Financial Contagion and the Global Financial Crisis Pt. 1

Instead Of Soiling Nappies And Doing Other Baby Things, I Should’ve Shorted The U.S. Housing Market.

T. J. Ellis

THE GLOBAL FINANCIAL CRISIS – A PAIN FELT BY MILLIONS, BUT CAPITALISED BY THE VERY FEW. After recently watching a movie called The Big Short and coincidentally studying for the Economics Preliminary Exam, the GFC, and the implications of financial contagion as a result of accelerated globalisation mobilised by technological development and TNCs started to itch the back of my brain, posing a big question: how did we end up here? After several hours of intense investigation into the catalysts of what is known as the ‘worst financial crisis since the Great Depression’, I’ve come up with a few reasons as to why the world entered a state of financial and economic shock. 

Reason 1: Corruption within the U.S. Credit Rating Agencies

Whilst taking in the masterful rendition of the GFC as depicted in The Big Short, one significant issue was blatantly clear, as ForeFront partners stormed into the office of a manager at one of the big three credit rating agencies in the U.S. 

So what is a credit rating agency, you might ask? 

Well, a credit rating agency, as defined by the Council of Foreign Relations, refers to a financial institution established to provide investors with an informed analysis of the risk associated with debt securities, such as government bonds, corporate bonds, certificates of deposits, and collateralised securities (remember this – will be discussed later). These agencies determine the risk attached to the investment in said securities by calculating the likelihood that the debt issuer (a corporation, sovereign nation, or government) fails to repay timely interest payments to creditors on the debt it has acquired. 

Ratings range from AAA, being the highest rating a security could acquire, all the way down to a BB, being the lowest. These credit rating scores are typically attached to an associated FICO (Fair Isaac Corporation) score, ranging from 300 to 850. As exemplified by the tyranny induced by these credit rating agencies, the rating that debt securities pose to investors strongly influences the perception of the creditworthiness of the investment. For example, if garbage securities were given an A, AA, or AAA rating by a credit agency through corruption (will be mentioned further on), investors by nature, will purchase these securities and will expect almost guaranteed returns on their investments. 

Now, onto the fun part – corruption. The big three credit rating agencies in the US, Standard & Poor’s, Moody’s and Fitch Ratings, were criticised for their unreliable credit calculation models, whereby critics stated that these agencies ‘failed to account for a decline in housing prices and its effect on loan defaults … and for the greater systematic risk attached with structured and compounded products’. Whilst this may seem like the big beast behind the foppery of the credit rating agencies, a much bigger, darker and scarier beast looms in the shadows, being corruption. Large banks, such as Morgan Stanley, Goldman Sachs and Merrill Lynch, were accused of paying these credit rating agencies to boost credit ratings attached to garbage securities, known as CDOs. If credit rating agencies failed to accept the offerings of these banks to increase ratings, then they would just turn to other rating agencies which were more willing to accept. So the corruption that took place within Wall Street was inevitable, and was mostly driven by an unregulated and lucrative financial market, which aimed to generate as much wealth for the tippy top of the Wall Street pyramid. 

Reason 2: Collateralised Debt Obligations (CDOs)

Explained by chef Anthony Bourdain using the analogy of seafood, the CDO, which led to the GFC, refers to an investment security which essentially grabs unsold BBB components of the mortgage bond and collates them with other, usually garbage securities into a completely new form of security, known as a Collateralised Debt Obligation. More formally, it refers to a structured finance product that is backed by a pool of loans and other assets which have failed to sell, and its worth is derived from the value of the unsold securities compiled into the CDO.

 

The CDO is then repackaged by the level of associated risk into what is known as tranches, or discrete classes based on the level of credit risk assumed by the potential investor. Now, how did CDOs lead to one of the largest financial recessions in human history? Well, the CDOs offered by banks such as Goldman, Merrill Lynch, etc. were backed by subprime mortgage, which was adjustable in its interest, and were ultimately designed to fail (a mortgage that is issued to borrowers with low credit ratings, and didn’t require proof of income = risky). Investors believed that house prices would continue to rise, allowing for the collection of near infinite wealth and returns. However, this was not the case. As house prices fell, the value of the subprime mortgage backed CDOs plummeted, with subprime borrowers owning homes valued less than what they owed on their mortgage.