2000-2001: Dot-com bubble and 9/11 attacks

Starting in 2001, to help the economy escape from the consequences of the Dot-
com bubble and 11/9 attacks, the US Federal Reserve (FED) had continuously lowered
interest rates, leading to banks also lowering interest rates on loans for real estate
purchases. In mid-2000, the FED's basic interest rate was above 6%, but then this interest
rate was continuously cut, until mid-2004, when it was only 1% to stimulate lending and
people's consumption. This policy made it easier for Americans to access cash and
improve their quality of life Because of this policy, Americans gradually rushed to buy
houses. These loans are called mortgages, which means that when people buy a house,
they must have assets to secure their loans. At that time, people used their newly
purchased house as collateral for that loan. In return, the bank can repossess that house at
any time if people are unable to repay the debt.
In the mortgage securitization process, a borrower takes out a loan from a lending
institution. At the early time of the process, the lending institution sells the mortgage to
the investment banks, who package the mortgages into mortgage - backed securities
(MBS) and then sold them to investors all over the world, including pension funds,
insurance companies, mutual funds, hedge funds, and other investment banks. This
means that the borrower didn’t pay the mortgage payment to the commercial banks
anymore, but actually the borrower now paid that amount to the investors. The US
government was also backing this system, as two government-sponsored organizations
(Fannie Mae and Freddie Mac) also created and sold MBS.
Because people were easy to borrow, the demand for buying houses was very
high, leading to continuous increases in real estate prices. The average house price
increased in just 6 years from 2001 (the year when interest rates were cut sharply) to
2007. This also leads to speculation and the belief that house prices will continue to
increase. As a result, people were willing to buy houses at high prices, regardless of their
real value and ability to repay the debt later, because they thought that if necessary, they
could sell them to pay off the bank loan and still make a profit. Thus, a bubble formed in
the real estate market. As more and more people who could not afford to pay their debts
decided to buy houses, investment banks issued more CDOs, which were backed by MBS
with other loans (car loans, student loans,...). CDO were divided into 3 main tranches
(levels of risk), with the highest rank being AAA, although it was backed by subprime
loans/mortgages.
Another derivative in this system is CDS (credit default swaps) - a type of
derivative where one party pays another to insure against the default of a borrower.
Insurance companies created and sold CDS, which worked like an insurance policy for
those who owned MBS, CDO, and commercial banks. They purchased CDS and then
paid the insurance companies a quarterly premium. If MBS, CDO, or their loans went
bad, the insurance companies promised to pay for their losses. But unlike regular
insurance, speculators could also buy CDS from insurance companies in order to bet
against MBS, CDOs,.. they didn’t own. Normally, in insurance, you can only insure
something you own. If you own a house, you can only insure that house once. The
derivatives universe essentially enables anybody to actually insure that house. So 50
people might insure your house. So, if your house burns down, the insurance company
also has to pay the insurance amount for the other 50 people. According to the
International Swaps and Derivatives Association (ISDA), the notional value of the CDSs
in 2007 worldwide was $62.2 trillion, which was even bigger than the world GDP in
2007 ($58.39 trillion). Lehman Brothers and other investment banks then packaged all of
these CDS to create the synthetic CDO and sold them like other derivatives.
All of these financial derivatives received ratings issued by Standard and Poor’s,
Moody’s, or Fitch. Credit rating agencies were created for the benefit of people who don't
have much financial knowledge to look at and know what good investments are. But they
were paid by Lehman Brothers and other investment banks, the greediest people in this
story, to rate those derivatives.
In the old system, when a homeowner paid their mortgage every month, the
money went to their lender. (mortgage payment). And since the mortgage took decades to
repay, lenders were careful. But in the mortgage securitization process, lenders didn’t
care anymore about whether a borrower could repay, so they started to make riskier
loans. The investment banks didn’t care either. The more MBSs and CDOs they sold, the
higher their profits. And the rating agencies, which were paid by the investment banks,
had no liability if their ratings of CDOs proved wrong.
From 2005-2007, FED started to increase the interest rate to about 5%. This led to,
by 2008, declining home prices and rising rates on adjustable-rate mortgages triggered a
wave of foreclosures, causing devastation to millions of Americans. Lenders (commercial
banks) could no longer sell their loans to the investment banks. And as the loans went
bad, dozens of lenders failed. The market for derivatives collapsed, leaving Lehman
Brothers and other investment banks holding hundreds of billions of dollars in loans,
MBS, CDO, synthetic CDO, and real estate they couldn’t sell, which then led to the
collapse of Lehman Brothers.
2000-2001: Dot-com bubble and 9/11 attacks
2003 - 2004: With the U.S. housing bubble well underway, Lehman acquired five
mortgage lenders, along with BNC Mortgage and Aurora Loan Services. These lenders
specialized in Alt-A loans, which were made to borrowers without full documentation.
2004-2006: Its real estate business enabled revenues in the capital markets unit to surge
56% from 2004 to 2006. The firm securitized $146 billion in mortgages in 2006—a 10%
increase from 2005.
First quarter of 2007: Cracks in the U.S. housing market were already becoming
apparent. Defaults on subprime mortgages began to rise to a seven-year high.
August 2007: Lehman's stock fell sharply as the credit crisis erupted with the failure of
two Bear Stearns hedge funds. The company eliminated 1,200 mortgage-related jobs and
shut down its BNC unit. It also suspended wholesale and correspondent lending activities
by its Alt-A lender, Aurora.
2007: Lehman underwrote more MBSs than any other firm, accumulating an $85 billion
portfolio—four times its shareholders' equity.
2007: Lehman announced $4.2 billion in net income on $19.3 billion in revenue. Its high
degree of leverage was about 30, while its large mortgage securities portfolio made it
highly susceptible to deteriorating market conditions.
Fourth quarter of 2007: Lehman's stock rebounded, as global equity markets reached
new highs and prices for fixed-income assets staged a temporary rebound. However, the
firm did not take the opportunity to trim its massive mortgage portfolio, which would
turn out to be its last chance.
March 17, 2008: Lehman’s shares plummeted nearly 48% due to concerns that it would
be the next firm to fail following Bear Stearns' near-collapse.
April 2008: after an issue of preferred stock, which was convertible into Lehman shares
at a 32% premium to its concurrent price, yielded $4 billion, confidence in the firm
returned somewhat. However, the stock resumed its decline as hedge fund managers
began to question the valuation of Lehman's mortgage portfolio.
June 7, 2008: Lehman announced a second-quarter loss of $2.8 billion, its first loss since
it was spun off by American Express.
September 10, 2008: Lehman Brothers preannounces expected $5.6 billion of write-
downs on toxic mortgages and an expected loss of $3.93 billion for its third quarter.
September 13, 2008: Lehman, Barclays, and Bank of America (BAC) made a last-ditch
effort to facilitate a takeover of the former, but were unsuccessful.
September 15, 2008: Lehman declared bankruptcy, resulting in the stock plunging 93%
from its previous close on September 12.