very high demand for them.

The scarcity and popularity of tulips made their price rise insanely causing a TULIP MANIA.

However, after some time, the Dutch realized that the price they were paying for tulips far exceeded their worth. The demand suddenly ended and the price of tulips plummeted — low demand and high supply equals low prices — causing the tulip bubble to burst and the market to CRASH.

1929 : The Wall Street Crash

stock-exchange-1376104_1280The Roaring Twenties were a period of major economic prosperity and optimism especially amongst Western societies. It also saw the rise of new technologies such as radios, planes, cars, domestic goods — fridge, vacuum and so on — and the expansion of electrification.

It was the rise of mass consumption, yes, but the majority of items were bought on credit. It was the beginning of the “ buy now, pay later ” scheme.

Moreover, in this new economy and ideology, Americans were looking for new ways to get richer

Since World War I, people were encouraged to buy government bonds called “ liberty bonds ” — a way for the government to finance the war — and received interests on the bonds value.

This new investing culture enabled banks to convince people to massively invest in the stock market.

Everyone was speculating. Everyone had faith in the stock market. People even started buying stock with borrowed money — it was called “ buying on margin ”, here goes again the “ buy now, pay later ” mantra — which made up 90% of the purchase price of the stock by the late 1920s.

Comparably to the 1630s Dutch Tulip Mania, this “ stock mania ” caused a rapid rise in stock prices — high demand results in high prices.

No one knows why people suddenly lost confidence in the stock market but on Wednesday, 23 October 1929, millions of shares were sold and the next day marked the beginning of the CRASH.

2008 : Global financial crisis

suburbs-2211335_1280This one did not start with tulips or crazy investments but with housing.

What’s a mortgage ?

According to Investopedia :

A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses to make large real estate purchases without paying the entire value of the purchase up front. Over a period of many years, the borrower repays the loan, plus interest, until he/she eventually owns the property free and clear.

In a residential mortgage, a home buyer pledges his or her house to the bank. The bank has a claim on the house should the home buyer default on paying the mortgage. In the case of a foreclosure, the bank may evict the home’s tenants and sell the house, using the income from the sale to clear the mortgage debt.

The bank — the original lender — often sells it to third-parties.

Okey, so what happened ?

In the early 2000s, investors worldwide looking for a low-risk high-return investment started getting into the US housing market because they thought that they could get a better return on their investments from the interests homeowners were paying on their mortgages rather than from US treasury bonds which had, at the time, a very low interest rate.

So they bought mortgage-backed securities — or MBS.

Wait, what are those ?

Okey so we said that when someone wants to buy a house and doesn’t have all the money to buy it, they go to a bank to get a mortgage. So now the person gets a loan from the bank to buy the house but has to repay this loan back to the bank with interests.

However, the bank keeps the mortgage but also has to keep the principal — the original sum of money lent that is slowly repaid by the borrower — and the interests for the duration of the mortgage — let’s say 30 years.

That’s not good business for the bank since it can’t loan that money to other potential borrowers for 30 years — see this article on how money is created.

Therefore, the bank sells this mortgage — which means principal and interests — to investors. To do that, it packages several thousands of mortgages together and sells this bundle — in the form of a single bond which is the MBS — to an investment bank.

This investment bank receives several of these MBSs, partitions them according to quality and sells them to investors.

So the homeowner makes payments to a bank for a mortgage that is owned by investors.

Why would investors buy these MBSs ?

Well they thought that they were a very secure investment since that’s what credit rating agencies — such as Standard & Poor’s, Moody’s, Fitch — were saying by giving them AAA ratings. Plus, if one borrower were to default, as house prices kept going up and up, they could just seize the house and sell it for a good price.

Again — and as usual — the demand for these MBSs rose as more and more investors became interested in them. At the time, mortgages were only granted to borrowers with good credit —  PRIME MORTGAGES. However, lenders — the banks — needed more mortgages to create more MBSs to sell to investors.

So that’s when it all went wrong !

road-sign-1274312_1280Lenders started loosening their standards for granting mortgages, making loans to people with low income and bad credit. These are the famous SUB-PRIME MORTGAGES. Some institutions even started making loans without verifying income and with adjustable interest rates that quickly became unsustainable for the borrowers.

The problem is that, as these practices were new, credit rating agencies were still giving MBSs AAA ratings even though they had become very risky investments.

Traders also started selling collateralized debt obligations — or CDOs — which are an even riskier product.

This whole phenomenon created the housing bubble driving prices higher and higher. But we all know that bubbles always end up bursting.

After a while, people just couldn’t keep up with the payments and more and more of them started defaulting. Well, if only a few were to default, it’s fine since owners of mortgages — investors — can simply sell the house.

However, if many were to default, many houses are put back on the market and if there are no buyers for these houses, prices go down — low demand and high supply causes low prices.

So these houses that could be sold for a good price couldn’t anymore.

Moreover, as house prices were collapsing, some borrowers suddenly had a mortgage for way more than their house was worth on the market and just stopped paying. This intensified the collapse of house prices.

So now investors have realized how bad of an investment MBSs were and stopped buying them — they still lost a bunch of money — leaving subprime lenders with bad loans. Some of them — major ones — were forced to file bankruptcy.

As if this wasn’t enough, financial institutions — such as the American International Group or AIG — had previously issued thousands upon thousands of credit default swaps — or CDS, check out its explanation here — that were sold as insurance over MBSs but had no money to back them up if things went wrong.

These CDSs were sold as securities in the same way MBSs were.

So when the bubble burst, the entire financial system exploded and the stock market CRASHED.

If there’s anything you would want to add or share, please do so in the comment section :). I am learning as I do these articles so don’t hesitate to correct me if I said something wrong.

Additional resources — you should definitely check them out as they really help understand all of this more easily :

A video on the Tulip Mania — definitely a must-watch

A video on the Great Depression in the US

A video on the Roaring Twenties in the US

BBC2 documentary on the Great Crash 1929 — definitely a must-watch

A video on the 2008 Financial Crisis

Another good video on the 2008 Financial Crisis

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