Banking system
The global savings glut is not a sufficient explanation for the crisis of 2008. The meltdown of the financial system raised a lot of issues about the banking system and its role in causing global economic downturn. The excessive risk-taking and constant underestimation of risks worsened the consequences of the global imbalances discussed above.
In a background of low interest rates, some economic agents, the banks especially, took excessive risks to keep high rate of returns. The easing of borrowing conditions encouraged the housing demand and created a bubble. The banks provided subprime mortgages to high-risk borrowers with weak credit or a bad credit history that do not qualify for conventional mortgages. They are called NINJA credit because borrowers had “No income, no job, no assets”. Moreover, some mortgage credit contracts had a low interest rate initially to make them attractive, but the interest rates increased over the repayment period. The securitization developed to transfer these risks from the lender to the investors on the financial markets. Due to a rise of interest rates and a reduction of housing prices, payment defaults started exploding in 2007.
Due to a lack of regulation, banks affected monetary policies with anarchic and unlimited money creation through loans provided to ordinary people and businesses. It was impossible to know the amount and the allocation of these toxic assets. The financial product bundling consists of a mix of low-risk assets with toxic assets in order to sell them easily. After numerous seizure of property, uncertainties raised on the financial markets and between the banks in particular, provoking a liquidity crunch. There was no secondary market for some securities, that is why some financial institutions were forced to reevaluate financial assets and recorded huge write-off debts. The credit market collapsed and triggered a domino effects leading to bankruptcies of a large number of companies.
Following these bankruptcies, the government was obliged to intervene to save the jeopardized system. According to Paul Krugman5, the intervention was needed even though it would cause in the future more “moral hazard”, which is a “situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly”. The financial institutions made risky loans without considering the potential losses because they knew they were “too big to fail”. If their investments turned badly, they would be bailed out by the taxpayers so the there is a privatization of profits and a socialization of losses. The faulty compensation system encouraged the employees (asset managers) to focus on short-term benefits without thinking of the long-term value of such loans.
The rating agencies aggravated the crisis because they were pro-cyclical. They produced self-fulfilling prophecies on the financial market and false assumptions behind securitization. Due to the underestimation of risk level for mortgages pools, the demand for these assets with AAA ratings was significantly higher. Moreover, the agencies earned more money for grading complex products than for bonds. In the centre of the system lied a conflict of interest because the agencies were paid by the companies that create the complex securities.