Great Recession of 2008 (draft)

WHERE
This crisis started in the US and spread to Europe. The whole world were affected but less so than those 2 regions.

WHY
Monetary expansion (by way of increase of credit or debt esp. in US and Europe) in early/mid 2000s caused bubbles to develop in various markets (like stock, housing, commodities) all over the world.

As prices of everything rose, more and more people used borrowed money to invest and profit from rising prices.

By 2007, shares in US and Europe for example were trading at PE of 20. Average US house prices ($230K) were more than 4 times median household income ($50K).

The US and European countries had huge amounts of private and public sector debts that were more than 200% of their countries' GDP. The UK is the worst with total debt of more than 500% GDP (85% government but 800% banks and private sector)!

Those governments used private consumption financed by debts as a way to keep their economies 'growing' but those growth were not from production.

Note: Since the start of 'modern' fractional banking system about 100 years ago, debt can be created almost unlimitedly. That is why there were so many crises in the past 100 years (one every 10 years or so).

WHAT HAPPENED

World Wide
From 1990s onwards, outsourcing and shifting of factories to lower cost countries (like China which was just admitted into WTO) reduced the number of jobs available in the US and Europe.

In addition, global economy slowed/shrank as a result of the bursting of the Internet Bubble in 2001-02. To re-inflate their economies, those governments increased public spending financed by government borrowings and lowered the cost of money to encourage their people and businesses to borrow money to spend and invest.

But because most of their productive industries had already moved out or had been decimated over the decades before that, there were fewer real investment options in the western countries. As a result, the increasing borrowings were directed into their housing and financial markets which went up in value and created the illusion of wealth.

In reality, they created ponzi-like bubbles that later burst. People who borrowed early on in the cycle made a lot of money but those that joined in late suffered huge losses.

Government debt growth were also aided by global banking 'regulations' (developed by the same governments) that encouraged banks to make loans to governments. Basel II regulations, for example, did not require banks to reserve capital for holdings of OECD government bonds because of the assumption they were 'risk-free'!


US
From 2002 onwards, their Federal Reserve lent money out at very low rates and as a result there were more money available than real business to invest them in.

(Note: the terrible state of their economy may be a reason behind 'Sept 11' where the World Trade Center buildings that house a lot of bank offices were 'attacked' and a 3rd building (Building 7) that housed many government offices from CIA, DOD to SEC were 'taken down'. Documents of those bodies including thousands of SEC cases were destroyed in Building 7. Their subsequent attack of Afghanistan and Iraq were to re-stimulate the economy - by increasing spending and employment in defense sector - and to control world oil)

Some people said the other reason for so much money floating around was because foreign governments with trade surplus were 'lending' them back to the US government (by buying US treasuries). But foreign countries had so much USD because the US were printing them to buy things from foreigners in the first place. Foreigners' fault were to stupidly accept them thinking that those USD will 'keep its value'.

Banks looking for borrowers then gave easy loans to people to buy houses. The government aided by passing new laws to promote house ownership with the idea that with people rushing to buy houses, rising prices will increase consumer 'wealth' and people will spend more thus supporting the economy. That started a bubble where rising house prices enticed more and more people (including those that cannot afford it known as 'sub-prime borrowers') to jump into the housing market in the hope of making easy money. It worked till 2006 when house prices peaked.

In 2007 the housing bubble burst & house prices fell causing US banks to start collapsing in 2008 because house owners stopped servicing and repaying their loans (many loan terms allowed people to get out by just returning the house keys without further penalty). The US government stepped in to arrange for other 'more healthier' banks to buy up the small ones like Countrywide, WaMu, Bear Stearns etc. and to help mortgage holders 'restructure' their loans to try and stop people from defaulting and abandoning their houses/loans (and thus making the problem worse).

Initially, they tried to say that it was just a 'sub-prime crisis' i.e. only people who had never been able to afford the loans that were defaulting.

But the problem worsened and the US government had to bail out the bigger 'too big to fail' banks like Citibank, BOA, etc too firstly by buying the mortgage backed securities (MBS, backed by those bad housing loans) from those banks and then outright cash injection in return for share (e.g. Citibank).

In October 2008, the Fed refused to bail out Lehman Brothers and the bankruptcy of that bank triggered a huge liquidity problem in the banking system where huge amounts were withdrawn from banks (bank run) and banks refused to lend to each other for fear of being caught by another bankrupting bank.

The 'sub-prime crisis' had morphed to 'housing loan crisis' and then 'bank solvency crisis' and after that 'liquidity crisis'. Basically, all hell broke loose!

The housing bubble and banking collapse brought on a collapse of wealth and consumption thus affecting the whole economy and businesses started retrenching people to cut costs etc. Unemployment rate jumped to 10-20% depending on which measure/source is used.

Companies like GE, GM etc were also given government bailout money. Some critics called it 'iron rice bowl for the capitalists'.

To promote consumption to re-inflate the economy the government even subsidised car purchases ('Cash for Clunkers' programme). In Q4 2011, car purchases jumped 50% because of easy loans. The country just moved from easy loans to buy houses to easy loans to buy cars (car sales is 20% of total US retail sales). 45% of borrowers were 'sub-prime' (again)!

With shrinking tax from abandoned houses (housing tax is quite high in US), high unemployment and collapsing economy, municipal, state and central government revenues collapsed resulting in their inability to service their already high public debts. Again, their Fed stepped in to 'bail out'.

They were bailing out everyone but in doing that the government had effectively transferred all the bad debts previously held by banks and companies into the 'country's books' meaning the whole country (instead of bank and company shareholders) ended up having to pay for those bad debts.

All those crises above had morphed into 'sovereign debt crisis'.

The bailing out of mortgage holders, banks, companies and state/municpal/central governments by the Federal Reserve caused the US central government debt level and the country's money base (and balance sheet) to soar. The already high US federal debt increased by $4-5T (from $9T to $14.5T) and money base grew from 800B in 2008 to 2.4T in 2012.

In addition, most of the adjustable rate or ARM housing loans (esp. those by subprime borrowers) which were issued during the boom with 'teaser rates' were due for interest rate resets starting around 2010 through 2012. To pre-empt further collapse of the housing market and banks' loan books the US government actively suppressed interest rates to lighten loan servicing costs, and the Fed even announced they will keep rates low till 2014! Banks were allowed to do away with marking-to-market their bad MBS holdings to hide their loses.

To deflect world attention from the US 'refinancing problem', their media tried to focus on talks of a 'double dip' and debt problems in EU countries (like the PIIGS) as a way to spook people to stay away from stock markets and keep their money in cash and 'safe haven bonds' (meaning US bonds) which in effect reduces their borrowing cost. As result, in 2009 and 2010 I heard many people talking/advising others to 'keep cash'.

The bail out money and low interest rates in effect is 'money printing' and caused holders of US bonds like China to express concerns about the US Dollar's value, and Brazil to raise concerns of 'currency wars' (where governments compete to devalue their currencies to gain competitive advantage).

2009: US Fed started paying interest on 'excess reserves' banks put with US Fed. This allows US banks to earn interests from banks' excess cash. Bank excess cash comes from:
 - 'loan loss reserves' (for bad loans)
 - cash they cannot lend out due to lack of demand by people deleveraging
 - cash from selling sub-prime assets to US Fed
2010 Q2-Q3: reports of US banks increasing substantially their interest rate swap (IRS) books to support low US bond interest rates and illusion of demand for US bonds and 'flight to US safety'.

2011 Q2: reports of US Fed selling put options on US bonds to support price of those bonds and keep interest rates low.


Rest of the World

In Europe and elsewhere in the world, similar housing bubbles appeared about the same time as the US housing bubble because other governments also expanded credit and money supply to 'match' the US as part of keeping their currencies from appreciating too much against USD.

In addition, the introduction of Euro in 2001 lowered cost of debt for less competitive European countries (like Portugal, Italy, Ireland, Greece and Spain) which encouraged them to borrow more.

So when the US housing bubble collapsed, the same thing happened elsewhere to varying degrees. The government responses were also very similar all round the world - bank bail outs, reduction in interest rates, subsidies to promote consumption etc.

Europe's public debts were like the US. In addition, their banks were holding a lot of the US mortgage backed securities (MBS) 'backed' by US housing loans! (a sort of double whammy). Some of those MBS were also sold to other parts of the world.

Others in the world bought those US MBS because they were rated 'AAA' by rating agencies paid to do the rating by US banks that packaged them! In addition, all the 3 top rating agencies (S&P, Fitch, Moody's) were American! See how stupid the world is?

The first country to 'fall' was Iceland. Next was Ireland and then Greece. The top topic of the 'next one to go' was the weak PIIGS countries using the Euro: Portugal, Ireland, Italy, Creece and Spain.

See separate writeup on 'Eurozone Crisis' - Europe has similar problem of over indebtedness by government and private sector as US and UK but are undertaking slightly different solutions due to their 'lack of fiscal union' and refusal to solve problem by 'money printing'.
http://cckplanetblog.blogspot.com/2012/05/eurozone-crisis.html