The Great Recession

Summary

This video script delves into the central theme of financial intermediation during the 2008 Great Recession. It explains the risks of high leverage in mortgages and how it contributed to financial fragility. The script also discusses the role of securitization, the shadow banking system, and the incentives that led to risky behavior by financial institutions like Lehman Brothers. It highlights the consequences of these factors, including asset devaluation, credit crunch, and economic downturn, and ponders on potential solutions and regulations enacted post-crisis.

Takeaways

• 🏠 The script discusses the Great Recession of 2008, focusing on the theme of financial intermediation and its role in the crisis.
• 💰 Homeowners were encouraged to buy properties with minimal down payments, leading to high leverage and a small protective cushion against market downturns.
• 📉 The concept of 'owner's equity' and 'leverage ratio' is introduced, highlighting the risks of high leverage when property values fall below mortgage amounts, resulting in negative equity.
• 🏦 Banks also increased their leverage, borrowing more and using less of their own cash to buy assets, which amplified the financial fragility in the economy.
• 📈 The investment bank Lehman Brothers is cited as an example of excessive leverage, which led to insolvency when asset values plummeted.
• 🤔 Excess confidence in the housing market and a lack of understanding of the potential impact of falling home prices contributed to risky investment decisions.
• 💼 Incentives for managers, such as bonuses based on profits, encouraged risk-taking, which could lead to excessive leverage and potential financial instability.
• 🔄 The process of securitization is explained, where individual mortgages are bundled and sold as financial assets, which became difficult to value and often riskier than advertised.
• 🌐 The shadow banking system, including investment banks and other financial intermediaries, is described as a significant factor in the financial crisis due to its reliance on short-term loans and lack of government guarantee.
• 📊 The complexity and risky nature of mortgage-backed securities, along with the failure of rating agencies to accurately assess risk, contributed to the crisis.
• 💔 The credit crunch that resulted from the collapse of financial intermediaries had a widespread impact on the economy, leading to business failures, layoffs, and increased unemployment.
• 🛡️ Post-crisis, regulations have been implemented to require more equity and less leverage in both shadow banking and traditional banks, though the effectiveness of these measures is still uncertain.

Q & A

What is the main theme of the video script discussing the Great Recession of 2008?

The main theme of the video script is financial intermediation and its role in the Great Recession of 2008.

What is meant by 'owner's equity' in the context of buying a home?

'Owner's equity' refers to the difference between the value of the house and the unpaid amount of the mortgage, which initially is the down payment made when purchasing the home.

How does a high leverage ratio impact the financial stability of homeowners and banks?

A high leverage ratio means there is very little room for the home's price to drop before its value is less than the unpaid mortgage amount, leading to potential insolvency for both homeowners and banks if they need to sell the asset.

What was the leverage ratio of Lehman Brothers in 2004, and how did it change by 2007?

In 2004, Lehman Brothers had a leverage ratio of about 20, which increased to as high as 44 by 2007, indicating a significant increase in their debt relative to their equity.

Why did the managers of Lehman Brothers take on such high levels of risk?

The managers of Lehman Brothers took on high levels of risk due to excess confidence in the housing market, the potential for larger profits and bonuses, and the limited personal downside they faced if things went wrong.

What is securitization, and how did it contribute to the financial crisis?

Securitization is the process of bundling individual mortgages and selling them as liquid financial assets to outside parties. It contributed to the financial crisis by creating securities that were hard to value, often riskier than advertised, and sometimes filled with high-risk loans.

What is the 'shadow banking system', and how did it play a role in the Great Recession?

The 'shadow banking system' consists of investment banks, hedge funds, issuers of asset-backed securities, money market funds, and some parts of traditional banks not covered by deposit insurance. It played a role in the Great Recession by lending more than traditional banks and being highly dependent on short-term loans and investor confidence, which led to a run when the crisis hit.

What was the impact of the housing price fall in 2007 on the financial sector?

The fall in housing prices in 2007 led to many homeowners being 'under water', causing the value of assets owned by banks, such as mortgage-backed securities, to drop. This pushed many banks closer to insolvency due to their high leverage.

What is a 'fire sale' in the context of the financial sector, and how did it exacerbate the crisis?

A 'fire sale' occurs when many financial institutions sell assets simultaneously to raise funds, causing asset prices to drop even lower and pushing more institutions toward bankruptcy, thus exacerbating the financial crisis.

What measures have been suggested or enacted to prevent a similar crisis in the future?

Some suggested measures include a government guarantee for some or all liabilities of the shadow banking system, while enacted regulations require more equity and less leverage in both shadow banking and traditional banks to create a larger financial protective cushion.

What is the current status of the effectiveness of the new regulations post-financial crisis?

The effectiveness of the new regulations is yet to be fully determined, as there has been no market turmoil comparable to the 2008 crisis to test them.

Outlines

00:00

🏠 The Impact of Financial Intermediation and Leverage on the Housing Market

This paragraph discusses the role of financial intermediation and high leverage in the lead-up to the Great Recession of 2008. It explains how homebuyers with minimal down payments had little equity, creating a fragile financial situation where a drop in home prices could lead to homeowners being 'underwater'—owing more on their mortgage than their home is worth. The concept of 'leverage ratio' is introduced to illustrate the degree of financial risk taken on by both homeowners and banks. The script uses Lehman Brothers as a case study to show how excessive leverage led to insolvency, highlighting the risks of overconfidence in the housing market and the flawed incentives that led managers to take on too much risk for potential profit.

05:02

📈 The Role of Securitization and the Shadow Banking System in Financial Fragility

The second paragraph delves into the mechanisms of securitization, where individual mortgages are bundled and sold as financial assets, indirectly funding home purchases. It points out the issues with the valuation and risk assessment of these securities, which often contained high-risk loans and were sometimes fraudulently sold or misrated by agencies. The paragraph also introduces the concept of the 'shadow banking system,' which includes investment banks and other financial intermediaries not covered by government deposit insurance, making them more susceptible to investor panic and runs. The shadow banking system's reliance on short-term loans and its growth to surpass traditional banks set the stage for a significant financial crisis when housing prices began to fall.

10:04

📉 The Financial Crisis, Asset Fire Sales, and the Broader Economic Impact

The final paragraph examines the consequences of the 2008 financial crisis, starting with the asset price decline that pushed many banks toward insolvency due to their high leverage. It describes the complexity and opacity of mortgage-backed securities, which obscured the true exposure of banks and exacerbated the crisis. The paragraph discusses the investor flight from the shadow banking system, leading to a credit crunch that affected the entire economy. It also touches on the concept of 'fire sales' where financial institutions selling assets simultaneously drove prices down, increasing the risk of bankruptcy. The economic downturn led to business failures, reduced growth, and increased unemployment. The script concludes by posing questions about potential solutions, such as government guarantees for liabilities, and the implementation of new regulations to reduce leverage and increase equity, while acknowledging the uncertainty of their effectiveness.

Keywords

💡Great Recession of 2008

The Great Recession of 2008 refers to a severe worldwide economic downturn that began in late 2007 and continued until the end of 2009. It is the most significant recession since World War II and is central to the video's theme, illustrating the consequences of financial mismanagement and high leverage. The script discusses how this crisis was precipitated by various factors, including high-risk lending practices and the collapse of the housing market.

💡Financial Intermediation

Financial intermediation is the process by which financial intermediaries, such as banks, invest funds provided by savers in financial assets. In the context of the video, it is the central theme that the script explores, particularly how the failure of financial intermediaries contributed to the 2008 crisis. The script explains how banks and other institutions facilitated risky lending practices that led to a lack of financial stability.

💡Down Payment

A down payment is the initial portion of the purchase price of a home or other large purchase that a buyer pays upfront, with the remaining amount financed through a loan. In the video, the script uses the down payment as an example to explain the concept of owner's equity and leverage, noting how lower down payments contributed to the housing market's vulnerability.

💡Owner's Equity

Owner's equity is the difference between the value of an asset and the amount still owed on its mortgage. It is a measure of the homeowner's investment in the property. The script discusses how the down payment represents initial owner's equity and how it acts as a protective cushion against market fluctuations, with lower equity increasing the risk of foreclosure.

💡Leverage Ratio

The leverage ratio is a financial measurement that compares the amount of debt a company or individual has to the equity they hold. It indicates the degree of risk in an investment or financial strategy. The video script uses the leverage ratio to illustrate the high-risk strategy adopted by both homeowners and banks, which magnified the impact of the housing market collapse.

💡Securitization

Securitization is the process of pooling financial assets and selling them as securities to investors. In the video, securitization is highlighted as a contributing factor to the financial crisis, as it allowed for the bundling and sale of risky mortgage loans, leading to a lack of transparency and understanding of the true value of these assets.

💡Shadow Banking System

The shadow banking system refers to the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but are not subject to the same regulations. The script explains how this system, including investment banks and hedge funds, played a significant role in the financial crisis by extending credit without the safety net of government insurance, leading to a rapid withdrawal of funds during the crisis.

💡Lehman Brothers

Lehman Brothers was a global financial services firm that filed for bankruptcy in 2008, which was a pivotal event in the financial crisis. The video script uses Lehman Brothers as an example of excessive leverage and risky investment practices that led to insolvency, illustrating the broader issue of financial fragility within the banking sector.

💡Incentives

In the context of the video, incentives refer to the motivations that influenced the behavior of financial managers, particularly in taking on excessive risk for the potential of higher profits and bonuses. The script discusses how these incentives may have contributed to risky lending and investment practices that ultimately led to the crisis.

💡Asset-Backed Securities

Asset-backed securities are financial securities backed by a loan, lease, or receivables against assets other than real estate. In the video, the script describes how these securities, particularly mortgage-backed securities, were bundled with high-risk loans and sold to investors, contributing to the crisis when the underlying assets lost value.

💡Credit Crunch

A credit crunch is a reduction in the general availability of loans in the economy. The video script explains how the financial intermediaries' collapse led to a credit crunch, impacting businesses that relied on credit, leading to layoffs, business failures, and increased unemployment.

Highlights

The Great Recession of 2008 is a complex topic that requires more than one video to fully examine.

Financial intermediation was a central theme of the crisis, impacting both homeowners and banks.

A typical down payment for a home was 20%, but many purchased homes with less than 20% down, increasing financial risk.

The protective cushion created by a down payment is known as 'owner's equity'.

The 'leverage ratio' is the ratio of debt to equity, indicating the amount of financial protection.

High leverage means there's very little room for home prices to drop before the homeowner is 'under water'.

When homeowners are 'under water', both they and the bank suffer financial losses.

Banks also increased their leverage, buying assets with more debt and less of their own cash.

Lehman Brothers' leverage ratio increased from 20 to 44, making it highly susceptible to asset devaluation.

Excess confidence in the housing market and risky investments contributed to the crisis.

Managers at Lehman Brothers and other firms were incentivized to take on more risk for higher profits and bonuses.

Securitization bundled individual mortgages and sold them as financial assets, increasing complexity and risk.

The shadow banking system, which includes investment banks and other intermediaries, was a significant factor in the crisis.

The shadow banking system was lending more than traditional commercial banks by 2008.

When housing prices fell, it triggered a chain reaction of asset devaluation and insolvency among banks.

The complexity of mortgage-backed securities obscured the true exposure of banks to risk.

Investors' flight to safety during the crisis led to a run on the shadow banking system, similar to the Great Depression.

The withdrawal of short-term loans from the shadow banking system caused financial institutions to sell assets, leading to a 'fire sale'.

The collapse of financial intermediaries led to a credit crunch and widespread economic damage.

Post-crisis regulations aim to reduce leverage and increase equity in banks and the shadow banking system.

The effectiveness of new regulations remains to be seen, as there has been no comparable market turmoil since their implementation.

Transcripts

♪ [music] ♪

[Tyler] A lot of ink already has been spilt

discussing the Great Recession of 2008.

And a full examination of that would require

a lot more than just one video.

So today, I'm going to limit our discussion

to just one central theme of the crisis,

namely financial intermediation.

Let's say you're buying a home that costs $100,000.

A typical down payment might have been, say, 20%,

and that would mean your mortgage was for 80% of the home value,

or $80,000.

Now in the lead up to the crisis, many homes were being purchased

with much less than 20% down -- 10% down or 5% down.

Or in a lot of cases,

nothing was put down at all -- zero down.

When you put money down on a house,

that creates a kind of protective cushion.

Now, the difference between the value of the house

and the unpaid amount of the mortgage --

that's called "owner's equity."

So now, when you first buy a house,

your down payment is your owner's equity.

Over time, as you pay down your mortgage

and if your home value goes up,

well, in those cases, your owner's equity rises

and that makes the protective cushion bigger.

The ratio of debt to equity, which represents

how much of a protective cushion is in a home or in a company --

that's called the "leverage ratio."

So, a 5% down payment on a $100,000 house

would mean you'd have $5,000 in owner's equity,

which when compared to the mortgage of $95,000,

would give you a leverage ratio of 19.

So what's the effect of high leverage?

It means there's very little room for the price on your home to drop

before the value of your house

is less than the unpaid mortgage amount.

That is, if you needed to sell the home

to pay off your mortgage,

the proceeds from the house sale would not be enough

to pay off the bank.

Being under water is clearly not good

for the individual home owner.

But very importantly, it's also not good for the bank.

In the case of foreclosure,

say the homeowner cannot keep on paying the mortgage.

Well the bank is getting a home but the home isn't worth enough.

The bank loses money because the value of the home is less

than what the bank was expecting to receive from the home owner

in the form of mortgage payments.

So again, back to the broader picture.

It wasn't just home owners who were using more leverage.

Banks were using more leverage.

They were buying assets using more debt

and less of their own cash.

So what we're doing here is stacking problems:

the problem of the home owner's leverage,

the problem of the bank leverage.

And the more problems like these you stack,

the more financial fragility you're bringing into the economy.

Now in 2004, the investment bank Lehman Brothers --

it had a leverage ratio of about 20.

But it continued to borrow more money.

And by 2007, that leverage ratio went as high as 44.

Now in that setting,

if Lehman Brothers sees its assets fall in value very quickly,

Lehman Brothers too will in essence be under water.

That is the assets of the company will be worth less

than the debt the company owes.

In other words, in that case, the company would be insolvent.

This sounds like such a terrible state of affairs.

So you have to wonder

"Why would the experienced managers

of a large firm like Lehman Brothers have been so risky?"

There are a few reasons,

but the first and most important reason

was just sheer excess confidence.

Those managers bought mortgage securities

and they made other risky investments.

But the managers, like indeed most other people,

they just didn't think

that American home prices could fall so much.

And they also didn't understand

that a fall in home prices could potentially create

so much turmoil in American capital markets.

Another key factor behind the failure was incentives.

The managers at Lehman -- they got big bonuses

based on the profits of the company.

And in some cases, this can lead managers to take on too much risk.

How does that work? Well think about it.

Bigger profits typically meant bigger bonuses.

So if you go from a leverage ratio of 20 to 44,

as Lehman Brothers did, that means you can buy

more than double the amount of assets

with the same amount of initial capital,

because you're using more debt.

That means more than double the profit

if asset prices rise as indeed they had been doing.

But what if the assets fall in value?

What if the initial risk does turn out badly?

And you have to ask when the asset prices did fall

and Lehman Brothers went bankrupt,

did the managers also personally go bankrupt?

No, they did not. They still, for the most part,

had a lot of money in their bank accounts.

So in this setting, Lehman managers had a lot to gain

if things would go well,

but they faced only limited downside

in the scenario where things would go sour.

Let's add another factor to this mix

that ended up pushing the economy

even a bit closer toward the edge of the cliff,

and that additional factor was securitization.

So how does securitization work?

Briefly, individual mortgages are bundled together

and sold to outside parties as liquid financial assets.

So rather than lending a company money directly,

as you would do with a bond, you buy a mortgage security,

and indirectly you provide money to people

who use it to buy homes.

So it turned out there were all these securities out there

which were very hard to value,

many of them were riskier than advertised,

and many of them were just bad outright,

filled with too many high-risk loans.

How is it that this happened? Well there were a few factors.

Sometimes the problem was outright fraud

in terms of how the security was sold and how it was explained.

Or sometimes it was a failure of the rating agencies,

which were supposed to assess risk more or less accurately,

but they performed poorly.

But probably the biggest single problem was again

a kind of complacency.

Most people incorrectly assumed

American housing was really quite a safe investment,

and that prices would either continue to rise,

or at the very least hold fairly stable.

One final factor set the stage and brought all of this together,

and that's what is called the shadow banking system.

So what does that mean?

Well here I need to give some terminology.

What you and I commonly would just call a bank

is actually more technically a commercial bank.

And that means a bank that takes deposits

from individuals and businesses

and it's insured by the government through the FDIC.

Because of the government guarantee,

depositors don't feel the need to run to the bank

at the first sign of trouble and pull out their money.

Now investment banks -- they're different.

Investment banks, like Lehman Brothers,

were a different kind of bank

without a comparable governmental guarantee

for deposits or liabilities.

The money they used -- it came from investors,

not from depositors.

So the investors were always asking,

"If I lend to an investment bank, are my funds safe?

Will I get my money back?"

And these investors were more watchful

and sometimes even prone to panic

if something seemed to be wrong with the investment bank.

Now the shadow banking system as a whole is made up

of investment banks

along with other complex financial intermediaries,

such as hedge funds, issuers of asset-backed securities

like the mortgage bonds discussed earlier,

money market funds,

and even some parts of traditional commercial banks,

which are not covered by the deposit insurance guarantee.

So, in that setting, by the year 2008,

the shadow banking system actually was lending considerably more

than were traditional commercial banks.

So we've got highly leveraged houses and banks,

banks and other investors holding risky mortgage securities,

and a massive shadow banking system

highly dependent on short-term loans,

which in turn were dependent on investor confidence.

This was the proverbial case of being very close to the cliff

and needing only an extra nudge to fall off.

And that nudge came in 2007

when housing prices started to fall,

causing many home owners to be under water.

This meant that the assets owned by banks,

such as mortgage-backed securities, were dropping in value.

Remember, banks were highly leveraged too.

So this fall in asset values pushed many banks closer to insolvency.

Worse yet, the complexity of investments

in mortgage-backed securities obscured how much exposure

particular banks faced.

The market started to think of virtually all banks

as really quite risky,

and this exacerbated the financial crisis.

The investors who provided the short-term loans

to fund the shadow banking system -- well, they fled to safety.

They pulled their capital away from these short-term loans

to investment banks such as Lehman Brothers,

and this run on the shadow banking system

was similar to the runs on traditional commercial banks

by depositors, as seen in America's Great Depression.

And that was a time when even bank deposits were not insured

by the government.

Without these short-term loans,

investment banks and other financial institutions --

they were starved of the money they needed to function.

They couldn't keep on making loans of their own

and so they started selling their own assets

to get operating funds just to stay up and running.

But that leads to yet another problem.

When a lot of financial institutions are all selling assets

at the same time, you end up with what's called a fire sale.

As they all sell,

that selling pushes asset prices lower -- even lower.

And those lower asset values --

that pushes even more financial institutions

closer toward bankruptcy.

So, financial intermediaries came crashing down

and this led to a credit crunch that damaged the entire economy.

In this setting, many businesses that depended on credit --

they failed or they stopped growing.

Maybe they laid off workers to conserve cash

and unemployment spiked.

So, looking back we have to ask, "What could have been done?

What should have been done?"

It's now considered a general problem

that short-term loans for the shadow banking system

can flee rapidly in times of crisis

and cause widespread financial and economic turmoil.

So what to do?

In response to this, some suggest a similar solution

to what we did for runs on traditional commercial banks,

namely a government guarantee

of some, or all, of those liabilities.

However, that's a pretty radical step.

It would put an even larger potential burden on taxpayers,

maybe trillions.

And it also doesn't fix the incentive problems

I mentioned earlier, namely that when there’s leverage,

and especially guaranteed liabilities,

the managers have an incentive to take too much risk.

It would make that problem worse.

Since the financial crisis, other regulations have been enacted

to cover the shadow banking system, and also traditional banks.

Those regulations require more equity and less leverage.

And that makes sense in terms of my earlier discussion

of needing a larger financial protective cushion.

Still, it remains to be seen

just how effective these regulations will prove.

So far there's been no market turmoil

comparable to the crisis of 2008.

So we just don't know exactly how well

the new institutions will work.

There's a lot more to cover on the Great Recession.

And if you're interested in learning more,

please just let us know.

Thanks.

[Narrator] If you want to test yourself,

click "Practice Questions."

Or, if you're ready to move on,

you can click "Go To The Next Video."

♪ [music] ♪

You can also visit MRUniversity.com

to see our entire library of videos and resources.