The Cause of 2008 Stock Market Crash

2008 Stock market crash was one of the biggest stock market crash of all times. On January 11, 2008 BSE Sensex closed at 20,827 points. But from the next trading day Sensex’s free fall started. It continued for next 13/14 months. On March 08, 2009 BSE Sensex bottomed and closed at 8,225 points.



This was one of the biggest stock market debacle of all times.

On March 08, 2009 BSE Sensex was 39% of what it was on Jan 11, 2008.

It was my first stock market bloodbath that I saw as an investor.

Earlier BSE Sensex also crashed in year 2000-2001.

Back then BSE Sensex crashed from 5,933 points (February 11, 2000) to 2600 points (September 21, 2001).

On September 21, 2001, BSE Sensex was almost 44% of what it was on Feb 11, 2000.

But, by far the 2008 stock market crash had more disastrous effect on this world than year 2001.

Did you ever thought that what caused the 2008 stock market crash?

As an investor, we must know the cause of all stock market crash. But 2008 stock market crash was special.

It was not only a stock market phenomenon, what caused the crash had deep roots into ones personal finance management.

Yes, it was the people of USA who were responsible for this mess. But there were American Banks who further made the matter worse.

If Americans were not managing their money well, it can be understood. But banks started taking advantage of this mismanagement, and the problem became huge.

The extent of the problem was so huge that it is said that America alone lost $10 Trillion USD in 2008.

This blog post is about the cause of 2008 stock market crash.

Few days back I saw a movie called The Big Short. This movie is about the 2008 stock market crash.

I heard about the movie as it was nominated for five Academy award including the “best picture”.

Basically it was this movie, that has prompted me to write this blog post abour the 2008 stock market crash.

So let me present you the some facts related to 2008 market crash and the causes that led to that disaster…

The Cause of 2008 Stock Market Crash4

#1. Corruption and Weak Economy of USA

By the time it was 2008, USA’s economy was not doing so well.

USA was involved in Iraq (since 2003) and in Afghanistan (since 2001).

For sure these wars were causing a huge hole in their reserves.

Moreover, in 2001, due to dot com bubble burst, several companies in the Silicon Valley had to close down.

This was a big set-back for the Start-ups in USA. It will not be wrong to say that what America is today is only because of the Start-ups it has produced.

But the year 2001 posted a big threat on the prospective start-ups.

So, starting from dot com bubble burst, Attack on WTC, Afghanistan War, IRAQ Invasion etc, all contributed to USA’s economy getting weaker.

By the time it was 2008, unemployment was sky high in USA.

It was common to meet people who had no jobs. They were not earning any money.

As a result, people started defaulting on their loan EMI’s payment.

The banks were also responsible as they were incessantly issuing too many bad loans.

On one side banks were issuing bad loans, and on other side unemployment was increasing.

There were cases in 2006-2008 where one individual was carrying multiple loans on one property.

To make the matter worse, people were buying multiple real estate properties without caring about their income-expense balance.

Banks were also issuing home loans to people without doing due diligence.

By the year 2008, the situation in USA was such that the whole economy of the USA was like a sitting-duck on BOOMING real estate market.

But from the inside, the economy which was already weak, became completely unstable due to bad loans.

But why bad loans are so dangerous?

Bad loans means, loss for banks. When multiple people start defaulting on their loan EMI’s, banks get severely effected.

Weaker banks means weaker economy.

This is one reason why in 2008, USA Government had to bailout several big banks like Wells Fargo, JP Morgan, Citigroup, Morgan Stanley, Goldman Sachs etc.

On one side, banks were allowed to get careless and issue bad loans.

On other other side, credit rating agencies like S&P’s were not rating the securities issued by the banks correctly.

And when things went from bad to worse in 2008, these same banks were bailed out by the government (without punishment).

When the system is so corrupt, what is the doubt that the disaster like 2008 stock market crash happened.

The Cause of 2008 Stock Market Crash3

#2. Mortgage Backed Securities (MBS)

This was the main devil.

If issuing bad loans by banks was bad, the way Mortgage Backed Securities (MBS) was packaged was a henious crime.

To allow this kind MBS mayhem to continue, I am sure it was possible only when all agencies (government, SEC, Wall Street, Lending Banks & Investment Banks) were hand in hand.

The nexus is big and hence it is complicated to understand how MBS works.

But I will try to explain MBS, and would also try to establish a link between MBS and 2008 stock market crash.

But before that, some basics, what are Mortgage Backed Securities (MBS)?

MBS is a financial instrument like Mutual Funds. People buy and sell (trade) units of MBS like they do with traditional mutual funds.

Traditional mutual funds has stocks, bonds, cash etc as their holdings.

But MBS has “home loans” as their primary holding.

Who manages MBS? Investment banks.

Who manages home loan issuance to public? Commercial banks.

Commercial banks issus home loans to people like you, and millions of other needy borrowers.

In turn, these commercial banks receives EMI’s every month from the borrower.

So, commercial banks are lenders, and we are the borrowers.

When commercial banks gets many such borrowers, they sell all those loans as a package to investment banks.

Investment banks buy those package loans with open arms. This is a big asset for investment banks.

But what makes such package-loans an ASSET?

Have you ever defaulted on your home loan? The majority answer will be NO.

If 99.9% borrowers are like you and me, the package-loan will generate a steady streams of income for banks.

The EMI’s that we pay monthly on our loans is a steady income stream for the banks. This steady income makes loans an ASSET.

But if loans are such reliable income generating assets for banks, why commercial banks sell them to investment banks?

The reason is PRICE that they get from investment banks against such package-loans.

Not only good price, commercial banks were also able to transfer all the risks associated with lending to investment banks.

After the sale, commercial banks has CASH plus zero risk. This is a deal made in heaven for commercial banks

But Investment banks buys loans just to earn EMI, and that to after paying premium price to commercial banks?

No. Investment banks use these loans to build a financial instrument called Mortgage Backed Security (MBS).

The units of this MBS (like mutual fund units) are then sold in the market by Investment banks to the public.

Here, in this sale, investment banks make huge money. Sometimes the money that they make by selling MBS units are seveal times of the total value of the loan itself.

So for investment banks, MBS was a money making machine.

Why public bought MBS units? To earn dividends and capital appreciation.

Doesn’t the whole business model of MBS looks promising?

People get loans. Commercial Banks make money. Investment Banks makes money. Investors in MBS makes money.

MBS was that financial product that made money for everyone.

But there was a catch.

The whole business model of MBS was based on one BIG ASSUMPTION that borrowers will pay back the loan each month (EMI) without defaulting.

But till year 2008, the whole USA economy was becoming weak. People were losing jobs.

Hence, the number of people defaulting on loans were also rising at an alarming pace.

No EMI’s meant, MBS’s asset valuation getting a beating.

When valuation of MBS goes down, people will start selling their units.

In case of massive selling, a situation will come when there will be no buyers for the MBS units.

So investors will further loose money.

On other side, as EMI are not getting paid, once a GOOD ASSET, the same loans start becoming a liability for the investment banks.

As in 2008, majority Investment Banks were relying on Mortgage Backed Securities for their profits, dip in MBS’s profitability hit their bottom line.

It is said that some banks were so badly effected by this crisis, banks employees were asked to leave jobs on day’s notice.

On hindsight we can say that MBS itself was not such a bad financial instrument. But the way it was packaged in USA , ultimately led to the 2008 stock market crash.

When big investment banks of USA goes down, the whole world’s financial system goes down the drain as well.

The Cause of 2008 Stock Market Crash

#3. Bad loans issued by commercial banks

If somebody should be blamed more than MBS for the 2008 stock market crash, it should be the commercial banks.

It was the responsibility of commercial banks to prevent issuance of bad loans.

But commercial banks did not care about due-diligence of the borrower. They kept issuing loans to anybody and everybody.

For them that target was to issue as much loans as possible in lesser time.

Once they have enough borrowers, they package the loan and sell it to investment banks. Their job is finished.

Traditionally, it is the commercial banks themselves who has to collect the EMI’s from the borrowers. So they are more careful while approving loan to a borrower.

In India, before a home loan is issued, EMI paying potential of the person is thoroughly checked.

But if banks start doing this in a negligent manger, what will be the end result?

In Indian terms we call is NPA’s (non performing assets). Bad loans are NPA for banks.

Ideally, banks are very cautious about not allowing NPA’s to rise above a predefined level.

But in USA of 2008, commercial banks were not bothered about NPA’s.

The question still remains, why big commercial bank of USA behaved like this?

The reason was simple. Prime customers who could have paid back the loan comfortably were no longer taking home loans.

Why?

Because they already had homes.

So now the people who remained were those people who were either not earning well, or were already carrying too many loans on their head.

But banks must continue doing business. So what they did, they started lending money to those sub-prime borrowers.

So it all started like this, but commercial banks eventually ended up being more and more careless.

#4. Housing bubble

Who created this housing bubble? People and availability of easy loans.

Before 2008 stock market crash, every individual in USA purchased multiple residential properties.

Generally for common men, one or two property is more than enough.

But in USA of 2008, property prices were rising at a very fast rate.

To take advantage of this surge in property prices, common men started buying real estate property like mad.

People were buying residential properties like shares. They were buying it only for a shorter holding time.

Their objective was to buy low and sell high.

As the property prices were going only up, people even did not care if they are buying property at overvalued price levels.

Even when the person didn’t had the EMI paying capacity, but for the sake of buy-low and sell-high, they were taking this risk.

But market cannot remain bullish forever.

The housing bubble ultimately burst and prices of properties began to fall.

People who took loans to buy-low and sell-high found themselves in extremely tight conditions.

This ultimately led to loan default, which eventually triggered the MBS downfall.

#5. Availability of abundant foreclosure properties

In year 2006 itself, the phenomenon of loan defaulting started becoming noticeable.

We know that sub-price borrowers were issued load by the commercial banks.

To make it further easy for these borrowers, the loans were issued with facility of adjustable rates.

These loans were called adjustable loan mortgages (ARM).

ARM’s charged very low interest rates in initial years. This made loans very affordable for sub-prime borrowers.

But after few years when rates were revised (almost doubled), people started feeling the pinch.

They found the EMI too expensive. Hence they started defaulting.

As a result the foreclosures of properties started.

Foreclosure properties are one which banks are selling off in a hurry as the borrower is not able to pay the home loan EMI’s.

In this such a situation, the properties are sold in a haste. The properties are sold at hugely discounted price levels.

In a property market, where huge amount of foreclosure property is available, what will happen to new properties?

The new property will find less buyers.

As a result the there will be price fall.

In such a situation where property prices are falling, banks will issue smaller home loans.

When the volume of loans will go down, what will happen to MBS?

The MBS Asset valuation will also take a hit.

Final Words…

No matter whatever was the cause, weak economy, MBS, bad loans, housing bubble etc, all were shaping the peril of big investment banks of USA.

Generally, banks never come under direct attack during crisis.

But this time it was banks who were under direct threat and took the beating.

An economy whose banks are not healthy, cannot keep its stock market bullish.

When banking stocks of USA fell, it took with it the stock of the whole world.

The way banks in USA were playing the MBS game, 2008 stocks market crash was only inevitable.





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About the Author

Mani
I am a Blogger with a passion for investment education. I started blogging in 2007-08. Blogging didn’t happened to me as a coincidence, it was a conscious decision. The idea with which I started blogging still stands true. In my starting days my finances remained tight. I was reading heavily about how to manage finance. One day I got hold of a book which my father gifted me in 2003. It was stacked below my graduation books. It was a small-thin book with its cover named "Rich Dad Poor Dad".....more

2 Comments on "The Cause of 2008 Stock Market Crash"

  1. That explanation was simple and thanks for the effort. I like the passion you hold in stock market investment. Since the last couple of years, i am watching the market with an aim to TIME IT CORRECTLY. Well… there are many who say that one should not time the market. My simple understanding is that when the markets tank, they bring the indices down by 50%. The large caps come off by 60-70% while the mid and small caps tank by 80-90%.

    But when it rises, the returns are huge. It takes the market around 1-2 years to scale the highs of the previous bull runs. In doing that, the rate of returns from the low is around 100-150% for the index AND its 2-3 times for the large caps and around 5 times for the small and mid caps.

    You have briefly alluded to the downside of the market. My question to you is… isnt the NPA issue of the Indian banks at precarious levels? Every 8 years or so we see a crash. Isnt it time for another one?

    • Regarding NPA, there is an interesting observation. Government owned banks has highest NPA ratios. Private banks has lowest. Adding this fact to your query, for sure NPA levels are currently at dangerous levels.

      Regarding crash, as market is trading at record high levels, speculations of crash will always be there.

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