This is where things begin to go awry. Banks needed to underwrite more mortgages to create more mortgage-backed securities, and since they were going to get the new mortgages off their books ASAP, the banks no longer cared whether the mortgage applicant was able to pay off their mortgage. Banks started to loan money to anyone, even those with no income, no job and no assets (known as NINJA loans). The rating agencies hired to grade the risk of the mortgage-backed securities all rated them as safe as government bonds, since they would lose the bank’s business if their report was anything but glowing. Pension funds, retail investors, foreign banks and everyone in between loaded up on mortgage-backed securities, assuming that they were investing in an asset that was as good as risk-free. The entire world had essentially bet the house that US home prices would keep on rising forever, and the regulators were asleep at the wheel.
Then the music stopped. Interest rates began to rise and tens of thousands of homeowners began to default on their mortgages. The value of the mortgages underlying the mortgage-backed securities plummeted in value, and now the biggest institutions in the world were facing losses in the hundreds of billions. The sudden collapse of investments deemed to be as safe as government bonds caused hysteria in financial markets, with banks no longer lending out money in fear that they might not be paid back. This credit crunch ground the global economy to a halt, and Lehman Brothers, a bank with $639b USD in assets, had to file for bankruptcy because it couldn’t borrow money to fund day to day operations.
So what lessons are there to learn from the GFC?