Analysis: 15 years after Lehman, have we learnt the lessons? | Latest News India - Hindustan Times

Analysis: 15 years after Lehman, have we learnt the lessons?

Sep 15, 2023 01:34 PM IST

The Subprime mortgage crisis, which sparked the 2008 crisis, refers to subprime borrowers of home loans. Some borrowers were labelled “Subprime” because of their risky creditworthiness

Fifteen years ago today, a dire financial crisis triggered by the implosion of the Lehman Brothers in the US shook the world. Soon after, countries became focused on banking, liquidity standards and financial regulations, asleep at the wheels as they were when the Subprime mortgage crisis rippled around the globe.

Collapse of Lehman Brothers took place in 2008 (Representative Photo)
Collapse of Lehman Brothers took place in 2008 (Representative Photo)

Back in the 1970s, EF Schumacher, a professor of economics at Columbia University, wrote a bestselling classic, “Small is Beautiful, A Study of Economics as if People Mattered”. As the subtitle implies, Schumacher argued the biggest problems in the economy largely arose out of not caring much about the average person who earns, borrows, saves and invests, four critical economic activities around which everything revolves.

Schumacher argues that financial regulations should ultimately be primed to save the average person, which would in turn save an economy’s aggregate investments.

Most economists act on the impulse of solving ‘larger macro problems’ to benefit society at large. But policymaking fundamentally relies on a cost-benefit analysis, and the fixes they come up with purport to solve problems of the economy, not of the people.

Last year’s Economics Nobel Prize went to former Federal Reserve chair Ben Bernanke and two other US-based economists for their research into responses to the financial crisis, building on lessons from the Great Depression of the 1930s.

Bernanke shared the laurel with Douglas W. Diamond and Philip Dybvig, whose research shows “why avoiding bank collapses is vital”, according to the prize’s citation.

The debate on how well these policies worked is a valid one. Of the trio, Bernanke was the most high-profile winner. As Fed chair, Bernanke put into practice his own work in the 1980s on the financial crisis to deal with a real-world situation- the 2008 meltdown led by the Subprime mortgage crisis.

He funnelled hundreds of billions of dollars worth of bailouts for banks, essentially a form of economic stimulus known as quantitative easing. His policies, according to his supporters, prevented the 2008 recession from assuming proportions of the Great Depression.

On the other hand, critics argue that the Bernanke-led Fed was out of depth, as it failed to see the subprime crisis coming because it had too much faith in the markets to self-correct.

The Subprime mortgage crisis, which sparked the 2008 crisis, refers to Subprime borrowers of home loans. Some borrowers were labelled “Subprime” because of their risky creditworthiness. Yet, a hyper-speculative housing boom meant loans continued to flow to them.

Banks became greedy. Having exhausted credit-worthy borrowers, they began targeting working-class borrowers with sweeteners, overlooking their inability to repay. Slow and steady returns weren’t always preferred. Not satisfied with EMIs, these banks began selling their loan assets to investment bankers for quick money. This process is called securitisation.

Investment bankers created bundled products called mortgage-backed securities (MBS), typically bought by pension funds. In these transactions, it is the assurance that changes hands, not the actual cash.

They turned illiquid assets into liquid ones. MBSes were then traded as engineered financial products called collateralised debt obligations (CDOs), which were at the root of the subprime crisis. CDOs are basically a collection of debts.

CDOs became so popular that people bought highly-rated CDOs from a secondary market and went to banks, using the CDOs as upfront payments to get home loans. Lowering of interest rates after the dotcom bust triggered a collapse, as returns on CDOs plunged rapidly in a chain reaction that became a full-blown crisis.

How did the Subprime crisis in the US turn into a sovereign debt crisis in Europe? It all had to do with the interest-rate differential.

The nominal interest rate in the US was 0%, while in Europe, it was 4%. Investors in CDOs began investing in Europe, which offered a higher interest rate, especially in southern European nations with a construction boom.

Investors were sanguine about the fact that the European sovereign bank was the guarantor of their debts, but the Subprime crisis ultimately cut off money supply to European markets, where housing prices fell.

Bernanke missed the signs of the subprime crisis. But he kept credit creation going by bailing out the large US banks, which ultimately did lead to a recovery. Yet, the 2008 crisis was driven by the Fed’s uncritical faith in the banking system’s ability to self-correct.

The critical question, 15 years later, is whether we have learnt our lessons sufficiently tightened oversight enough, and placed alarm bells in the global financial system that will go off automatically at the slightest hint of trouble.

Clearly, there is more to be done. Currently, the US is in the course of trying to implement a new set of Basel III rules, but this has triggered a furious resistance from Wall Street, including from bankers such as David Solomon of Goldman Sachs.

While banking regulations have been tightened considerably, scrutiny of non-banking financial institutions remains far too lax. The game has gotten bigger, but there are too few umpires.

A new International Monetary Fund paper states the funds have been warning that financial supervisory systems in most Western countries are still weak. (Good Supervision: Lessons From The Field)

When we had a mini global crisis this year with the Silicon Valley Bank collapse, the sirens went ignored. The San Francisco Federal Reserve was again sleeping at the wheel.

This was quickly followed by the Credit Suisse meltdown. The Swiss regulators were sanguine to the fact that the bank had not violated any of the vast capital and liquidity rules. Regulators must collectively up their game.

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