Background

Early in September 2008, Lehman Brothers, one of the most famous Wall Street investment banks, filed for bankruptcy. It was the largest bankruptcy the world has ever seen. The loss of confidence in the global financial system in the immediate aftermath of Lehman's collapse nearly brought the whole system down. It was only saved after coordinated efforts by governments and central banks around the world pumping cash and providing guarantees to the banks.

How such an established name in finance met its end? Why was the global financial system so affected? What was the consequence of the crisis? I hope to give my own view of the events from my 'ring side seat' as a credit risk professional in an investment bank. It was a very scary time as all the previous assumptions of how the system worked were thrown out and no-one knew what rules to follow and where was it leading all us to, both within our industry and the wider world outside finance.

The root of the whole financial crisis can be traced back to mortgages, specifically US sub-prime mortgages. Mortgages are a very simple and common financial product. Almost everyone will have one at some point in his/her life. It is effectively a form of collateralized lending. A buyer finds a property to buy and approaches a bank to lend him a pile of money to complete the purchase. Of course, the bank would not lend the money without some form of protection. This comes from the right to claim ownership of the property if the borrower files to service the loan. In the banking circle, the size of the loan compared to the value of the property is called loan-to-value ratio (LTV). The higher the LTV, the more risk the bank is exposed to. This is because if the borrower fails to service the loan, the lender has to seize the property in order to sell it and recoup the money lent. The higher the LTV, the lender is more sensitive to falls in property prices.

In the old days banks seldom lent more than 70% of the value of the property. LTVs of 80% were very unusual. However, since the mid 90s, a new type of mortgage came to the market which allows the borrower borrow up to 95% (and sometimes even higher) of the property value. This development allowed a whole new set of people to enter the property market. As demand for properties outstrip supply in certain areas, typically city centers, this fed a property boom. So, by lowering the initial capital requirement (the deposit), banks created a boom. This had a feedback effect on the mortgage market - you lend 95% of the value of the property, which allowed more people with less capital to become home owners, which created more demand and pushed prices, which in turn lowered the LTVs of existing loans, so the loans looked less risky. So as long as property prices went up, and people keep servicing the loans, banks can keep lending.

Of course, while house price increases were one of the major factors that contributed to the continued increase in mortgage lending, the other major component was people's continued ability to service the loans. In a low interest rate environment and high employment in a growing economy, that should be relatively easy. To assess the borrowers' abilities to repay, the lenders were required to undertake a vigorous series of checks. Things like credit histories and employment records allow the lenders to form reasonable assumptions on the borrowers' continual abilities to repay. However, in a low interest rate environment, with strong competition, this spread was compressed and hence created a need to lend more to make the same amount of money. 

Banks, by nature, are good at attracting deposits and then lending the pooled cash out to needy borrowers. In doing so, they earn the difference between they pay their depositors and the interest they earn from their borrowers - the interest rate spread. Therefore, the more mortgages they underwrite, the more money they earn.
They are not the most efficient at gathering credit data on individuals, especially those who don't bank with them. Also, while banks have extensive branch networks, they don't have an army of people running around helping people buying and owning their homes. So banks hired mortgage brokers to write new mortgages or to refinance existing borrowing. In most cases, this relationship is actually more of a teaming up rather then 'hiring'. The brokers most probably have little or nothing to do with the lending banks except pushing the banks' mortgage products. The only gain the mortgage broker would get from tying up to a specific bank may be marginally better commission rates and possibly faster processing of mortgage requests. So, the only revenue driver for the mortgage brokers is the number of mortgages they broker, but not the quality of the loans. It is not impossible to believe that some brokers looked after their own financial interest first before those of the borrowers and lenders.
 

So we have a financial product, the mortgage, which has been used as a money making tool for the lenders, the brokers and even borrower - as long as house prices continued to increase and borrowers continued to service their loans. This is a feedback loop. The problem is: if one part of the loop fail, the rest will fall away very quickly.