We will cover the 2008 Mortgage Crisis (also known as the Great Recession) and examine derivatized financial instruments, liquidity and supervision problems, which were the major causes of the crisis.
Fears of a “recession” are being voiced a lot by business circles these days. Is a “recession” really something to be feared or is it a reflex that healthy economies can respond to? As controversial as this issue is, it is not enough to explain the business community’s great fear of “recession”. Today, we will examine that great fear that still affects us today, and which may have awakened governments from the dream of Neo-Classical economics and led them to a Keynesian approach.
Derivatized Financial Instruments
- MBS (Mortgage Back Securities)
The story was started by the Solomon Brothers, who created a new innovation in an otherwise normal banking industry. A mortgage is a mortgage insurance document in the United States that represents a mortgage against a home loan. Until 1978, when the Solomon Brothers created the first MBS (Mortgage Back Securities), mortgages were traded as a low-profit investment vehicle and enjoyed a high level of confidence. The MBSs that emerged at this point came with two approaches;
1- Why not spread the risk by diversification?
2- Why not aggregate more than one and increase the rate of profit?
On the surface it seems like a great way, but like all good things, this investment vehicle had a flaw, and that flaw came from the approach “Who the hell does not pay their Mortgages?”
MBSs thus functioned as a loan pool where multiple mortgages were pooled together. Of course, not all mortgages in this pool had the same payment cycle, profit and risk. For this reason, MBSs were divided into “Tranches”;
1- Unsecured (High rate of profit and risk)
2- Mezzanine (Moderate profit and risk)
3- Sr.Secured (Low Rate profit and risk)
Thus, a derivatized investment instrument emerged and the American real estate market deepened with this popular investment instrument. For many years it was the engine of the US economy. While this was happening, the investor felt no worries because the real estate market was like a “Stone”, wasn’t it?
- CDO (Credit Debt Obligation)
CDOs are investment vehicles made up of a combination of multiple insurance policies and mortgages. As a system, they behave just like an MBS but with one difference, these investment instruments do not only include Mortgages. These investment instruments include many insurance market instruments such as car insurance, commercial mortgages. The most striking part of CDOs was to include hundreds of MBSs in this cake, which was already a derivatized investment instrument. Thus, a secondary derivative was created and the market became deeper and deeper.
- Synthetic CDO’s
We would not be lying if we said that we have reached the atomic bomb of this story. Synthetic CDOs represent an investment instrument that recovers Unsecured Tranches that have failed and transforms them back into a CDO structure and turns this business into a relatively “Gambling” structure. Betting systems created new deposits on top of the investments, giving birth to a tertiary derivative financial instrument, which gradually pushed the system into a deep impasse.
A brief summary can be summarized as follows;
Mortgage’s MBS (x100 Mortgage) CDO’s (x100 MBS) Synthetic CDO’s (being broken CDO’s)
The belief that house prices would rise steadily and that household demand for real estate would grow steadily was shaken in the second quarter of 2007. House prices, which had been stable for a long time, started to fall due to the contraction in demand. One of the main reasons for this is that people buy houses with an investment instinct beyond their needs and their investment appetite reaches saturation after a certain point. The sharp difference between Need and Want showed itself here again, and real estate prices started to fall gradually. Before real estate prices, this is what happened in an MBS respectively;
1- Households aiming to sell the house for a higher value than they bought it and borrowing accordingly realized that the house would not actually appreciate that much and refused to pay their debts.
2- In the face of a sharp real estate market contraction, high-risk borrowers lost the value of their assets, their houses, and their debts exceeded the value of the house, and they refused to pay the mortgage.
3- In response, the borrower, the smallest starter in the system, defaulted on their mortgages and the cash flow in the system froze. Banks could not get back the cash they had lent, and with mortgages triggered, they were left with only empty houses.
4- There was a liquidity crisis due to the interruption of cash flow in the system and the Real Estate Bubble burst strongly.
Thus, this hormonal expansionary adventure, which started in 2001 with the FED decision led by Alan Greenspan (1% Policy Rate), ended with the lack of supervision and liquidity crisis.
3- The Problem of Lack of Supervision
One of the biggest problems is that American auditing agencies and lending institutions are caught up in competition and do not objectively analyze real data. The fact that the interest rate, which is the cost of borrowing, has been reduced to such an extent not only points to “Easy and Cheap Money” for Wall Street, but also raises the question of “A profitable new investment instrument” for investors. It is precisely at this point that the Wall Street and Investors coincide and turn this bubble into a gigantic one. In the meantime, lack of supervision emerges as the biggest problem, and individuals who should not have borrowed are borrowed by trusting the market (or a consensus). The result was the “Great Recession” that is still feared today.
A recession is a healthy reflex of an economy when it operates within natural limits, but it becomes an unhealthy curse when all markets around the world do the same. At this point, we assume that world markets have learned the lessons of the 2008 crisis, so that the fear of recession has become a current topic of discussion in business circles around the world. The mortgage crisis was superficially caused by these reasons; the real estate bubble pushed first the country where it burst (the United States) and then the world into a deep recession. While capital movement in the world has become easier and simpler with the Communication and Information Age, the emergence of risks has also become easier and simpler. For this reason, the idea that a controlled supervision of derivatives markets without intervening in the free market may be reasonable found support after the Mortgage Crisis. Although today’s hyperinflationary environment has the expansionary effects of government spending during the Covid-19 period, this process actually started with the Mortgage Crisis. The US government and other governments, especially the US government, turned to reflationary policies in order to recover from the effects of the crisis and to stimulate their shrinking domestic demand. The monetary expansion created by this expansion is still in effect today and continues to be one of the main drivers of the crisis. It is still a matter of curiosity when the World Economic System will withdraw this excess money and when it will get rid of this burden. Who knows, maybe a new system will emerge and we will find a solution, just like in 1929…
Best Regards and Wishes