Credit Crisis of 2008 – 09 &

Failure of US Banks

Submitted To: Prof. P. K. Seth

Submitted By: Abhishek Laddha

Enrollment No: 09BS 000 0081

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Introduction
This report seeks to identify the multitude of events leading upto the Credit Crisis in 2008, as
without understanding them we cannot learn how to avoid another one in the future.

First we understand some of the terms we hear whenever we have a discussion on the said
topic. Next, we try to identify the commonalities between the Credit Crisis of 2008 and the
previous crises and the foundations thereof. What became the immediate trigger to the crisis?
And, ultimately the aftermath of the Crisis.

An Overview:
Investment Banks, Commercial Banks & Universal Banks

Commercial banking and investment banking have historically been separated. Commercial
banks accepted customer deposits and made loans to businesses and consumers. This was
considered a safe and stable business with relatively low profit margins. Investment banks
helped raise money for companies and governments through stock or bond sales, advised
companies on mergers and acquisitions, and traded securities for customers or their own
accounts. These activities were considered riskier than commercial banking, but profit
margins were higher.

This separation between commercial and investment banking began during the Great
Depression. Previously, individual firms were allowed to conduct both investment banking
and commercial banking operations. However, as part of a plan to reform the financial
system, the Glass-Steagall Act separated investment banking firms from commercial banking
firms. While commercial banking firms grew to be much larger companies, investment banks
became the companies most closely identified with Wall Street. Firms such as Goldman
Sachs, Lehman Brothers, Merrill Lynch, Salomon Brothers and Morgan Stanley eventually
became the most prestigious investment banks on Wall Street.

In the 1980s and 1990s, many firms began to merge as the globalization of financial markets
and increasing capital requirements prompted the creation of increasingly larger companies.
This trend culminated in 1999 with passage of the Gramm-Leach-Bliley Act, which
essentially reversed the Glass-Steagall Act. By allowing commercial and investment banking
operations to once again occur within the same firm, the Gramm- Leach-Bliley Act facilitated
the creation of the so-called "universal bank". Universal banks such as Citigroup, JPMorgan,
Barclays and UBS combined commercial and investment banking and use their massive
balance sheets to under price the traditional investment banks. By the onset of the credit
crisis, the investment banking "bulge bracket" included not only traditional investment banks
such as Goldman Sachs and Morgan Stanley, but also universal banks like Citigroup, UBS
and JPMorgan.
The Ascent of Risk

In the not-too-distant past, the bulk of investment banks' business consisted of advising
corporations on mergers and acquisitions, raising capital for companies and governments, and
facilitating stock or bond trades for their customers. Over time, though, the profitability of
these activities began to decline as the investment banks faced increasing competition from
emerging universal banks.

Seeking higher profits, investment banks such as Goldman Sachs increasingly turned to
riskier activities such as principal trading and investing to generate the bulk of their profits.
Principal trading and investing occurs when a firm uses its own capital to invest in the
markets in hopes of generating profits. During good times, these activities can be
phenomenally profitable, and many firms posted record profits in the years leading up to the
credit crisis. However, principal trading and investing also exposed Wall Street firms to much
higher risk.

While investment banks were increasing the amount of risk that they took in their principal
trading, they were also becoming increasingly dependent on complicated derivatives and
securitized products. The complicated nature of these products allowed firms with an
expertise in them to generate large profits. However, derivatives and securitized products are
also difficult to value; these difficulties would eventually result in many firms having much
higher levels of risk exposure than they had intended.

What Is a Financial Crisis?

A financial crisis is often preceded by a bubble. A bubble occurs when many investors are
attracted to a market sector, usually due to attractive fundamentals. Speculators then rush to
this newest hot market, searching for quick profits and driving prices even higher. At some
point, the amount of money flowing to the market increases to the point that valuations are no
longer supported by attractive fundamentals, signaling the end of a bull market and the
beginning of a bubble. Although many market participants may realize that valuations are
stretched, greed drives them to bid prices ever higher.

When enough market participants eventually realize that valuations are not supported by the
fundamentals, the market begins to decline. As prices fall, more and more investors rush to
sell. This wave of selling quickly escalates, driving prices even lower. As this downward
spiral continues, fear replaces greed, and market participants stop making rational decisions
and instead rush to sell their holdings at whatever price they can get. Profits made over the
course of many years can turn into losses in a frighteningly short time. A sufficiently bad
downward spiral is commonly referred to as a crisis.
Commonalities between 2008 Credit Crisis & Previous Crises

In addition to the emotions of greed and fear, a review of the historical record shows that
several factors have been present at the onset of many financial crises. These factors include
an asset/liability mismatch and excessive leverage and risk. Frequently more than one factor
is present, and each factor can multiply the damage caused by one of the others.

Asset/Liability Mismatch –

When a financial institution has a wide differential between the duration of its assets (loans or
investments) and its liabilities (depositors or creditors), it is experiencing an asset/liability
mismatch. Asset/liability mismatches are the main reason why the business model of the
standalone investment bank came into question during the 2008 credit crisis. Investment
banks are extremely dependent on short-term financing to conduct their operations. However,
the assets (investments) of the firms are longer term in nature, particularly during periods of
market illiquidity when selling is difficult. Asset/liability mismatches are part of the reason
why Bear Stearns and Lehman Brothers collapsed and Goldman Sachs and Morgan Stanley
chose to become bank holding companies.

While commercial banks also have asset/liability mismatches, their customer deposits are
seen as a relatively stable source of funding and have become the preferred method of
financial company financing.

Excessive Leverage –
Under normal circumstances, asset/liability mismatches are manageable. However, the
mismatch becomes a problem when financial institutions employ excessive leverage. While
commercial banks have traditionally employed leverage of 10-12 times their capital,
investment banks such as Bear Stearns and Lehman Brothers saw their leverage ratios
increase dramatically in the years leading up to the onset of the credit crisis. Leverage ratios
in excess of 30-times capital were not unusual for investment banks. As so often happens,
this leverage proved fatal when markets began to experience much higher volatility levels.
Excessive Risk –

Financial crises often occur when excessive risk-taking is present in the financial sector. This
may occur intentionally, such as when Savings & Loans (Small Commercial Banks) invested
in risky real estate deals in the 1980s, or unintentionally, such as when investment banks
purchased 'AAA'-rated mortgage-backed securities prior to the 2008 credit crisis. Excessive
risk, whether intentional or due to miscalculations in valuation models, has been a part of
nearly every financial crisis in history and is likely to be an important factor during future
crises as well.

Credit Crisis: Foundations

Risk

As the global savings glut contributed to extremely low interest rates in many traditional asset
classes, investors sought higher returns wherever they could find them. Asset classes such as
emerging market stocks, private equity, real estate and hedge funds became increasingly
popular. In many instances, investors also found above-average returns in staggeringly
complex fixed-income securities. 

Leverage

The use of leverage can enhance returns and does not appear to carry much additional risk
during periods of low volatility. Investors used derivatives, structured products and short-
term borrowing to control far larger positions than their asset bases would have otherwise
allowed. At the same time, consumers made increasing use of leverage in the form of easy
credit to make possible a lifestyle that would have otherwise exceeded their means. The early
parts of the decade provided a near-perfect environment for this increasing use of leverage.
Low interest rates and minimal volatility allowed investors to employ leverage to magnify
otherwise subpar returns without exposure to excessive risk levels (or so it seemed).
Consumers also found the environment conducive for increasing their use of leverage. Low
interest rates and lax lending standards facilitated the expansion of a consumer credit bubble.
In the U.S., the savings ratio dropped from nearly 8% in the 1990s to less than 1% in the
years leading up to the credit crisis.

As long as interest rates and volatility remained low and credit was easily available, there
seemed to be no end in sight to the era of leverage. But the increased use of leverage and
increasing indebtedness were placing consumers in a dangerous situation. At the same time,
higher leverage ratios and an increasing willingness to accept risk were creating a scenario in
which investors had priced financial markets for a near-perfect future.
Housing

To understand what happened in the housing market, we need to step back in time to the
aftermath of the tech bubble and stock market meltdown of 2000-02. The precipitous decline
in the stock market, combined with the accompanying recession and the terrorist attacks of
September 11, 2001, caused the Federal Reserve (the Fed) to lower the federal funds rate to
an unprecedented 1%. The economy and stock market did recover, but the slow pace of
economic expansion prompted the Fed to maintain unusually low interest rates for an
extended period of time. This sustained period of low interest rates accomplished the Fed's
objectives, but they also contributed to a huge boom in the housing market.

As housing prices soared in many areas of the country, mortgage providers offered a variety
of creative products designed to help buyers to afford more expensive homes. At the same
time, lenders relaxed underwriting standards, allowing more marginal buyers to receive
mortgages. The combination of low interest rates and easy access to credit prompted a
dramatic increase in the value of homes. Consumers have historically believed that home
prices do not decline, and that buying a home is one of the best investments they can make.
The soaring housing market reinforced these beliefs and prompted a rush among consumers
to buy a house as quickly as possible before prices rose even further. Many people also began
speculating in the housing market by purchasing homes in the hope of "flipping" them
quickly for a profit. As home prices continued to soar, the market began to take on all of the
characteristics of a classic bubble.

Securitization
Securitization describes the process of pooling financial assets and turning them into tradable
securities. The first products to be securitized were home mortgages, and these were followed
by commercial mortgages, credit card receivables, auto loans, student loans and many other
financial assets. Securitization provides several benefits to market participants and the
economy including:

Providing financial institutions with a mechanism to remove assets from their balance
sheets and increasing the available pool of capital

Lowering interest rates on loans and mortgages Increasing liquidity in a variety of

previously illiquid financial products by turning them into tradable assets
Spreading the ownership of risk and allowing for greater ability to diversify risk
In addition to its benefits, securitization has two drawbacks.

The first is that it results in lenders that do not hold the loans they make on their own
balance sheets. This "originate to distribute" business model puts less of an impetus
on lenders to ensure that borrowers can eventually repay their debts and therefore
lowers credit standards.

The second problem lies with securitization's distribution of risk among a wider
variety of investors. During normal cycles, this is one of securitization's benefits, but
during times of crisis the distribution of risk also results in more widespread losses
than otherwise would have occurred.

In the years leading up to the credit crisis, investors searching for yield often focused on
securitized products that seemed to offer an attractive combination of high yields and low
risk. As long as home prices stayed relatively stable and home owners continued to pay their
mortgages, there seemed to be little reason not to purchase 'AAA'-rated securitized products.
Credit Crisis: What Caused The Crisis?

The Housing Bubble

It's a widely held belief that home prices do not decline and it is this belief that led
generations of consumers to regard a home purchase as the foundation of their financial
programs. More recently, speculators have used this logic as part of their rationale for
purchasing homes with the intention of "flipping" them. As the rate of appreciation in home
values dramatically increased during the early years of the 21st century, many people began
to believe that not only would home values not decline, but that they would also continue to
rise indefinitely.

The belief that home prices would not decline was also fundamental to the structuring and
sale of mortgage-backed securities. Therefore, the models that investment firms used to
structure mortgage-backed securities did not adequately account for the possibility that home
prices could slide. Likewise, the ratings agencies assigned their highest rating, 'AAA', to
many mortgage-backed securities based partly on the assumption that home prices would not
fall. Investors then purchased these securities believing they were safe and that principal and
interest would be repaid in a timely fashion.

Home Prices Decline

Unfortunately, in 2008, the belief that home prices do not decline turned out to be incorrect;
home prices began to slide in 2006 and by 2008, they had declined at rates not seen since the
Great Depression.

According to Standard & Poor's, as of 2008, home prices were down 20% from their 2006
peaks, and in some hard-hit areas, that number was even higher. As prices began to decline,
homeowners who had planned to sell for a profit found themselves unable to do so. Other
homeowners found that the outstanding balance on their mortgages was greater than the
market value of their homes. This condition, known as an "upside down" mortgage, reduced
the incentive for homeowners to continue to make their mortgage payments.

One particular corner of the housing sector that experienced a dramatic bubble and
subsequent collapse was the subprime mortgage market. Subprime mortgages are issued to
households with below-average credit or income histories and are generally considered more
risky than traditional "prime" mortgages. Although they constitute a minority of the overall
market, subprime mortgages became increasingly important over the years. Many people who
took out subprime mortgages during the real estate boom did so with the hope of "flipping"
the house for a large gain; in fact, this tactic worked well when home prices were soaring.
Other subprime borrowers were lured into their mortgages by the initially low payments, but
when these "teaser" rates reset to current market rates, many homeowners could not afford
the new, much higher payments.

Trouble in the Mortgage-Backed Securities Market

As the decline in home prices accelerated, an increasing number of people found themselves
struggling to make their monthly mortgage payments. This situation eventually led to higher
levels of mortgage defaults. Many of these mortgages had been "securitized" and resold in the
marketplace. This dispersion of risk is generally a good thing, but in this instance it also
meant that potential losses from defaults were spread more widely than they otherwise might
have been. Defaults had an inordinate impact on certain bond issues. This is because in a
typical mortgage-backed security deal, any mortgage defaults initially affect only the lowest-
rated tranches. This means that even if the overall default rate for the pool of mortgages is
relatively low, the loss for a particular tranche of mortgage-backed securities could be
substantial. When the investors that hold these tranches employ leverage, losses can be even
greater.

As concerns about the housing decline grew, market participants began avoiding mortgage-
related risks. Investors became even more nervous after Bear Stearns was forced to close two
hedge funds that had suffered very large losses on mortgage-backed securities. As the size
and frequency of mortgage-related losses began to increase, liquidity started to evaporate for
many other types of securitized, fixed-income securities, leading to increasing uncertainty
about their true value.
Financial firms had previously used actual market prices in order to value their holdings, but
in the absence of trading activity, firms were forced to use computerized models to
approximate their holdings' value. As the market continued its decline, investors began to
question the accuracy of these models. The implementation of new mark-to-market
accounting rules exacerbated the situation by requiring financial firms to continually report
losses on securities, even if they did not intend to sell them. This well-intentioned rule was
implemented at precisely the wrong time and had the effect of adding fuel to afire.

The Downward Spiral

Investors soon began to question whether financial institutions knew the true extent of the
losses on their books. This uncertainty led to sharp declines in the stock prices of many
financial firms, and a growing unwillingness to bid for risky assets.

As investors attempted to sell in a market with no buyers, prices fell further. Soon, most risky
assets were dropping rapidly in price and panic began to creep into the marketplace. The
credit crisis had begun
AFTERMATH: Disappearance of Investment Banks

At the start of 2008, Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and
Bear Stearns were the five largest stand-alone investment banks. The companies had existed
for a combined total of 549 years, but within the span of six months, they would all be gone.

In March 2008, Bear Stearns teetered on the edge of bankruptcy. J.P. Morgan purchased the
bank for $10 a share, a fraction of its all-time high of $172 a share. The purchase was
facilitated by the Federal Reserve, which guaranteed a large portion of Bear's liabilities as
part of an effort to mitigate the potential impact of a Bear Stearns bankruptcy.

Following a tumultuous summer, Lehman Brothers succumbed to the credit crisis on

September 15, 2008 when it filed for the largest bankruptcy in U.S. history. The Federal
Reserve had attempted to facilitate a purchase of Lehman Brothers, but it had been unwilling
to guarantee any of the firm's liabilities. Following its bankruptcy, parts of Lehman Brothers
were purchased by Barclays PLC and Nomura Holdings

At the same time that Lehman Brothers filed for bankruptcy, Merrill Lynch was struggling
for survival. Unsure of its ability to continue as a stand-alone entity, Merrill chose to sell
itself to Bank of America, ending 90 years of independence.

The only two remaining independent investment banks were Goldman Sachs and Morgan
Stanley. These firms were the two largest and most prestigious of the investment banks. As
the credit crisis intensified, it became apparent that both of these firms were also in a struggle
for survival. With confidence in the investment banking business model evaporating,
Goldman Sachs and Morgan Stanley chose to convert to bank holding companies, thus
ending their existence as stand-alone investment banks.
While several much smaller investment banks still exist, the dramatic reshaping of the
financial landscape means that the bulge bracket of investment banking now consists entirely
of universal banks. Seventy-five years after the Glass-Steagall Act originally separated
commercial and investment banking, events have come full circle and these activities are
once again performed by the same firms.