Economic history · The 2008 Financial Crisis
Eight steps, about twelve minutes, a question at each. You need no economics and no preparation, only a willingness to guess before you are told.
American house prices had never fallen across the whole country until they did, and by 2006 much of the new lending was going to people who could not have borrowed a few years earlier.
American mortgages were gathered into pools and each pool was sold on as a bond. The slices at the top of a pool were graded triple-A, the highest grade there is, and Moody's, one of the firms paid to grade them, put that grade to 30 mortgage-related securities every working day in 2006.
The losses that followed were counted in trillions of dollars, on four different measures at four different dates. The firms holding these securities had borrowed to buy them, and the two American bodies that measured how much they had borrowed do not agree with each other.
Eight steps take it in order: how a pool became a bond, how slicing it produced safe-looking securities, who graded it, what the losses came to, how the firms were funded, the leverage disagreement, the run on collateral, and where ordinary cash met it.
What this module covers
Written for every level. Tap any underlined word for what it means, and open the boxes below for the economics behind each decision. If you already know the theory, skip both and the history reads straight through.
Step 1 of 8
A bank that lends someone the money for a house waits years to get it back. Selling the loan on meant it did not have to wait.
American mortgages were gathered into pools, and each pool was turned into a bond and sold to investors.
A bond is a promise to pay whoever holds it. Bonds built out of pools of mortgages are called mortgage securities, and whoever buys one is owed the payments the American households in that pool make.
The bank had its money back straight away once the loan was sold, and an American bank could lend it to somebody else.
Moody's, a , gave the top grade to nearly 45,000 of these mortgage securities between 2000 and 2007.
Take a guess. You are not expected to know the answers, and being wrong is what makes a number stick.
The pool has been turned into a bond and sold. Who now loses money if the mortgages in it stop being paid?
For scale. Six private-sector companies in the United States carried that same top grade in early 2010.
A pile of loans that people might never pay back is a hard thing to sell. Cutting the pile into ranked slices is how it was sold.
Each pool of mortgages was cut into ranked slices, and most of what came out of a pool of risky American mortgages was sold as low-risk securities.
Every payment the pool collects goes to the top slice first, and only what is left goes down the ranking. Losses run the other way, from the bottom upwards: the lowest slice is wiped out before the next one loses anything. An investor buys one slice and chooses which, taking a larger share of the payments in return for taking the first losses, or a smaller share in return for being paid first. The top slice is covered as long as enough of the households in the pool keep paying, which is why spreading the money across many loans was thought to make it safe.
Put it another way. Think of it like a queue at a payout window: the people at the front are paid out of whatever comes in, and only the people at the back go home with nothing when the money runs short.
The slices are s, ranked against each other. The top slice is paid first out of whatever the pool collects, and the bottom slice takes the first losses.
The top slice of a pool of risky mortgages was routinely given triple-A, the highest grade a bond can be given.
What made the top slice of a pool of risky mortgages count as low risk?
For scale. The bottom slice of a pool had to be wiped out completely before the slice above it lost anything.
Moody's put its triple-A grade on mortgage securities every working day through 2006.
Moody's was paid for each grade by whoever was selling the security, and the grade was what an investor bought on.
In 2006 Moody's gave that grade to 30 mortgage-related securities on an average working day.
The grade did the work no buyer could do alone, which was to judge thousands of separate American mortgages. The firm that wanted the grade chose who would give it and paid for it.
Of the mortgage securities Moody's rated triple-A in 2006, how many out of every hundred later had that grade taken away?
For scale. Triple-A is the highest grade there is, and it is the grade Moody's was giving here.
The bonds had been graded safe. Then the households behind them stopped paying, and somebody had to carry what was lost.
By October 2008 the losses marked against mortgage securities were being counted in trillions of dollars.
Each figure answers a different question. A mark-to-market loss is what a security would fetch today if it were sold today. A credit loss is what the loans behind it are expected to fail to pay in the end. A write-down is what a firm has already recorded as a loss in its own accounts. The three move apart when buyers want a large reward for holding something they cannot value or sell quickly. So the same crisis carries several totals: around US$2.8 trillion marked to market across three areas in October 2008, and a separate estimate in April 2009 of nearly US$4.1 trillion of write-downs on some US$58 trillion of assets, with banks bearing about two-thirds of those.
A loss marked to market prices is what an American mortgage security would fetch that day. It is not the same as what the loans behind it will fail to pay in the end.
American sub-prime mortgage securities are built out of loans to people the banks rated high risk. Their loss of market value came to around US$310 billion, and the loans behind them were expected to fail to pay around US$195 billion.
The figure is what the securities would have fetched at the prices of that month. It covers the United Kingdom, the United States and the euro area together.
Across the United Kingdom, the United States and the euro area, how much had been marked off the value of these securities by October 2008?
For scale. About US$500 billion of write-downs, which are losses a firm has already recorded, had accumulated around the world by the end of August 2008.
The American firms holding these mortgage securities had borrowed to buy them, on loans that fell due the next morning.
They borrowed in the market, putting up securities as . The five largest American investment banks trade and raise money for companies rather than taking deposits, so their lenders had no behind them.
At the end of 2007 Bear Stearns, one of those five, was renewing as much as $70 billion of borrowing every night.
The Financial Crisis Inquiry Commission, the panel Congress set up to examine the crisis, calls this a repo market of many trillions of dollars and gives it no size.
Money that has to be borrowed again every morning means the firm stays open only for as long as somebody is willing to lend it, whatever it owns.
The lenders had no government guarantee behind them. What made them willing to lend to these firms again every morning?
For scale. The inquiry commission says the lending that went on outside the banks matched the ordinary banking system for size, and publishes no figure for it.
Every firm doing this was doing it with borrowed money, and very little of their own. The question in the room was whether that mattered.
In 2007 the five largest American investment banks were carrying as much as $40 of assets for every $1 of their owners' money.
A firm's in 2007 was everything it held set against the money its owners had put in, the . Less than a 3% drop in what the assets were worth could wipe out a firm.
Goldman Sachs was one of those five. The Financial Crisis Inquiry Commission, which Congress set up to report on what had happened, puts its borrowing at 17 to 1 in 2000 and 32 to 1 by 2007.
The Financial Crisis Inquiry Commission puts Goldman Sachs at 32 to 1 for 2007, sourced to a market database and to public filings, with no formula printed beside the number. The Government Accountability Office puts it at 26.2 to 1 at the end of the firm's 2007 financial year, and names its measure: total assets divided by equity, from the firm's own annual report. It counts only the assets the firm lists, and treats them all as equally risky. Neither body explains the other. Several investment banks sold assets just before their financial year ended and bought them back after, so the date changes the answer.
Put it another way. Think of it like two people measuring the same room, one including the alcove and one not: both tapes are honest and the answers differ.
The other three were in the same place. The Government Accountability Office audits federal spending for Congress. It puts Morgan Stanley at 33.4 to 1, Merrill Lynch at 31.9 and Lehman Brothers at 30.7 at the end of their 2007 financial years.
It is 2007 and you sit on the board of one of these five firms. For every $1 of your owners' money you are carrying as much as $40 of assets, a great deal of it bonds built out of American mortgages. What do you do?
They carried on. Goldman Sachs was at 17 to 1 in 2000 and 32 to 1 by 2007 on the inquiry commission's figures, and at the end of their 2007 financial years the accountability office puts Morgan Stanley at 33.4 to 1, Merrill Lynch at 31.9 to 1 and Lehman Brothers at 30.7 to 1.
What followedEvery one of them was therefore a firm where less than a 3% fall in the value of what it held would take the whole of the owners' money. They held bonds built out of American mortgages, graded by an agency the seller paid.
Every one of these figures was on the public record while the firms were deciding, and every firm carried on. Nothing here was hidden from anybody.
The run on these securities in 2008 was not a queue of people at a bank branch: lenders demanded far more collateral for the same loan.
The gap between what a lender will lend and what the collateral is worth is the . A bigger haircut means the borrower has to find more of its own money to hold the same securities.
Prime brokers are the banks that lend to investment funds against the securities they hold. By August 2008 their haircut on bonds built out of ordinary American mortgages was 10% to 20%, against 2% to 4% in April 2007.
By August 2008, how big a haircut were lenders demanding against each of these? Put them in order, from the smallest to the biggest.
For scale. Haircuts charged by prime brokers at least doubled for every kind of bond after the crisis began, and rose by a factor of at least five for bonds built out of loans.
American s were where ordinary cash met the run, because they lend companies' and households' money on for very short periods.
People treat such a fund as somewhere to keep cash rather than as an investment. The fund lends that cash on, and a great deal of it went to banks outside the United States.
American money market funds had an estimated US$1 trillion placed with banks outside the United States by the middle of 2008.
Records for the fifteen largest of these funds show what portion of their money sat with banks outside the United States?
For scale. About 85% of that money went to European banks.
Module 2 of 7 in The 2008 Financial Crisis
The pool, turned into a bond
nearly 45,000 mortgage securities given the top grade, 2000 to 2007The slicing
the top slice paid first, the bottom slice taking the first lossesMoody's triple-A grades, 2006
30 every working day, and 83% of that year's losing the grade laterLosses marked to market prices, October 2008
around US$2.8 trillion, of which only some is directly borne by banksHow the firms holding it were funded
borrowing renewed every morning, against the securities themselvesGoldman Sachs , 2007
32 to 1 on one measure, 26.2 to 1 on another, and no reconciliationThe , April 2007 to August 2008
prime mortgage securities 2%-4% to 10%-20%, and no lending at all against the worstAmerican money market funds, mid-2008
an estimated US$1 trillion placed with banks outside the United StatesYou met nine terms in this module
, , , , , , , ,
Moody's was paid for the grade, and the funding had to be found again every morning against the securities themselves.
[1] The grades, and how little equity there was: Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report, Official Government Edition, January 2011. The figures below were read off rendered images of the printed pages, because a text extraction of this file returns the prose with every numeral silently deleted. Page xxv: "In 2006 alone, Moody's put its triple-A stamp of approval on 30 mortgage-related securities every working day", and "83% of the mortgage securities rated triple-A that year ultimately were downgraded", and "From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010." Page 211 states the daily figure a second time as "an average of more than 30 mortgage securities each and every working day". Page xix: as of 2007 the five major investment banks were operating with extraordinarily thin capital, "By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm." Pages xix to xx: "at the end of 2007, Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the overnight market." Page xx: the panel "permitted the growth of a shadow banking system-opaque and laden with short-term debt-that rivaled the size of the traditional banking system", including "the multitrillion-dollar repo lending market", and gives that market no size. Page 65: "At Goldman Sachs, leverage increased from 17:1 in 2000 to 32:1 in 2007. Morgan Stanley and Lehman increased about 67% and 22%, respectively, and both reached 40:1 by the end of 2007. Several investment banks artificially lowered leverage ratios by selling assets right before the reporting period and subsequently buying them back", and "From 2000 to 2007, large banks and thrifts generally had $16 to $22 in assets for each dollar of capital, for leverage ratios between 16:1 and 22:1." The notes to chapter 5 source the leverage figures to "SNL Financial Database and SEC public filings" and print no formula beside them.
[2] The same firms, measured a second way: United States Government Accountability Office, GAO-09-739, Financial Markets Regulation, 22 July 2009. The figures below were read at the office's own accessible full text, over four agreeing passes. Figure 6, "Ratio of Total Assets to Equity for Four Broker-Dealer Holding Companies, 1998 to 2007", from "GAO analysis of the firms' annual report data", gives for 2007: Goldman Sachs 26.2, Morgan Stanley 33.4, Lehman Brothers 30.7, Merrill Lynch 31.9. Bear Stearns is not in that table and the office publishes no assets-to-equity ratio for it at any date. Figure 4 is a separate exhibit and is the five firms IN AGGREGATE, including Bear Stearns: 22.5 in 2002 and 30.5 in 2007, which the text rounds to "from an average ratio of around 22 to 1 in 2002 to around 30 to 1 in 2007". The measure is "the ratio of total assets to equity on the balance sheet", and the office prints its own limitation: "Although commonly used as a leverage measure, the ratio of assets to equity captures only on-balance sheet assets and treats all assets as equally risky." The phrase "at fiscal year-end" is the office's own and attaches to the per-firm table.
[3] What the losses came to, and what lenders demanded: Bank of England, Financial Stability Report, Issue No. 24, October 2008. "Across the United Kingdom, the United States and euro area, these mark-to-market losses are now estimated to be around US$2.8 trillion. The eventual expected loss of economic value on these assets is expected to be lower." And: "Total mark-to-market losses across the three currency areas have risen to around US$2.8 trillion. This is equivalent to around 85% of banks' pre-crisis Tier 1 capital globally of US$3.4 trillion, though only some of these market value losses are directly borne by banks." Box 1: "Projected credit losses on US sub-prime RMBS are now larger (at around US$195 billion), but remain significantly lower than the estimated loss of market value (of around US$310 billion), consistent with investors continuing to demand substantial uncertainty and illiquidity premia." Table 5.B, "Typical haircuts applied by prime brokers", was read off a rendered image of the printed page. It sets April 2007 against August 2008: prime mortgage-backed securities 2-4 to 10-20, consumer asset-backed securities 3-5 to 50-60, and every ABS collateralised debt obligation row blank for August 2008. The text beside it: haircuts "have at least doubled for all types of fixed-income securities since the start of the financial crisis and by a factor of at least five for asset-backed securities. Prime brokers are typically not lending at all against ABS CDOs."
[4] The write-downs still expected: International Monetary Fund, IMF Survey, Further Action Needed to Reinforce Signs of Market Recovery, 21 April 2009. "potential writedowns, including about $1 trillion already taken, could be nearly $4.1 trillion on some $58 trillion of assets", and "Banks will likely bear about two-thirds of the $4.1 trillion in writedowns". The same sentence goes on to give that two-thirds a dollar value, and that figure is a different quantity from the Bank of England's total above — a projection of write-downs at April 2009 rather than losses marked to market prices at October 2008 — so it is not printed anywhere in the steps above, and neither figure is used to support the other.
[5] Where ordinary cash met it: Bank for International Settlements, 79th Annual Report, chapter II, The global financial crisis, June 2009. "Records of the mid-2008 holdings of the 15 largest prime funds, accounting for over 40% of prime funds' assets, show that these placed half of their portfolios with non-US banks (and roughly 85% of that sum with European banks). Thus, US money market fund investments in non-US banks reached an estimated $1 trillion in mid-2008 (out of total assets of over $2 trillion), more than 15% of European banks' total estimated US dollar liabilities to non-banks." The word estimated is the report's own: the figure is extrapolated from the fifteen largest funds and is not a census. The report also records "additional losses to come on top of the $500 billion or so in global writedowns that had accumulated by the end of August 2008", and its timeline entry for 19 September 2008 records the American guarantee of money market funds with no amount attached.
[6] What euro area banks absorbed: European Central Bank, Financial Stability Review, June 2009. "By end-May 2009, the accumulated portfolio losses absorbed by euro area LCBGs since the start of the turmoil had reached just over EUR100 billion, of which about EUR65 billion was reported in 2008." LCBGs are large and complex banking groups, not all euro area banks, and the preceding sentence defines the quantity as write-downs of the values of portfolios containing complex credit products as their market or economic values sank.
[7] Haircuts, surveyed independently: Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality, CGFS Papers No 36, Bank for International Settlements, March 2010. Table 1, "Typical haircut on term securities financing transactions", sits on printed page 2 and was read off a rendered image. Its source line is the study group's own survey rather than a dealer. Prime mortgage-backed securities rated AA- and A go from 8, 12 and 25 per cent in June 2007 to a full hundred per cent in June 2009, and triple-A structured products from 10, 15 and 20 per cent to the same full hundred, the three columns being prime, non-prime and unrated borrowers. The paper defines the term: "When the cash lent on repo trades is lower than the market value of the collateral security, market participants refer to the applicable discount as a haircut."
[8] The part of the market that held: Adrian, Begalle, Copeland and Martin, Repo and Securities Lending, Federal Reserve Bank of New York Staff Report No. 529, December 2011, revised February 2013. "In the bilateral market, stress manifested itself in the form of a large and rapid increase in haircuts, creating a generalized run on the market. In the tri-party repo market, haircuts barely moved but some firms experienced dramatic decreases in the amount of financing they obtained in this market." And: "This evidence suggests no generalized run on the tri-party repo market... However, it appears that Bear Stearns and Lehman Brothers did experience runs, and the loss of funding in the tri-party repo market contributed to their difficulties." Tri-party repo is settled through a clearing bank and is not the same arrangement as a trade cleared through a central counterparty.
[9] Government bonds, and what did not change: Financial Stability Board, Securities Lending and Repos, Market Overview and Financial Stability Issues, 27 April 2012. "In the bilateral inter-dealer repo market against G7 government bond collateral, market practice often does not require haircuts and CCPs in those markets have also kept haircuts stable. But haircuts on lower quality assets (e.g. ABS) did increase sharply in the inter-dealer repo and leveraged investment fund financing segments." The G7 qualification is carried here in full because the same paragraph records central counterparties raising haircuts significantly on repo of bonds issued by peripheral euro area governments, so the unqualified claim would be wrong.
Country data from the World Bank (CC BY 4.0) and the UNDP Human Development Report (CC BY 3.0 IGO)
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