At the end of the 90’s, investing in the bull market was kind of a walk in the park for all the people hunting for a quick profit. The internet was promising to revolutionize how people buy what they need and many companies ending with .com flood the market with IPOs. Thousands of speculators rush on them, certain to bet on the next IBM. Their illusions are quickly scattered when they notice that most of those companies burn more cash than they can get on the open market. Between 2000 and 2001, investors pull out of the market and many speculators follow them swiftly, causing one of the worst panics to hit the stock market since the Oil crisis. However, those events remained silent for most people because they were eclipsed by the horror of 9/11.
Governments were quick to react, in most industrialised countries; they asked their central banks to reduce interest rates at levels so low to make credit inevitable. That spurred a takeoff in consumer spending, mostly financed by credit and avoided a recession in some countries. It also generated an explosion in the housing market and the mortgage market at the same time. That was a close call. Banks were able to offer really affordable mortgages to almost anybody who wanted to buy a house.
For those same banks, making money on those mortgages wasn’t enough, they had to make more; mostly on the lower quality mortgages that could easily default. Some investment banks, like Lehman Brothers (OTC: LEHMQ), started recycling those mortgages in investments vehicles of smaller size called collateralized debt obligations. They also got rating agencies to give those financial instruments a rating ranging from AAA to B depending of the seniority of those vehicles. To make sure they would be able to repay in case of default, they bought bond insurance, to companies like AIG (NYSE: AIG) on those CDOs to ensure payment on the holders, hence the AAA ratings, no matter the safety of the underlying investments. That system could have worked forever based on the assumption that home prices ALWAYS go up; since people could have refinanced their mortgages.
Closer to us, in 2007, the first wave of mortgage try to get some refinancing. But there is a big problem; since 2002, interest rates have almost doubled, affecting mortgage rates and at the same time doubling mortgage payments. Millions of homeowners in the US could not afford their new payment and since home prices were not going up; in some cases, they were going down! This led to an increase in the number of bankruptcies, forcing many financial institutions to write-down many of those mortgages, which in turn caused most of the sophisticated investors who had acquired CDOs to write-down their assets. What we have here a good example of systemic risk.
This is the chain of events that caused the current recession. It has been many years in the making and many rational investors saw it coming. The good thing with the current financial environment is that it will force most companies to deleverage, making them safer and reducing their systemic impact in the process. Those events also showed the need to regulate the market of derivative contracts that are still selling over the counter because their current value is now a staggering 600 trillion dollars.