Role of Securitized Lending and Shadow Banking in the 2008 Financial Crisis

THE ROLE OF SECURITISED LENDING AND SHADOW BANKING IN THE 2008 FINANCIAL CRISIS
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An economic crash has significant effects because its impacts extend beyond the financial sector. It harms both the economy and its citizens. One lesson of the 2008 scandal was that shadow banking outside the conventional banking system poses a risk to the financial instability of a country (Huang, 2018). The failure of several shadow financial institutions aggravated the crisis, such as the insurance company American International Group, investment bank Lehman Brothers, and the General Electric Capital finance company. Shadow banks fuelled the global financial crisis by developing subprime mortgages, organising them into Mortgage-Backed Securities (MBS), and distributing them in the financial market (Nijs, 2020). In essence, "too big to fail" is a perceived problem that could lead to systemic risks regarding complex financial bonds, regardless of traditional or shadow financial institutions. This write-up will explore the global financial crisis, shadow banking concerning the 2008 financial crisis, the collapse of AIG, and the failure of the Lehman Brothers. The paper will also discuss securitised banking and the repo market. Lastly, the write-up will explore the FBS recommendations and the responses to curb the reoccurrence of a future financial crisis.
The Global Financial Crisis of 2007-2008
Since the Great Depression of 1929, the financial crisis of 2008 recorded the second most severe global economic crash. Financial institutions incurred severe damages leading to the bankruptcy of some firms, such as the Lehman Brothers, and a subsequent global crisis. The crisis resulted in other economic breakdowns, including the Icelandic financial crisis of 2008-2011 and the 2009 European debt crisis (Gilreath, 2017). While the causes of the global economic crash are not clear, the main contribution was the crush of the U.S. housing bubble and the subsequent turmoil resulting from missed payments and the repurchase of mortgages by investors. According to the Financial Crisis Inquiry Commission report, the crisis was avoidable were it not for various factors that came into play (Cecchetti, 2018). They include inconsistent action and ill preparation of crucial policymakers and government regarding the financial system, deregulation of credit default swaps, widespread failures in financial regulation and supervision, and systemic breakdown in ethics and accountability.
Other factors include the collapsing mortgage securitising pipeline and mortgage lending standards, failures of credit agencies to correctly price risks, dramatic failures of risk management and corporate governance, and a combination of risky investment, risky borrowing, and lack of transparency. Securitisation contributed to the growth of subprime mortgage lending. Banks came together, took thousands of subprime mortgages, and sold them in capital markets as securities to pension and hedge funds (Hament, 2009). The securities consisted of Mortgage-backed bonds that entitled the purchasers to a share of principal payments and interest on the loan borrowed. In this essence, selling MBSs was considered a creative way for investors and banks to increase their liquidity and reduce their exposure to risky loans.
In mid-2006, house prices peaked, coinciding with the increasing supply of newly built housing with readily available mortgage loans. In this regard, as house prices deteriorated due to the economic market rates, the number of creditors who failed to pay their Mortgage loans increased. On the other hand, in 2007, a crisis in the financial system emerged whereby some investors and lenders incurred mass losses because they could not sell their repossessed assets with prices below the loan balance of the borrower's missed payments (Gilreath, 2017). In this case, investors who had purchased the subprime mortgage-backed securities incurred losses because their prices deteriorated, eventually reducing their net worth value. In turn, the investors who had purchased the securities with short-term loans could not repay these loans, which further declined subprime mortgage-backed securities prices.
After the onset of the crisis, the Federal Reserve deployed massive bailouts to prevent the collapse of financial institutions. Many banks incurred significant global losses, relying on government support to cash them out, as seen with the AIG. Also, millions lost their jobs as the significant economy experience deep recessions. Additionally, investors began pulling their money from banks worldwide because they did not know how exposed their firms were to subprime and other loans and who might be next to fail. Consequently, the financial markets became dysfunctional, businesses became less willing to invest, and households were scared of spending due to the collapse.
Congress approved the Dodd-Frank Wall Street Reform Act to allow the Federal Reserve to reduce banks to manageable sizes for those firms that become too big to fail (Gilreath, 2017). The Act also prevented banks from taking on too much risk, resulting in a fire sale of assets and later bankruptcy. On the other hand, today, banks keep expanding and are taking little regard for the regulation, posing a risk to future financial stability. In this essence, the global crisis proved that banks operating without government insight could create another economic crisis. Additionally, securitisation and repo markets have incorporated other institutions outside the financial sector, whereby the state should enact more robust policies for these derivatives to prevent further systemic risks.
Shadow Banks and the 2008 Financial Crisis
According to FSB, shadow banking is a financial system characterised by the intermediation of credit activities and entities outside the traditional banking system. The shadow banking system transforms debt into safe money claims through securitisation (Subramanian, 2013). The production of short-term liquid assets in securitisation is similar to traditional banking roles of liquidity transformation and credit maturity. Conversely, shadow banking takes several steps in the balance sheet as a form of risk transfer. The first step is the transfer of credit risks by converting the money-like assets into safe long-term security and equity. Secondly, shadow banks sell the credited long-term security to short-term money markets. In this case, short-term investments reflect the transfer of maturity risks (Claessens et al., 2012). Thirdly, the mature short-term acquisition is made liquid by the transfer of liquidity risks.
Banking is a fragile enterprise offering long-term liquid assets through investments such as loans and short-term liabilities like deposits. The banks utilise borrowing to fund their acquisitions. They also leave a trim level of equity to absorb the potential losses during borrowing and financing the assets. On the other hand, the economic model of maturity and liquidity transformation is vulnerable to fire-sale when creditors run when they withdraw their investments to other institutions (Subramanian, 2013). In this essence, if short-term creditors fail to pay their existing debts, the bank is forced to sell its illiquid assets to generate quick cash to cater to other creditors' demands at fire-sale prices. By doing this, the sale erodes the bank's equity asset levels by increasing the probability of more creditors running, which drives the firm towards bankruptcy (Holmstrom, 2015). In this case, the fall of the financial institution affects the economy by negatively influencing business investment and credit supply to households which in the long run stresses business investment and consumer spending.
Before the global financial crisis, regulations on complex financial institutions were light without specific limitations. These banks lacked liquidity rules, supervision, risk management requirements, capital requirements, and other laws to minimise the risk of the economy's fragility (Ivashina & Scharfstein, 2010). Unlike traditional banking systems, shadow banking can perform various financial functions, such as providing credit to households and businesses, managing risks, and offering payment services. Additionally, shadow banks engage in maturity and liquidity transformation by offering short-term money claims, which puts these firms at risk. They can also deploy substantial leverage by engaging in extensive financial activities against the Act enforced by Congress. Conversely, before the crisis, safeguards and regulatory scrutiny applied to the traditional banking system were not embraced by shadow financial institutions like finance companies, asset management firms, hedge funds, insurance companies, and investment banks (Hament, 2009). In this case, the primary focus of shadow banking concentrated on policyholder protection, consumer, and investor but not financial stability.
Shadow banks also contributed to the global crisis when creditors ran from the banking sector to other financial institutions, similar to traditional depositor runs (Subramanian, 2013). The complexity of assets, leverage, interconnectedness with other financial firms, susceptibility to bank runs, and reliance on short-time funding made some shadow banks susceptible to failure. Nonbanks such as mortgage lenders and investment banks were at the centre of securitisation that distributed systemic risk of MBS bonds throughout the global economy (Huang, 2018). In advanced economies, economic intermediaries had significant investments in illiquid assets. They could not run even when highly leveraged creditors drew a large number of funds to avoid the aftermath of the crisis. It led the shadow banks to fire sale assets which intensified the financial crisis by spreading stress to traditional banking and reducing asset values. Therefore, the financial crisis made it clear that risky shadow banking activities can harm the global economy by destabilising the financial system.
The Collapse of American International Group
Between 2000-2007, AIG increased its assets from 300 billion to 1 trillion dollars. The firm actively participated in capital markets whereby, before the crisis, it operated in more than one hundred and thirty countries. Like other financial institutions, the state regulators were responsible for AIG, who did not have the expertise nor resources to foresee the clash (Cecchetti, 2018). Its financial products involved writing Credit Default Swaps that protected consumers from security default on MBSs. Its activities involved writing credit default swabs that were not regulated by the state because they were not licensed. Moreover, the risks of insuring MBSs bonds were complex compared to those covered by the traditional banking system.
In this case, AIG indulged in extreme risk-taking in the financial markets because the Credit Default Swaps enabled borrowers of MBSs to hedge their risks and provide a platform they could bet. In this regard, if the mortgages remained healthy, the firm could gain profits through premiums it received after writing the swaps. Additionally, when the MBS market started to deteriorate, so did AIG's financial assets through fire sales (Claessens et al., 2012). Therefore, the company sought ways to begin paying out on the swaps. It also had to incur additional collateral against the products' low market rates, resulting in further losses. AIG also suffered other losses from its MBS lending business. It lent out the bonds in its shadow banking balance sheet in exchange for quick cash from the borrowers. Instead of investing money from the borrowers in safe short-term assets, it invested it in illiquid high risky MBS bonds and high-risk investments.
Investing the collateral money in illiquid MBS bonds made its assets lose value once the housing market collapsed. AIG resorted to firing sales to generate cash, for it had incurred losses. In this regard, its position in the market sector worsened as more security borrowers closed out their position creating a creditor-like run to the AIG. In September 2008, the firm failed and transmitted stress to its counterparts through the global financial markets (Gilreath, 2017). On the other hand, the international insurance firm was too complex and extensive to fail but eventually, the under-regulated shadow bank threatened financial stability in America. The Federal Reserve Board stepped into the bankruptcy crisis and provided financial incentives by bailing AIG using 182 billion dollars of taxpayer assistance. Therefore, AIG's extreme risk-taking using MBS bonds brought up financial losses regarding capital markets, banking, and the global real estate crisis.
The Failure of Lehman Brothers
Before the government bailed out AIG, Lehman Brothers filed for bankruptcy which sparked creditors to run through massive withdrawal of investments within short notice. The Lehman Brothers financial firm is similar to the tradi...