Understanding the 2008 Financial Crisis: A Detailed Analysis
The 2008 Financial Crisis: A Detailed Analysis
2001-2006: Phase of Liquidity Degradation in Subprime Lending. The credit crisis begins to expand due to central bank stimuli aimed at paying back banks and securitizing their loans. Investment banks shift away from short-term debts that are renewed daily.
Therefore, interest rates fall dramatically, reducing the WACC (Weighted Average Cost of Capital), and projects with very low ROA (Return on Assets) become profitable. Families begin to demand housing, increasing property prices and creating a bubble. This generates greater leverage in the economy. Since some are unwilling to participate, the market begins to show signs of strain, especially in premiums. Material costs increase, reducing the profit margin of companies.
The Struggle for Liquidity
This phase is characterized by rising interest rates. At the end of 2006, with the rise in interest rates, things begin to change. As housing prices rise, people demand housing with the intention of selling it later, leading to speculation. Speculators begin to buy homes. Increasing unemployment and rising interest rates cause agents to be unable to afford their mortgages. Prices drop, and they cannot sell or pay off the mortgage. In states where mortgages were executed without recourse to the remaining value, people tended to abandon their homes.
The Securitization Process
Securitized packages were rated by rating agencies responsible for assigning a solvency grade, indicating whether the default risk was very small or very large. Their view changed over time, with debt initially considered very reliable later becoming trash. Many blame them for the crisis, arguing that they had not properly analyzed the creditworthiness of the assets and liabilities. However, this occurred because the state required them to be assessed by these agencies if they wanted to issue debt. Even in cases where qualifications were absent or deemed good, the losses would have been the same.
During the phase of the struggle for liquidity, there is pressure on current property values, raising their prices, and pressure on short-term interest rates. This can lead to short-term interest rates being higher than long-term rates, inverting the yield curve. This produces the liquidity crisis in August 2007, causing interest rates to soar. Central banks around the world begin to expand credit again, implementing extraordinary liquidity injections to calm panic in financial markets and prevent the economy from entering liquidation.
The Liquidation Phase (Late 2008-2009)
The disaster began on September 15th when Lehman Brothers, one of the five largest investment banks, declared bankruptcy. The decision was made not to rescue it. On the same day, Merlin Leands faced bankruptcy, but it was rescued through the acquisition by another bank. Lehman Brothers’ bankruptcy meant the liquidation of all its assets to repay its debt, leading to a new settlement. Panic ensued after the bankruptcy of the bank. All banks stopped lending to each other, leading to the risk of secondary contraction. If banks stop lending to each other, and everyone wants to hoard money and pay the bank, banks have to over-liquidate assets, overloading the economic system.
Official Response to Bank Failures
The liquidity ratio was very low, reflecting the relationship between assets and liabilities. Only about 20% of the debt was covered by assets; the rest, liabilities, had to be refinanced. If refinancing is interrupted, the only option left is to settle the long-term asset, which takes them out of business because liquidating the long run is what happens.