How the financial crisis of 2008 started? The global financial crisis of 2008, or sometimes called The Great Depression, started by the extraordinary drop in short-term interest rates which was caused by a variety of reasons: 1- In 1990, Central banks were increasingly adopting inflation targeting policies which resulted in Taylor rules, are a model for forecasting interest rates that recommends how central banks should adjust interest rates to account for inflation and other economic factors. 2- The fall of the Soviet Union and the subsequent opening of the Chinese economy have affected positively the labor supply which led to decreasing labor wages as well as decreasing prices. Furthermore, basic advancements in the IT industry increased productivity in a variety of industries, reducing the overall pressure on price rise which resulted in declining interest rate. 3- Unemployment continued to rise. Low interest rate pushed down the cost of wholesale funding, and inexpensive wholesale funding has been a major element in the expansion in credit supply. The increase in wholesale funding has rendered the financial sector as a whole more fragile. A huge capital inflow goes from Asia to US which has an indirect impact on the US mortgage market. The majority of this money was put in government bonds which led to decreasing long term interest rates. Lower government bonds yield resulted in a crowding-out effect, as additional investors hurried to the securitized bond market, the most important market for allocating capital to the US mortgage market, in search of greater yields so the demand for mortgages increase which encouraged producing risky assets on a grand scale. Household debt and non-performing loan rates are greater in regions with higher levels of inequality, and inequality has been associated to increases in household debt more broadly as those people took out loans to finance unsustainable expenditure or housing. The contribution of the market for securitized bonds in the crisis: The interaction between regulatory capital and leverage ratios, as well as the equity of the credit-creating institution, limits a financial system's credit-creating potential. Increasing the banking sector's equity, of course, enhances its ability to create credit. When banks sell credit-based assets, they can reinvest a certain amount of capital in the credit-creation process multiple times before repaying any of the created debts. Banks gather loans into tradable securities like securitized bonds and sell them. prior to the crisis, banks depended more on trading income ,coming from securitized bond brokerage, and less on interest income ,coming from the interest rate differential between loans and deposits. This approach allowed the banking sector to meet the increased demand for loan creation in the United States without a corresponding increase in overall equity. Before the crisis, firms had a structural increase in their liquidity preference, which boosted institutional cash holdings. As a result, institutional investors' cash reserves increased significantly, and they began to invest more in the securitized bond market. The securitized bond holdings of US-based mutual funds and insurance firms alone surged fourfold from 1998 to 2007, reaching about USD 2 trillion. There were some investment regulations that prevent institutional investors from directly exposure to mortgages so they found another way for channeling their funds into the securitized bond market (and thus ultimately into the US housing market) which is the rapidly expanding shadow banking sector. Shadow banks use money markets to increase short-term funds, which they then use to purchase assets with longer maturities. However, because they are not regulated like banks, they are unable to borrow from the Federal Reserve (the US central bank) in an emergency and do not have traditional depositors whose funds are covered by insurance; they operate in the "shadows." While many money market funds participate in government bonds, the vast majority invest in commercial market paper and agency debt, which must be recognized as safe and hence have a significant connection to the mortgage market. Money market funds sell shares to investors in order to fund their investments and ensure that they will be returned at least at face value The role of credit rating agencies: Credit rating agencies had previously focused on single-name company finance. However, in the run-up to the crisis, they began to evaluate securitized bonds as well, using the same rating process that they did for corporate bonds (i.e. AAA, etc.) Most securitized bonds included assumptions about the joint probability of default, in addition to the probability of default of the individual underlying loans, which, of course, has a bigger potential for errors. These factors modified the information value of the ratings, causing an almost automatic shift in investor behavior, in this case encouraging them to take greater risks. To summarize, institutional investors' direct and indirect exposure to securitized bonds expanded significantly before the crisis, owing to products that involved term transformation, such as money market funds and commercial market paper. The backstop of deposit insurance and a lender of last resort did not cover this term transformation. Deposit insurance was replaced by securitized bonds which were far from perfection. At the peak of the crisis, it became evident that securitized bonds did not provide the needed protection against risks, and as confidence in the securitized bond market weakened, the entire market was smashed by capital flight and here The Great Depression occurred. Reference: Ramskogler,p. (2015).Tracing the origins of the financial crisis. OECD Journal.
