10 Years of US Financial Crisis

The bankruptcy of investment bank Lehman Brothers on September 15, 2008, is considered the seminal moment in the global financial crisis.

But an event two months earlier deserves mention. On July 13, government-sponsored mortgage finance companies Freddie Mac and Fannie May got a big boost from the US Federal Reserve, which said it would lend more to the entities, in a bid to calm the markets that were already roiling, AFP reported.

Banks had already stopped lending to each other due to fears of potential losses on high-risk US mortgages. The July 13 move was the government’s attempt to prop up the two providers of liquidity to financial institutions. The entities then owned or guaranteed almost half of all US home loans, at the core of the crisis.

  How the Crisis Began

Led by a booming housing market since the mid-1990s, mortgage lenders in the US started handing out home loans like free candies—almost every passing person got one. Lenders did not even mind “subprime” borrowers—those who do not earn enough to afford a home loan. These borrowers were charged a nominal rate initially. This drove up housing prices. Subprime loans were hardly a phenomenon before the turn of the century.

The mortgage lenders wanted more money to lend to homebuyers, so they sold their existing loans to banks and to Freddie Mac and Fannie May, which in turn sold these to investment banks.

The investment banks combined these loans with hundreds of others into what are known as collateralized debt obligations, or CDOs, and sold these to investors worldwide as mortgage-backed securities.

The returns depended on monthly payments on the loans. CDO issuance hit $634 billion in 2007. Credit rating agencies called these sound investments, when they were not. No surprise there, as the investment banks were their clients.

  Credit Default Swaps

This is where another infamous term from the crisis comes in: credit default swaps. Insurance companies used these instruments to cover investors’ losses if homebuyers defaulted on loans. No one expected the party to wind down and so there were no worries.

Housing prices started falling in 2006 and homebuyers began defaulting on their loans, which meant insurance companies couldn’t honor all their credit default swaps.

Investment banks and investors were left holding the can. Governments on either side of the Atlantic had to step in and throw a lifeline to these errant institutions.

  Big Worries Remain

While the world economy has recovered from the crisis and the Dow Jones Industrial Average has risen nearly four times since its 12-year low in March 2009, big worries still remain:

- S&P, Fitch and Moody’s are still dominant players, earning more than $9 out of every $10 in the credit-rating industry

- Top 10 commercial banks still account for more than half of the assets held by 100 largest commercial banks, similar to a decade ago

- Some complex derivative instruments vilified during the crisis are back in demand. For instance, synthetic CDOs, which invest in CDSs, were expected to quadruple to $100 billion in 2017 from 2015

- US President Donald Trump wants to dismantle the Dodd-Frank Wall Street Reform and Consumer Protection Act, a key law passed in 2010 to tighten financial regulation in the aftermath of the crisis.

  Bank Clients Worried

Clients of giant US banks are increasingly nervous about growing trade tensions, but are not yet significantly curtailing business activity due to the uncertainty, banks have said, after reporting mixed earnings.

JPMorgan Chase chief executive Jamie Dimon cautioned Friday that “there are unpredictable outcomes when you start skirmishes like this with multiple countries.”

“It’s a worry,” he told reporters in a conference call, but “I don’t know if I’d use the word ‘major’ yet.”

Citigroup chief financial officer John Gerspach agreed with his counterparts that the concerns are not yet driving business decisions. “When you get into this kind of rhetoric, it does impact sentiment,” he said. “It’s going to slow down decision making in some cases, but that hasn’t translated yet into anything we’ve seen.”

  Bank Earnings Rise

The comments came as the two major US banks reported earnings that easily topped analyst expectations, in contrast to slumping Wells Fargo which badly underperformed forecasts.

However, a series of trade battles launched by Trump against key trading partners, including China and the European Union, have clouded the overall business outlook.

Another worry particular to bank stocks is whether the benefits from higher federal reserve interest rates are ebbing. Higher interest rates boost bank profits by allowing them to charge more for loans. However, as rates continue to rise, banks also must pay more to depositors.

A note from S&P Global credit analyst Brendan Browne this week warned that the gains for banks from higher interest rates “are likely to diminish, because we expect deposit rates to rise more materially over the next year.”

Banks will need to sweeten the incentives for depositors to compete with improved rates for certificates of deposit and money market mutual funds, Browne said in an interview.

JPMorgan, the biggest US bank by assets, reported an 18.3% surge in net income compared to the year-ago period to $8.3 billion. Revenues came in at $28.4 billion, up 6.5%.

Highlights included increases in net interest income following two fed rate hikes this year, and a rise in overall loans compared with the year-ago period, a sign of strengthening economic conditions.