The global financial crisis 2007–2009

What you will learn

• How US mortgage losses spread through securitisation to banks around the world, including in Germany
• Why high leverage and short-term funding made banks fragile
• The key dates from the first fund freezes in 2007 to the market low in March 2009
• What happened to an all-equity portfolio compared with a mixed portfolio

Explanation

Drawdown and recovery maths are covered in the risk-management course; here they are applied to a real crisis.

From home loans to securities

A subprime mortgage is a home loan to a borrower with weak credit history or low income relative to the loan. In the US housing boom of the early 2000s, many such loans were made with low starting rates that rose after two or three years.

Banks did not keep most loans. Through securitisation, thousands of loans were pooled and sold as a mortgage-backed security (MBS): a bond paid from the borrowers' monthly payments. Parts of several MBS were then repackaged into a collateralised debt obligation (CDO), split into layers called tranches. Senior tranches were paid first and often received top credit ratings. The ratings assumed that house prices would not fall everywhere at the same time. When prices did fall across the country, defaults rose together and many "safe" tranches lost value.

Leverage and short-term funding

Leverage here means assets divided by equity (the owners' own capital). With leverage of 30, a fall of about 3.3% in asset value wipes out all equity. Many large investment banks were in this range.

Banks also financed long-term assets with very short-term money, for example repurchase agreements (repo): loans for one day or a few weeks secured by bonds. This is a maturity mismatch. When lenders doubted the collateral, they refused to roll over the loans. This was a bank run, but by professional lenders rather than savers.

Timeline

Central banks cut interest rates sharply and lent to banks against collateral. Governments guaranteed deposits and injected capital into banks. The recession that followed was the deepest since the 1930s in many countries.

Lessons for private investors

• A credit rating is an opinion about default risk, not a guarantee of price stability or liquidity.
• Risks that look independent can fall together when one common factor (here: national house prices) turns.
• High-quality government bonds and cash held their value much better than shares, corporate bonds and bank shares.
• Recovery took years: the S&P 500 only passed its 2007 closing high again in 2013, and investors who sold near the low missed that recovery.

Worked example

Hypothetical example: two investors each hold €100,000 at the 2007 peak. Investor A holds 100% equities. Investor B holds 60% equities and 40% high-quality government bonds. Assumptions, round numbers for illustration: equities fall 55% to the low, the bonds gain 10% over the same period. Fees, taxes, dividends and currency effects are excluded.

1. Investor A: €100,000 × (1 − 0.55) = €45,000. Loss −55%.
2. Investor B, equities: €60,000 × 0.45 = €27,000.
3. Investor B, bonds: €40,000 × 1.10 = €44,000.
4. Investor B, total: €27,000 + €44,000 = €71,000. Loss −29%.
5. Gain needed to return to €100,000: A needs €100,000 ÷ €45,000 − 1 = +122%; B needs €100,000 ÷ €71,000 − 1 = +41%.

The mixed portfolio still lost money, but the loss was small enough to recover in a realistic time and, just as important, small enough to sit through without panic selling.

Common mistake

Practice activity

On paper: a hypothetical bank has €200 billion of assets and €8 billion of equity. (1) Calculate its leverage. (2) What percentage fall in asset value wipes out the equity? (3) Assets fall by 2.5%. Calculate the loss, the remaining equity and the new leverage.

Key takeaways

• The crisis spread because mortgage risk was packaged, rated as safe and held with very high leverage.
• Short-term funding turned doubts about collateral into a run on banks.
• A mix of equities and high-quality bonds reduced the drawdown from −55% to −29% in the example.
• The deeper the loss, the larger the gain needed to recover, so limiting the drawdown matters more than catching the low.

Next step

In the next lesson you will see how the financial crisis turned into a debt crisis for euro-area governments, with Greece at its centre.