Money Market Fund Article: The Credit Crisis and its Effect on Money Markets

The 2008 financial credit crisis was a culmination of several large factors, which had a devastating effect on the United States' and world economies. What exactly caused this credit crisis to come about, and what was its overall impact on short-term debt money market instruments ? The chronological sequence of events described below, attempt to clarify how this crisis materialized.

• It is fair to assume that the problem was initiated due to the fact that borrowing costs were extremely low. The United States and Japan were suffering from stagnant economies early in the 21st century, and this resulted in their respective central banks keeping interest rates artificially low, to help stimulate the economy. Specifically, the Federal Reserve of the U.S. brought the federal funds rate (the rate which banks charge each other for overnight loans) to a historically low point in 2003. These low rates in turn, helped encourage real estate speculation, which caused home values to appreciate rapidly.

• Mortgage companies and banks jumped into the real estate frenzy full-force, lending money to borrowers, who were less than qualified. The proliferation of these subprime loans accelerated dramatically. To disguise or hide these subprime loans, they were packaged with more sound fundamental loans, and then sold in these packages to investors. To make these less-than-stellar loans attractive to the investment community, various underwriters purchased "insurance policies" (known as credit default swaps) which guaranteed that these subprime loans would be repaid. With these loans now "insured", credit-rating agencies rated these loans packages as AAA, which is the highest rating a debt instrument can receive.

• These packaged loans reached the investor community as CDO's (collateralized debt obligations), which were sold in a multitude of ways, each having its own associated level of risk. Although these loan packages were rated AAA, many of them contained these highly risky subprime mortgages, which were "insured" by these instruments known as credit default swaps. What is interesting, and certainly not within the bounds of the insurance industry, is that these credit default swaps were not bound to maintain a minimum of cash-on-hand, in case these "insurance policies" ever needed to be paid out. These credit default swaps were contrived mathematical instruments that were devised by physicists and mathematicians hired by Wall Street, that were effectively unregulated by the insurance industry or Wall Street, and hence, not subject to any financial or insurance regulations.

• Eventually, home prices started declining, as the housing bubble burst. The Federal Reserve reversed course and started raising interest rates, which severely impacted the adjustable-rate mortgage market (largely effecting the subprime loan market). Since 2006, and through 2008 (the year that this article was written) average home prices have seen a steep decline. For many homeowners who had borrowed via the subprime market, the declining value of their homes made their homes worth less than the amount of money they owed on their mortgage. As a result, defaults (foreclosures) began to dramatically rise.

• As defaults began to rise, the rating agencies started to severely lower their ratings on the subprime loans, to "junk" levels. As such, the investment community that had been purchasing CDO's (namely pension funds, investment banks, and commercial banks), now saw their investments begin to decline rapidly, and begin to default. These holders of CDO's suddenly found that there was no longer a market for them, as no one wanted to buy them. Resultingly, this debt market began to seize up.

• The financial markets' accounting standards mandate investment companies and banks to "mark to market" the value of all of their investments on a daily basis. Since CDO's had no virtual market due to their seize up, these companies were forced to venture a guess to their worth, and were forced to "write-down" these CDO instruments. The plummeting value of these instruments led to massive quarterly write-downs of these hard-to-sell instruments, which in turn, created a financial free-fall.

• As a result of all these write-downs, many financial institutions were deemed as tremendously under-capitalized. Billions upon billions of these bad loans were written off each quarter, as these debt instruments continued to plummet in value. Investment institutions' reserves began to severely decline as a result of all this. Some banks were leveraged at a 30-to-1 rate, far exceeding the norm of a 10-to-1 asset-to-capital ratio. Additionally, both Freddie Mac and Fannie Mae, which stood behind over $ 5 trillion dollars in mortgages, were found to be extremely over-extended.

• Adding to the overall financial crisis, was the fact that commodity prices started soaring since many Asian economies' need for these commodities (oil, coal, steel, etc.) increased dramatically since their economies were growing so fast. Oil, for one, reached $ 148 per barrel in the summer of 2008.

• As the crisis worstened, a series of bank failures and mergers (to alleviate failure) occurred. IndyMac, a California subprime lender failed first. Then Countrywide, the countries' biggest mortgage lender, avoided failure by selling itself to Bank of America. Next, Bear Stearns, a renown boutique investment bank, was so overextended that it failed. The U.S. government stepped in to "purchase" Fannie Mae and Freddie Mac, to avoid their demise.

• Lending continued to freeze up all over the place. Banks no longer considered making overnight loans, protecting their cash to an extreme level, for fear that the borrowing bank would default on their loan. This mentality continued to persist, despite the efforts of the major central banks injecting billions of dollars into the system, in attempt to add liquidity to the system. Additionally, many investors started withdrawing in large numbers from money market funds, which invest in short-term corporate debt.

• Nothing that the U.S. government attempted to do seemed to restore confidence in the financial system. These events were followed by the failure of Lehman Brothers, Merrill Lynch being sold to Bank of America, and the U.S. government's takeover of a failing AIG. AIG had issued many credit default swaps that were being called, and in which they could not redeem the insured.

• With everything else not working, the U.S. government implemented an $ 850 billion dollar bank buyout, and the first $ 250 billion of this money was directly supplied to some banks. The government's intent was to get banks to lend again, and the government also decided to guarantee repayment of interbank loans.

• Home prices continued to slide, but the inventory of unsold homes seemed to have leveled off. Banks have lost almost $ 1 trillion to bad debt during this crisis, and some economists believe the final tally will be twice that, when all is said and done. Surely, less available capital will mean less money for borrowers along with sticter loan requirements. This will undoubtedly lead to the U.S. digging itself into a deeper recession (and perhaps, even a depression).