Why are bonds and mortgage rates intertwined

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How did the 2008 financial crisis come about?

In the decades before the crisis, US politics had deregulated financial markets. Banks were able to exploit loopholes with unregulated institutions abroad in order to take more and more risks and make high profits. The terrorist attacks of September 11, 2001 and the falling share prices of the new Internet companies around the turn of the millennium threatened to plunge the country into an economic crisis. The central bank, the Fed, wanted to prevent this and has been printing more and more money since 2001, while interest rates fell at the same time.

This allowed people with low incomes to take out loans and buy houses, even though many could not produce collateral that the banks would get in the event of default. The "American Dream" of owning a home should come true for as many as possible. The banks thought that was good because they made money on every loan they gave. The fact that this business was risky - interest rates are only fixed for a short time in the USA - didn't bother them at first, because they were able to bundle the loans with other, better products in securities and sell them worldwide. The risk that a loan was not paid off lay with the buyer, i.e. mostly with the nearest bank.

Such risky deals are actually supposed to be restricted by rating agencies that give bad grades for unsafe financial products. Before the financial crisis, the big agencies rated the packages of real estate loans as “low risk” - even if they weren't covered. So many “bad” loans came into circulation and a so-called real estate bubble developed. The US government later even sued Standard & Poor’s, one of the major rating agencies, for incorrect ratings that are believed to have contributed to the crisis.

After some time, the US Federal Reserve raised the key interest rate, which also caused mortgage rates to rise and many borrowers could no longer repay their mortgages. They had no choice but to sell their new home again, because many did not have any other security. At first it was easy because real estate prices were still booming. With the house sold, the loan could be paid off without incurring major losses. However, the more debtors had to sell their homes, the more property prices fell across the country. The sale of the property therefore no longer brought enough money to pay off the loans. The banks never got their loaned money back - one bank crash followed another.

On September 15, 2008, the investment bank Lehman Brothers, which was heavily involved in the real estate loan business, filed for bankruptcy - with far-reaching consequences. The financial crisis had reached its peak.

What were the consequences of the financial crisis?

As a direct consequence, many people in the USA lost their homes and large parts of their savings. Global trade collapsed because companies could no longer be sure whether a trading partner's bank would still be solvent until the deal was concluded. And the banks could no longer trust each other either. Usually they are constantly lending money to each other to make up for surpluses and keep their money flowing. But that was hardly possible anymore because it was not clear whether one bank would get the money back from the other bank the next day. That is why the banks started to hoard their money instead of making it available to the companies.

For the first time since the Second World War, the German economy contracted by around five percent in 2009. Since 1946 there had only been five years of negative economic growth in Germany.

As a result of the economic slump, many lost their jobs, youth unemployment rose particularly in southern Europe, and those who kept their jobs also had cause for concern. Displeasure about risky business and the power of banks led to the Occupy Wall Street movement, which first occupied Zuccotti Park in the financial district of Manhattan and later other public spaces in protest.

The crisis also had consequences in the global south. In sub-Saharan Africa, for example, banks were barely involved in the global financial market, but speculation was on food and oil as well as real estate, which had a dramatic impact on the prices of staple foods and petrol until 2008. Since the possibilities to increase local production were limited and the governments hardly subsidized food, consumers in many African countries were at the mercy of rising market prices. The World Bank's World Food Price Index peaked in June 2008. Food became priceless for many people. The result: The number of hungry people worldwide rose by 75 million.

How was the crisis absorbed and banks rescued?

An acute danger for banks was that many customers would suddenly withdraw their savings out of fear of the bankruptcy of their bank - a so-called "bank run". Many governments therefore issued guarantees that funds in private accounts would be safe to calm the situation. Guarantees have also been issued for business between banks. One state promised the banks in the country that if in doubt they would repay debts in their place. With this certainty, banks were able to lend each other again.

Government aid saved the banks from bankruptcy, and some were even saved directly with government aid. In Germany, for example, Hypo Real Estate or Commerzbank. Many criticized the procedure as unfair, as the losses in the banking business were socialized (i.e. borne by society), while the profits of risky businesses were privatized (i.e. the banks and their managers benefited). On the other hand, the disorderly bankruptcy of Lehman Brothers in 2008 triggered a snowball effect. The US government had not classified the bank as systemically important and therefore did not support it with state funds.

The federal government decided on two stimulus packages, which made available around 80 billion euros for companies, education and infrastructure, for example, in order to help economic growth.

How did a financial crisis become a European debt crisis?

The money that was made available for bailing out banks put a strain on the budgets of all euro countries. Your debt increased. This was particularly problematic where public debt had previously been high.

In Greece, a further complication was that the newly elected government in October 2009 revealed that the national debt was significantly higher than previously indicated. This started a vicious circle of high national debts and high interest rates for new loans, because banks naturally did not want to lend money to Athens, which was so indebted, or only at very high interest rates. After all, it was extremely uncertain whether they would get the money back. In April 2010 Greece was therefore considered to be as good as bankrupt. There was no way of getting any more money. A Greek national bankruptcy would have meant that investors would have lost confidence in government bonds from other euro countries and interest rates would have risen sharply. Other heavily indebted countries such as Portugal, Spain, Ireland and Italy threatened a fate similar to that of Greece. This sovereign debt crisis is also known as the euro crisis.

The most important stages of the financial crisis from 2008 to 2018

What has been done to overcome the euro crisis?

It is a peculiarity of the euro area that different independent states use the same currency. The independent European Central Bank (ECB) is responsible for monetary policy for all euro countries. During the crisis, this construction revealed itself to be a problem, because it prevented the countries with high national debts from being able to put money into circulation themselves in order to pay off debts - even if they might later have had to accept inflation in return.

Since Greece did not have its own currency that it could devalue, national bankruptcy was prevented in 2010 by financial aid of 110 billion euros from other euro countries, the European Central Bank and the International Monetary Fund (IMF).

The money was initially made available via a short-term rescue fund (EFSF for European Financial Stability Facility) and later via the long-term European Stability Mechanism (ESM) for euro countries in critical situations. Since 2010, Greece has been supported by the euro countries and the International Monetary Fund with loans amounting to around 289 billion euros, but not all of them have been called.

However, the money is not free, it is only granted as a loan. If the Greek economy stabilizes over the next few decades, then donors could earn money from the interest. So far, Germany has made a profit of 2.9 billion euros with aid to Greece. It is not certain whether it will stay that way. Because Greece could still go bankrupt or get part of the debt canceled. In addition, the money is only available on condition that the countries concerned implement far-reaching austerity measures in order to ensure economic growth in the future. Whether saving is really the best way to go is a matter of dispute. There is a conflict between two fiscal policy assumptions: reducing government spending through savings or stimulating the economy through investment, as the federal government did with the two stimulus packages.

The European Central Bank has also made a lot of money available. With his promise to buy unlimited government bonds from over-indebted euro countries if necessary, the chairman of the ECB, Mario Draghi, made sure in the summer of 2012 that government bonds that had been risky up to then were again an option for investors. Its mere announcement is considered a turning point in the euro crisis.

Incidentally, the last rescue program for Greece, which has now returned to the financial markets, ended in August.

How does the EU intend to prevent further financial crises from occurring?

There are many ideas how future euro crises could be prevented. And most of them require European countries to work more closely together on financial matters.

Some think it makes sense to appoint a European finance minister to take care of the financial policy of all countries in the euro area. It remains questionable whether the governments of the euro countries want to give up this competence.

Instead of national government bonds, Eurobonds could be introduced. Investors would thus invest in all euro countries at the same time, and the problems of a country would have less of an impact on the interest on such paper. Critics say that the economically weaker states would have little incentive to operate solidly. After all, all participating states could borrow money equally cheaply.

The proposal that banks in Europe should be uniformly controlled and insolvency should be dealt with jointly is known as the “banking union”. Most of it has already been implemented. Critics criticize, however, that the supervisory authority is located under the umbrella of the ECB, although it should actually be independent. Finally, situations are conceivable in which the two institutions could have different interests. The exception rules are also too far-reaching. In 2017, the Italian state was able to save two small banks with 17 billion euros in tax money. And that shouldn't be the case if the bankruptcy of a bank is not dangerous for the entire financial system.

Together, the EU countries could again save potential crisis countries. But caught up, caught up: Critics of these measures warn that a debt crisis in individual euro countries would then also affect the other countries more severely.

Cover picture: Sebastien Micke / Paris Match via Getty Images