Derivatives
Financial derivatives, such as mortgage-backed securities, allowed financial institutions to spread the risk of subprime mortgages throughout the global financial system by packaging and selling them to other investors. These securities were created by pooling together thousands of individual mortgages, and then selling shares in the pool to investors.
The problem was that these securities were often rated as safe investments by rating agencies, even though they were based on risky mortgages.
Ratings agencies like Moody’s played a significant role in the Financial Crisis of 2008 by giving high ratings to mortgage-backed securities that were based on subprime mortgages. These securities were often rated as AAA, indicating that they were considered to be as safe as US Treasury bonds, even though they were based on risky mortgages. This high rating allowed these securities to be sold to a wide range of investors, including pension funds, insurance companies, and other institutional investors, who were looking for safe investments. Because of the high rating, many investors believed that these securities were a safe investment and bought them without fully understanding the risks involved.
However, as the housing market began to decline and many of these risky mortgages defaulted, the value of these securities also dropped, causing widespread losses for investors.
It was later revealed that the rating agencies had conflicts of interest, as they were paid by the financial institutions issuing the securities, which may have led them to be less rigorous in their evaluations. They also lacked the capacity and expertise to properly assess the risks associated with these securities. As a result, many people believe that the high ratings given to these securities by the rating agencies contributed to the Financial Crisis of 2008 by giving investors a false sense of security and allowing risky securities to be sold to a wide range of investors. As a result, when the housing market began to decline and many of these risky mortgages defaulted, the value of the securities based on them also dropped, causing widespread losses for investors and contributing to the failure of many financial institutions. The use of derivatives also made it difficult for regulators to track and assess the risk in the financial system, exacerbating the crisis.
“Too Big to Fail”
The first major banks to suffer from the financial crisis of 2008 were Bear Stearns and Lehman Brothers. Bear Stearns, a large investment bank, was the first major financial institution to suffer significant losses as a result of the subprime mortgage market in 2007. The Federal Reserve arranged for JPMorgan Chase to purchase Bear Stearns with government assistance in March 2008, to prevent a failure that could have led to a domino effect on the financial system.
Lehman Brothers, another large investment bank, was the next to suffer significant losses from the subprime mortgage market. The bank had significant exposure to mortgage-backed securities, and as housing prices began to decline and defaults increased, the value of these securities dropped, causing Lehman Brothers to suffer huge losses. The bank was unable to find a buyer and filed for bankruptcy on September 15, 2008.
Lehman Brothers’ bankruptcy was a pivotal event in the financial crisis, as it caused a panic in the markets, leading to a freeze in the credit markets, and a sharp drop in the value of stocks around the world. This event also led to the US government’s interventions and the implementation of many rescue packages to stabilize the financial system. Other large banks, such as AIG, Fannie Mae, Freddie Mac, Washington Mutual, and Wachovia, also required government assistance or were acquired by other banks to prevent their collapse during the financial crisis.