Gryphon writer, Sagar Kar, explores the factors which led to the financial downturn and whether we have learned our lessons from the past economic crisis, or not.
It has been a decade since the 2008 financial crisis that economists now call “The Great Recession”. However, what was it that led to the biggest financial crisis since the Great Depression?
While there are numerous factors, most economists in the US agree that it began as a result of the mortgage bubble bursting. Banks like Lehman Brothers were earning a large profit by offering subprime mortgages and lending to borrowers with poor credit, unable to repay the money that they had borrowed. Despite this, former Lehman Chief Financial Officer, Brad Hintz, is reported to have said that “no one anticipated a crash”. The banks were offering subprime home mortgages, in other words, mortgages were being offered to high-risk families, who most likely would not be able to repay them because of their low income. The general rule is to ‘offer loans to people who would be able to repay it’. So why were the banks offering loans knowing that they may not be repaid?
The Community Reinvestment Act is the answer: a federal regulation which makes it easy for low-income families to get home loans. From an economic perspective, this law means that subprime borrowers will still be granted loans even if they may not be able to repay them. Because of this law, the banks went ahead with it. In his book Big Debt Crisis, Ray Dalio states that
“the general belief amongst the banking giants was, ‘who doesn’t repay their mortgage?’”
Despite the fact that most people who were offered loans were working class citizens living in the suburbs of America, this financial crisis spread to the centre of finance in New York because of the fragile nature of the banking industry. Adam Tooze, a professor at Columbia University, has since explained that “classically we think of them [banks] as funded by deposits, but banks like Lehman don’t have deposits, what they do is borrow deposits from other banks.” At the time of the financial crisis, investors then invested in bonds supported by subprime mortgages and immediately began to withdraw their investments as defaults on repayments began. According to Adam Tooze, this is when banks stop lending and “credit simply freezes, [as] a modern economy can’t function without credit for even more than a couple of hours.”
10 years on, one may ask, have we learnt our lessons? On the one hand, many people in banking who promoted subprime lending aren’t continuing their jobs anymore, but despite this, a significant number of them now work at the US Department of Treasury instead. Furthermore, at the beginning of the recession in 2008, more than 1.5 million students graduated in the US and stepped right into the recession, directly competing with people that were made redundant who possessed a degree as well as 10 years of practical experience. Many students decided that going back to university was the only option. But how did they pay for the degree? Students loan and more debt is the answer.
Because of this, the National Student Debt in the US has grown to $1.5 trillion. If someone were to ask whether this figure was too dangerous, the most likely answer you would receive would be, ‘well, who doesn’t repay their student loan’.