The Financial Greed

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1 The Financial Greed Cristopher Lucero 1234- Finance 315-01 Doctor Seung Hee Choi February 23, 2023  Interest rates allowed for an increase of leverage to be taken out and consumed by Financial Institutions  The Dot.com bubble burst allowed for fear to circulate amongst federal procedures (such as the lowering of interest rates); caused investors to want to invest into something more reliable (such as the housing market); and caused individuals to want to attain more of a secure lifestyle (such as owning a home)  Greed had a huge part to play in the 2008 Financial crises, especially when CDOs were established along with Sub-Prime Mortgagees

Figure 2 Figure 1 2 A dream for many individuals around the world is to own a place that they can call their own- a home- and for the beginning part of the 2000s, especially in the United States, those dreams were turning into a reality. As depicted by S&P/Case- Shiller, the U.S National Home Price Index was at 100 during January for the year 2000 (a number that was climbing up quickly) (as demonstrated in Figure 1) 1 . This price index continued raising up until it hit a high of 184 during July 2006 (as demonstrated in Figure 2) 2 . In essence, what this price index represents is the change in value of the U.S residential housing market through the tracking of purchases prices of single-family homes. Thus, through this index alone we can see that at this time there was a demand for houses that was greatly being fulfilled by the individual living within the United States. From these statics, we can see no issue. However, what was occurring behind the screen was that there was a housing bubble, which started in 2000 and caused a catastrophic burst during the year 2006; causing a financial crisis that started in 2007 and finished around 2009. The subprime mortgage crisis is one of the terms used for the housing tragedy that occurred from 2007-2009. As stated by Brian Duignan, the financial crisis can best be defined as a “severe contraction of liquidity in global financial markets that originated in the United States 1 S&P/Case-Shiller studied the U.S National Home Prices Index from year 1988 till 2022 which focuses on data from January 2000. From S&P/Case-Shiller U.S National Home Price Index ( https://fred.stlouisfed.org/series/CSUSHPINSA ) in 2023, S&P Dow Jones Indices LLC, Copyrighted 2022. 2 S&P/Case-Shiller studied the U.S National Home Prices Index from year 1988 till 2022 which focuses on data from July 2006. From S&P/Case-Shiller U.S National Home Price Index ( https://fred.stlouisfed.org/series/CSUSHPINSA ) in 2023, S&P Dow Jones Indices LLC, Copyrighted 2022.

Figure 3 3 as a result of the collapse of the U.S. housing market . It threatened to destroy the international financial system; caused the failure (or near-failure) of several major investment and commercial banks , mortgage lenders, insurance companies, and savings and loan associations ; and precipitated the Great Recession (2007–09)” (Duignan, B. 2019) The question, which is still debated amongst many economist and the general public, is (1) what caused for this perfect storm to develop and (2) where did the financial systems and government regulations go wrong? From my perspective, I believe that this crisis was aided by the interest rates that was being promoted by the Federal Reserve at the time and the scare that the dot.com bubble burst caused. Said interest rates and scare, allowed for investors and financial systems to take out large sums of leverage in order to invest back into something that they believed to be reliable, such as the housing market. Topics for which I am going to introduce, expand on, and defend with data in association to the claim just made is (1) Interest levels at the time and how it promoted a desire for greed and (2) the formation of CDOs, which necessarily was not a bad idea up until greed, once again, took control of peoples decisions. First, to start off, a brief history as to what was the dot.com bubble and how the burst encouraged interest rates to plumet in order for the economy to “recover.” As mentioned in Investopedia the dot.com bubble was the rise of internet-based companies; As stated by Patrice Williams “The value of equity markets grew exponentially during this period, with the technology-dominated Nasdaq index rising from under 1,000 to more than 5,000 between the years 1995 and 2000.” (Hayes, A. 2022). However, as good as this may sound, things started to change and the bubble burst between

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4 2000-2002. Consequently, this allowed for the Federal Reserve to become worried about the potential future, regarding the economy of the United States; ultimately causing the Federal reserve to lower interest rates from 4.4% (Jan 2001) to 1.25% (Dec 2002) (as demonstrated in Figure 3) 3 . Furthermore, the reason for this, as described by Taylor Tepper, was because even though the dot-com recession lasted until November 2001, the Federal Reserve was worried that the economic recovery was anemic, with consumer confidence hitting nine-years lows. (Tepper, T. 2023) As I have explained what dot.com burst was and how that correlated with the decision made by the Federal Reserve to lower interest rates, I am now going to explain how these interest rates gave a pathway for greed to be developed amongst financial institutions. As explained by J.B Maverick, “lower interest rates make borrowing cheaper; allowing for people to spend and invest more freely.” (Maverick, J.B. 2021). Thus, as described by The Crisis of Credit Visualized- HD, because interest rates were low- investors found it more favorable to take out larger amounts of leverage in order to receive a greater return and possibly make up for the loss that they encounter during the dot.com burst. As a result, these Financial Institutions planned on purchasing mortgages from Mortgage lenders, which they would then compile into Collateralized Debt Obligations (CDO) in order to sell it to other investors to make a profit. To simplify the relation CDOs had with the 2008 financial crises, I have made a chart which illustrates the relationship between the common people, financial systems, and large institutions. (Figure 4) 3 Macrotrends shows the Federal Funds Rate from 1954 until 2023. From Federal Funds Rate - 62 Year Historical Chart ( https://www.macrotrends.net/2015/fed-funds-rate-historical-chart ) By Federal Funds, 1954, updated 2023.

5 4 The 2008 Crises Mind Map chart, listed under “The Common People” (in a green box), displays the system in which an individual would go about in order to secure a mortgage. In the middle of the chart, it displays the financial systems and how they’re goal was to use their 4 This chart “2008 Financial Crisis Mind Map” shows a timeline of events that occurred leading up to the 2008 Financial Crisis. This chart was adapted from multiple articles. It was adapted from What Is a Credit Default Swap (CDS), and How Does It Work? ( https://www.investopedia.com/terms/c/creditdefaultswap.asp ) By Hayes, A. 2022, Investopedia. It was also adapted from The Crisis of Credit Visualized- HD ( https://www.youtube.com/watch? v=bx_LWm6_6tA&ab_channel=graphixmdp ) By Jarvis J. 2011. Moreover, it was adapted from Were Collateralized Debt Obligations Responsible for the Financial Crisis? ( https://www.investopedia.com/ask/answers/032315/were- collateralized-debt-obligations-cdo-responsible-2008-financial-crisis.asp ) By Silver, C. Attkisson, A. Gould, H. and more. 2022, Investopedia. Furthermore, it was adapted from Collateralized Debt Obligation ( https://corporatefinanceinstitute.com/resources/fixed-income/collateralized-debt-obligation-cdo/ ) By CFI team, CFI, 2022. Additionally, it was adapted from Were Collateralized Debt Obligations Responsible for the Financial Crisis? By Silver, C. Attkisson, A. Gould, H. and more. 2022, Investopedia. Finally, it was adapted from What Is a Credit Default Swap (CDS), and How Does It Work? ( https://www.investopedia.com/terms/c/creditdefaultswap.asp ) By Hayes, A. 2022, Investopedia.

6 leverage, acquired through the federal reserve, in order to purchase mortgages from mortgage providers. This, in essence, would then allow these financial systems (banks) to categorize these mortgages into CDOs. As described by Andy Smith, a CDO is like a box which receives monthly deposits (in payment form) from individuals who are paying their mortgages. However, these CDOs would be divided into three trenches, representing different risk levels. The first level (Trench 1) would be considered the safest and made out of mortgages from which mortgagees would have great credit score, good source of income, etc.; Thus, the investors who bought these CDOs received lower returns due to the safety aspect promised of said CDOs. The second level (Trench 2) was considered medium risk for the reason that the mortgagees related to said mortgages had lower credit scores in comparison to that of Trench 1 CDOs. Therefore, the investors who bought Trench 2 CDOs received higher interest returns for their investment than Trench level 1 investors, as it was a riskier CDO investment. Finally, Trench Level 3 was considered high risk, because most of these mortgagees did not have good credit and have previously defaulted on previous loans. The benefit for the investors who chose to go with Trench 3 CDOs was that they would receive a higher return of investment greater than what Trench level 1 or 2 would receive. Finally, all of these CDOs would be furthered insured by Credit Default Swap, which essentially was the seller of the CDOs ensuring the buyer of said CDOs against some reference asset defaulting. Moreover, as I have explained what a CDO is and how it works, this decision by financial systems to categorize mortgages into groups is not what essentially caused the 2008 Financial crises. As said before, it was the greed of said financial system that caused it. At the peak of the housing bubble financial systems were receiving a lot of demand from investors who were eager

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7 to buy CDOs however, there weren’t enough mortgages to keep buying from the mortgages lenders as all mortgagees who were considered prime mortgages where already given out. In other words, there were not any other individuals, in the United States, that would effectively qualify for a mortgage under the requirements needed to be considered a Prime Mortgage. This resulted in a theory, which at the time for financial systems made sense. Said theory was, since the house market value keeps going up and since these financial systems are covered if the homeowner defaults, lenders can than start adding risk. This, caused a cycle of issues to occur, beginning with the mortgage broker. The mortgage broker no longer did due diligence, meaning that they no longer required a down payment, proof of income, etc. Ultimately, causing mortgage lenders to grant out loans to individuals who were considered way above risky. In order to compensate for this, they created a new classification called Sub-Prime mortgage, which simply meant less responsible mortgagees. If this wasn’t already bad enough, financial systems purchased these mortgages and pilled them up with other CDO levels, such as Level 1s and 2s, and called them CDOs cubed, which normally should have decreased the value of said CDOs into level 3 trenches because of the risk factor. However, because of deregulations and misinformed government individuals these financial systems were able to get these CDOs graded as level 1 Trippel AAA Trenches. Thus, as these homeowners, who in reality couldn’t afford to be homeowners, defaulted, said CDOs turned into a foreclosure home which went back into the real-estate market for sell. Ultimately, as an increase of defaults came in, a large sum of houses went back onto the market that caused the housing market value to go down as there was too much supply and very low demand. Consequently, making various banks go broke, causing unemployment rates to skyrocket, and increasing the homeless population.

8 All in all, the American dream has always been to purchase and own a home; financial institutions took advantage of said dream. Moreover, I introduced, expanded on, and defended topics with data to prove how financial systems took advantage of said dreams. They took advantage through (1) the Interest levels at the time and how it promoted a desire for greed and (2) the formation of CDOs along with the effect that Sub-Prime mortgages caused through the trickling effect. As an immigrant who desires to own and buy a home for his parents, researching this topic was really sad and difficult; specially to see how greed can cause people who are supposed to have the best interest of others to turn a blind eye. As Nikki Giovanni states “Mistakes are a fact of life. It is the response to error that counts.” In other words, all people even those who are in high-end government positions can make mistakes that cost people’s livelihoods. Therefore, we must not allow companies to take advantage of us anymore, lets become more educated about financial resources.

9 References Duignan, B. (2019). Financial crisis of 2007–08 . Encyclopædia Britannica. Retrieved February 25, 2023, from https://www.britannica.com/event/financial-crisis-of-2007-2008 Federal Reserve Bank of San Francisco. (2002, January 1). Why did the Federal Reserve System lower the federal funds and discount rates below 2 percent in 2001? San Francisco Fed. Retrieved February 25, 2023, from https://www.frbsf.org/education/publications/doctor- econ/2002/january/federal-funds-discount-rate-2001/ Geier, B. (2015, March 12). Tech stocks and the 2000 dotcom bust: 15 years of wall street lessons . Time. Retrieved February 25, 2023, from https://time.com/3741681/2000-dotcom- stock-bust/ Hayes, A. (2022, July 18). What ever happened to the dotcom bubble? Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/terms/d/dotcom-bubble.asp Hayes, A. (2023, January 10). What is a credit default swap (CDS), and how does it work? Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/terms/c/creditdefaultswap.asp Jarvis, J. (2011, January 22). The crisis of credit visualized - HD . YouTube. Retrieved February 25, 2023, from https://www.youtube.com/watch? v=bx_LWm6_6tA&ab_channel=graphixmdp Kasoff, S. (2022, May 10). Inside the CDO market that catalyzed the financial crisis . Yale Insights. Retrieved February 25, 2023, from https://insights.som.yale.edu/insights/inside- the-cdo-market-that-catalyzed-the-financial-crisis Kenton, W. (2023, February 15). Financial crisis: Definition, causes, and examples . Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/terms/f/financial-crisis.asp Liberto, D. (2022, July 8). What is The case-shiller u.s. national home price nsa index? Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/terms/s/sp_case_shiller_us_nhpi.asp Maverick, J. B. (2021, September 27). How do interest rates change spending habits in the economy? Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/ask/answers/071715/how-do-changes-interest-rates-affect- spending-habits-economy.asp Nolen, J. (n.d.). Key events of the crisis . Encyclopædia Britannica. Retrieved February 25, 2023, from https://www.britannica.com/event/financial-crisis-of-2007-2008/Key-events-of-the- crisis

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10 S&P/case-shiller U.S. national home price index . FRED. (2023, January 31). Retrieved February 25, 2023, from https://fred.stlouisfed.org/series/CSUSHPINSA Team, C. F. I. (2022, December 22). Collateralized debt obligation (CDO) . Corporate Finance Institute. Retrieved February 25, 2023, from https://corporatefinanceinstitute.com/resources/fixed-income/collateralized-debt- obligation-cdo/ Team, T. I. (2022, July 14). Were collateralized debt obligations (CDO) responsible for the 2008 financial crisis? Investopedia. Retrieved February 25, 2023, from https://www.investopedia.com/ask/answers/032315/were-collateralized-debt-obligations- cdo-responsible-2008-financial-crisis.asp Tepper, T. (2023, February 1). Federal Funds Rate history 1990 to 2023 . Forbes. Retrieved February 25, 2023, from https://www.forbes.com/advisor/investing/fed-funds-rate-history)